Banking Crisis: regulation and supervision - Treasury Contents

Supplementary written evidence submitted by Dr Kern Alexander


  The credit and financial crisis has exposed major weaknesses in UK banking supervision and regulation. This written evidence elaborates further on the issues discussed at the Treasury Select Committee's hearing on 23 June 2009. Specifically, it will address the recommendations set forth in the Turner Report with respect to capital and liquidity regulation and the FSA's supervisory responsibilities for cross-border banks that operate in the European Union. Further, it will address the regulation of the shadow banking sector, and the meaning of macro-prudential regulation and how it should fit into the UK's reformed regulatory framework.

1. The need for macro-prudential regulation

  UK financial regulation will need to expand its focus to include not only individual financial institutions and investor and depositor protection, but also the broader financial system. This means that UK supervisors will have to manage and control systemic risk in the financial system by monitoring the aggregate levels of leverage in the financial system and by adjusting micro-prudential regulation of individual firms to take account of macro-economic factors. One of the major failures in UK regulation over the last ten years was that prudential regulation was too market-sensitive; it focused on the individual institution and did not take into account the level of risk or leverage building up in the whole financial system. The FSA thought that, if individual firms were managing their risk appropriately, then the financial system would be stable. This failed to take into account the fallacy of composition that what appears for individual firms to be rational and prudent actions in managing their risk exposures under certain circumstances can, if followed by all firms, potentially produce imprudent or sub-optimal outcomes for the whole financial system. The challenge now is to link micro-prudential regulation of individual firms within a robust macro-prudential framework.

2. Counter-cyclical capital adequacy rules

  Capital adequacy regulation will need to become more rules-based. The main aim of Basel II and the Capital Requirements Directive is to make bank regulatory capital more sensitive to the economic risks which individual banks face, while ignoring the larger social risks which bank risk-taking poses to the financial system. Indeed, the FSA has adhered to the Basel II approach by permitting banks to use their own economic capital models to measure credit, market and operational risk and to estimate lower levels of regulatory capital than what regulatory rules would normally require. An important weakness of the CRD/Basel II is that it fails to address liquidity risk, which precipitated the present credit crisis, and allows banks to hold lower levels of regulatory capital for assets which banks securitize through special purpose vehicles in the wholesale debt markets.

Another weakness of Basel II/CRD is that it is procyclical because regulatory capital calculations are based on the riskiness of assets on the bank's balance sheets. Rather, regulatory rules should impose counter-cyclical capital requirements, such as higher capital charges during an asset price boom and lower charges during a market downturn. The experience of using counter-cyclical capital rules—or dynamic provisioning—in Europe has generally been positive. Spain had counter-cyclical capital rules which led to their banks having more capital than other banks in Europe and, therefore, they were able to withstand the crisis much better. Spanish banks did not receive bailouts from the Spanish Central Bank. The FSA and other EU member states should adopt counter-cyclical rules as well, and they need to be somewhat formulaic, but there should be some regulatory discretion to adjust their application to changing market structures and financial innovations.

3. Rules versus discretion in capital regulation

  It is necessary to have a rules-based capital adequacy regime in order to bind the regulator's actions so that they do not acquiesce to political pressure by failing to apply counter-cyclical capital rules. A rules-based regulatory regime is also necessary in the European Union where many member state regulators are, by law, required to have more rules-based regulatory regimes and the regulators are not allowed so much discretion as, say, the FSA has, and this is because of constitutional law principles of due process and equal protection under the law. Nevertheless, efficient capital adequacy requirements need to provide regulators with a combination of rules and discretion, and the rules need to provide reference points or guidelines for regulators. This means that there needs to be a balance between rules and discretion. Some supervisory discretion, however, is necessary in a rules-based capital adequacy regime, which provides flexibility for the regulator to adopt different rules and practices when market conditions change. This allows regulators to learn and adapt their supervisory practices to evolving markets and to adjust to innovations in the market.

