BBA PAPER: THE CREDIT CRUNCH, THE NORTHERN
ROCK: OME IMPLICATIONS AND CHANGES REQUIRED
1. As the credit crunch continues to wash
through, the most obvious casualty to date in the UK is the Northern
Rock. This paper analyses a number of the issues that surround
that case and looks at reviews required and solutions, both on
a global and local basis.
2. The BBA believes that however uncomfortable
it may be, it is necessary to deal with the issues as they are
and answer the question that is being asked by the international
community about the handling of the Northern Rock"did
it really have to be done like this?"
3. It is well recognised that a number of
factors combined together to bring about both the liquidity problem
that the Rock experienced and also the subsequent customer panic.
The BBA believes that the most appropriate way forward is for
a clear examination of the points raised in this paper, an open
and considered review and sensible changes made where it is appropriate
to do so.
4. The BBA has been examining the implications
for the banking industry, from a regulatory and structural point
of view, and proposes that the following steps are taken.
5. AT THE
6. Reviewing institutions' liquidity,
market and credit risk practices: This would particularly
cover their risk management and treatment of complex credit products
and their exposure to off-balance sheet vehicles such as conduits
and SIVs. We believe that this should be closely aligned to the
Pillar 2 framework under Basel II, and particularly the Internal
Capital Adequacy Assessment Process (ICAAP) and the Supervisory
Review and Evaluation Process (SREP) which are in the process
of being introduced and which already provide a basis on which
to develop this assessment. Although the ICAAP is an institution's
specific tool, in order to broaden its usefulness to regulators
and the system as a whole, it will require significant investment
in terms of both training and experience for regulators to make
it truly effective. This is particularly true in relation to the
ICAAP for liquidity, and we also make a specific suggestion below
in relation to the supervision of institutions' liquidity.
7. Reviewing accounting and valuation
practices for financial derivative instruments, particularly
complex, narrowly traded products which become difficult to price
in times of stress. There needs to be a review of how these instruments
are valued, what market benchmarks can be used, and how value
impairment is accounted for. A further feature is that conventional
stress testing techniques, for instance "normal" confidence
intervals, may not capture the full amount of exposure in abnormal
markets, and institutions and regulators should examine what further
re-assuranceparticularly in relation to risk management
practices and value impairment accountingis needed in this
8. Reviewing basic oversight principles
for regulated financial entities: this would especially cover
off-balance sheet items, including contingent claims. We suggest
here that this issue should again be closely linked to the existing
Basel II framework. A particular concern is whether regulators
have concentrated, in recent years, on capital adequacy at the
expense of liquidity risk management. Institutions manage liquidity
on a centralised and global basis, but often regulatory requirements
are determined at a local or national level. We therefore call
on trans-national regulatory agencies such as the Basel Committee
and the Committee of European Banking Supervisors (CEBS) to complete
work on ensuring that institutions can take advantage of their
existing centralised liquidity management practices, including
modelling techniques. It is particularly important that any developing
framework should be well thought out, should not be fragmented
into local approaches, and does not penalise institutions through
additional regulatory requirements. We particularly commend in
this context the liquidity risk management principles developed
by the International Institute of Finance (IIF).
9. Reviewing the role of Credit Rating
Agencies (CRAs) in the valuation of structured credit products:
CRAs play an important role in the global financial system, with
ratings providing a proxy for the assessment of risk in the underlying
counterparty. In general terms, this system works wellfor
instance in a Pillar 1 of Basel II capacity, or acting as a haircut
for the acceptance of collateral in a central bank's monetary
operations. That said, we welcome the Financial Stability Forum's
examination of this issue, and support the work of IOSCO and others
in bringing greater transparency and disclosure to the main features
of these products. This can only assist institutions and investors
in their assessment of the risk characteristics of such products.
10. It should be borne in mind that CRAs
issue opinions based on the probability of default and delinquency.
