Select Committee on Treasury Written Evidence

Memorandum from the British Bankers' Association


  1.  The British Bankers' Association (BBA) is the leading UK banking and financial services trade association and acts on behalf of its members on domestic and international issues. Our 225 banking members are from 60 different countries and collectively provide the full range of banking and financial services. They operate some 130 million accounts, contribute £50 billion to the economy and together make up the world's largest international banking centre.


  2.  The Treasury Select Committee inquiry into the circumstances of the Northern Rock affair is well named: it is an inquiry into financial stability and transparency. Financial stability should be the paramount aim of everyone in the UK's burgeoning financial services sector. Transparency should be pursued as far as possible without providing messages which might be misunderstood by an anxious public.

  3.  The BBA was active during the Northern Rock affair in emphasising to the public that the UK banking system remained robust throughout. It also produced a paper on the so-called credit crunch and its implications (reproduced here as Annex I). It offers the following observations to the Treasury Select Committee.

  4.  The high profile, international media coverage garnered by the queues at Northern Rock risks permanently damaging the UK's reputation as a leading financial centre. The Government, working with the financial services industry, needs to develop a proactive strategy aimed at rebuilding the UK's reputation across the globe.

  5.  On the tripartite regulatory structure (comprising HM Treasury, the Financial Services Authority and the Bank of England), we note that such a structure exists with varying degrees of formality in most countries: it is very unlikely that any banking problem would be handled by a single regulatory authority. However, there was insufficient clarity in the allocation of roles, responsibilities and authority among the Tripartite authorities and no one entity had clear power to take the lead. What the UK needs is the retention of our current tripartite structure to minimise disruption, but with a thorough review in terms of regulatory oversight, focusing on providing clarity of issue ownership, co-ordination of leadership and responsibilities, intervention policies (including dealing with crises), and the balance sought between transparency and confidentiality.

  6.  On the framework of the money markets, the virtual disappearance of liquidity from mid-August tested the limits of the current arrangements and we wonder whether the Bank of England no longer met its core objective in terms of providing an efficient, safe and flexible framework for banking system liquidity management. The Bank of England offers a standing facility at a penalty rate of 1% above the base rate: a lower rate of between 0.25% and 0.5%, particularly during stressed or abnormal market conditions, should be considered. The range of collateral accepted by the Bank should be reviewed: a formal consultation should be initiated on expanding the list of eligible collateral. We are also concerned about the adverse publicity which now accompanies any application for borrowing from the Bank of England. This stigma should be removed by separating the Bank's day to day lending from its crisis management role. The Bank of England should recognise the need at times to strike the right balance between transparency and confidentiality in order to maintain an orderly market.

  7.  On liquidity, the FSA is using the internationally-recognised tools to assess banks, although these evidently failed in the case of Northern Rock. An exercise should be undertaken to determine why this was so, and whether earlier intervention would have been possible. However, this needs to be done in the context of the various other international reviews that have already been launched (Basel, IMF etc).

  8.  On depositor protection, HM Treasury's current review should be part of a wider review into regulatory supervision and crisis management and not just focus on a narrow remit of the deposit protection aspects of the Financial Services Compensation Scheme. Deposit guarantees are only necessary when the regulatory system fails a financial institution and its customers: therefore the emphasis of any review should be on the earlier stages of the regulatory process.

  9.  We also recommend that accounting conventions be reviewed to ensure structured investment vehicles and disclosures about them are properly reflected in the figures.


  10.  The reasons for the difficulties faced by Northern Rock and the events that led up to the run on the bank are now becoming increasingly well documented. Northern Rock concentrated almost exclusively on mortgages, it had little diversified product range, a comparatively small deposit base, a very high exposure to the wholesale markets when considering both the liquidity and the securitisation requirements, it had sought to grow business strongly over a short period of time and was particularly dependent upon short term borrowing. It was therefore vulnerable in a number of different ways to changes to market conditions but appropriate scenario planning was evidently not undertaken.

