Banking Crisis: regulation and supervision - Treasury Contents

Examination of Witnesses (Questions 1-19)


23 JUNE 2009

  Q1 Chairman: Good morning and welcome to our inquiry into banking and supervisory regulation. If I can start with yourself, Dr Alexander, could you introduce yourself for the shorthandwriter please and say where you come from.

Dr Alexander: I am Kern Alexander from the Centre for Financial Analysis and Policy at the University of Cambridge.

  Professor Morrison: I am Alan Morrison from the Said Business School at the University of Oxford.

  Dr Lilico: I am Andrew Lilico from Europe Economics and Policy Exchange.

  Q2  Chairman: Now, there are quite a number of things we want to get through this morning, capital and liquidity regulation, cross-border supervision, macro-prudential tools and narrow banking, so these are the issues that we would like to focus on before Lord Turner comes in at 10.30. Talking about Lord Turner, how culpable is the FSA in the development of the financial crisis, and what has been its biggest failing? What can it take forward as a lesson?

  Professor Morrison: It is hard to say precisely who is responsible for the financial crisis, but there were clearly some failings in some supervisory institutions and one of those was the FSA. I should say that, to the extent that it experienced problems, those problems came from two sources. The first was the fact that it has culpability both for conduct of business and for financial supervision and, to some extent, and the FSA has acknowledged this in recent years, it over-emphasised the conduct of business at the expense of financial supervision. The second problem the FSA had, which it has also acknowledged, is that, possibly by virtue of the way that it is constituted, it was concerned largely with understanding the risks at the level of the individual firm and, whilst the risks at the level of an individual firm could each look perfectly acceptable, combining those things and thinking about them in the aggregate could sometimes generate a picture that was much less attractive, and I think the FSA and other supervisors in this country sometimes failed to focus on the aggregate picture or the macro-picture, what we now call the `macro-prudential'.

  Q3  Chairman: Dr Alexander, what should be the priorities for financial regulation in the future?

  Dr Alexander: Well, I think financial regulation needs to focus more on the broader financial system, as we have seen it set forth in the Turner Report, focusing on systemic risk. One of the major failures in regulation over the last ten years certainly in the US and in the UK has been that the 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 total financial system. The regulator thought that, if individual firms were okay and seemed to be managing the risk appropriately, then everything was fine. We now need to link that, and micro-prudential regulation is fine, but it needs to be linked with a robust macro-prudential framework.

  Q4  Chairman: Dr Lilico, the next financial crisis is likely to arise from the same source as this one. Lord Turner, on 18 March, set out his stall for the future, but are the FSA just closing the stable door after the horse has bolted, or is it ahead of the curve here?

  Dr Lilico: I think it is always very difficult to anticipate what the next financial crisis is going to look like. My view is that the Turner Review has drawn some of the wrong sorts of lessons in ways which mean that it is unable to see the right kinds of lessons, so, in particular, I think that it is a mistake. We have a set of financial regulations which grew out of certain assumptions which were then interpreted through economic theory so as to produce some recommendations, so he decided that those recommendations did not produce the results he liked, and what the Turner Review then did was to ditch the economics. I would rather have kept the economics and challenged the assumptions. In particular, I think there are two kinds of assumptions worth challenging. One is the idea that it is a net gain to replace individual diversified analysis by shareholders, depositors, purchasers of retail financial products with regulatory badging, and the other is that you reduce systemic risk by co-ordinating internationally.

  Q5  Mr Fallon: One of the other aspects of Turner, which now seems incredibly fashionable, is that capital should be held on a counter-cyclical basis. How should that be done? Should that be done in a discretionary way, or should it be more formulaic, as is done in Spain?

  Dr Alexander: I think that you have to have a combination of rules and discretion, and the rules need to provide reference points or guidelines for regulators. The reason I say that is that in other jurisdictions in Europe the regulators, by law, are 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 principles of due process and constitutional law, so, when we get into the rules versus discretion debate, I think we have to have a balance between both. I would simply say that Europe needs to be working from the same playbook and you need to have a rules-based framework in place, but yet it needs to be flexible enough to change as market conditions change, but regulators need to learn as markets evolve and take advantage of innovations that occur in the market.

  Q6  Mr Fallon: Yes, but the rules did not change in Spain or in Canada; they were simple and fairly straightforward and people kept to them.

