Financial Services Bill

Memorandum submitted by Intellect (the trade association for the UK technology industry) (FS 04)

Critical omission from the Financial Services Bill – reducing the opacity of the financial system

Purpose of this briefing

Intellect, the trade association for the UK technology industry, believes that there has been a significant and potentially dangerous omission from the text of the Financial Services Bill, which the House of Commons standing committee is now considering.

The Government has failed to include a crucial recommendation put forward by the Joint Select Committee on the Draft Financial Services Bill in the final text that was published on the 27 th January. Specifically that:

"The Bill should be amended to place a duty on the Bank of England (or its subsidiary the PRA) to develop information standards for the UK financial services industry and to report regularly on progress in improving these information standards in order to support financial stability."

(p58, Final Report, Joint Select Committee on the Draft Financial Services Bill)

This recommendation is a response – acknowledged and addressed by the equivalent legislation in the United States (the Dodd-Frank Act which created the Office of Financial Research) – to the frequently lamented opacity of the financial system amplified by deficiency in the standards and timeliness of reporting data that banks submitted to regulators before, during (and indeed since) the financial crisis. Data, and the information gleaned from it that informs actions of both banks and regulators, underpins the entire financial system and every firm therein. Bad data equals bad decisions and this is something that was painfully apparent over the course of the financial crisis where regulators were not able to interpret the mass of often meaningless and inaccurate data submitted by banks into actionable information.

The reporting data that reflected the exposures and positions of every bank was not sufficiently granular, accurate or standardised enough for regulators to either identify the build up of the crisis in the first place, nor act quickly or decisively enough to limit its worst effects. In over three years since the crisis, there has been virtually no progress – most notably by UK policy makers & regulators – in addressing this glaring failure of financial supervision and corporate governance.

As the Government has set out in recent weeks, limiting the wider „fall out‟ on the economy of the Financial Policy Committee‟s (FPC) interventions is a crucial element of the new regulatory regime. Given the current opacity of the financial system and the poor standards of data that the FPC will be basing its decisions on if there is no change, there is a significant chance of collateral economic damage from untargeted, blanket market interventions based on inaccurate information. Manipulation and modelling of data is crucial to allowing the FPC to not only predict future risk events and act before the worst effects are felt, but also, it will allow it to bury down into the cash flow of an instrument or investigate a specific „corner‟ of the financial system. This would allow the FPC to target its interventions more accurately – reducing the wider impact of intervention on the economy. This will not be possible unless banks start to produce and submit standardised and granular risk data.

As things stand the new regulatory authorities will not be equipped to form an accurate assessment of the current and future risks to the financial system or individual financial institutions and therefore they will not be in a suitable position to make effective, targeted and timely judgements/interventions – as was the case in the financial crisis. The US Treasury Department and Congress have appreciated this reality and acted accordingly to address this failing. However, it unfortunately appears that the Government and the UK regulatory authorities have yet to do so. By omitting this recommendation, it demonstrates a presumption that „someone else will deal with it‟ – a dangerous oversight when the effectiveness of the rest of the Bill‟s provisions rest on the ability of regulators to take a holistic view of the financial system.

Challenging the Government’s reason for exclusion of the recommendation

Intellect acknowledges the Government’s response to this recommendation (published on the 1st February 2012) stating that the PRA and currently the FSA already has the power to make such rules, under the direction of the FPC. However, the financial crisis exposed the poor state of the risk data collated by banks and how the regulatory authorities were not able to act decisively to limit the worst effects of the financial crisis as a result. It is therefore particularly worrying that this clear deficiency of the system has not been addressed over three years since the height of the crisis. A report published in December 2010 by the Senior Supervisors Group (of which two members are FSA representatives) acknowledge the inability of banks to provide timely and granular risk data to regulators. As such, Intellect would argue that the FSA has not exercised this power to date.

Similarly, the recent publication of the Bank of England’s paper „Instruments of Macroprudential Policy‟ - setting out proposed tools for FPC market intervention - demonstrates a significant element of ‘cart before horse’. Intellect believes that in order for the FPC to effectively and decisively exercise these tools to mitigate systemic risk, it needs to first have a macro view of the financial services ecosystem. The current lack of transparency across the system, the complexity of instruments and service/transaction mechanisms means that regulation is, to all intents and purposes, being applied blindly.

