Banking Crisis - Treasury Contents

Memorandum from the Financial Services Authority (FSA)

  1.  This memorandum is submitted to the Committee as part of its inquiry into the Banking Crisis and in advance of the FSA's evidence session on 25 February. It covers:

    —  the origins of the financial crisis;

    —  the required regulatory response to the crisis across the world;

    —  the UK Tripartite Authorities' response to the crisis; and

    —  the steps the FSA has already taken and is planning in response to the crisis.


  2. 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. The FSA Chairman set these out in a speech on 21 January, and we expanded on this analysis in our Financial Risk Outlook (published on 9 February). 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.

  3.  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.


  4.  In response to the Chancellor of the Exchequer's invitation to Lord Turner to conduct a review of banking regulation, we will publish a Discussion Paper in March on reforming the banking regulatory policy framework. The main purpose of this paper is to set the direction and define the changes that we believe are required in international regulation, and which we will be proposing in discussions with international colleagues and in the European Union.

  5.  The Discussion Paper will address some fundamental questions raised by the unprecedented events in financial markets over the past year. It will set out our thinking on liquidity and capital policies, our wider view on a global regime and some observations on the regulatory architecture that determines such policies.

  6.  It will outline a range of concerns and possible solutions to deal with them. Within these, capital and liquidity are particularly important.

    —  Capital: Important issues for the international capital framework raised in the Discussion Paper 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). We will also address questions relating to cyclicality/procyclicality of risk-based capital requirements and, linked to that, the complementary roles of micro and macro-prudential regulation. 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. This will involve adjusting Basel II in a number of ways, including requiring higher minimum levels of bank capital than have been required in the past, and in particular capital which moves more appropriately with the economic cycle. 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. It is crucial that the regulation of liquidity is recognised as at least as important as capital adequacy. The lack of a defined international standard has reflected the extreme complexity of liquidity risk. Measuring and limiting liquidity risk is crucial, and reforms to international regulation need to include both far more effective ways of assessing and limiting the liquidity risks individual institutions face, and a better understanding of market-wide liquidity risks. In December 2008, we issued a Consultation Paper proposing a tighter surveillance regime for liquidity. The Discussion Paper will consider whether any additional action is required, including to help deal with macro-prudential considerations.

    —  Accounting: The Discussion Paper will consider the extent to which accounting standards contributed to the swings in the market and potential responses to limit this.

    —  The institutional coverage of prudential regulation: Significant steps have already been taken, or are under international discussion, to extend accounting and regulatory coverage to the so-called "shadow banking" institutions (such as investment banks and off-balance sheet vehicles). The Discussion Paper will consider whether these actions go far enough.

    —  Cross-border cooperation and coordination within Europe and globally: The Discussion Paper will consider whether there is scope for better coordination and cooperation between regulators in normal times and during periods of crisis. It will also comment on regulatory cooperation in the EU.

    —  Executive remuneration: Last autumn, we issued a Dear CEO letter on incentive frameworks. The Discussion Paper and related publication will continue to develop our work in this area to seek to ensure incentives are aligned with responsible risk management practices.

    —  Credit ratings agencies: We continue to support the Treasury in the negotiation of a new European registration regime for credit ratings agencies (CRAs) and we will prepare for subsequent implementation. We believe there is a need for international consistency in the approach to overseeing CRAs and we will continue to contribute to the various international fora considering this issue. We will also continue to work with market participants to mitigate the risk that investors could rely on ratings as a guarantee of asset quality (both now and in the future), or could assume that it is intended to carry implications for price levels rather than purely for probability of default.

    —  Credit default swaps and counterparty risk: 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 credit default swaps (CDS) more robust. In particular this work will support the further development of central counterparty (CCP) facilities for the majority of CDS trades. We will work with others to ensure that any CCP facilities are appropriately structured and risk-managed, with a suitable level of regulatory cooperation to reflect the international nature of these markets.

  7. The financial crisis has revealed two major weaknesses in the overall approach to regulation and to wider macro-economic policy, which need to be addressed: the lack of macro-prudential analysis and policy, and the inadequate approach to the supervision of multinational financial institutions.