  11.  During the course of 2007, the market had become increasingly aware that there were issues surrounding Northern Rock's business model. We are aware that the FSA reviewed Northern Rock's stress testing processes in May 2007. Furthermore, in its profit warning of 27 June 2007, Northern Rock stated it was suffering from a "structural mismatch between LIBOR and bank base rates" and its share price fell by 10% on that day. This was therefore a very clear signal both to the market and to the authorities that Northern Rock was experiencing increasing difficulties in respect of its funding as the "credit crunch" speedily impacted inter bank lending arrangements generally.

  12.  By mid-July the share price was some 30% lower than at the start of the year. Sterling LIBOR was clearly demonstrating the absence of liquidity in the market, particularly through the overnight and three month rates, and discussions were being held between the industry and the Bank of England both to reduce/remove its "penalty rate" and to broaden the range of acceptable collateral. These proposed changes to the money market regime were requested in order to restore reasonable liquidity but were not accepted by the Bank. As the BBA owns LIBOR, the problems associated with the money market were evident to us as was the position in the US and in the eurozone via the $ and € fixings. Again, this information was widely known and publicly available. Indeed throughout June, July and August we received a historically high number of enquiries relating to LIBOR.


  13.  The functioning of the tripartite system, including the Memorandum of Understanding and the actions undertaken by the Tripartite authorities during the crisis, both in relation to the overall market and the situation regarding Northern Rock, requires explanation.

  14.  Tripartite agreements, whether formalised as in the case of the UK or not, operate in most countries. It is very unlikely that a banking problem would only be handled by one authority, for example the regulator, without reference to and consultation with the other two authorities, namely the central bank and the government.

  15.  From the perspective of the BBA and irrespective of the precise nature of the tripartite agreement, the external impression received was that there was:

    —  a lack of true appreciation of the exposure to wholesale markets of the Northern Rock by the members of the Tripartite;

    —  a lack of appreciation of the interconnection between liquidity and solvency;

    —  an adoption of a "wait and see" attitude when, based on the same fact pattern, the market assumption was that the tripartite was taking action;

    —  no one entity clearly in the lead;

    —  insufficient clarity in the allocation of roles, responsibilities and authority of the parties to the Tripartite authorities;

    —  a lack of awareness of the likely reaction of the consumer to a perceived problem with Northern Rock;

    —  no attention given to the complex and obscure message in the Lender of Last Resort Statement; and

    —  a lack of preparedness by the authorities to explain and communicate their Lender of Last Resort statement either at the point at which the leak took place or once the formal announcement had been made the following morning.

  16.  Although, there have been a number of proposals for moving bank regulation to one or other of the tripartite authorities, the services that banks offer are multi-faceted and complex. Any decision to, for example, move banking regulation in its entirety back to the Bank of England would therefore result in significant co-ordination issues with the FSA for the purposes of, at the very least, securities regulation and conduct of business rules. Alternatively, reducing even further the role of the Bank of England would be disadvantageous to the reputation of the UK overseas.

  17.  As a result, we believe that the least disruptive option is to retain the current arrangements but fully review them, particularly in terms of supervisory oversight, and paying close attention to what changes need to be made, especially in the areas of:

    —  clarity of leadership;

    —  clarity of responsibilities and ownership of issues;

    —  clarity of remit;

    —  senior representative participation in the Standing Committee;

    —  co-ordinating the regulatory requirements and ensuring no gap or overlap;

    —  intervention policies (including responding to particular crises); and

    —  confidentiality policies.


  18.  The new system, introduced this year, has generally worked well and, through the maintenance of remunerated reserve accounts, has expanded the range of counterparties with which the Bank of England deals. The system has been mostly successful, until the onset on money market turbulence, in narrowing the borrowing spread on overnight money, and thereby reducing volatility.

  19.  More recently, during the credit crunch, Sterling money market rates, as measured by the BBA's sterling LIBOR benchmark, have been driven upwards. There has been a noticeable differential with euro and US dollar rates as also quoted on BBA LIBOR. While some of these problems can be put at the door of institutions safeguarding their liquidity and being reluctant to lend to their usual counterparties at any price, we believe that there may be technical and other impediments to ensuring that the Sterling market operates in a less stressed manner during periods of turbulence. We question whether the Bank of England contributed towards this nervousness, through failing to follow its objectives for Sterling Money Market Operations, and particularly its core objective in terms of providing an efficient, safe and flexible framework for banking system liquidity management.