They should be judged on this basis rather than on price or liquidity
of such instruments. An in depth study of ratings transitions
over time and through this crunch period should be carried out
before any additional measure or regulation is considered. By
definition ratings that are lower down the scale are both more
likely to be delinquent or to default but also by their nature
are more unpredictable and therefore likely to be upgraded or
11. The BBA has been involved in the consultation
process carried out by IOSCO, the Committee of European Securities
Regulators (CESR), and the European Commission. We would expect
that in the current review of CRAs being carried out by CESR they
will not focus heavily on the initial rating of a structured finance
instrument but rather investigate the issues around the surveillance
and monitoring that go into maintaining that rating. We believe
that questions could be asked about:
the seniority of staff which "maintain"
the extent to which CRAs receive
all the information they should from trustees on a transaction
and who rely on a much more qualitative, as opposed to quantitative,
review of that information;
similarly issues of staff turnover,
and the numbers of deals that staff are required to review on
an ongoing basis in what has been a rapidly expanding market;
finally, we would put forward that
CESR/IOSCO should consider the drivers within rating agencies
given the revenue attributable to new ratings as opposed to the
surveillance and monitoring of old ratings.
12. Re-examining whether EU and the global
crisis assessment and management arrangements are adequate:
Recent events have been different in that problems in the US sub-prime
market and resulting liquidity constraints have been transmitted
globally. It will be important to understand the transmission
mechanisms by which this contagion is spread and why some markets
appear to have been affected in a more serious manner than others.
We welcome the conclusions of the September Informal ECOFIN Council
that the financial authorities in the EU will be reviewing their
Memorandum of Understanding to encompass the assessment of financial
stability. In relation to EU supervisory arrangements, in general,
we believe these are fit for purpose and should be developed along
the lines of the Lamfalussy four level system. (See BBA paper
"Giving Europe a Regulatory Advantage").
13. During this period of turbulence the
financial system infrastructure, notably the payment and settlement
system, has been resilient, proving more than capable of dealing
with the increased volatility and the markedly higher transaction
volumes, whether traded, cleared or settled. We believe that there
are no particular recommendations to make in this sphere, save
to continue the work that is being undertaken to develop an efficient
and risk neutral system for settling non-exchange traded funds
and investment products.
14. We expect the UK authorities, with their
global counterparts, to fully play their part in examining and,
where necessary, re-shaping regulatory and other requirements,
and that their effect on the UK system of regulation is mitigated.
That said, there do appear to be specific lessons for the UK which,
in the light of the problems affecting Northern Rock during the
course of 2007, need to be addressed:
15. Re-examining the regulatory framework
for institutions' liquidity risk management: as noted above,
we recommend that the FSA play its part in the shaping of centralised
and global liquidity risk management requirements for institutions.
As part of this process the FSA will need to ensure that the best
features of the existing Sterling Liquidity Stock requirement
16. Re-visiting some features of the
Sterling Money Market framework: 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 generally
successful, until the onset on money market turbulence, in narrowing
the borrowing spread on overnight money and thereby reducing volatility.
17. More recently, during the credit crunch,
Sterling money market rates, as measured by BBA Libor 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 impediments
to ensuring that the Sterling market operates in a less stressed
manner during periods of turbulence.
18. We therefore call on the Bank of England
to re-examine the key features of the present system, in three
particular respects. First, we believe the Bank 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. Second, we suggest that
the Bank should review its philosophy on collateral, in launching
a consultation on extending the list of eligible collateral which
can be placed with it.
19. 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 type of instrument
(eg mortgage backed securities). We in particular welcome the
Bank's statement on 19 September that it was prepared to accept
another range of collateral during stressed conditions. We in
particular welcome the Bank's statement on 19 September that it
was prepared to accept up to £10 billion of wider collateral
against three-month funds. These arrangements should be made permanent.
We consider that, had the Bank acted in this vein at the beginning
of September, then many of the problems affecting the money markets
in general and Northern Rock in particular might have been mitigated.
20. We also refer to our comments about
institutions managing liquidity on a centralised and global basis.
Ensuring greater consistency between the range of collateral that
can be deposited with the three major central banks (the Bank
of England, 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.