The Financial Services Bill does not address this deficiency and the effectiveness of the rest of the Government’s reforms will be potentially undermined as a result. Intellect believes that there should therefore be a commitment by either Government or the regulatory authorities to address this issue as a priority - as it has, to date, been left unaddressed by all parties. As set out by the cross-party Joint Committee, the Financial Services Bill would appear to be the ideal vehicle to facilitate this crucial requirement.

Why is this amendment important?

... Ultimately because the UK regulatory authorities have not fully acknowledged that this was a supervisory failing exposed by the financial crisis and which therefore needs to be addressed as part of the wider reform of the system.

AND

The opacity of the financial system is good for business, shedding light on it may be deemed to be counter to the banks’ own commercial interests. The poor standard of data within banks will require significant time and resource to rectify with limited immediate return on investment for banks. Therefore a mandate is required for it to happen.

Problem:

The 2008 financial crisis exposed the weakness of the UK‟s financial services regulatory framework, in particular the asymmetry of information between the regulators and financial services providers. Specifically:

· The banks themselves were either not able or not willing to prioritise the reporting of enterprise risk to board level. Bank‟s failed to collate and interpret risk data of suitable quality so that they could identify the risk that they were holding across their disparate operations. That they were taking excessive risks during the economic boom has, in hindsight, exposed this failure of corporate governance.

· Regulators received significant amounts of data from banks but were unable to interpret it, were unable to make informed judgements and therefore unable to make decisive interventions in the market. That there was no standardised format to this data meant that in trying to build up an holistic picture of the financial system, regulators were not only trying to compare apples and pears, but oranges, bananas, and so forth.

"The problem is that every firm, indeed virtually every division and trading desk, has developed piecemeal approaches to the recording of financial information. Regulators can indeed ask for data dumps, for multi-Gigabyte files that contain all exposures. But even when regulators have the requested information they can do nothing with it. Information without uniform data standards is simply not accessible."

[Professor Alistair Milne, Loughborough University School of Economics & Business]

Result:

The financial crisis was not identified in good time and action taken by regulators (and indeed banks themselves) to prevent it. This was a massive failure of corporate governance and was ultimately responsible for the depth of the crisis and the depth of the public bail out of stricken banks.

The Government had to step in and save RBS and HBoS without full knowledge of the risks that the banks faced, and an accurate assessment of what impact their collapse would have posed to the financial system as a whole. Similarly in the U.S., a slowed response time resulting from poor actionable data meant that regulators had to choose between saving one of Lehman Brothers and AIG. The decision was made to let Lehman Brothers fail, demonstrating the inability within the regulatory system to react quickly and effectively. It has taken three years so far to untangle who is owed what from the collapse of Lehman Brothers due to the complexity of its holdings and relationships with other parties.

So what?:

Whilst there has been progress to address poor data quality and standardisation in the U.S. (OFR - Dodd-Frank Act) and international efforts to set standards for a Legal Entity Identifier, there has been very little progress on a UK level since the financial crisis as part of wider reforms of the financial services industry – which poses questions of the UK Government's and regulatory authorities‟ appreciation of the operational realities of the financial system. The Bank of England has begun consulting on what tools it will require to intervene in the financial system – but there is a significant element of „cart before horse‟ here. These tools will only be effective if the intervention is timely and based upon accurate and standardised data gleaned from banks. The risk of negative economic effects resulting from poorly targeted interventions will remain for as long as the regulators are unable to drill down into the cash flow of an instrument or accurately identify complex linkages between firms across the financial system.

As things stand, the Bank of England will not be receiving accurate information from the banks on their own health and risk positions, and therefore the Financial Policy Committee’s (FPC) actions to maintain financial stability will be based upon information of questionable quality and integrity. There has been significant retrospective learning about the causes of the financial crisis based on data that has now been collated (slowly) and interpreted over three years on from the onset of the crisis, but this does not help in the identification of imminent or future threats across the financial system and empowering the FPC to take actions to mitigate them in a timely and targeted manner.

Solution:

Increasing the transparency of the financial system through more granular and standardised data at individual institutional level that will afford regulators an accurate, macro view of the system when this data is collated and analysed.

This standardisation of data will allow the Bank of England to identify discernable groupings of risk within the financial system, then allow it to identify correlations across any data elements across the system; which in turn will allow for the visibility of patterns that can point towards specific risks. This „critical chain‟ will facilitate root cause and hinge factor detection as the system evolves so the regulator is able to plan, mobilise and implement interventions based on accurate data that can be manipulated and modelled to give numerous perspectives of the financial system.