  8.  In retrospect, one of the crucial policy failures in the years running up to the crisis was not the inadequate supervision of any specific financial institution, but the failure to recognise huge inherent system-wide risks and that the cycle of irrational exuberance was close to reaching a crisis point. Regulators, central banks and finance ministries need significantly to improve their system-wide analysis of financial stability risks and design appropriate policy responses, whether via regulatory action, such as counter-cyclical capital and liquidity requirements, or via monetary policy tools. This needs to be coordinated at international and national level and buttressed by procedures to ensure that international bodies are free to carry out reviews of major countries' management of their economies, including their financial services sector.

  9.  A further priority is to ensure that in future financial activities are always regulated according to their economic substance, not their legal form. One of the striking features of the years running up to the crisis was that a core banking function—maturity transformation—was increasingly being performed by institutions that were not legally banks, but the off-balance sheet vehicles of banks (SIVs and conduits), investment banks and mutual funds. To different degrees in different countries these "near banks" or shadow banks escaped the capital, leverage and liquidity regulation which would apply to banks. In the case of SIVs they also escaped the degree of disclosure and accounting treatment which would have applied if the economic activities were performed on balance sheet. In future, it is essential that if an economic activity is bank-like and poses a significant risk to consumers or to financial stability, regulators can extend banking-style regulation. In addition, it is important that accounting treatment reflects the economic reality of risks being taken.

International view

  10.  Regulators need to address issues in the current approach to the regulation of cross-border financial institutions. Weaknesses arise from the inherent contradictions between the desire for open competition and for cost efficiency, which argue for treating firms as global entities, and the fact that bankruptcy laws, depositor protection regimes, and the fiscal resources which support bank rescues, are national.

  11.  The entry into administration of the UK-regulated investment firm in the Lehman Brothers group raised issues in two major areas: prime brokerage (particularly in relation to access to clients' assets following insolvency) and the post-trade infrastructure. In other respects, the UK and international financial architecture was able to manage the default of an entity of this scale.

  12.  The collapse of Lehman Brothers, caused by underlying solvency problems, highlighted a number of areas of international regulation, which will need to be reviewed, including:

    —  whether the existence of better early warning mechanisms could have identified the build-up of problems in the firm;

    —  whether a simpler group structure would have improved transparency regarding the firm's activities and strengthened regulatory oversight of the group;

    —  whether the capital framework for investment banking is appropriate;

    —  the extent to which there should be a degree of consistency in limits on firms' rights to use a client's assets;

    —  whether the regulatory framework generally should place greater emphasis on ensuring firms are structured to deliver better or quicker outcomes in an insolvency situation, eg through enhanced planning for their own insolvency;

    —  how the international framework for crisis management can be strengthened; and

    —  whether the collapse of the group into separate insolvency proceedings for each legal entity and jurisdiction is the optimum way to resolve the failure of a large, cross-border group.

  13.  This raises fundamental issues about the appropriate future regulatory and supervisory approach to such international groups, including:

    —  whether host-country supervisors should take a more national approach, requiring strongly capitalised local subsidiaries, ring-fenced liquidity and restrictions on intra-group exposures and flows; how far this would mitigate risks in inherently interlinked global groups; and what implications for cost efficiency and international capital flows would result;

    —  how international "colleges of supervisors" can be made effective in enhancing cooperation between home and host supervisors; and

    —  whether it is feasible to achieve greater cooperation in crisis resolution and whether this could extend as far as shared decision-making and agreed burden-sharing.

The EU dimension

  14.  As a member of the EU, the UK operates and applies its regulatory regime within the framework of EU law. Recent events, including the crisis in Icelandic retail bank branches, demonstrate that the EU single market rules need to be reconsidered. There are two possible directions for change.

    —  Restrictions on passporting: There could be limitations placed on the passporting rights that firms in EEA Member States have, and which permit them to set up a branch in another Member State and operate there subject to the authorisation and prudential oversight of the home state. These limitations might, for example, enable Member States to require firms to undertake their retail operations in fully capitalised subsidiaries, thus increasing the jurisdiction of national regulators. Alternatively, host state oversight and control of branches might be increased by giving the host more explicit rights to prudential data, and in consultation with the home state, permitting the host to impose proportionate and graduated restrictions on the activities of a branch. The aim would be to limit the exposure of depositors in the branch to material weaknesses which the firm is failing to address effectively, well before there is a risk of default. Host state oversight over EEA branches would therefore approach that of branches from non-EEA countries.

