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Too important to fail-too important to ignore - Treasury Contents

3 Evolutionary reform

48.  There has been a great deal of emphasis on using existing tools to make the system safer. The G20 Pittsburgh Leader's statement made the following progress report: "Substantial progress has been made in strengthening prudential oversight, improving risk management, strengthening transparency, promoting market integrity, establishing supervisory colleges, and reinforcing international cooperation".[43] This chapter examines some of these evolutionary reforms.

Better risk management

49.  We were told that the quality of risk management had been one of the factors determining whether or not a firm survived. Mr Corrigan, Managing Director, Goldman Sachs, made a distinction between risk monitoring and risk management. He suggested that risk monitoring at some financial firms appeared not to have been sufficient and this would have made it harder to manage risk in general. As he said:

[ ... ] one of the clear lessons that emerges is that we must all, first of all, do a better job of recognising the distinction between risk monitoring and risk management. They are two different things. Risk monitoring has to do with getting the right information to the right people at the right time. Risk management has to do with what you do with the information once you have it. I would suggest, Chairman, that casual observation across major financial institutions over the period of the crisis suggests to me that there were important failures in risk monitoring that by their nature suggest to me that risk management would suffer accordingly.[44]

50.  However, our inquiry raised questions as to whether there were limits to the effectiveness of current risk measurement practices. Professor Goodhart told us that "speaking as an economist, I do not think we economists have done very well in actually providing a proper measurement of risk or an analysis of the dangers of default and how the financial systems should be constructed. The theory and analysis in this field is not as good as it should be."[45] Professor Kay was even more pessimistic. He stated that "last week I gave a talk whose essential theme was that I no longer believed the theories of risk and risk measurement and management that I have been teaching for 20 years of my life".[46] The Governor was also cautious as to how effective attempts to measure risk would be:

in any risky activity—which we want people to engage in: we want innovation, we want the real economy to be prepared to take risks—things will happen that we cannot even easily define or imagine, let alone measure today. If that is the case, the idea that you can always approach regulation in terms of saying, 'We know all the risks that are being taken. We can calibrate them precisely, measure them and work out the precise capital requirement,' it simply will not work. For some risks, you can behave in that way; but for other things, unexpected events will come along, and the lesson from that is to create a resilient system.[47]

51.  In contrast, Mr Varley of Barclays was confident that:

I think we can measure risk. In a sense, who am I to contradict such august commentators. I just talk about risk in Barclays. Can we measure it? Yes. Do we measure it? Yes. Do we conduct stress tests on a very regular basis so that we can model the impact of a macroeconomic set of assumptions on Barclays loan books and market risk? We do that on a very regular basis. We have to be able to do that.[48]

Mr Sáenz of Santander, was however more nuanced in his reply, noting the need for judgement, and failures in the past:

For measuring risk there are two main elements. First, we can measure risk with models, with analytics, with systems we have at hand in our organisations, depending on the kind of risk. There are many kinds of risk: credit risk, market risk, liquidity risk, reputational risk, operational risk, so if you think about the main risks we are talking about, which are the credit risk, the liquidity risk and market risks, all three can be reasonably measured with the tools, with analytics, with models, but always with personal judgment. I would like to insist that personal judgment in measuring risk is important so prepared, educated, trained people in the risk management area are fundamental to measuring risk.[49]

52.  Lord Turner felt that improvement in risk measurement was possible, but that perfection was not. He too thought that judgement would always be necessary:

Within institutions we were often led astray in the past by apparently sophisticated mathematical tools like value at risk which purported to suggest that we had a precise fix on how much risk there was on trading books. Both bank management and regulators took far too much assurance from that apparent mathematical precision and failed to realise the inherent uncertainties and pro-cyclicalities of that approach. We can get better at it but we will never achieve perfection because the key point is that in the trading area in particular however we define the probable distribution of future potential risks it is inherently uncertain and not susceptible to precise mathematical modelling[ [ ... ].[50]

53.  In effect, there are two different approaches to risk. One deals with what might be called the "mathematical" components of the risk, analysing the impact of various defined scenarios, and looking at their likelihood. The other recognises that, however thorough the modelling, there can be no certainty about future events, and that nothing can be ruled out. Risk is knowable; uncertainty is not.

54.  It is clear that many financial companies could and should improve their risk monitoring and their risk management. But we agree with those who consider risk measurement is an incomplete science, and that there will always be significant uncertainties. Judgement will always play a role, and error is always a possibility, whether it be by firms or regulators. The possibility of the failure of a bank, or number of banks, always remains. Indeed, over time, it is certain that such failures will occur. While it may always be desirable to reduce risk, the primary objective of reform should be to ensure that the system is resilient if failures occur.

