Select Committee on Treasury Written Evidence

Memorandum from the Association of British Insurers

  The Association of British Insurers (ABI) represents the collective interests of the UK's insurance industry. The Association speaks out on issues of common interest; helps to inform and participates in debates on public policy issues; and also acts as an advocate for high standards of customer service in the insurance industry.

  The Association has around 400 companies in membership. Between them, they provide 94% of domestic insurance services sold in the UK. ABI member companies account for almost 20% of investments in the London stock market.


  The situation at Northern Rock poses a crucial test for confidence in, and the credibility of, the Tripartite system. The way in which the authorities are perceived to have dealt with the situation will be vital to protect London's position as the leading global centre for financial services. Any reform and next steps must be focused on achieving this.

  There now needs to be clearer demarcation of responsibilities and co-ordinated crisis management planning. To ensure future stability, both the Tripartite authorities and the market must be clear about where responsibilities lie.

  Additionally, it is important that the Financial Services Compensation Scheme (FSCS) provides compensation where necessary in a manner that is fair, affordable and does not advantage one part of the financial sector at the expense of another.


The functioning of the Tripartite system

  The ABI supports the current UK model of financial regulation, in particular the position of the FSA as a single integrated regulator. Increasingly, many financial firms carry out banking, insurance and investment business, so it makes sense to have a single regulator.

  Reform of the Tripartite system should concentrate on improving its operation, rather than changing its nature. In particular, we do not support the separation of banking supervision from the supervision of other financial services. However, there needs to be clearer delineation of responsibilities, particularly between the Bank of England and the FSA, in order to ensure better linkage between the oversight of systemic issues and the supervision of individual institutions, and co-ordinated crisis management planning. The underlying role of the Bank of England as lender of last resort requires it to have a good understanding of the markets and institutions at risk without duplicating the role of the FSA.

Regulatory requirements regarding liquidity

  The current supervisory regime concentrates on prudential solvency (ie ensuring that a firm has sufficient assets to meet its liabilities). However, the events at Northern Rock were caused largely by liquidity issues.

  There are a number of important distinctions between banks and insurers with respect to liquidity risk. Banks hold long-term, illiquid assets (such as mortgage loans) but short-term liabilities (deposits and inter-bank loans). This makes banks vulnerable to a sudden withdrawal of their sources of funds. Insurance companies, on the other hand, hold liquid assets (cash, bonds and equities), but longer-term liabilities. Therefore any mismatch between assets and liabilities (for instance, due to under-reserving for liabilities) would only emerge slowly over time.

  For insurers the current focus of prudential solvency is correct, and no additional requirements on insurers are needed to address liquidity issues.

  We would support measures to ensure that overall market liquidity could be maintained and enhanced, particularly in situations of market turbulence.

Other regulatory changes

  The Takeover Code and the regime within which the Panel operates is of fundamental importance to the integrity of the equity market and the confidence that investors place in it. It affords flexibility and provides scope for important judgments by the Panel Executive in often challenging circumstances. We do not believe that either the Panel or the Code does, or should, represent an unnecessary impediment to achieving the right outcome for shareholders and their companies.

  The market needs information to ensure informed trading, but it is also important to avoid public disclosure that would be likely to be prejudicial to the interests of a company. That difficulty is recognised in the Market Abuse Directive (MAD), which allows information to be withheld in circumstances where it would be damaging to the interests of the company to make it available. Varying interpretations of this Directive have been offered. In any event, we are struck by the FSA's comment that, in today's markets, it would be difficult to keep the news of such support secret. It therefore seems sensible to concentrate on strengthening the operation of the Tripartite arrangements, and instilling greater public confidence in the system of depositor protection.

  On disclosure, a "false market" should not be allowed. If a bank is seeking emergency support, it should already have made a trading statement. It is then a matter of judgment whether subsequent undisclosed development warrants suspension of the shares.

  We recommend a reassessment of the appropriate level of transparency for banks dependent upon short-term liquidity. Also, our members are concerned by the limited formal disclosure of the amount of borrowing by Northern Rock and the terms on which this has been drawn down over the course of several weeks. It is possible that there is a false market at this time in the shares of Northern Rock.


  We strongly support a credible and effective scheme to compensate the customers of failed financial institutions. The events at Northern Rock mean that compensation arrangements, particularly for deposits, need to be reviewed. The Government should be cautious in making changes; any reforms should be affordable and should not distort the market for savings.

Compensation limits

  The Financial Services Authority (FSA) has to ensure that compensation limits are sufficiently generous to protect ordinary investors, but do not give rise to issues of moral hazard, or distort competition between different products. There must be a limit to the protection offered, as otherwise financial institutions and consumers will become reckless, thereby, paradoxically, increasing the likelihood of a serious failure.

  Events have shown that the previous FSCS limits were not sufficient to prevent a bank run. However, the problem with these limits was not the overall level, but the fact that people only got 90% of their deposits back over a £2,000 limit and uncertainties over the timing of compensation.