  20.  We therefore call on the Bank of England to re-examine the key features of the present system, in three particular respects:

The Interest Rate Corridor

  21.  First, we believe the Bank of England should review whether the standing facility (and the deposit) rate is set at an appropriate level. In the consultation phase for the Sterling Money Market Reform, the BBA argued that a much narrower corridor, 25 or 50 basis points around base rate, should have been established and we believe this should be revisited. In particular, it is suggested that the Bank should review whether it should maintain a degree of flexibility around the corridor during stressed or abnormal market conditions. It could consider either:

    —  waiving the "penalty" rate above the Bank rate altogether (as the ECB did during its August and September market operations); or

    —  reducing the margin over the Bank rate significantly (as the Federal Reserve did on 17 August in relation to its Primary Credit Rate by 50 basis points).

  22.  We suggest that market institutions could be usefully consulted over which mechanism they would prefer. Clearly reaching an understanding in general with the market about what range of funding could be available, but without tying the authorities' hands, is important. A particularly important public policy aspect is to avert stigmatisation for institutions being obliged to seek funds at a "penalty" rate.

Diversifying Collateral

  23.  We propose that the Bank of England should review its philosophy on collateral, and launch a consultation on extending the list of eligible collateral which can be placed with it. We believe that a range of additional instruments such as sterling certificates of deposit (CDs) and commercial paper (CP) should be accepted in the weekly and monthly money market operations, and that the Bank should also review the range of collateral, including non-Sterling, it is prepared to accept during stressed conditions, both as to the type of instrument (eg mortgage backed securities), and to maturity. We considered that, had the Bank acted in this vein at the beginning of August, then many of the problems affecting the money markets in general and Northern Rock in particular might have been mitigated. While we welcomed the Bank's statement on 19 September that it was prepared to offer three month funds against a further range of collateral during a series of £10 billion auctions, the question of whether the standing facility rate is applied to these facilities needs to be revisited. We believe there is appetite in the market for three month money and that the extension of these correctly priced arrangements should be made permanent.

  24.  Ensuring greater consistency between the range of collateral that can be deposited with the central banks in the major financial centres (the Bank of England, the Bank of Japan, the ECB, and the US Federal Reserve) is also desirable from this perspective. Greater collateral inter-changeability could well assist in the maintenance of liquidity pools and in smoothing the financial transmission mechanism.

Transparency and Disclosure

  25.  We understand well the reasons why the central bank is reluctant to reveal publicly which institutions it engages with in relation to weekly and monthly money market operations, and more specifically when an institution has been obliged to obtain funds under the standing facility. We remain concerned at the adverse publicity given to one bank which was obliged to seek standing facility funding because of a system technical glitch in August, and the statement on 14 September that Northern Rock was obtaining "emergency" funding, also under the standing facility was wholly detrimental. A situation has now resulted whereby the stigma attached to this facility renders it unusable. Ceasing to use the terms `emergency funding' and `lender of last resort' would help to avoid panic in these situations, as would separating the Bank's day to day lending from genuine crisis management activity.

  26.  Whilst it is well recognised that transparency in this area as in others has brought a greater clarity to the operation of the market, nevertheless there are times when confidentiality is essential in order to bring about a result which otherwise would either be difficult or impossible to achieve. Furthermore, there is evidently a requirement for a broader range of money market operation options, a clear articulation that the use of "non standard" options equates to stressed market conditions and not institutional problems and that, whilst there may well be a justification for the application of a penalty rate under certain circumstances, this is not necessarily appropriate and particularly in extreme market conditions.

  27.  Lastly, the regional and global nature of the banking industry means that where central authorities operate different policies in respect of their money market, banks operating in more than one jurisdiction will access that market which is providing them with liquidity at the best price. For smaller banks operating in one jurisdiction only, in this case the UK, that option was not available to them. The difference in the operation of the money market by the Bank of England compared with that of the ECB is widely known, and particularly amongst policy makers and the industry. This difference has added to the sense of disquiet internationally over the authorities' handling of the Northern Rock problem.