55.  We must also be wary of 'survivor bias'. The firms that have made it through the crisis have much to teach us on how to build more resilient banks. But we must also recognise that a shock or event of a different nature would probably have resulted in different survivors.

56.  Better risk management may go some way to meeting our objectives, but it cannot remove the risk that Governments will have to provide support for the sector. It can only guarantee a stable flow of lending to the economy if financial firms can consistently immunise themselves from the enthusiasms of the market or the failures of their own judgments. We do not believe this is possible.

Better supervision

57.  Better supervision was also proposed as a way to reduce the risk of future crises. Mr Sáenz told us that in his view supervision was "even more important than regulation".[51] He went on to note that Santander had in its head office in Madrid "roughly 60 people permanently standing there and following [its] operations".[52] This meant that "90% of the entries [Santander] do into [their] ledger are supervised real time by [their] supervisors in terms of affecting the P & L, affecting the capital, affecting the reserves, affecting the tax consequences of this entry, affecting whatever and affecting how you account for it".[53] Mr Sáenz, was confident of the benefits of such close supervision. He told us that:

if the kind of supervision we have had been in place in Lehman Brothers then at least the measurement of the consequences of the bankruptcy would have been much better enumerated and we would have known much better what was going on after the intervention or after the bank collapsed, and all these things would be much more at hand. The kind of purpose that the living wills now are trying to give, I do not mean that it would be completely solved but the degree of understanding and knowledge of the institution would have been much better.[54]

He considered that post-liquidity crisis bail-out and management would be much easier as a result of better supervision.[55]

58.  Others were also keen to criticise the previous application of the regulations. Mr Corrigan identified a failure of regulators to act early enough, despite having the capability. He told us that "in virtually all jurisdictions the authorities already have the capability to step in, order an institution to shrink its balance sheet, cut its dividends, et cetera I think that one of the failings of the past has been that this so-called doctrine of prompt corrective action, stepping in early, was much more a slogan than it was a practice. We have to change that."[56] These sentiments echo the arguments we made at the time of our report into Northern Rock, where we saw great merit in the 'prompt corrective action' approach.[57]

59.  Regulation of cross border entities relies on cooperation between regulators in different countries. On our visit to central and eastern Europe we were told that as a result of the crisis, colleges of regulators were working far better than before. Formerly, meetings had largely been formal and infrequent. Now there was much more engagement. Cross border regulation has improved as the risks posed by cross border banks have become more obvious.

60.  However the Governor of the Bank of England warned against relying on regulators to ensure that the financial system was completely secure, as it was inevitable that at some point, everyone would get something wrong. He provided the following example to illustrate his point:

if you take Citibank, the biggest bank in the world, five years ago, if we had all gone to New York, we would have been met by people on Wall Street who felt that Citibank was the model to follow and they were worried about whether they could keep up with it. In that intervening period with Citibank, there have been regulators all over it. There were dozens of regulators living and working inside the building, not just living in a separate building reading annual reports, but they were actually in the building. Look at the senior people who worked in Citibank. Four of the most respected people in the world of finance were at the top of Citibank: Bob Rubin, former Treasury Secretary, Chief Executive of Goldman Sachs; Sandy Weill, one of the most streetwise Wall Street people; Bill Rhodes, who has seen every emerging market debt crisis for 40 years; Stan Fischer, one of the world's most respected economists and number two at the IMF. Those four people did not set out to destroy Citibank. Things happened and events changed in a way that they realised too late that they were taking large risks. Now, the regulators did not spot it and the people in the management did not spot it. I think we have to accept that, when you get a very large, complicated institution like that, from time to time, through no one's fault, things will happen which means that the strategy that they took turns out to have been badly wrong.[58]

More damning was comment by John Kay, who in a note commenting on questions regularly asked of him, when asked whether better regulation would prevent major financial institutions from engaging in excessive risk taking in future, replied "If you believe that, you will believe anything".[59]

61.  We note a single regulatory system has its own dangers. As we have seen, some of the regulatory assumptions in use before the crisis have proved mistaken. The more consistent a system is, the greater the danger if it is consistently wrong. Hector Sants, Chief Executive of the FSA, in a speech in November 2009, acknowledged the limitations of the regulator, and expressed a desire to achieve a more desirable culture in financial services:

I believe it is important to recognise that there are limits to what regulatory rules can achieve. It would be a mistake not to recognise that some of the failures which have occurred have their roots in issues of culture and behaviour. However, whilst progress has been made in the global debate on prudential rules, this fundamental question of ensuring the development of the right industry culture, has not been adequately addressed—no doubt because of the difficulty of both defining the problem and the solution. However, this must be tackled if we are to truly address all of the issues. Real reform requires both change to the regulatory rules and change to the industry's culture. Expressions of acceptable ethical frameworks exist in a variety of guises. There are numerous thoughtfully articulated industry codes. The problem is not so much about defining the ethical framework but rather the issue of identifying and encouraging the right cultures which ensure their application. The FSA believes that such issues are potentially so important to improving governance that we, as the regulator, should try to take them into account. We recognise that there is no single ideal culture across the financial services industry, and that all cultures are likely to have good and bad aspects. Our aim would, therefore, be to seek to facilitate the creation of good cultures and intervene when bad ones seem to be creating unacceptable outcomes.[60]

62.  A more active and effective regulator will, of course, be beneficial, as would a change in the culture of financial services. But we must accept we will never have a perfect regulator. So while better supervision may reduce the probability of firms failing, it will not eliminate it. Regulators are as prone to herd thinking and belief in current wisdom as those they regulate, and are under pressure to be so. The chance of a catastrophic failure within the financial system will remain, and Governments will remain obliged to provide emergency support.

63.  One of the concerns about relying on 'better' supervision is that firms and consumers begin to believe that the regulator, rather than the firm, should be monitoring the risks being taken in the firm. When we asked Lord Turner about this, he replied that:

I think there are enormous dangers if we get it wrong that both regulators will not be good at making these decisions and that in some circumstances we can increase moral hazard. For instance, if we have product regulation at retail level there is a danger that the regulator has said, "Trust me, that is a good product." [ ... ][61]

Moreover, the more intensive regulation is, the more the regulator has to make difficult choices on the basis of inadequate information:

[ ... ] we do not have easy answers. We have gone through a period of believing in wholesale markets and that because something is the product of a free market it must be a good development. That has been our very strong assumption in the FSA. We have therefore been insufficiently searching about some of the risks involved in complex structured credit and CDS and over-amenable to arguments that we should not regulate because if we do liquidity will be driven out of the market. We have to shift that philosophical assumption to being willing to accept that there may be some things that are socially or economically useful but without having any easy algorithm, rubric or rule that tells us what it is. I think we are just in a much more difficult space and people do not like that; they like nice easy assumptions.[62]

64.  The more the regulator is expected to make difficult judgement calls, the greater the lack of clarity about who is in fact responsible, regulator or market participant. This reduces the incentive on market participants to consider and assess the risks they take. Moreover, such an approach increases the likelihood that company failure will be seen as regulatory failure, for which some market participants should be compensated. We fully support the principle that victims of maladministration by public bodies should be compensated. However there is a real difference between the losses caused directly by the actions or failures to act of public bodies, and losses attributable to the misfortune or mismanagement of a private body. The more regulators are expected to second-guess those they regulate, the more blurred this distinction becomes.

65.  Regulators can never be fully effective. Individual companies are responsible for their own actions. We must be careful, when considering a more active regulator, not to overly raise either consumers' or financial firms' expectations of its role. The regulator can not and should not replace due diligence by market participants. A system which assumes that regulators can be completely effective reduces the incentive for market participants to monitor the risks they are taking, whether they are banks, investors in banks or counterparties. Furthermore, such unattainable expectations raise the risk that should financial firms fail, the regulator will be found liable, and the Government will once again have to foot the bill. This, in turn, reduces incentives for consumers to monitor their own risks and ensure they understand their investments. The regulator is not the first but the last line of defence.

The Basel reforms


66.   As a result of the worldwide drive for reform, the Basel Committee on Banking Supervision is consulting on capital and liquidity reform. On 17 December 2009, it described its proposals in a press release. They included:

1. Raising the quality, consistency and transparency of the capital base. This will ensure that the banking system is in a better position to absorb losses on both a going concern and a gone concern basis [ ... ]

2. Strengthening the risk coverage of the capital framework. In addition to the trading book and securitisation reforms announced in July 2009, the Committee is proposing to strengthen the capital requirements for counterparty credit risk exposures arising from derivatives, repos and securities financing activities. The strengthened counterparty capital requirements will also increase incentives to move OTC derivative exposures to central counterparties and exchanges. The Committee will also promote further convergence in the measurement, management and supervision of operational risk.