  Dr Alexander: Well, the regulators did change them, I think, in 2004 because of pressure from the banking industry, but you are right, that generally Spain had counter-cyclical rules which basically led to their banks having more capital than other banks in Europe and, therefore, they were able to withstand the crisis much better, they were not getting bail-outs from the Central Bank. I would suggest that the FSA in the UK and other Member States in the EU ought to have counter-cyclical rules as well, and they need to be formulaic somewhat, but there needs to be discretion built into it to adjust to market conditions as they change.

  Professor Morrison: I agree that there is a need for a focus on rules-based systems, and ideally they should be as simple as possible and as hard to bend as possible, but one very good reason for rules-based regulation is the one that has been pointed to by people like Charles Goodhart, that in times of boom it is incredibly difficult to put the brakes on when a rule gives you something to refer to and, to the extent that discretion is built into the system, it is incredibly important that the people have the right to exercise discretion, have the right incentives and are accountable, otherwise, I suspect, counter-cyclical regulation will simply have little effect.

  Q7  Mr Fallon: How do we reflect counter-cyclical requirements in the banks' accounts?

  Dr Alexander: In the accounting standards for reporting?

  Q8  Mr Fallon: Yes.

  Dr Alexander: I am not an accounting expert, but I believe that one of the things the banks are going to raise is that, if they have to set extra capital aside, they do not have to report it as profit and pay tax on it if they are just having to hold it, so, if we could allow them some flexibility to set capital aside, reserve capital, and not to have to report it and pay tax on it, then they may be more willing to do that. If they, however, put this in the profit and loss statement and pay tax, then they are going to want to pay dividends, so I think we need to be flexible on how we allow the banks to set aside reserve capital.

  Q9  Mr Fallon: So the accounting treatment for banks is going to have to change? Is that right?

  Dr Alexander: Possibly, yes, for banks that are subject to prudential regulation, we need to change it in this situation.

  Q10  Mr Fallon: Overall, Dr Lilico, are we going to be, or should we be, seeing banks holding much more capital than in the past?

  Dr Lilico: I think the likelihood is that we will see banks holding more capital than in the past, but, as much as anything, I think that that would be a reaction by the market to the circumstances that other people have learnt some lessons, and one should be wary of over-reacting at the regulatory level until you have some idea of how the market itself is going to react to circumstances.

  Q11  Sir Peter Viggers: You have, quite interestingly, danced away from the question, saying the market should lead, but I just wonder what you can bring to the table in terms of assessing how much capital banks should have. Can you contribute by suggesting what is the optimal level of capital for a bank?

  Dr Lilico: My view is that it is useful to have rules, but what I think it is more useful to have is guidance numbers, so I think that prudential regulation is the proper pair to the lender of last resort function. What is happening in prudential regulation is that the Central Bank is deciding whether the institution that it is supervising is a worthy recipient of lender of last resort at a pinch, so I think that means that in normal times it is useful to have some guidance as to what you think is about right for people to hold, and that is a judgment, but that, once you come to difficult periods, such as that from 2007 onwards, I do not believe that formulaic capital adequacy requirements have any role at all and I think that they should be abandoned, so I do not think you could hope to devise a rule that would apply in good times and bad.

  Q12  Sir Peter Viggers: But Basel I and of course the Turner Review are looking at ratios for core tier one and tier one capital and so on, but you would not place a great deal of reliance on those?

  Dr Lilico: I think that those are useful indicators. I think that it is a mistake to try to have exactly the same rule apply everywhere in the world. The Basel I framework arose at a time when there was some scepticism about the way that the Japanese were treating their capital and I am not convinced that it turned out that the Basel I framework improved the situation for Japan. I think that there is an issue of discretion which is around how the Central Bank interacts with its own system of banks that it is overseeing.

  Q13  Sir Peter Viggers: Dr Alexander and Professor Morrison, would you agree with that?

  Professor Morrison: I agree with much of it. The capital regulation, I think, should be as simple as possible. There is a case for some simple rules on things like tier one and core tier one ratios and, at the same time, one should be prepared to relax those requirements in an extreme crisis. However, in an extreme crisis those ratios never bite; the market demands far higher capital requirements before it is comfortable with a bank in a time of crisis than the regulators do. Actually, this is one of the problems with counter-cyclical regulation, that, when you attempt to relax capital requirements, the regulator relaxes capital requirements and it may have very little effect because the market is requiring such massive levels of core capital. One of the problems we have had, however, with capital regulation has been an excessive reliance on highly technical models that feel like the national science's, but in fact are not, so we rely on parameter estimations and things like correlations and so on and this is according a level of scientific validity to these theories which they do not have. They are very useful tools for managers, but whether they should be hard-wired into regulation is a very moot point, in my opinion.