  28.  We would therefore urge the Bank of England and the Tripartite Authorities to undertake a full review which clarifies:

    —  the nature of any underlying disclosure requirements applying to either the Bank or the affected institution.

    —  the areas for which confidentiality is necessary.

    —  the terms (maturity, coupon), instruments and rates of the money market facility; and

    —  the timing of any announcement that is required.

Enhancing London's Competitiveness

  29.  The high profile, international media coverage garnered by the queues at Northern Rock risks permanently damaging the UK's reputation as a leading financial centre. The Government, working with the financial services industry, needs to develop a proactive strategy aimed at rebuilding the UK's reputation across the globe.

  30.  There is a further point in that London as an international financial centre may lose out. Most smaller-sized overseas institutions that tap the Sterling markets have found conditions in recent years hard going, notably with the decline in FX spreads, relative illiquidity of the Sterling money market in periods above one or two weeks, the squeeze on Gilts and the narrow range of Sterling collateral accepted in money market operations. Their treasuries have found it genuinely difficult to make a decent turn on capital and they are beginning to question whether it is worth maintaining a presence in the London market to source Sterling borrowing. This particular sentiment has been exacerbated by the credit crunch, with Sterling market rates rising and funding difficult. Institutions have compared the London market unfavourably with, for instance, the availability of funding from the ECB's expanded money market operations, which they believe UK-based institutions have heavily taken advantage of.

  31.  So allied to the point on about more consistency about the range of collateral that key financial market central banks are prepared to accept, we believe that this will also assist in maintaining London's attractiveness as a funding centre.


Basel II—The Right Regulatory Tool

  32.  Basel II which has been introduced in Europe via the Capital Requirements Directive in 2007 is more risk sensitive than the predecessor Basel 1 capital requirements regime. As such, it is welcomed by banks because it more accurately matches regulatory capital needs to the risks they face. It is likely that Northern Rock has benefited from its introduction as under Pillar 1 of Basel II banks are generally required to hold less capital against less risky assets, such as mortgages, which comprised the great majority of its business. At no time did Northern Rock's available capital fall below its regulatory capital requirement. The problems it faced were caused by lack of access to liquidity.

  33.  Since the beginning of 2005 banks have been required to undertake stress testing and scenario analysis, to have in place contingency funding plans and to document them adequately. Under Pillar 2 of Basel II, banks are required to assess regularly and regulators to review their liquidity funding plan in a stressed situation. The FSA had reviewed Northern Rock's stress testing processes in May 2007 and has already accepted that there are lessons to be learnt about the level of its supervisory engagement with stress testing. So although they are still novel and the execution of the new Pillar 2 stress testing processes failed in the case of Northern Rock, regulators do have the right policy tools to quiz banks about their stressed liquidity plans.

Policy for Early Intervention

  34.  With the knowledge in the market, analyst reports, the FSA's own work in May and the profit warning of 27 June, it is essential that an exercise is undertaken to determine what alternative actions the FSA could have taken (including in conjunction, where necessary with the other members of the Tripartite) to determine whether a more orderly outcome to the Northern Rock problem could have been achieved if "intervention" rather than "wait and see" policies had been followed.

  35.  No substantive decisions should be made without such work both being undertaken and made publicly available. There is a growing market belief that timely, decisive action by the FSA in conjunction with easing the money market conditions could have resulted in a more appropriate outcome than that which was achieved.

Liquidity Regulation—The Wider Context

  36.  There is no global standard for liquidity regulation other than under Pillar 2 of Basel II, meaning that banks face different liquidity requirements for their local operations in different countries. In the UK two parallel quantitative liquidity regimes exist: the Sterling stock regime for 17 larger UK banks and building societies; and the mismatch regime for all others. These regimes were introduced in 1996 and banks and regulators alike recognise that they are due an overhaul.

  37.  In other countries there is a mix of quantitative and qualitative requirements. In the EU, the Netherlands, Germany and Ireland have recently reformed their liquidity regulation, which is the only remaining area of banking supervision that is host rather than home state regulated. We believe that such a parochial approach can lead to trapped pockets of liquidity and collateral which can compound, rather than mitigate, liquidity risk problems within specific banks that are active across international borders or at times of systemic stress.