4. What type of regulatory capital?

  The definition of "core tier one capital" should be made more precise to include any financial instrument that can fully absorb losses on the bank's balance sheet. Core tier one capital should constitute most of a bank's regulatory capital and it should be included as tier one only if it can absorb losses fully. Under this more limited definition, tier one capital will mainly include common equity shares. If you include preferred shares or subordinated debt, those types of capital have a more limited ability to absorb losses, because they are essentially debt claims. Capital regulation should focus not necessarily on having higher capital charges, but instead on ensuring that regulatory capital consists of equity shares and similar instruments that have the ability to absorb losses for the bank, and that this core tier one capital should constitute most of the bank's regulatory capital. Tier 2 capital—subordinated debt and preferred shares and other hybrid instruments—should be relied on less as a regulatory requirement for banks to demonstrate adequate capital. In the European Union, the lack of a harmonised and meaningful definition of tier one capital under the CRD has led to an unbalanced playing field across EU states because there are different definitions of what composes regulatory capital and in particular tier one capital. The main point is that the definition of "regulatory capital" should be linked to its ability to absorb losses.

5. Bank size and interconnectedness of financial firms

  A bank's or financial institution's regulatory capital level should be linked, in part, to its size and interconnectedness in the financial system. Larger banks pose a larger systemic risk to the financial system and, therefore, they should pay a tax or a higher charge for how big they are, and smaller banks perhaps do not need such high capital charges as they pose less systemic risk. Interconnectedness brings us to the capital markets and how they have certainly become complex. The crisis demonstrates how liquidity risk can arise in the wholesale capital markets, not necessarily with individual banks. Securities regulation has traditionally focused on conduct of business rules and the segregation and protection of client account money, but the crisis shows that securities regulators should focus much more than they have in the past on systemic risk in capital markets.

6. Regulating liquidity risk

  Before the credit crisis, there was an under-appreciation of liquidity risks in the financial system. Much of the policy debate and so many of the academic models had analysed financial stability issues from the perspective of market risk and credit risk. In fact, Alan Greenspan praised credit-risk transfer and securitisation as spreading and smoothing risk in the financial system and that this had enhanced liquidity in financial markets. Indeed, Dr. Greenspan's view was that securitisation and other types of credit risk transfer financial instruments had spread risk and thus had enhanced financial stability. As a result of this conventional wisdom, there was not an appreciation that liquidity risk could arise in these inter-connected and highly leveraged financial markets. The academic and bank models, and the regulatory frameworks, were built upon the fact that credit risk transfer was promoting liquidity, but what we did not count on was the fact that suddenly liquidity could evaporate in the wholesale funding markets. In the summer of 2007 institutional investors in the wholesale debt markets suddenly refused to roll over their short-term investments, thus causing liquidity to dry up. That was something that was not foreseen and it is a major failing on the part of academics, policy-makers, regulators and, of course, the risk managers in the banks and investment firms who failed to appreciate this. Therefore, regulation should address the maturity mismatches which special purpose entities and structured investment vehicles have in the wholesale funding markets and control and limit these exposures, and require banks to hold some regulatory capital against these exposures, even though they have been swept off their balance sheets.

7. The European dimension of UK regulation

  UK prudential regulation should take account of the cross-border risks which UK financial institutions pose to other countries—especially in the European Union. The UK financial crisis with the collapse of the Royal Bank of Scotland demonstrated how the risk-taking of UK banks can generate cross-border externalities to other countries and financial systems. Banks have exposure to each other throughout Europe in the money markets through a variety of risk exposures, and European policy-making needs to begin to have better surveillance of the systemic risk posed by certain banking groups and financial institutions that operate in Europe. It does not mean that EU regulation and oversight should displace national regulators; it simply means that member state regulators, at the national level, must have more accountability to committees of supervisors at the EU level in order to carry out more efficiently cross-border supervision of the largest forty or so of Europe's banks that have extensive cross-border operations. The De Larosiere Committee's proposal for a European Systemic Risk Council and for a European Financial Supervision Committee, consisting of the Lamfalussy committees, is an appropriate institutional step to developing a more accountable and efficient EU regulatory structure.