3. Introducing a leverage ratio as a supplementary measure to the Basel II risk-based framework with a view to migrating to a Pillar 1 treatment based on appropriate review and calibration. The leverage ratio will help [ ... ] introduce additional safeguards against model risk and measurement error. [ ... ]

4. Introducing a series of measures to promote the build-up of capital buffers in good times that can be drawn upon in periods of stress. A countercyclical capital framework will contribute to a more stable banking system, which will help dampen, instead of amplify, economic and financial shocks. In addition, the Committee is promoting more forward-looking provisioning based on expected losses, which captures actual losses more transparently and is also less procyclical than the current "incurred loss" provisioning model.

5. Introducing a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio. The framework also includes a common set of monitoring metrics to assist supervisors in identifying and analysing liquidity risk trends at both the bank and system wide level.[63]

67.  We note that even the Basel reforms will depend on reforms in other systems, such as in international accounting standards. Despite this, the Governor of the Bank of England explained why capital and liquidity reform would be useful:

The banking sector is running with a much smaller amount of capital and a tiny amount of liquid assets in comparison to the banking system of 40 years ago, and that inherently makes it more unstable, so more capital makes some sense. It is not an answer in itself because the only logical capital requirement that removes all risk is a 100% capital requirement.[64]

Mr Sáenz felt that liquidity reform, currently being worked on in Basel, would be of particular importance:

my personal experience[ ... ] is that in the field of credit risk or other risks we have been very accurate in general but in the liquidity risk we have had some flaws. In fact the recent crisis has been a liquidity risk translated to, let us say, a credit risk, and in the liquidity field we have to work harder in the future..[65]

68.  However, others stressed that the Basel process would not be a panacea. Professor Kay was adamant that this reform would not be suitable. He explained that "frankly, in saying we need better rules from Basel is just the familiar story, that when the snake oil does not work, people tell you that what you need is more snake oil and there ought to come a point at which we say, 'Well, I think we'll try something else instead.'"[66] When it was put to him that experience of the Basel II reforms "do not exactly give you a great deal of confidence that Basel III will solve the problem" even Mr Corrigan replied "I have some sympathy with that".[67] Mr King warned us that "It is all about recognising that tinkering with capital requirements may not be enough, that the structural changes will also be important".[68] He questioned the sufficiency of the reforms:

the spirit, I think, of the reforms that are needed is not to pretend that, by imposing the right balance of taxes and capital requirements, banks will be persuaded not to take too many risks, but it is to recognise that from time to time things will happen that we cannot prevent or imagine or calibrate the risk of in advance.[69]

He also noted that "One of the reasons why capital alone will not work is because banks can just take more risks to offset a higher capital requirement, getting you right back where you were before".[70]

69.  Mr Sáenz also drew our attention to the cost that the current Basel proposals may inflict upon the banking system, and how that would then impact on the real economy:

Yes, we have rough draft figures—very rough ones—taking into account if all these elements that are being discussed under the Basel 3 umbrella are put in place, extra capital requirements with extra liquidity requirements et cetera et cetera, all these elements, without knowing exactly what will be the thresholds for every element, I will be very honest, it will be a heavy burden on the profitability of the banking system or the banking industry. There are several consequences that we all have to determine, firstly how will this affect the supply of credit because it is not easy to have that weight. Secondly, how will it affect the cost of credit, not only the supply? Maybe the cost is not so important, it depends who you are; if you are a competitor the cost is important, so that is the second element. Thirdly, what is going to be the profitability of the industry and ourselves with the new requirements. I would say that altogether it is an equation that is difficult to give a final say on.[71]

Professor Lamfalussy though was unfazed by the potential costs of reform. When asked whether a higher cost of capital was a concern, he replied "I think it would be very helpful to increase the cost of capital."[72]

70.  Mr Varley though was keen to reassure us that the process of strengthening the financial system via items such as the Basel process could be made to work:

I do not think we should be fatalistic about this crisis. We should have confidence that we can create an infrastructure in capital and in liquidity, in regulation broadly defined, that creates much greater resilience in the future. I feel that we should be self-confident about our ability to do that because the learnings have been so painful."[73]

71.  Capital and liquidity reform is on its way. It will, at best, ensure a lower probability of default, and a lower loss given default, for financial firms. Higher capital and liquidity requirements will also impose a cost on firms and their customers. They may go some way to meeting our objective of an appropriate correlation between risk and reward. We also consider that more emphasis on anti-cyclical capital requirements should go some way to ensuring a more stable supply of credit to the real economy. We welcome this even though the changes will also result in lower profits to banks and higher costs to consumers. Banks taking advantage of differing regulatory environments may limit the scope for such action.

