Supplementary written evidence submitted
by Dr Kern Alexander
BANKING CRISIS:
REGULATION AND
SUPERVISION
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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