8. Who should regulate systemic risk

  The Bank of England has broad powers over macro-economic policy, interest rates and managing the currency, but in the recent crisis it was shown that systemic risk can arise not only from individual financial institutions, but also from the broader wholesale capital markets and in the over-the-counter derivatives markets. Indeed, the failure of AIG demonstrated that a non-banking financial firm can have huge counter-party exposures in the credit derivatives market that can put the whole financial system at serious risk. The regulation of the structure of the financial system—in particular clearing and settlement—is another source of systemic concern. The FSA is the primary regulator of wholesale capital markets and the post-trading system in capital markets. The FSA has the data not only for supervising individual institutions, but also for regulating the clearing and settlement system and the exchanges, which is where much of the systemic risk in the recent financial crisis arose, and that is why the FSA is well-positioned to exercise supervision over these systemically-important areas of the financial system. By possessing market intelligence, the FSA is well-positioned to supervise and control systemic risk as it occurs in the broader capital markets and trading systems. Nevertheless, there should be improved operational linkages with the Bank of England regarding the FSA's regulation of systemic risk in the capital markets and its relationship to macro-prudential regulatory policy.

9. Banks' business models and corporate governance

  Effective supervision and regulation require banks to have robust corporate governance arrangements that incentivise bank management and owners to understand the risks they are taking and to price risk efficiently in order to cover both the private costs that such risk-taking poses to bank shareholders and the social costs for the broader economy if the bank fails.[2] Corporate governance plays an important role in achieving this in two ways: to align the incentives of bank owners and managers so that managers seek wealth maximisation for owners, while not jeopardising the bank's franchise value through excessive risk-taking; and to incentivise bank management to price financial risk in a way that covers its social costs. The latter objective is what distinguishes bank corporate governance from other areas of corporate governance because of the potential social costs that banking can have on the broader economy.[3]

Major weaknesses in UK bank corporate governance have resulted not only in substantial shareholder losses, but also have contributed significantly to the significant contraction of the UK economy, which has, among other things, led to massive layoffs in the financial services industry and related economic sectors and dramatically curtailed the availability of credit to individuals and businesses. Most UK bank senior managers and board members did not understand the risky business models that drove UK bank lending and which led to much higher levels of leverage in deposit banks and investment banks. Moreover, they failed to grasp the true risks which their banks' risk managers had approved based on faulty value-at-risk models that were used to determine credit default risk and market risk. Equally important, they allowed irresponsible compensation packages to be awarded to bankers which incentivised them to book short-term profits based on excessively risky behaviour which increased systemic risk in the financial system and weakened the medium and long-term prospects and profitability of the bank. Moreover, weak governance and risky business models contributed to the poor performance of banks and in some cases to their failure and bailout or nationalisation by the government.

  The UK regulatory regime should establish new corporate governance standards that cover most areas of bank management, including controls on remuneration that are linked to the long-term profitability of the bank, while foregoing short-term bonuses. The FSA should exercise the power to approve bank director appointments and ensure that bank directors have the knowledge and training to understand the bank's business and risk models and its financial implications not only for the bank's shareholders, but for the broader economy. Bank management should be required to understand the technical aspects of stress-testing, which the regulator should require to be done on a much more frequent basis than what was done prior to the crisis. Essentially bank corporate governance regulation should focus not only on aligning the incentives of bank shareholders and managers, but also on aligning the broader stakeholder interests in society with those of bank managers.

10. Regulating off-balance sheet structures

  Structured investment vehicles (SIVs) and special purpose vehicles (SPVs) are important elements in financial innovation and these structures largely were responsible for allowing securitisation to thrive and to provide increased liquidity in the financial system. However, these structures were also a type of regulatory arbitrage that allowed banks to reduce their regulatory capital requirements and to lower the costs of managing their balance sheets. Excesses occurred in the use of these off-balance sheet structures that allowed leverage to grow unchecked. Nevertheless, securitisation is an important component of our financial system and we should not prohibit banks from using it and other off-balance sheet operations to generate liquidity and to manage more effectively their balance sheets. Regulators should understand better the systemic risks which securitisation structures pose to the financial system and impose efficient regulatory charges on firms which transfer assets off their balance sheets through such structures and on the risk traders who invest in these risky assets. The real regulatory challenge will be how to require the market participants to internalise the costs of the risks they create in these structures. If we properly regulate securitisation, SIVs, and the various conduit funding mechanisms that banks have been using, then they will provide appropriate and economically beneficial ways to raise capital. They are a part of financial innovation and we should not curtail financial innovation, but we have to understand that the funding through SIVs is short-term and that it can disappear quickly, and we have to think about how to regulate that by devising pricing mechanisms that require issuers and investors to internalise the social costs of these risks.