    —  Greater pan-European coordination: This could extend the EU's arrangements for peer review, which are currently confined to how supervisors have implemented EU directives. They might include rigorous assessment of how supervisors perform specific supervisory functions, and of how individual supervisory colleges are working. It could include peer review of the viability of deposit insurance schemes in Member States. It might include deposit insurance requirements that are less dependent on the industry or fiscal resources of individual countries. Longer term, it might be necessary to introduce an EU mechanism which could include, for example, central monitoring and oversight on countries' implementation of regulatory standards.

  15.  We do not have a clear set of proposals on these issues, but we believe it is important that there is real debate. In our view, the current approach is not sustainable.

  16. The European Commission has invited a group chaired by Jacques de Larosie"re to make proposals to strengthen European supervisory arrangements covering all financial sectors. We expect the Larosie"re Group to report to the Commission by the end of February. The Group's terms of reference are to consider:

    —  how the supervision of European financial institutions and markets should best be organised to ensure the prudential soundness of institutions, the orderly functioning of markets and thereby the protection of depositors, policy-holders and investors;

    —  how to strengthen European cooperation on financial stability oversight, early warning mechanisms and crisis management, including the management of cross border and cross sectoral risks; and

    —  how supervisors in the EU's competent authorities should cooperate with other major jurisdictions to help safeguard global financial stability.


  17.  We have been working closely with the other Tripartite Authorities and the Financial Services Compensation Scheme (FSCS) to respond to the financial crisis. The Government announced two packages of measures in October 2008 and January 2009 combining the following elements:

    —  Bank recapitalisation scheme: The deliberate creation of bank capital buffers sufficient to enable banks to maintain lending to the real economy even if future credit losses and asset write-downs are large. To achieve this, we conducted stress tests which modelled the potential for future credit losses and write-downs in the event of a severe economic recession. We required banks to attain capital levels such that, even if such stresses arose, their core tier-1 capital ratios would remain above 4%. The Government stood ready to provide the required capital if it was unavailable from private sources, making capital investments in Royal Bank of Scotland, Halifax Bank of Scotland, and Lloyds TSB.

    —  Regulatory approach to capital regulation: We explicitly clarified that these capital buffers are intended to be used to absorb losses and not to maintain core tier-1 ratios significantly and permanently above 4%. We supplemented this in January by further action to ensure that the detailed implementation of Basel II capital adequacy rules did not introduce unnecessary and unintended procyclicality in capital requirements.

    —  Asset protection scheme: The announcement in principle of a government bad asset insurance scheme which will help ensure that bank losses do not exceed stress test estimates, thus offsetting potential fears that lending growth combined with higher than expected losses could drive capital ratios below minimum acceptable levels.

    —  Bank funding: Government guarantees of bank medium-term funding to overcome the decline of confidence in the banking system, and to ensure that banks are not constrained from extending credit by inability to raise funds.

    —  Securitised credit: Further government guarantees, announced in principle in the January 2009 package, for the issue of securitised credit and in particular of residential mortgage-backed securities.

    —  Bank of England liquidity facilities: The extension of Bank of England liquidity support facilities to banks.

    —  Credit easing: Authority to the Bank of England to conduct significant "credit easing" activities, directly buying assets (such as corporate bonds) in markets where it appears yields have been significantly swollen, and prices depressed, by exceptionally high liquidity premia.

Banking Act 2009

  18.  The Banking Act 2009 was given Royal Assent on 12 February. We are now working with the other Authorities to draw on the lessons learned from events since summer 2007. This includes reviewing and where necessary enhancing the Tripartite arrangements for coordination both at times of crisis and in "normal times", including keeping the FSCS informed in a timely way to enable it to discharge its responsibilities effectively.

  19.  We are also close to finalising a Cooperation Protocol with the Bank of England, which builds on and codifies the bilateral relationships that have developed since 1997 and also reflect the Bank's new responsibilities under the Act.