21. We need to clarify the nature of any
disclosure requirements applying to either the Bank or the affected
issuer, bearing in mind that in this case disclosure had a clear
and significant adverse effect on consumer confidence at a time
when all of the regulators were insisting that Northern Rock was
solvent and depositors' money safe.
22. Evaluating the implications of the
credit crunch on the move to principles-based regulation:
The BBA supports this initiative from the FSA, notably through
our MiFID Connect project. There is no reason why this move from
rigid hard-coded rules and regulations and detailed guidance in
the FSA Handbook should be discontinued. But there may well be
areas that, in the light of recent events, do require firm, explicit
and continued regulatory advice.
23. Safeguarding the interests of depositors
and the financial system: there are three aspects to our recommendations,
which are broadly intertwined:
Reviewing deposit protection arrangements:
we share HMT and FSA's view that this needs to be reviewed. Considerable
numbers of depositors and savers in Northern Rock clearly did
not trust the authorities' reassurances about the solvency of
Northern Rock and hence the safety of their savings. A further
feature peculiar to the Northern Rock is that many individuals
had considerable sums deposited in the Northern Rock: a factor
in deciding to withdraw their funds was the relatively low amount
of maximum compensation. We suggest therefore that these aspects
be examined and consideration given to whether a simpler and faster
system can be introduced. We are aware that the FSA is reviewing
the funding arrangements for the Financial Services Compensation
Scheme (FSCS). We regard post-event funding as proportionate and
believe that the scheme should continue on this basis. We note
also that, at the EU level, the results of a recent EU consultation
were that member states generally believed that the pan-EU arrangements
When initial assurances about the
solvency of the Northern Rock and the significance of the Bank
of England backing proved not to be resilient, the Government
issued a statement guaranteeing all of Northern Rock's deposits.
While successful in reducing the level of panic among depositors,
this has also led to further confusion about what was being guaranteed
(which deposits, and for how long, and whether the rest of the
financial system was covered). The effect of such a move is also
unclear, for instance whether this effectively "nationalised"
Northern Rock. Again, we suggest that greater clarity about these
issues is needed.
Clarifying the Operation of Bank
of England facilities to the banks. We believe that some confusion
existed in the public's mind about the use of these. What Northern
Rock appeared to access were the Bank of England's Standing Facilities,
at a so-called 1% "penalty" rate above the Bank Rate.
Had the authorities been clearer about what giving access to this
facility to the Northern Rock was meant to achieve, this confusion
might have been avoided.
We consider that clarifying the operation
of normal money market operations, the standing facility, and
the lender of last resort role is required. We recommend that
the authorities examine whether the current arrangements are fit
for purpose. They should begin by clarifying publicly, in a paper
or a speech, what range of assistance is available to institutions
and how this differs from day-to-day monetary operations. A particular
aspect is the need for clear and precise terminology, and an explanation
of the various lending rates and maturities. In addition, the
authorities should review how assistance is made and how this
is communicated to the market, if at all (see also below).
A further aspect is confidentiality.
According to the Governor, the Bank was obliged to disclose its
support operation because of obligations in relation to the Market
Abuse Directive ("MAD") and other EU legislation. The
European Commission has refuted the Bank's legal interpretation
in relation to the MAD, so this aspect clearly needs to be reviewed.
In the past, the Bank's support operations for the banking sector,
notably during the "Lifeboat" operation in the 1970s,
have been kept confidential and we suggest that this should be
possible again. Such confusion over whether or not to disclose
support operations would not have occurred in other EU Member
Reviewing the Tripartite Memorandum
of Understanding Arrangements: From a technical point of view,
we would wish to understand how theseand particularly the
Standing Committee's rolehave worked, and notably the decision
in arriving at the funding support for the Northern Rock and the
timing for that decision.
It is, however, without doubt that
the authorities could have better managed the communications aspects
of offering re-assurance to the markets. We notably mention the
Bank of England and FSA's refusal to comment until some days later.
We suspect that the authorities were caught by the speed of events
and believe that greater efforts should have been made at the
time of the leak and immediately after to make key personnelin
addition to the Chancelloravailable to explain to the media
and the public why the facility from the Bank of England was necessary,
and its implications.