Select Committee on Treasury Written Evidence


Memorandum from Dr Paul Hamalainen, Lecturer in Accounting and Financial Management, Loughborough University

EXECUTIVE SUMMARY

  1.  This written evidence statement indicates that the Northern Rock crisis has brought to light a number of problems in the UK deposit taking institutions regulatory environment. The statement argues that it is primarily these weaknesses, rather than the actions of a specific person or persons, that have caused and perpetuated the Northern Rock turmoil. Therefore, the remedial focus of the committee in preventing a similar bank run in the future should be on tightening the UK deposit taking regulatory environment. The key weaknesses in the current regulatory system are: 1) a poorly structured and operated deposit insurance scheme; 2) a lack of a specific insolvency regime for deposit taking institutions; and 3) a poorly structured supervisory framework for dealing with deposit taking institutions that are experiencing difficulties.

  2.  This statement provides recommendations to strengthen the current regulatory environment. In summary, they are: 1) to introduce a deposit insurance scheme that transfers insured depositors' money within a day either through a bridge bank approach or the insured deposit Transfers method depending on the deposit taking institutions characteristics; 2) to guarantee 100% of depositors funds at the current level of £35,000 or potentially up to say £50,000 per person per bank; 3) to consider moving from a "pay as you go" deposit insurance funding approach to a pre-pay approach; 4) to introduce risk-based deposit insurance levies on deposit taking institutions; 5) to introduce a clear uniform order for distributing the assets of failed deposit taking institutions; and 6) to introduce a Prompt Corrective Action (PCA) regulatory approach for dealing with deposit institutions that are experiencing difficulties. In contrast, to the PCA regime in the United States, the PCA approach should be based on tripwires that reflect both solvency and liquidity risks.

  3.  These recommendations reflect the fact that the UK deposit taking regulatory environment requires fundamental revisions at two levels (both pre-crisis and post-crisis) rather than simply to the deposit insurance scheme. This is due to the fact that there are tradeoffs between different aspects of the regulatory environment. For example, introducing a PCA approach should limit the potential claims on a deposit insurance scheme and thus a "pay as you go" funding approach could arguably be retained. This written evidence statement discusses the recommendations for the regulatory environment in detail under the headings provided in the Treasury Committee's press notice No 88 with regard to a focus on pre-crisis and post-crisis solutions.

NORTHERN ROCK

4.  Pre-crisis events

  Northern Rock has suffered financial difficulties as a result of a liquidity squeeze in most credit markets during summer and autumn 2007. Its funding model placed significant reliance on access to wholesale credit markets. Although the scale of the shutdown in credit markets was unprecedented, deposit taking institutions have historically failed for liquidity reasons as much as solvency ones. Therefore, liquidity should be afforded the same level of importance as solvency in the deposit taking regulatory regime. The failure of Northern Rock's management to appreciate the bank's liquidity risks and the weak regulatory regime concerning liquidity risk allowed Northern Rock to develop a potentially vulnerable position, which was exposed during the summer of 2007. The Northern Rock management can argue that it has a good quality loan book, but this loan book cannot be funded without extreme support from the regulatory authorities. Solvency should not be used as an excuse to support a deposit taking institution that suffers severe liquidity problems, because it can encourage future moral hazard behaviour. Therefore such an institution should be allowed to fail. The benefit of the bank being solvent is that investors should be able to recoup the majority of their funds.

  5.  The Bank of England's approach in providing liquidity to UK deposit taking institutions through the short-term money markets compared to the approaches adopted by the European Central Bank and the Federal Reserve may have exacerbated the problems at Northern Rock. However, the Bank is right in its attempt to restrict future moral hazard behaviour by allowing only top quality collateral to be used and for short maturities. The difficulty for the Bank of England is that certain UK deposit taking institutions were able to access the "softer" regimes available in continental Europe and the US, thus undermining the Bank's stance.

