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Themes and Trends in Regulatory Reform
Memorandum from the Financial Services Authority
1. This memorandum is submitted to the Committee as part of its 'Themes and Trends in Regulatory Reform' inquiry. It covers: · the role and remit of the FSA; · the origins of the financial crisis; · the required regulatory response to the crisis; and · our regulatory philosophy. 2. The second and third topics are covered in detail in The Turner Review issued on 18 March by Lord Turner, the FSA Chairman, in response to a request by the Chancellor of the Exchequer to conduct a review of banking regulation.
A. Role and remit of the FSA
3. The Financial Services Authority (FSA) is an independent non-governmental body, given statutory powers by the Financial Services and Markets Act 2000 (FSMA). FSMA gives us four statutory objectives: market confidence; public awareness; consumer protection; and the reduction of financial crime. These are supported by a set of principles of good regulation which we must have regard to when discharging our functions.
B. Origins of the financial crisis
4. Over the last 18 months, and with increasing intensity over the last six months, the global financial system has suffered its greatest crisis in over 70 years. The origins of the crisis can be explained by a number of factors. They include: · Growth of significant global imbalances over the last decade: Large current account surpluses accumulated in the oil-exporting countries, China, Japan and some other east Asian developing nations, while fiscal and current account deficits grew in the US, UK and some members of the Eurozone. · Increasing complexity of the securitised credit model: Lower risk-free interest rates produced an intense search for higher yield at low risk. This demand was met by an increase in volume and complexity of the securitised model of credit intermediation. · Rapid extension of credit and falling credit standards: Between 2000 and 2007, credit extension in the US, the UK and some other countries grew quickly. This credit extension was partly driven by the rapid development of securitisation, with an increasing proportion of UK mortgages credit packaged and sold as residential mortgage-backed securities, thus not appearing on the originator bank's balance sheet. In addition, lending on balance sheet grew rapidly, as banks competed for market share, often funding their rapid growth with easily available wholesale funding. This rapid expansion of credit was accompanied by declining credit standards both in the household and corporate markets. · Property price booms: The rapid extension of mortgage credit and of commercial real estate loans developed into a boom where rising property prices drove the demand and supply of mortgage credit, resulting in even higher property prices. Continuously rising prices convinced both borrowers and lenders that high loan-to-income ratios or high loan-to-value were acceptable given the potential for future capital appreciation. The widespread extension of credit on terms that could only be justified on the assumption of future house price appreciation was particularly symptomatic of the US sub-prime market. · Increasing leverage in the banking and shadow banking system: The increasing scale and size of securitised markets and their mounting complexity were accompanied by a significant escalation in the leverage of banks, investment banks and off-balance sheet vehicles, and the growing role of hedge funds. Large positions in securitised credit and related derivatives were increasingly held by banks, near banks, and shadow banks, rather than passed through to traditional, hold-to-maturity investors. Hence, the new model of securitised credit intermediation was not one of 'originate and distribute'. Rather, credit intermediation meant passing through multiple trading books in banks, leading to a proliferation of relationships within the financial sector. This 'acquire and arbitrage' model resulted in the majority of incurred losses falling not on investors outside the banking system, but on banks and investment banks themselves involved in risky maturity transformation activities. The explosion of claims within the financial system resulted in financial sector balance sheets becoming of greater consequence for the economy, with financial sector assets and liabilities in the UK and the US growing far more rapidly as a proportion of gross domestic product than those of corporates and households. · Underestimation of bank and market liquidity risk: The growth of the securitised credit market and bank leverage and the multiplicity of inter-bank claims were also accompanied by changing patterns of maturity transformation and in many cases by serious underestimation of bank and market liquidity risk. Maturity transformation - holding longer term assets than liabilities - was increasingly performed not only by banks, but also investment banks, off-balance sheet vehicles and, in the US, by mutual funds. This made the financial system overall increasingly reliant on liquidity through marketability - the ability to meet liabilities through the rapid sale of an increasingly wide range and much increased value of long-term credit instruments. When the crisis struck, the assumption that the markets for these instruments would remain liquid was proven wrong as concerns spread about the quality of such instruments. These interrelated effects and relationships resulted in a self-reinforcing cycle of irrational exuberance in pricing of both credit and volatility risk. Credit spreads on a range of securities and loans fell steadily from 2002 to 2006 to reach very low levels relative to historical norms. In addition, the price charged for the absorption of volatility risk fell, since volatility itself appeared to have declined to very low levels.