Ultimately, this may facilitate a forward-looking systemic risk „early warning system‟ based upon a dashboard that highlights key changes in the characteristics of the financial system; through a „system of systems‟ that collates standardised data from across disparate individual financial institutions and ultimately uses predictive analytics to identify future market „events‟.

By reducing the opacity of the system and exposing the complex linkages between institutions, this tool will allow the FPC to more confidently require financial institutions to shrink in size, become less entwined, reduce their dependency on short-term debt, revalue their assets, or set aside additional capital, among other options. I.e. the macro prudential tools that the Bank of England have already set out. Under current conditions, the risk of wider (unintended) economic fallout as a result of FPC market interventions is much greater as there is not the granularity of data to target such interventions on specific instruments or „corners‟ of the market.

However, this is all underpinned by the critical need for accurate data. Herein lies the current challenge for the House of Commons – to ensure that the regulatory authorities have the means to prescribe what data they need, and that banks are obliged to provide this. It is disappointing that the Government has chosen to ignore this, despite the recommendations of Parliamentarians in both Houses, but the legislative scrutiny of this crucial Bill presents an opportunity to redress this. It is essential for the effectiveness of the proposed regulatory regime, that the Financial Services Bill provides the Bank of England with the statutory obligation to develop uniform standards for risk data within banks, and that these standards are enforceable at a bank and financial institution level.

Case study – The U.S. taking the initiative – The Office of Financial Research

In the United States the OFR has been established within the US Treasury Department as a result of the Dodd-Frank Bill. Its remit is to improve the quality of reference data available to policymakers, facilitate more robust and sophisticated analysis of the financial system and it has the means to enforce individual institutions therein to do so.

Often compared to a storm-warning system, the OFR through its two units, a Data Center and a Research and Analysis Center, can continually gather up and analyse detailed financial information collected from a variety of banks and other financial firms. The OFR will share this with the Financial Stability Oversight Council and its member agencies so they can act as the storm approaches to prevent, prepare and intervene. As a result, for the first time it is hoped that regulators will have the necessary tools to evaluate the stability of the entire financial system, not just individual banks. Moreover, instead of outsourcing to the financial firms themselves, as was done on occasion in the past, regulators may control the data and possess the capability in-house to make independent determinations.

In effect, the OFR is permitted by law to demand data from financial companies including banks, hedge funds, private-equity firms and brokerages. It would be able to track information such as counterparties for credit-default swaps and would, crucially, afford regulators the sort of system-wide overview (including darker parts of the market) that will allow it to identify when and where there is a risk to financial stability. The OFR also has the authority to coerce financial institutions to standardise data types and data formats to facilitate its wider role.

All this, and the fact that the OFR has recently started defining reporting standards for the financial community, puts it way ahead of the FPC in terms of establishing tools to head off the next financial crisis.

"The OFR will enable regulators and the Treasury to better understand the complex financial products, more effectively uncover fraud, better monitor risks from large financial institutions, and for the first time be able to see the critical linkages between important institutions in the market....Only the most ardent opponent of regulation would oppose providing regulators and policy makers with the data, research and monitoring tools needed to provide for the safety and security for our financial markets. The cost of regulators continuing to fly blind is a cost that the U.S taxpayers cannot afford."

(Testimony Before the Subcommittee on Security, International Trade and Finance - Committee on Banking, Housing and Urban Affairs; United States Senate; „Providing Financial Regulators with the Data and Tools Needed to Safeguard Our Financial System‟; Allan Mendelowitz & Professor John Liechty)

As the Government also set out in its response to the Joint Committee, an equivalent of the OFR would not be appropriate for the proposed UK regulatory regime as the FPC will have the power to set data standards. Intellect acknowledges that whilst establishing a carbon copy of the OFR in the UK may not be appropriate, the important point here is that setting up the OFR was an acknowledgement by the US Treasury Department that there remained an unaddressed deficiency exposed by the financial crisis, that it was a potential threat to the effectiveness of wider reforms and that, crucially, this deficiency would not simply „sort itself out‟. The financial crisis exposed the same deficiencies in the UK that it did in the U.S., but the difference is that there has been no action taken to plug this gaping hole in the UK and no commitment, by Government or regulator, that it will be.