6.  Pre-crisis solutions

  The key point to take on board from the events leading up to the Northern Rock crisis is that a suitably structured pre-crisis regulatory regime could have prevented the problem from escalating. The key limitation with the current approach in the UK is not the Tripartite system and which party has responsibility for what part of the financial system; rather it is how to regulate the system. Focusing specifically on the case of potential failure of a deposit taking institution, the regulatory authorities are, and always will be, reluctant to decide if an institution should fail until it is too late. For example, who out of the Tripartite group would have been be willing to have closed Northern Rock, either prior to them taking out Lender of Last Resort facilities, or even now when an estimated £23 billion of taxpayers money has been expended propping up the institution, whilst at the same time wholesale financial institutions are not renewing their funding arrangements with Northern Rock. The fear of law suits from Northern Rock stakeholders such as the junior bondholders and shareholders would be too heavy a burden for any one person to bear in making this decision. This forbearance problem is common across most financial regulatory regimes in the world and should be addressed in future UK regulatory reforms to prevent a similar crisis occurring in the future. A solution to the forbearance problem is a PCA regulatory approach such as the one in operation in the United States. This is because a PCA approach formalises specific ratio tripwires which when breached serve as the basis for mandatory action by the supervisory authorities. In the United States, tripwires are based on an institution's solvency and increasingly harsh restrictions apply as their solvency deteriorates. Such prompt corrective actions include increased monitoring, raising additional capital, requiring acceptance of an offer to be acquired, and closure of the institution.

  7.  The UK should consider adopting a similar PCA approach, but go one stage further and include both solvency and liquidity ratios in the tripwire categories. Thus, the primary causes of bank failures would be captured. The UK regulatory regime does already have informal solvency and liquidity ratio targets, but in both cases they are one-dimensional and there does not appear to be any specific corrective actions proposed if targets are breached. The corrective actions should be formalised and for both solvency and liquidity risks tripwire categories should be constructed, so as to accelerate regulatory authority action. For example, in the case of large UK deposit taking institutions, 5 day, 10 day and 1 month Sterling Liquidity Ratios should be calculated and different percentage tripwire categories created for each calculation. Such a framework means that the supervisory authorities would have a comprehensive structural/legal mechanism enabling them to act early in preventing a bank problem becoming a full-blown crisis and warding off potential lawsuits if an institution has to be closed. Two additional benefits to the whole deposit taking supervisory regime as a result of introducing a PCA approach are firstly, that tripwires also place bank management under increased scrutiny to ensure adequate solvency and liquidity of their institution, and secondly, a likelihood that fewer claims will be made on the deposit insurance scheme as a result of bank failure. This last point is discussed in further detail in the section on depositor protection below. The linkage between pre-crisis mechanisms such as PCA and post-crisis mechanisms such as deposit insurance emphasises how a suite of pre-crisis and post-crisis deposit taking regulatory reforms should be considered in the UK following the Northern Rock crisis.

DEPOSITOR PROTECTION

8.  Post-crisis events and implications

  The government's response to the run on Northern Rock to protect all of its depositors (and the implicit guarantee that this has been extended to depositors in all other banks) has set an extremely dangerous moral hazard precedent, especially for larger banks. However, a lack of clearly structured and adequate post-crisis regulatory structures left the government with little choice but to protect depositors, otherwise it may have led to potentially significant systemic financial consequences. The problem for the Tripartite Group now lay in providing a sufficiently credible no bailout policy so as to extinguish investors' safety perceptions in the event of a future deposit-taking institution failure. This can only be achieved through fundamentally revising the UK deposit taking regime to clearly place the risks of bank failure on large depositors, all junior bondholders and all shareholders. These are the stakeholders that should be taking on the risks and costs of bank difficulties and failures. However, an inability to have clear and adequate pre-crisis and post-crisis regulatory mechanisms in place has provided sophisticated investors with time to remove their investments from Northern Rock, thus forcing Northern Rock to continue drawing down funds from the Bank of England. In effect, any potential cost of bank failure is gradually being passed on the government. Recommended pre-crisis mechanisms that should reduce the likelihood of having to implement a post-crisis response were discussed in the previous section. The remainder of this section covers the post-crisis mechanisms that could alleviate a repeat of the farcical situation that has been witnessed as a result of the liquidity crisis at Northern Rock.