  In most EU countries compensation is limited to the Directive minimum of €20,000 (about £13,500). The new UK limit of £35,000 is sufficient to protect the overwhelming majority of depositors. Research carried out on behalf of the ABI last year suggests that a limit of £35,000 provides full coverage for 98% of cash-only savers. Indeed it would cover the total non-pension savings, across all types of instrument, of over 80% of the population.

Potential changes to the compensation scheme

  The discussion paper issued by the Tripartite Authorities rightly points out that the UK has, hitherto, rejected a pre-funding regime for compensation on the grounds that this would result in resources being tied up which could otherwise be used productively. The ABI also strongly opposes a pre-funding regime.

  In particular, we believe that the US pre-funding model is not an appropriate basis for a UK scheme. In the UK, insolvencies among banks and insurers are rare, so the compensation scheme is rarely called upon. Indeed, it has not been called upon in the case of Northern Rock. In the US, failures of small, local banks are relatively common.

  More generally, the US model would require fundamental changes to UK legislation—to insolvency law and the Financial Services and Markets Act, as well as to the existing compensation scheme. For example, in the US model the Federal Deposit Insurance Corporation has regulatory responsibilities to require struggling banks to take action to become recapitalised. If this fails, it has the power to declare the bank insolvent and assume the role of liquidator. In the UK such matters are the responsibility of the FSA, as the regulator (or a court appointed liquidator in the case of an insolvency), rather than the compensation scheme. We do not believe that such a radical change is needed to the current regulatory system, which, despite the events at Northern Rock, is generally seen as a model for other countries and has the support of the financial services industry.

The FSA's review of FSCS funding

  The FSA has, for the past 18 months, been conducting a major review of FSCS funding, and has recently finalised proposals to introduce a cross-subsidy between different sectors.

  The ABI has made clear its opposition to cross-subsidy throughout the FSA's consultation process. We believe that cross-subsidy between deposit protection and other parts of the financial sector will increase the risk that difficulties in one sector could be passed onto others. Such contagion could lead to a loss of confidence in financial services as a whole. We do not believe that our customers would understand or support increases in their insurance premiums because an institution in another part of the industry goes out of business.


  Financial markets have recently made increased use of complex instruments such as credit derivatives. Valuations derived from models have been used to develop instruments of commercial merit.

  It appears that shareholders in banks were provided with limited information about the nature and extent of highly leveraged SIVs and Conduits. Often these structures were regarded as being off balance sheet, but in practice full exposure remained with the managing bank. Banking regulations should ensure that full potential capital requirements are recognised in such circumstances.

The Role and Regulation of Rating Agencies

  The events over the summer have renewed interest in Credit Rating Agency (CRA) activity. CRAs have been reviewed in recent years by, amongst others, IOSCO (the International Organisation of Securities Commissions), the European Commission and CESR (Committee of European Securities Regulators).

  Institutional investors see rating as only one of several sources of information in the due diligence process. Many have their own in-house credit analysis teams. CRA opinions focus on the limited question of default risk, while investors' interests will often extend to recovery levels. A credit rating awarded to a bank should not be seen as a broader guarantee of its business model. Institutional investors frequently receive mandates from clients limiting them to investments above a certain credit rating, but they do not believe that ratings should be the sole basis for investment decisions.

  Prescriptive regulation could therefore be counter-productive, as it would encourage market participants to rely even more heavily on ratings, which of their nature provide only limited reassurance. The ABI supports the IOSCO Code for CRAs, rather than regulation at European or national level.

  Regulation may also discourage entry to the market, and stifle innovation in modelling techniques. The ABI has indicated areas of concern, where change may be required as the markets evolve. For example, there are inherent conflicts in the standard "issuer pays" business model, combined with the user perception of ratings as a "public good". The conflict of interest has been highlighted in the symbiotic relationship between the issuer and CRA in generating ratings in the structured products area. However, no practical alternative business model is available.

  The ABI favours competition between CRAs, both in terms of methodology and pricing. Any proposals on CRAs should be evidence-based and subject to cost benefit analysis. They should also be developed in a multilateral forum such as IOSCO.

Hedge Funds

  We do not consider that hedge funds caused the events over the summer. Some funds invested in the financial instruments that have caused difficulties, but it is unlikely that they have exacerbated the situation. Hedge funds are dependent on investment banks, both for the instruments in which they have invested, and for financing facilities. Some hedge funds may have encountered difficulties as banks reduced their general preparedness to lend, and also their assessment of the credit worthiness of these clients. This will have led some funds to reduce their exposure and to raise cash for prospective redemptions. However, we have no reason to suppose that hedge funds behaved improperly.

  The ability of the private equity sector to undertake buy-outs of increasingly large quoted companies has been facilitated by the appetite of the debt markets to finance such deals. High leverage and the use of complex capital structures have been characteristic of these transactions. This increasing demand for debt finance capability has no doubt increased the strain on the markets, but again we would not consider this to have contributed significantly to the summer's events.

November 2007

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