Compensation scheme

  20.  The Tripartite authorities and the FSCS have worked closely to ensure the faster payout of compensation to depositors. The scheme has worked well in unprecedented circumstances, compensating hundreds of thousands of savers in a matter of weeks, including paying compensation on behalf of the Government and Iceland in the case of Icesave. (Further details are provided in the separate FSCS memorandum to the Committee).

  21.  We are also working closely with the Tripartite Authorities and the FSCS to reform the compensation scheme in light of recent experience. We published a Consultation Paper in January outlining: how fast payout of compensation can be facilitated; eligibility for the scheme; information disclosure requirements on firms; and how, working with the FSCS and the industry, we will raise consumer awareness of the compensation scheme. A further Consultation Paper will cover the treatment by the FSCS of temporary high deposit balances and deposits held on behalf of third parties, eg solicitors' client accounts. We will continue to review whether changes need to be made to the limits, tariff measures, classes and cross subsidy arrangements within the current structure of the FSCS, and will take account of the debate around pre-funding. We continue to believe the scheme should focus on protection within FSA-regulated entities and should not be extended to offer protection to UK citizens investing into offshore entities.


Regulatory philosophy

  22.  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".

  23.  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, working in a proportionate and risk-based way. We also believe that events have demonstrated the importance of an integrated approach to the supervision of individual firms. To analyse fully the risks inherent in a given firm, the supervisor must have oversight of both the full range of the firm's business and its prudential and conduct issues.

  24.  We are determined to incorporate the lessons we have learned from recent events in our drive to improve the delivery of this regulatory philosophy through our supervisory process.

FSA supervision

  25.  In our Financial Risk Outlook and Business Plan, published recently, we have set out our view of the risks to markets, firms and consumers and our work programme to mitigate these risks.

  26.  A key area of our focus will be to maintain and secure financial stability. We must in particular manage and address the risks associated with valuations and asset quality; deleveraging; the lending outlook; business models; corporate defaults; and competition and market consolidation. At the heart of our efforts to promote financial stability and manage these risks is our supervision of firms. Over the coming year we will continue to challenge individual firms to be well governed, to be financially sound, to manage effectively the risks inherent in their business models and markets, and to meet our standards in the way they deal with their customers. Our Supervisory Enhancement Programme has built on our existing capabilities.

  27.  This programme has, in fact, now closed. We believe that it has given us enough of a foundation for the longer term structural, as well as cultural, change necessary to achieve the intensity and rigour of supervision to which we aspire. The onus is now on all staff involved in supervision to embed the revised components of our strengthened operating model in the day-to-day running of our business.

  28.  Key deliveries from the programme included the following:

    —  A compulsory and irreducible programme of regular meetings with the senior management, control functions and non-executive directors of firms subject to our "close and continuous" regime (that is, high impact firms). This is to establish and communicate to the firm the minimum level of interaction we expect, and will now include:

    —  an annual meeting with the firm's senior management to focus specifically on the business and strategic plans for the firm;

    —  an annual meeting with the external auditors; and

    —  specific items of management information to support these meetings (such as annual strategy documents, operating plans, particular Board reports and the Management Letter provided from the external auditors).

    —  A regulatory period between formal ARROW assessments of maximum two years for each high-impact firm. During this period, we are now holding more formal internal "checkpoints" on a six-monthly basis to provide more FSA senior management input and oversight of the supervisory approach for the firm.

    —  Increased scrutiny of candidates for Significant Influence Functions (SIFs), particularly the Chair, CEO, Finance Director and Non-executive Directors of high-impact firms. This scrutiny includes interviewing SIF candidates where appropriate and a greater focus on their personal accountability in post.

    —  A new group of supervision advisory specialists who will conduct a regular quality review of the supervisory process for all high-impact firms. It will also provide support to the supervisory teams.

  29.  There are a small but critical number of outstanding elements remaining, each with a longer-term delivery timeframe. These are in the areas of risk identification (particularly our ability to collect and then harness effectively the use of information and intelligence so that front-line supervision staff benefit from more timely and relevant financial analysis, business model and other data based on peer firm review). The other area is the delivery of a Training and Competence regime for our supervisory staff, which is part way through development, although the training element of this has already gone live. Alongside this, the introduction of a tenure policy, to provide continuity of supervision for relationship-managed firms, should enable a deeper level of supervision to be achieved.