9.  Post-crisis solutions

  The two key post-crisis solutions that have been found to be wanting as a result of the Northern Rock problems are a poorly structured and operated deposit insurance scheme and a non-existent specific insolvency regime for deposit taking institutions. I will deal with each in turn and stress that both mechanisms have to be improved so that they work in tandem with each other. In addition, clearly outlining ex ante how failing deposit taking institutions will be dealt with in the future provides the regulatory authorities with clear resolution structures and options, and highlights to investors their risk ranking.

10.  Deposit Insurance Scheme failings and recommendations

  The whole ethos of the current UK Financial Services Compensation Scheme (FSCS) is reactive rather than proactive and herein lays the fundamental problems with the scheme. This is reflected both in the way that the scheme is funded and in the slow manner in which depositors are paid following bank failure. The FSCS does provide a good degree of payment protection compared to other European countries, but the scheme can learn a lot from the ethos of the Federal Deposit Insurance Corporation (FDIC) in the United States where they are required to select the resolution method for failing deposit taking institutions that results in the lowest cost to the deposit insurance fund (and hence taxpayer).

  11.  Looking first at how insured depositors are dealt with. They have to be assured that within one day of bank failure they will have access to their insured deposits. The time taken to repay insured depositors can be thought of as a liquidity risk for depositors. It is the fact that the current FSCS may take up to six months to repay investors (as well as the co-insurance element that use to exist in the FSCS pre-October 2007) that drove insured Northern Rock depositors to withdraw their money. In addition, to further reassure insured depositors and reduce the opportunities for a bank run, insured depositors should not only have access to their funds swiftly, but also to crucial banking facilities so that they can continue to undertake day-to-day activities. Deciding on an appropriate level of deposit insurance coverage is an extremely difficult process. 100% of the current £35,000 appears reasonable to cover the so-called "widows and orphans" as would raising it to £50,000. Introducing a substantially higher limit than £50,000 does raise the prospect of moral hazard behaviour by deposit taking institutions, but at the same time increases bank's potential costs of funding the depositor protection scheme. However, under the "pay as you go" FSCS funding approach no deposit institution is currently paying a levy to the FSCS for deposit protection. Therefore, the "pay as you go" approach is exacerbating the moral hazard problem. The problems with the current UK FSCS funding arrangements will be addressed more specifically later in this section.

  12.  There are a number of different resolution methods available for failing deposit taking institutions, some of which should be considered in any future UK depositor protection scheme. These include Straight Deposit Payoff, Insured Deposit Transfers, and Bridge Banks. The Straight Deposit Payoff method will pay insured depositors with a cheque once a bank has failed. The current FSCS is based on this approach. Downsides with this method are that there will be a number of days of depositor liquidity risk whilst the cheque is clearing and it can lead to disruption in the local community (particularly relevant for building societies) where the institution is a key provider of local financial services. An alternative is the Insured Deposit Transfers method. This approach involves transferring insured deposits and secured liabilities of the failed deposit institution to a healthy institution that agrees to act as the agent for the deposit insurance scheme. The deposit insurer would make a cash payment matching the amount of the transferred liabilities to the agent bank. This method reduces the disruption caused by a Straight Deposit Payoff to insured depositors and the local community [FDIC, 1998]. Finally, the Bridge Bank approach is where a temporary bank is created to transfer the insured depositors, secured creditors and assets of the failing institution. In that way, key banking facilities can continue to operate without disruption. The remaining creditors remain with the deposit institution that is in receivership. The FDIC's intention with a Bridge Bank is to sell it to a bidder within two years of its creation. The FDIC's experience with the Bridge bank approach is that it can be particularly useful in dealing with deposit institutions that have failed as a result of liquidity problems. This is because, compared to a situation in which asset quality problems have built up over time, a bridge bank gives the FDIC and potential bidders an opportunity to review the bridge bank in a more stable environment and arrange a permanent transaction [FDIC, 1998]. The FDIC has also found the bridge bank approach especially useful if the failing deposit institution is large or complex. This is partly because they did not have to negotiate with a failed institution's shareholders and bondholders. However, the United States experience of bridge banks did highlight the necessity for additional legislation after a couple of years in the form Cross Guarantee provisions. This legislation enabled the deposit insurer to recover some of the costs for handling troubled banks from other solvent deposit institutions in the same banking group, even if the FDIC actions will subsequently force the other deposit institutions to become insolvent.