72.  However the financial crisis occurred despite repeated attempts to reform the capital and liquidity regimes. The lessons of this and preceding crises can be used to improve the capital and liquidity regimes, but that will at best be only a contribution to the wider structural reforms that are required.


73.  The Basel Committee is consulting on a leverage ratio. In its written evidence, the British Bankers' Association acknowledged that excessive leverage appeared to have had a role in the crisis:

While the circumstances of each failure differs, a common theme appears to be high leverage with undue reliance on short term wholesale funding. Banks that are less reliant on short term funding have found it easier to restructure their business mix.[74]

Mr Corrigan pointed out that financial firms were themselves were taking action in this area. He noted though that:

institutions both in the United States and elsewhere and through the [Bank for International Settlements] discipline are now publishing and paying more attention, as they should, to so-called leverage ratios. Again, if you look at leverage ratios at the end of, say, 2009 at Goldman Sachs, which is broadly representative of other firms as well, they are now in the range of 12% or 13%, which is about half of what they were prior to the crisis.[75]

74.  If excessive leverage is a potential source of weakness, demanding that financial firms meet a given leverage ratio could act to limit the weakness. Piergiorgio Alessandri and Andrew Haldane made a case for such a ratio in their speech in November 2009. They noted that:

This is an easy win. Simple leverage ratios already operate in countries such as the US and Canada. They appear to have helped slow debt-fuelled balance sheet inflation. The Basel Committee is now seeking to introduce leverage ratios internationally. To be effective, it is important that leverage rules bite. They need to be robust to the seductive, but ultimately siren, voices claiming this time is different. That suggests they should operate as a regulatory rule (Pillar I), rather than being left to supervisory discretion (Pillar II). It is important, too, that leverage limits are set at the right level. Such limits need to be fundamentally re-evaluated. We have sleepwalked into a world in which leverage of 20 or 30 times capital is the rule rather than the exception.[76]

Professor Goodhart was also supportive of the concept of a leverage ratio on top of the Basel proposals for liquidity and capital regulation. He explained that:

I think it is very sensible for Basel to adopt a leverage ratio as well, because a leverage ratio effectively says we cannot measure risk very well but what we do know is that, if credit is expanding wildly, there are potential dangers around there; so I think there is advantage in a belt and braces approach where you do try and measure risk as best you can, which is, if you like, Basel II. Then you add to that a leverage ratio which says, 'We are not very good at doing this but we know that if credit is expanding wildly there can be problems ahead', so you put the two together.[77]

75.  Others though were critical of the concept. When asked whether he thought there should be leverage ratios, Mr Flint replied:

No, I do not believe so. I say that because a leverage ratio is simply one accounting number over another, and while I think it is a useful metric, the complexity of getting definition over the scope of consolidation and the risk would be that leverage would be taken in the products rather than on the balance sheet. It is a useful tool to look at but it is not a panacea. One could get seduced into thinking that one had made a great leap forward in terms of control when in fact it had not done very much. It is worth looking at. I think the three things to look at are capital ratios on an unweighted basis, which is your leverage ratio, capital ratios on a risk-weighted basis, and then liquidity, which is probably best expressed through the ratio of advances to deposits, ie to what extent are you dependent on wholesale funding?[78]

Mr Sáenz told us a leverage ratio:

[ ... ] is acceptable but it is not very sophisticated because the leverage ratio is a very basic kind of ratio so it does not qualify the kind of risks you have in the assets, and that means that the weight is similar. In high risk or low risk the weight is similar and you have the collateral. In a battery of different ratios I would say one of them, but at the bottom of the list, would be the leverage ratio. But I and in general my colleagues, at least in Europe—in the States it is different, in the States they like that, maybe because of their history and because they have had the habit of living with that leverage ratio for a long time—do not see the interest, what special information will give you this leverage ratio. We do not think it is very practical.[79]

Mr Corrigan of Goldman Sachs, when asked whether he supported leverage ratios, told us that:

Yes, but not in statutory terms. In the United States there is a statutory provision in the House Bill that as a matter of law they establish a 15% leverage ratio. I do not like the idea of that being a matter of law at all because who knows what the future will bring. I certainly do believe that Basel capital rules could be broadened out to include a leverage ratio. A leverage ratio only deals with so-called balance sheet leverage. In other words, the ratio of capital however defined to assets. A leverage ratio does not deal with what I like to call "embedded leverage". That is the leverage that is embedded in various classes of financial instruments, including certain classes of derivatives. We have to be very careful that, while we institutionalise some form of leverage ratio, we all are sensitive to the fact that embedded leverage may well be more of an issue than a so-called balance sheet leverage. This is where this idea of higher capital liquidity standards becomes so very, very important.[80]

76.  Given that capital and liquidity reform will not be sufficient, and that leverage appears to be an indicator of potentially increasing risk, we support the introduction of a leverage ratio. Such a ratio does not adjust for risk, and thus is not satisfactory on its own, but it is a useful addition to (inevitably imperfect) risk weighted measures.