C. The FSA response to the current economic crisis
5. In order to address these issues, the FSA has been involved in three key areas: · the Turner Review; · engagement with international authorities and regulators through the EU, G20 and Financial Stability Forum; and · the Banking Act 2009.
The Turner Review 6. In response to the Chancellor of the Exchequer's invitation to Lord Turner to conduct a review of banking regulation, we published the Turner Review on 18 March and which we attach as Appendix A. At the same time we published a more detailed FSA Discussion Paper which sets out our initial thinking on how the issues addressed in The Turner Review can be translated into practical policy proposals. 7. The Turner Review outlines the fundamental changes required in the approach to regulating banks. Specifically it covers the following issues: capital, liquidity, accounting, 'shadow banking', remuneration, credit rating agencies, derivatives trading, cross-border banking and EU supervision and regulation. 8. The Review also sets the direction and defines the changes we believe are required in international regulation, and which we will be proposing in the EU and internationally. · Capital: The crisis has revealed the importance of focusing on the implications of bank capital structure for the behaviour of banks and the implications of that behaviour for the whole economy. Important issues for the international capital framework include the level of capital that we expect banks to hold, the quality of capital and whether risk-based capital needs to be supplemented by a non risk-sensitive measure (such as a leverage ratio). In addition to this, any new system should include an overt counter-cyclical element of capital requirements to ensure institutions build up a buffer in good times which they can draw on in downturns. These views will feed into the Basel Committee on Banking Supervision and the Financial Stability Forum's consideration of new approaches to the regulation of the capital adequacy of banks. In addition, more capital will be required against trading books and the taking of market risk. · Liquidity: New approaches to the management and regulation of liquidity are equally important. The lack of a defined international standard has reflected the extreme complexity of liquidity risk. As such, the regulation of liquidity should be restored to a position of central importance. This should focus on individual guidance, stress-testing and cross-system analytical trends - not through a quantitative ratio regime. In December 2008, we issued a Consultation Paper proposing a tighter surveillance regime for liquidity along these lines. · Accounting: The current system of reflecting the 'facts' of the situation as at the balance sheet dates adds to systemic pro-cyclicality. It is important that the counter-cyclical approach to bank capital is reflected in a significant way in published account figures, such as by anticipating future losses before they are evident in trading book values or loan repayment problems. · Hedge funds and shadow banking: Regulators and central banks in their performance of the macro-prudential analysis role need to gather much more extensive information on hedge fund or other activities outside the banking sector. They also need to consider the implications of this information for overall macro-prudential risks. Off balance sheet vehicles which create substantive economic risk, either to an individual bank, or to total system stability, must be treated as on balance sheet for regulatory purposes. Regulators should also be given the power to apply appropriate prudential regulation to hedge funds or any other category of investment intermediary, if their activities have become bank-like in nature or of systemic importance. · Executive remuneration: Remuneration structures played a contributory role in the origins of the crisis by helping to create incentives for harmful risk-taking. We will need to include a strong focus on the risk consequences of remuneration policies within our overall risk assessment of firms, and we will enforce a set of principles which will better align remuneration policies with appropriate risk management. On 26 February, we published a draft Code of Practice which sets out these principles and issued a Consultation Paper on 18 March 2009. · Credit ratings agencies: The embedding, by institutions, of ratings based rules in operating procedures and the increase in the role of securitised credit increased the dangers of pro-cyclicality within the system. In addition, ratings for structured credit proved far less robust predictors of future developments. The resulting instability of ratings not only produced a pro-cyclical effect but also undermined confidence in the future stability of credit ratings. Questions were also raised regarding the governance of rating agencies and issues relating to conflict of interest. Regulation can and should address these issues, both through registration and supervision of rating agencies, and clearer understanding on the purpose of ratings and the requirements for institutions to hold securities of a specific rating. We continue to support the new European registration regime for credit ratings agencies (CRAs) and we will prepare for subsequent implementation. Given the global nature of capital markets, it is important that the European legislation is matched by agreement of compatible global standards, and the FSA is working through IOSCO to achieve this. · Derivatives trading and counterparty risk: The size and complexity of the derivatives market, and the fact that most of it is almost entirely traded in an over-the-counter fashion, creates a danger that the failure of one party could produce market disruption. The FSA strongly supports the objective of achieving central counterparty clearing arrangements for credit default swaps (CDS) trades. We will work with our international regulatory counterparts, market participants and infrastructure providers to make trading and operational arrangements for over-the-counter (OTC) derivatives, including CDS, more robust. · Cross-border banks: The financial crisis has revealed major fault lines in existing approaches to the regulation and supervision of cross-border financial institutions. The FSA's past approach placed significant reliance on the home country regulator. The failure of Lehmans highlighted that national legal entities and national bankruptcy laws have a major impact on the relative position of different creditors, and the decision to allow Lehmans to fail clearly had huge global economic implications. In light of this, we support a further strengthening of co-operation between regulators (e.g. through colleges of regulators for all major cross-border banks). However, this is not the basis for a fully integrated approach to the supervision of cross-border groups. Supervision needs to be done on a national basis, however, host regulators should be able to ring-fence, where necessary, more local capital and liquidity in the local branches, which would improve the position of local creditors and result in higher levels of capital and more liquid balance sheets. · EU supervision and regulation: The underlying framework for banking regulation in the European Union has been shown to be inadequate and unsustainable for the future. This was highlighted particularly in the case of Landsbanki which, as Iceland is a member of the European Economic Area, could operate in the UK as a branch over which the FSA had only limited powers. The Turner Review sets out the arguments for both a 'less Europe' and 'more Europe' approach, and highlights that the EU must now consider the appropriate way forward. The FSA Discussion Paper proposes for debate; the creation of a new European Union institutional regulatory structure, which would replace the Lamfalussy committees; and the reinforcement of host country supervisory powers over liquidity and the right of the host country supervisors to demand subsidiarisation and, in the extreme, impose capital requirements. Engagement with international regulators and authorities 9. Some changes to the international regulatory and supervisory framework have already been made and further work is in train. However, final conclusions as to the scope of the fundamental reforms that are clearly needed have yet to be reached. Work is currently under way to this end within the G20, the Financial Stability Forum (FSF) and the three main global regulatory standard setting bodies - the Basel Committee on Banking Supervision (BCBS), the International Organisation of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS). In addition, similar work is in train in various fora within the EU. This has included the recent publication of the de Larosière Group's report to strengthen European supervisory arrangements covering all financial sectors. Banking Act 2009 10. The FSA has worked closely with the Treasury and the Bank of England in the development of, and consultation on, the Banking Act 2009. This legislation forms a significant milestone in the work of the Tripartite Authorities to strengthen financial stability and depositor protection. 11. The Act's powers provide a framework for the successful resolution of failing banks, differentiating between the roles of the Tripartite Authorities. These powers are intended to be used as a last resort and therefore there is a high standard to be met before they can be exercised. The resolution tools themselves comprise a transfer of all or part of the failing bank to a private sector purchaser or to a bridge bank (owned by the Bank of England), or transfer of the failing bank to temporary public ownership. The FSA has responsibility for determining when the powers should be exercised in relation to a failing bank, whilst responsibility for choosing the particular resolution tool lies with the Bank of England or, in the case of temporary public ownership, HM Treasury. To ensure a co-ordinated approach, there is an obligation on the Authority taking these decisions to consult with the other Tripartite Authorities. 12. In circumstances where a successful resolution of a failing bank is judged not to be possible, the Act provides for a bank insolvency procedure. This procedure places an obligation on the insolvency practitioner to work with the Financial Services Compensation Scheme to ensure fast compensation in relation to eligible deposits. The Act contains further provisions in connection with the Financial Services Compensation Scheme, the purpose of which is to allow the Scheme to operate more efficiently and to clarify funding arrangements. The FSA will collect information on behalf of the Financial Services Compensation Scheme to enable it to perform its functions. In parallel to the changes made under the Banking Act, the FSA has made further changes to compensation arrangements, including increasing the level of compensation available to claimants. 13. The Act also addresses the oversight of certain systems for payments between financial institutions. The FSA is working with the Bank of England to establish a cooperation protocol to ensure clarity of their relationship in respect of the supervision of these payment systems and the payment systems, already supervised by the FSA, which are embedded in recognised bodies. 14. The FSA continues to work closely with the other Tripartite Authorities to ensure that the necessary operational framework is in place to enable effective action to be taken under the new legislation. The FSA is also involved in discussions at European level on the development of legislation to provide a suitable framework for the resolution of failing banks where there are international implications to be considered.