  13.  A revised UK depositor protection scheme should include clear guidance on the approaches that are available to resolve bank failures and necessary legislation introduced a priori to support these approaches. In addition, an overarching requirement that the least cost resolution method is undertaken will prevent excessive costs to the taxpayer. As a result, the regulatory authorities will be sending a clear message to bank shareholders, bondholders and large depositors that they are at risk in the event of deposit institution failures. These investors should in turn reflect this in the yields that they demand from deposit taking institutions for their investments. At the same time, insured depositors can be confident that swift resolution measures will be introduced to enable them to access their insured funds immediately.

  14.  Apart from discussing how to deal with insured depositors, the other key depositor protection scheme issue is how it should be funded. The current `pay as you go' funding approach exacerbates a reactive ethos to deposit insurance in the UK. Deposit taking institutions are called upon to provide support to the depositor protection scheme when there is a deposit taking institution failure. In contrast to a "pay as you go" funding model, a "pre-funded" approach is where deposit taking institutions pay annually into a deposit insurance fund which hopefully builds up over time to cover claims during times of bank stress. There are a number of problems with the "pay as you go" approach, which conflict with other desired aspects in a revised depositor protection scheme. Firstly, if the regulatory authorities want to ensure that insured depositors obtain their funds without disruption then a "pay as you go" deposit protection scheme is unlikely to deliver the necessary funds quickly enough. It can be envisaged that the government would have to step in temporarily to cover the deposit insurance fund's shortfall whilst the levies are being collected from supporting deposit institutions. The potential exception to this could be the Bridge Banks approach, although such an approach may be inappropriate for smaller bank failures. Secondly, a "pay as you go" scheme can lead to procyclical problems; namely that demands for levy contributions will be made at exactly the time when deposit taking institutions are experiencing a period of distress [Blinder and Wescott, 2001]. This could cause an exacerbated slow down in banking activity during business cycle downturns. In contrast, a "pre-funded" model can overcome the procyclical problem by deliberately being constructed to allow depositor protection funds to rise during more favourable economic conditions and decrease during less favourable ones. Finally, if the regulatory authorities feel that a "pay as you go" funding model is most appropriate for the UK then some form of PCA supervisory mechanism must be introduced. This is because PCA forces the supervisory authorities to intervene in impending bank difficulties at an early stage. Therefore the likelihood that there will be calls on the deposit insurance fund is significantly reduced and so the limitations of a "pay as you go" approach that are discussed above can be minimised.

  15.  Regardless of which depositor protection scheme funding model is used, there should be some consideration in introducing risk-based contributions. This could be based on amongst other things a deposit taking institutions probability of causing a loss to the deposit insurance fund due to the composition and concentration of the institution's assets and liabilities and the amount of loss given failure. In that way, the institutions that are most likely to cause deposit insurance payouts provide the majority of the funding.

16.  Insolvency regime failings and recommendations

  In line with other countries a specific insolvency regime should be introduced for failing deposit taking institutions. The special nature of banks can justify the immense regulatory and supervisory structures that exist to protect financial stability. The same justifications can be used to support the introduction of a specific insolvency regime. Such a regime should clearly state the order in which deposit taking liabilities will be refunded in the event of a deposit taking institution failing. At the moment in the UK, depositors rank alongside general unsecured creditors in order of repayment. This should be amended so that uninsured depositors are specifically placed in advance of general unsecured liabilities. As a result of this adjustment, the key deposit institution funding investors will be clear as to their risk ranking in the event of bank failure and should price this risk accordingly in their investments.