77.  One of the reforms announced by the Obama administration in January 2010 has been a Financial Crisis Responsibility Fee. The fee is designed to last for 10 years, or longer if necessary, to ensure the full pay-back of money in the Troubled Asset Relief Programme (TARP), the US measures to combat the crisis in the financial system.[81] According to the White House press release, the fee "would be levied on the debts of financial firms with more than $50 billion in consolidated assets, providing a deterrent against excessive leverage for the largest financial firms".[82] In this, it has some parallels with the Basel Committee's leverage rations. Over sixty percent of revenues, from the measures, expected to be $117 billion over about 12 years, and $90 billion over the next 10 years, will probably be provided by the 10 largest financial institutions.[83] We discussed the US levy's impact with Douglas Flint, HSBC. He noted that:

We have only seen the sketchiest of details. Clearly if there is a levy on wholesale funding, there would be a cost to us of paying that levy, although we have, relative to virtually all of our peers, significantly less wholesale funding in our business model than anyone else, so there would be, on the first level, a cost to pay. I think one would need to analyse what the levy was designed to achieve. I am not saying it is not an idea worth considering, I think it is, but it would have a modest cost to us.[84]

78.  The US fee is an example of an ex-post fee, paid after a financial crisis, to cover the cost of the Government's actions to assist the financial sector. Professor Kay was in favour of such a redistribution, but had a cautionary note: "I am in favour of getting back as much of the costs of what we have done in the public purse from the people who are responsible for it, but in relation to any of these kinds of levy proposals we have to ask who is actually going to pay the actual costs of these levies in the end. We need good answers to that."[85] Paul Tucker was supportive of the US levy. He told us: "I quite like what the President has done, because I aired similar thoughts in a speech nine or ten months ago".[86] He then outlined some of the benefits of a more permanent ex-post levy, than that proposed by the President:

I think that is the least we should do, for two reasons. First, unless we can rule out the state ever having to step in and support the banking system as a whole, which I frankly doubt, then we have to think about how the state will put some of the cost of that back on to the banking system. I suspect it would never be all of the cost, because the serious cost comes in the macroeconomic deterioration. Secondly, if the better banks, whoever they are, know that if the weaker banks fail they are going to pick up some of the tab, then it is not enough for them to cut their own exposures because the mess is going to come back to them via another route, and I think that is a fairly healthy thing. That is a minimum set of provisions. I would call it 'capital of last resort.' Unless you can rule out capital of last resort, then we had better think about how we would organise it when we do it. This is essentially for finance ministries.[87]

79.  However, Professor Goodhart was in favour of an ex-ante levy, rather than one designed to recoup losses after the event. He explained his thinking as follows:

I would have liked the levy to be more finely directed so that the levy goes to the short-dated wholesale liabilities rather than to the longer dated. Again, if you are going go down this kind of route, it ought to be ex ante rather than ex post [ ... ].[88]

The Governor of the Bank of England also discussed an ex-ante insurance levy's advantages:

the idea of a levy is not dissimilar to raising capital requirements, though it has merit in that it can bite in helping to produce revenues that might reduce the national debt in good years in order to help finance recoveries, if they are necessary, in bad years. If you were going to have a levy like that, I think its purpose would be looking forward as an ex ante proposition, it would be a tax on the balance sheet excluding insured deposits, as the US has done, but it would also, I think, make sense to exclude contingent capital and to perhaps differentiate between broad classes of maturity structure of the debt liabilities in order to penalise the sorts of debt instruments which are responsible for the possibility of runs on the bank which justifies or provokes the intervention.[89]

80.  In a speech in November 2009, Mr Tucker presented some problems with an ex ante levy:

One possibility is to establish a fund in advance. Another is to raise a levy on the surviving banks. An argument in favour of the former is that it would raise contributions from risky banks before they fail. And it would allow the levies to be related to the size of their uninsured creditors, as some in the US have suggested. But I do just wonder whether it would be realistic to raise, and over the decades sustain, a sufficiently large fund.[90]