  Q14  Sir Peter Viggers: Just moving on a bit, what types of capital should feature in the calculations?

  Dr Alexander: I think core tier one capital should be expanded, and of course the definition of `core tier one capital' should be the ability of the capital to absorb losses fully, and that is mainly common equity shares. If you get into preferred shares or subordinated debt, those types of capital have a more limited ability to absorb losses. What we want banks to have is not necessarily such high capital charges, but that they have good-quality tier one capital that composes most of the regulatory capital that they are holding. One of the problems in Europe is that you get different definitions of the type of capital that banks hold across Member States in the EU and the Capital Requirements Directive does not adequately address that. The point is that the definition of `capital' should be linked to its ability to absorb losses.

  Q15  Sir Peter Viggers: What I am hearing is a message that an abstract approach to this issue should be treated with extreme caution, but the Turner Review suggests that trading book capital requirements might increase by a factor of three. Would you like to comment on that rather specific and concrete suggestion?

  Professor Morrison: There is not doubt that trading book capital requirements, I think, are too low. The rationale for having lower levels of capital for trading book instruments is that a troubled bank can sell those instruments rapidly and, hence, does not retail as much capital, but actually we have discovered recently that, at the time you most need to sell those assets, they may be extremely illiquid because no other bank is prepared to purchase them, so that is one reason why more capital against those instruments might be held. Another is that the liquidity of these instruments is not a fixed and permanent number, it is something that depends on the expectations and the behaviour of market participants and those expectations and behaviour change in response to things like capital regulation, so it is quite conceivable that more capital will actually up the liquidity. Whether the right number is three, two or four, I do not know, but I believe that capital requirements should be much higher for the trading book.

  Q16  Sir Peter Viggers: From your earlier remarks, would you agree that the financial sector has relied too heavily on abstract models developed by mathematical experts at the expense of old-fashioned commonsense?

  Dr Lilico: I think that mathematical models can be very valuable and that they can provide important insights to those who are making regulatory judgments and are useful guidance, so I think it is a mistake to think that the crisis tells us that the mathematical theories and the mathematics of economics should all be abandoned and are proven to be invalid, but, on the other hand, I think that it is always useful in regulation to be humble and to understand that there are limits to your understanding as a regulator, so you must not think that you can produce some model which enables you to decide on exactly what the right kind of thing to happen is.

  Q17  Sir Peter Viggers: As to the division between the banking book, old-fashioned banking, if you like, and the trading book, which has been called the `casino' element of banking, when one puts to bankers that there might be some kind of division more clearly drawn between these two aspects, the banks tend to say, "Well, it's actually much more complicated than that. It's all shades of grey rather than black and white". How would you comment on that?

  Dr Lilico: I do not think that it is necessary or desirable to divide up the casino banking from the utility banking. I also think that it is a mistake to imagine that the utility banking is likely to remain unchanged by these events. I offer, for example, the point that, even if you go back to before the madness of the bonds market to 2004, 30% of income to the European banking sector from the non-wholesale customers was mortgages, and I do not think that that is going to continue in the future.

  Q18  Mr Fallon: If we could return to European regulation, whilst the fiscal responsibility for bail-outs and depositor protection remains national, why should we accept some supra-national power to override national regulators and their responsibilities?

  Dr Alexander: I would say because the externality is cross-border. 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 we displace national regulators, it simply means that we involve regulators at the national level having more accountability to a committee of supervisors consisting of the Member State regulators themselves so that there is more co-ordination at the European level.

  Q19  Mr Fallon: But that is not the proposal. The proposal is not just for surveillance, the proposal is that, under certain circumstances, the national regulator should be overridden and there should be binding mediation on the Latvian regulator or whoever it is. It is not just surveillance, what is being proposed, it is override.

  Dr Alexander: Well, it is override regarding the application of EU law. If there is a dispute regarding how the Capital Requirements Directive is being applied, there certainly needs to be a European policy input regarding how the CRD is being implemented by, say, the UK or Spain or Poland. In the past, it has just been up to the Member State to do whatever they wanted to do for the most part and it has been impractical to call a Member State to account.

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