11. The UK Tripartite System

  The UK Tripartite System was established by a legally non-binding Memorandum of Understanding in 1998 that was designed to provide flexibility to the FSA, the Bank of England and the Treasury to coordinate their regulatory interventions and systemic oversight in times of crisis. Although the Chancellor chaired the tripartite bodies and exercised ultimate decision-making authority, there was no clear delineation of responsibilities between the three for acting in a financial crisis. The FSA, the Bank and the Treasury had only committed themselves to consult and there was no clear procedure for determining how the bodies would act in a banking or financial crisis and who would take what decisions. The Tripartite Arrangement failed to work effectively in the summer of 2007 when Northern Rock failed and had continuing difficulties in its operations until the Banking Act 2008 was adopted that established stronger legal grounds and procedural rules for the Tripartite system's operations. Presently, the Banking Act 2009 reinforces many of the reforms that were made to the Tripartite system's operations in 2008. One weakness, however, which should be remedied is the Banking Act's creation of a Financial Stability Committee which is chaired by the Governor of the Bank of England. Membership of the committee is composed of two of the Bank's deputy governors and representatives from the Treasury, but there is no representation from the Financial Services Authority on the Committee. It is necessary to have the FSA as a member of the committee for the oversight of systemic risk because we have learned in the credit crisis that systemic risk can arise not only from individual banks (which the FSA regulates), but also from the broader wholesale capital markets and OTC derivative markets (which the FSA also regulates). Therefore, the FSA should be given statutory authority to supervise both individual institutions and to oversee the broader financial system (ie, wholesale capital and OTC markets) to ensure against systemic risk and other threats to financial stability.

12. Macro-prudential regulation and principles-based regulation

  Macro-prudential regulation will change in important respects the nature of principles-based regulation. The FSA's principles-based regulation (PBR) approach was focussed on individual firm outcomes and allowed firms to experiment with different risk management practices so long as they achieved satisfactory firm outcomes that was measured by shareholder prices and whether the eleven high level FSA principles were being achieved (ie, treating customers fairly). The FSA's PBR approach did not take into account the aggregate effect of firms' performance on the financial system in terms of leverage generated and overall systemic risks and liquidity risk exposures. To address adequately these macro-prudential risks in the future, principles-based regulation will necessarily become more rules-based at the level of the firm and at the level of the financial system. The Turner Report supports the creation of a macro-prudential regulatory regime that is directly linked to the micro-prudential oversight of individual firms. Macro-prudential regulation will change regulation for individual banks in two main areas: 1) the regulation of individual firms must take into account both firm level practices and broader macro-economic developments in determining how regulatory requirements will be applied to firm risk-taking (ie, the relationship of the growth of asset prices and GDP with contra-cyclical bank reserves and liquidity ratios) and 2) bank innovation in the types of financial products offered will be constrained by controls on the overall levels of risk-taking and leverage at the level of the financial system (ie, limits on loan-to-value and loan-to-income ratios). If adopted, macro-prudential regulation will require that principles-based regulation become more rules-based because tighter ex ante constraints will need to be applied to the risk exposures of individual firms (ie, leverage ratios and limits on maturity mismatches in wholesale funding). FSA regulation will gradually become more rules-based in order to achieve macro-prudential regulatory objectives. The FSA's PBR regime that focuses on individual firm outcomes will become much less relevant to achieving macro-prudential objectives. The FSA will need to adopt a new PBR approach based on macro and micro rule-based controls which will dramatically change the nature of FSA supervisory practices and potentially lead to new regulatory risks that will arise because of the responses of market participants who will undoubtedly seek to avoid these regulatory controls by adopting innovative financial instruments and structures. This will be the main challenge for the FSA and its PBR approach in the future.

23 June 2009

2   H Mehran, Critical Themes in Corporate Governance, (April, 2003) FRBNY Economic Policy Review; see also, J Macey, and M O'Hara, The Corporate Governance of Banks (2003) FRBNY Economic Policy Review, Federal Reserve Bank of New York, 91-107. Back

3   Moreover, it should be noted that regulatory intervention is necessary to address the social costs of bank risk-taking because the regulator is uniquely situated to assert the varied interests of other stakeholders in society and to balance those interests according to the public interest. Back

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