  17.  The insolvency regime would also have to accommodate PCA provisions if it was decided to introduce such a pre-crisis regulatory approach, because in some instances a deposit taking institution will be closed before it is technically insolvent.

  18.  In summary, there are a number of significant post-crisis mechanisms that can, and should, be introduced in the UK. These would clearly outline ex ante the regulatory authorities mechanisms for dealing with deposit taking institutions that are in difficulty and remove any doubt as to the position of bank investors in a resolution. In turn, this should enhance the important concept of market discipline by bank stakeholders, whilst at the same time providing insured depositors with ready access to their funds. Equally, a set of clear post-crisis structures would enable the regulatory authorities to invoke resolution procedures swiftly so that those investors that should be taking on the risks of bank failures do not have an opportunity to withdraw their investment. This is quite clearly not happening in the Northern Rock case. However, the Tripartite Group was severely restricted in the quality and types of mechanisms that it has had at its disposal. The size of the lender of last facility that was provided to Northern Rock suggests that there were significant concerns amongst the Tripartite Group as to the extent of potential funding difficulties at Northern Rock. However, the existing deposit insurance scheme structure and coverage and the poor insolvency regime meant that closing Northern Rock swiftly was out of the question without causing potential systemic concerns. Instead the Tripartite Group had to rely on either a buy-out by another deposit taking institution or the lender of last resort facility. As no buyer was forthcoming the Tripartite Group was left with no choice, but to advance an emergency lending facility.

OVERALL FUNCTIONING OF FINANCIAL MARKETS

19.  Transparency issues

  The shutdown in credit markets during the summer of 2007 can be wholly ascribed to a lack of transparency. Investors and financial institutions were unsure where the losses from sub-prime investments lay and therefore it was better to hoard cash than lend it to each other. Providing greater transparency on complex financial instruments would help to alleviate this problem. However, this is not the only transparency problem. It must be remembered that UK deposit taking institutions report with a significant delay and only provide detailed financial information twice during the accounting year. The timing of this financial crisis has meant that investors have been relying on unaudited interim financial statements and have to wait for the year-end audited statements for the next full reporting schedule. Equally, unlike in the US, no large UK bank has posted a third quarter trading statement as yet. Therefore, investors have little contemporaneous information on UK banks and the credit crisis to disseminate at the moment. The UK regulatory authorities should look at enhancing the frequency and quality of UK accounting disclosures per se for deposit taking institutions as well the issue of reporting more complex financial instruments.

CONCLUSION

  20.  This written evidence statement clearly argues that the UK deposit taking regulatory regime was shown to be wanting both in the run up to, and subsequent difficulties experienced, as a result of the liquidity crisis at Northern Rock. The statement argues that it is primarily these weaknesses, rather than the actions of a specific person or persons, that have caused and perpetuated the Northern Rock turmoil. Therefore, the remedial focus of the committee in preventing a similar bank run in the future should be on tightening the UK deposit taking regulatory environment. This written evidence statement recommends fundamental revisions at two levels (both pre-crisis and post-crisis) rather than simply focusing on the deposit insurance scheme. This is due to the fact that there are tradeoffs between different aspects of the regulatory environment, which the regulatory authorities can use to alleviate a bank run in the first place.

REFERENCES

Blinder, A and Wescott, R (2001), "Reform of deposit insurance: A report to the FDIC", [Available at: http://www.fdic.gov/deposit/insurance/initiative/reform.html] last accessed 28 October 2007.

Federal Deposit Insurance Corporation (1998), Managing the Crisis: The FDIC and RTC Experience 1980-1994, Washington, DC: Federal Deposit Insurance Corporation.

November 2007





 
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