  30.  All of this is underpinned by a necessary increase in our supervisory staff, including the level of senior FSA resource available to support supervision. We have increased resources in many of our specialist prudential as well as conduct risk areas and we also now assign an irreducible minimum to each of our high-impact firms. To date, we have filled 65% of the additional positions and are therefore on track to achieve 100% (280 additional staff) by our target of summer 2009.

  31.  There are, however, necessarily limitations to supervisory oversight and we believe that our improvements need to be matched by greater engagement by shareholders and non-executives who should be the first line of oversight of firms' executive management.

Remuneration policies

  32.  In October 2008 we wrote to the chief executives of major UK-based banks, both British and foreign-owned, making clear that remuneration policies in many firms have been inconsistent with sound risk management and have given staff incentives to pursue policies that undermined the impact of systems designed to control risk. We asked them to review their remuneration policies against a set of criteria and, if necessary, take action to change them. We are now considering the types of sanction that we can impose if firms do not comply with our requirements.

  33.  We are preparing a further paper on these issues which we will publish at the end of March. This statement will include:

    —  a summary of the findings of our review of remuneration policies;

    —  a revised set of the criteria set out in our October 2008 letter—which we are likely to issue as a Code; and

    —  a statement setting out the action that we intend to take in future on remuneration.

  34.  In pursuing this agenda, we will work with others. We welcome the announcement by the Treasury of an independent review of corporate governance of the UK banking industry being undertaken by Sir David Walker. We look forward to working closely with him. We are also contributing to international work on remuneration policies. A working group of the Financial Stability Forum has commissioned a survey of remuneration practices in global wholesale banking firms and is consulting with experts in the field. It will produce a report for the G7 towards the end of the first quarter of 2009.


  35.  We will adopt a balanced approach to conduct and prudential risk because we recognise that consumers are particularly exposed in these difficult economic times. We will ensure we are heavily engaged in mitigating the detriment which will stem from this fact. We will strengthen our supervisory focus on Treating Customers Fairly (TCF). The embedding of the TCF agenda into our supervisory process is critical to ensure that it is an enduring feature of our regulatory regime.

  36.  In addition to responding to the current economic downturn, we will continue our focus on consumer capability and adjust our programme appropriately in the light of the changed economic circumstances. Our focus on consumer issues will also continue to include work on transparency to ensure that, where appropriate, we properly equip consumers with the best information to make informed decisions. In the coming year we will continue the Money Guidance Pathfinder project in partnership with the Treasury, to test the provision of free, impartial guidance on money matters.

Short selling

  37.  Over the coming year we will continue our work on developing the regulatory regime for short selling. The market turbulence over the past year and concerns over the role which short selling has played in this prompted us to take various emergency measures, including a ban on short selling, and undertake a comprehensive review of the practice. We remain clear that in normal market conditions short selling is a legitimate technique that promotes price efficiency and assists liquidity, and is not in itself abusive. However, we recognise that in some circumstances, especially in times of market uncertainty, short selling can have a negative effect.

  38.  The proposals put forward in our February Discussion Paper on short selling are intended to mitigate these negative effects without removing the benefits which short selling brings. Rather than imposing permanent direct constraints on short selling, we consider that the best way forward is enhanced transparency. In our view, disclosing significant individual short positions to the market is the best way of improving transparency and we think that a regime of this type should be applied to all UK stocks.

  39.  We decided not to extend the temporary ban on the short selling of UK financial sector stocks when it expired in January. We considered that the circumstances which led to its introduction had changed, not least due to the initiatives by the government, with a lessening of the risks which had caused us the greatest concern. We have maintained the disclosure regime and continue to scrutinise closely trading in financial stocks, following up on any suspicious trading patterns which indicate the possibility of market abuse. We do not consider that short selling was a major contributory factor in determining the fall in the share prices of certain banks in the period following the ban's expiry. However, we have made it clear that we are prepared to reintroduce the temporary ban, without consultation if necessary, should circumstances require it.

16 February 2009

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