  38.  Work is currently being undertaken by the Basel Committee for Banking Supervision (BCBS) to review the liquidity regimes used by different countries and to examine how they performed in the recent credit crunch, with the objective of considering whether its February 2000 Sound Practices for Managing Liquidity in Banking Organisations should be revised.

  39.  Banks believe that regulation of liquidity in cross-border banking groups is best managed according to a set of principles proportionally applied by the home state regulator, recognising that in the complex world of liquidity management there is no one-size-fits-all answer. Any reform to the regulatory liquidity requirements in the UK should wait until the BCBS review is complete to ensure that it is aligned with any consequent international developments. Liquidity management has global ramifications—a UK centric solution may be counter productive.

  40.  Recommendations:

    —  Banks and regulators should focus more on liquidity stress testing in the Pillar 2 review process—which is the appropriate regulatory tool to mitigate the risk of a Northern Rock type event recurring.

    —  Any reforms of the UK liquidity regime should wait for the conclusions of the current BCBS review and recognise that liquidity is managed on a global basis by large internationally active banks.


  41.  In respect of the current position regarding the Government's guarantee to the Northern Rock's depositors, the BBA believes that this is not tenable for anything other than a short-term emergency period. We note that concerns over this guarantee and the associated funding, even though collateral is received in return, are increasing particularly in the EU. We look forward to an early resolution of this problem. Evidently had actions been taken earlier in respect of both the money market and the regulatory intervention, then this Government guarantee may well not have been required.

  42.  The BBA has commissioned the consultants Oliver Wyman to assist with its consideration of options for the Deposit Protection Scheme, including no change other than that which has already been announced. As of responding to this request for evidence, that work is not yet complete. When it is, we will share it with the Committee.

  43.  However, deposit protection cannot be considered in isolation from the regulatory framework and the supervision of the financial entity. It is not known whether, for example, if a high calibre FSA team had intervened earlier by at least challenging Northern Rock, questioning its Board and ensuring that better stress testing and lines of credit were in place, the issues would have been capable of resolution, in conjunction with a sensible money market framework, in a more orderly manner.

  44.  The authorities as a matter of priority must therefore undertake an exercise to determine an answer to this question, to then identify what aspects of the regulatory framework may need to be changed and what do not.

  45.  In addition, changes to the deposit scheme, especially the level of cover, need to be considered alongside the other tools of crisis management as well as the insolvency regime for banks.

  46.  We note that in every country for which we have information it is considered that either some banks are too big to fail or that no bank should be allowed to fail at all, for example in Germany where recent intervention prevented the failure of Land Sachsen Bank and IBK. Furthermore, it is self evident that in this current environment it is difficult to envisage the authorities allowing the failure of a retail deposit taker.

  47.  We need to be clear about what compensation can and cannot do. The Financial Services Compensation Scheme cannot create a zero failure regime and will not be able to cope with the failure of a systemically significant bank. Such a bank would need to be rescued to effectively protect depositors and limit systemic risk. The authorities need to be clear about which institutions they would look to rescue and how this would be achieved.

  48.  We note that the preferred option of the Bank of England is to change insolvency legislation to provide a special regime for UK deposit takers that allows early intervention to take place, deposits to be frozen and then released quickly under the administration of another entity. Such an option is currently reflected within part of the US process where a separate organisation, the Federal Deposit Insurance Corporation (FDIC), has responsibility for intervening within a deposit taking institution and taking the necessary action. To the best of our knowledge such regimes do not exist in major eurozone countries.

  49.  It is essential to properly investigate both the operation of this model and other options before making the next step decisions on the future of the UK deposit protection scheme. The exploration of special administration arrangements for UK banks would need to consider the interaction of company, insolvency and tax laws together with corporate governance and deposit protection arrangements. Equally, the arrangements would need to reflect cross-border scenarios given the locus of the large international banks.

  50.  The BBA would like to highlight the following key points:

    —  To date we have not yet found a country which has an investor protection scheme that is as comprehensive as the Financial Services Compensation Scheme in the UK. Whilst there are many examples of deposit protection, typically there is either no protection for other investments, or it is of a very limited nature. It is therefore important that in any changes that may be considered as a result of Northern Rock problems, not only is the broad coverage fully recognised but also that the banking community contributes substantially to many other parts of the scheme as well as the protection of deposits.