The Governor also set out the potential risks, as well as the potential advantages in such a levy:

The risk again, as with capital requirements, is that you encourage people to take even bigger risks so that, as with any kind of tax or levy of this kind, the right thing to do is obviously to try to make the levy specific to the risks of the individual bank, and that becomes very difficult and you start to chase your tail. It is worth doing some of it, but I come back to the point that one of the great difficulties in relying on regulation of the asset side of the balance sheet here is the idea that regulators can get it right.[91]

In its written evidence, the ABI was also less than supportive of the idea of a levy:

We are similarly wary of the introduction of a systemic risk levy because it would be extremely difficult to pitch a levy correctly, and to calibrate it to reflect the relative level of systemic significance of individual institutions. Moreover it could be difficult to ensure that any fund was actually used for the intended purposes. The proceeds could be used to pay down government debt or held in a separate fund which would invest in government securities. The accumulation of large funds could therefore simply lead governments to become less disciplined in their fiscal policy. More broadly if these levies are intended over time to cover the cost of a bail-out, they will create a moral hazard for regulators as well as banks. Both will know that there is money in the pot to cover their mistakes.[92]

Even Professor Goodhart warned that there were difficulties in an ex-ante levy:

[ ... ] One of the problems here, though, is that the markets' measures of riskiness are not actually at all accurate. Adair Turner continually points to the fact that CDS rates generally were at their lowest just before all this blew up in 2007, so that if markets could measure risk properly, then it would be relatively easy to use market mechanisms to apply to the levies. The problem here is that it is not just we cannot assess risk accurately, the markets cannot either, and that is one of the key difficulties.[93]

81.  The US proposal for an ex-post levy on the financial system to repay the Government for the support provided during the banking crisis has some attractions. It would meet the objective of reducing the costs to the US Government.

82.  An ex-ante levy, with ring-fenced resources, would also ensure there were resources in place at a time of crisis. Such a levy would, though, place additional costs on financial firms, and their customers.

83.  Ex-ante levies have also been mooted as a measure to curtail risk-taking. But it has been suggested to us that in the face of such a levy financial institutions may take on more risks, both because they believe they are covered by insurance and to recover at least some of the costs of the levy. There are also other proposals to curtail risk taking, and the cumulative effect of all these proposals must be considered, before determining whether such a levy is desirable to curtail risk-taking.


84.  We have previously recommended creating an ex-ante fund to pay for deposit protection in our Report The run on the Rock. Our conclusion then was as follows:

We believe that the 'pay as you go' approach to funding depositor protection, as currently used by the Financial Services Compensation Scheme, has two fundamental disadvantages. First, it does not create the requisite depositor confidence in the availability of a source of prompt funding, so fails to contribute towards financial stability. Second, a 'pay as you go' approach could cause significant pro-cyclicality problems. Such an approach could mean obtaining funding from banks at the worst possible time, whereas a pre-funded model could obtain most of its funding at times of plenty. [ ... ]. The principle that must underpin a future scheme is that it should be capable of coping with any foreseeable bank failure. We recommend accordingly the establishment of a Deposit Protection Fund, with ex-ante funding. [ ... ]. The establishment of a pre-funded scheme would be a significant cost to the institutions involved, but it seems only right to us that the costs of bank failure should be borne by the industry rather than the taxpayer, as would currently be the case. To ensure that the Fund is adequately resourced from the outset, we recommend that it be financed initially by a Government loan, which would then be repaid over time as banks' contributions accumulated.[94]

85.  Given that one of our objectives is to reduce the role for the Government in the financial system, and that protecting the consumer in the face of bank failure will always remain a priority for government, we continue to recommend that the deposit protection system should be pre-funded, despite the costs it imposes on firms.

Contingent capital

86.   The Governor of the Bank of England suggested the increased use of contingent capital. He explained both how such capital would work, and why it was necessary, in evidence to the Economic Affairs Committee of the House of Lords:

we at the Bank feel quite strongly that contingent capital—that is capital which banks raise which, when the bank starts to run out of money automatically converts to equity—is a very important part of the capital structure of the banking sector going forward because it does provide a way in which we are much less dependent on some regulator working out precisely what the right Basel ratio is; there is a big cushion of capital that can be converted to equity when necessary and the people who supply that—the creditors—will know that there are circumstances when they would bear the burden and would not just be bailed out by the government. So capital is one leg.[95]