D. Regulatory philosophy 15. Historically, our regulatory philosophy has been defined by the strapline of 'more principles-based regulation'. This has often been misunderstood. Principles-based regulation means, wherever possible, moving away from prescriptive rules to a higher-level articulation of what we expect firms to do. This has the major advantage of placing on firms' explicit responsibility to decide how best to align their business objectives and processes with the regulatory outcomes we have specified. The focus of our philosophy, however, is not only on our principles, but also on judging the consequences of the actions of the firms and the individuals we supervise. Given this philosophy, a better strapline would be 'outcomes-focused regulation'. 16. In our view, the global financial crisis and the problems in specific firms have demonstrated more than ever the need to adhere rigorously to this regulatory philosophy. We will therefore take into 2009/10 a clear commitment to embed fully outcomes-focused regulation in our supervisory processes, continuing to work, of course, in a proportionate and risk-based way. 17. As part of our work on our Better Regulation agenda, we are required to ascertain whether there has been a failure in the functioning of the market that has given rise to the problem before we can consider the introduction of new regulations. This is a requirement under FSMA. Only where we can establish that there has been a failure in the market can we begin to consider the need for regulatory intervention. If this test is passed we proceed to look at the various options to address the problem and investigate the costs and benefits of each. This analysis of costs and benefits would help our assessment of whether we would introduce new regulations. 18. In relation to our work on supervision, we have already embarked on a programme of change to improve our supervision of firms. The key feature of this programme is greater supervisory resource of a higher quality. We are on course to hire, by the end of 2009, 280 extra specialist and supervisory staff which will represent a 30% increase in our supervisory capacity. To ensure these individuals are properly equipped to do this job we have introduced a new Training & Competence scheme which also involves a regulatory testing regime for existing supervisors. 19. In the future we will seek to make judgements on the judgements of firms' senior management and take actions if in our view their actions will lead to risks to our statutory objectives. This is a fundamental change. It is moving from regulation based only on observable facts to regulation based on judgements about the future. This more intrusive and direct style of supervision we call 'the intensive Supervisory Model'. 20. As part of this we are moving from focusing on systems and processes to focusing on key business outcomes and risks, and on the sustainability of business models and strategies. This shift implies a greater willingness on our part to vary capital and liquidity requirements or to intervene more directly if we perceive that specific business strategies are creating undue risk to the bank itself or to the wider system. To do this we must have a clear understanding of business models on both an individual and sectoral basis. 21. This is supported by our more proactive approach to enforcement - our 'credible deterrence' philosophy. Since we set out this philosophy, last year, we have demonstrated by our actions that we will use all our powers, including criminal prosecutions, to deliver our mandate. 22. Effective risk assessment of a firm requires industry knowledge and for that assessment to be set in a macro-prudential context. This was not done in the past, but will be done in the future. We will work closely with the Bank of England to bring both regulatory and macroeconomic perspectives to this work.
31 March 2009 |