    —  The UK deposit protection scheme sits within the umbrella of the Financial Services Compensation Scheme (FSCS) and, following the recent changes made by the Treasury and FSA, protects 100% of deposits to a maximum of £35,000 per individual per bank net of any "set off" of loan or other borrowing with the bank. Although the statistical work is not yet complete, figures given to the BBA indicate that £35,000 covers in excess of 95% of all individuals deposits with the major UK banks, before any "set off" of borrowings has taken place. When the statistical work is complete the BBA will provide the information to the Committee.

    —  In providing deposit protection up to £35,000, the UK is covering approximately twice that of the EU directive requirement and is one of the more generous schemes in Europe. In its financial stability report of October 2007, the Bank of England (Page 66, Table 4b) highlighted the coverage limits per depositor of the G10 countries. From that table it can be seen that the UK is by no means low in adopting the current limit. Furthermore, although the UK no longer has the 90:10 co-insurance model, nevertheless some other countries have still retained this.

    —  The UK scheme also measures up favourably internationally.

    —  Northern Rock has not failed. However the current deposit protection scheme has paid out on a number of occasions to failed credit unions—the latest of which is StreetCred Credit Union with an estimated 3,000 members. Banks pay for these credit union failures. Although some schemes are pre-funded, these are both typically small amounts (eg, Norway €6,000 for a maximum of 50,000 customers) and have been built up over a long period of time. The US, for example, covers up to $100,000 (approximately £50,000); the fund has been built up over 50 years and is an integral part of the insolvency regime for banks.

    —  In most jurisdictions, deposit protection is for retail customers defined as individuals. However in the UK the FSA has and continues to define retail as including small businesses up to a turnover of £5.6 million. This has the effect of making protection more expensive and more widespread in the UK than comparable requirements elsewhere.

    —  The UK scheme is a post-funded scheme, not a pre-funded one. However, all regulated firms who are members of the FSCS are required to make a payment into the scheme from an annual assessment made by the Executive of the FSCS and at any other time should the scheme or part of the scheme require. This assessment is based on its known and/or estimated requirements. For deposit protection, this is currently up to a maximum of 0.3% of protected deposits on a cumulative basis in perpetuity, which is expected to be replaced by an annual limit of £1.8 billion for all deposit takers from April 2008.

    —  In our view, the current post-funding model is proportionate and should remain and that any reform must be affordable for the industry.

    —  Work in America has shown that the presence of the $100,000 limit has resulted in changing consumer behaviour in that individuals will keep deposits with more than one bank in order to keep below the insurance level. This has in turn had the effect of maintaining independent financial institutions which under other circumstances would have consolidated.


Valuation and Accounting

  51.  The banking industry agrees that fair value measurement provides an appropriate accounting base for financial instruments held for trading purposes or otherwise managed on a fair value basis. However, valuations in financial statements are merely snapshots at the reporting date and the key issue is not the accounting model used but uncertainty over asset values. Prices can change rapidly as investors reassess their views based on new information; past valuations were not necessarily incorrect but reflected market conditions at that time.

  52.  It must also be emphasised that consideration of additional disclosures must take into account the disclosures required by IFRS 7 and Basel II Pillar 3 that will be provided to the market by banks in the near future.

  53.  In our view, relevant questions include whether:

    —  the requirements of IAS 39, IAS 27 and SIC-12 in respect of the accounting treatment of structured investment vehicles and disclosures about them are proper and adequate;

    —  the guidance on fair value measurement given in IAS 39 results in appropriate valuations in markets experiencing temporary liquidity difficulties;

    —  the enhanced disclosures introduced by IFRS 7 (Financial Instruments: Disclosures) will ensure the provision of appropriate information on liquidity risk or whether the standard should be revised or supplemented by industry practice; and

    —  the fair value rules recently proposed by the IASB mirroring those in US SFAS 157 (Fair Value Measurement) would help or hinder and whether the fair value hierarchy provides an appropriate approach.

November 2007

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