Memorandum from the Association of British
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.
1. NORTHERN ROCK
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
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.
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
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 legislationto 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
3. OVERALL FUNCTIONING
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
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.
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.