Lloyds Banking Group recently issued some contingent capital, known as Enhanced Capital Notes. In a statement in November 2009, Lloyds stated that it would raise "Significant contingent core tier 1 capital" which would equate to additional core tier 1 capital of 1.6 per cent if the Group's published core tier 1 capital ratio fell below 5 per cent.[96]

87.  Douglas Flint of HSBC appeared lukewarm about the impact contingent capital would make on banks. He noted that:

I think it is an interesting concept in theory. I have yet to convince myself that there is a sufficient pool of capital out there that would be interested in buying such capital to make it a credible solution, other than for institutions that are already in difficulty and are converting existing subordinated debt or other debt to something that is contingent, ie, their bondholders are in a stress situation. I do not believe there is sufficient capital looking for that type of hybrid equity and debt return to be a meaningful part of the capital structure of banks. In theory it is an interesting idea, I just do not think it is big enough to be real.[97]

However, Mr Corrigan of Goldman Sachs was more positive. He told us that:

I think that the concept of contingency capital has a lot to be said for it. We have had a little experience again here in the UK with contingent capital in the very recent past. The thing that I worry a little bit about—you talk about belts and suspenders; this is going to be real belts and suspenders—is that if we institutionalise contingency capital I would hate to see it work in the direction of reducing the amount of core capital to keep in the first place. Again, it is one of those slippery slope things that we have to be careful with but if we can guard against the concern that it results in lower core capital to begin with I think it is a worthwhile concept.[98]

88.  Contingent capital has significant support in the Bank of England. It has also been used by Lloyds Banking Group. Yet market participants remain wary, either concerned there will be little demand if they issue such capital, or worried that it could diminish actual core capital. Experience will show whether these fears are justified. If contingent capital does place more risk back onto the financial market, rather than the Government, it seems likely to be useful in a crisis, and in addition gives its holders an incentive to monitor the banks in which they are invested, with the result that movements in the price of the debt on the market would be a source of information for the bank itself and for its regulators.

43   Leaders' Statement: The Pittsburgh Summit, September 24 - 25, 2009 Back

44   Q 289 Back

45   Q 69 Back

46   Q 70 Back

47   Q 171 Back

48   Q 216 Back

49   Q 406 Back

50   Q 462 Back

51   Q 414 Back

52   Q 415 Back

53   Q 415 Back

54   Q 420 Back

55   Q 421 Back

56   Q 308 Back

57   Treasury Committee, Fifth Report of Session 2007-08, The run on the Rock, HC 56-i, para 192 Back

58   Q 104 Back

59   'Narrow banking: FAQs', John Kay, p 3, , Jan 2010 Back

60   Financial Services Authority, Speech by Hector Sants, Chief Executive, FSA, Bloomberg, 9 November 2009 Back

61   Q 488 Back

62   Q 488 Back

63   Press release: Bank for International Settlements, "Consultative proposals to strengthen the resilience of the banking sector announced by the Basel Committee", 17 December 2009 Back

64   Q 94 Back

65   Q 406 Back

66   Q 17 Back

67   Q 325 Back

68   Q 163 Back

69   Q 101 Back

70   Q 94 Back

71   Q 456 Back

72   Q 575 Back

73   Q 186 Back

74   Ev 126 Back

75   Q 317 Back

76   A speech by Piergiorgio Alessandri and Andrew Haldane, Banking on the State, Bank of England, November 2009, p 12 Back

77   Q 72 Back

78   Q 391 Back

79   Q 457 Back

80   Q 346 Back

81   The White House, Office of the Press Secretary, President Obama Proposes Financial Crisis Responsibility Fee to Recoup Every Last Penny for American Taxpayers, 14 January, 2010 Back

82   Ibid. Back

83   Ibid. Back

84   Q 373 Back

85   Q 67 Back

86   Q 109 Back

87   Q 160 Back

88   Q 68 Back

89   Q 101 Back

90   A speech by Paul Tucker, Deputy Governor, Financial Stability, Bank of England, at SUERF, CEPS and Belgian Financial Forum Conference: Crisis Management at the Cross-Road, Brussels, The Crisis management menu, 16 November 2009, pp 13-14 Back

91   Q 101 Back

92   Ev 139 Back

93   Q 68 Back

94   Treasury Committee, Fifth Report of Session 2007-08, The run on the Rock, HC 56-i, para 263 Back

95   Oral Evidence taken by the Lords Economics Affairs Committee, 24 November 2009, Q 29 Back

96   RNS Number : 8298B, Lloyds Banking Group PLC, 3 November 2009 Back

97   Q 403 Back

98   Q 347 Back

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