ANNEX

Testimony

Intellect is not alone in noting the lack of transparency of the financial system, how this contributed to the financial crisis and to the depth of the economic turmoil since, and how this needs to be addressed as a priority. Many commentators from across the financial system have made public remarks on this issue, a small cross section of which is below:

"The events of the most recent financial crisis have laid bare the dire consequences that can flow from poorly understood and ineffectively regulated financial institutions and markets. In response to the crisis, a lot of attention has been paid to how to strengthen the legal authorities and organizational structure of the financial regulatory community. Unfortunately, far less attention has been paid to what data and analytical capability is needed to enable regulators to use those new powers effectively. Data and analytics are not the stuff of headlines and stump speeches; however, when they are deficient, they are the Achilles’ heel of financial regulation. Unfortunately, we have ample evidence that the recent crisis was due in part to a lack of appropriate data and analytic tools."

(Testimony Before the Subcommittee on Security, International Trade and Finance - Committee on Banking, Housing and Urban Affairs; United States Senate; „Providing Financial Regulators with the Data and Tools Needed to Safeguard Our Financial System‟; Allan Mendelowitz & Professor John Liechty)

"The recent financial crisis highlighted shortcomings in policymakers’ ability to measure systemic risk. Gaps are evident in both the analytical framework and the available firm-level and aggregate data that policymakers and market participants use in making decisions. These gaps hinder market participants in pricing and managing risk and policymakers in monitoring and responding to vulnerabilities. This experience should prompt improvements in macro surveillance and data collection."

[81st Annual Report (June 2011); Bank for International Settlements]

"Whereas financial markets have evolved over the past decades to operate globally through IT-intensive processes and networks data standardisation has lagged behind, hindering market – and often even firm-wide – data aggregation, analysis and operations, and reducing the transparency of financial transactions"

[Hökmark report on Global Economic Governance (October 2011); Committee on European and Economic Affairs in the European Parliament]

"The problem is that every firm, indeed virtually every division and trading desk, has developed piecemeal approaches to the recording of financial information. Regulators can indeed ask for data dumps, for multi-Gigabyte files that contain all exposures. But even when regulators have the requested information they can do nothing with it. Information without uniform data standards is simply not accessible"

[„The Fall of the House of Credit‟; Professor Alistair Milne, Loughborough University School of Economics & Business]

"Both banks [RBS & HBOS] found it difficult to provide the Treasury with appropriate and robust data on their assets. We found this alarming. It places a question mark over the standards and practices of the banks themselves, and whether or not there was effective oversight by regulators and the banks' own auditors’.

[31st Report: „HM Treasury – The Asset Protection Scheme‟ (April 2011); House of Commons Public Accounts Select Committee]

Intellect would urge Members of Parliament to consider the economic importance of equipping the new regulatory authorities with the correct tools for them to do their job, and to enforce the banks to truly reform the way that they operate so the chance of another financial crisis (and indeed the following economic fallout) can be significantly reduced. Intellect believes that the Financial Services Bill should be amended to include this provision – as the cross party Joint Select Committee had initially recommended.

About Intellect

Intellect is the UK trade association for the IT, telecoms and electronics industries; industries that generate around 10% of UK GDP and 15% of UK trade. Our Members include blue-chip multinationals as well as early stage technology companies and play a crucial role in virtually every aspect of our lives. Intellect articulates a cohesive voice for these industries across all market sectors, and is a vital source of knowledge and expertise on all aspects of the technology industry.

Intellect‟s Financial Services Programme brings together over 170 suppliers of information systems, services and consultancy to the banking and insurance sectors. The relationship between the financial services industry and the technology sector is one of fundamental importance. As the Office for Fair Trading has recently stated, "IT systems are the backbone of retail banking activities and are essential to the safety and resilience of financial systems". Technology not only plays a critical role in the functioning of the full spectrum of financial services, it is a hugely important factor in ensuring that the individual institutions within it can operate more responsibly and remain competitive in the global marketplace. The right technology can help depress costs, reduce risk and increase the confidence of lenders and investors, all of which are of paramount importance in the current economic environment. Applied inappropriately or to the wrong ends and it can contribute to systemic risk, lead to reduced inward investment and ultimately have a detrimental effect on the economy.

Notices of Amendments

Intellect, the trade association for the UK technology industry put forward a case to Members of the Financial Services Bill Standing Committee to support a number of amendments put forward by the member for Nottingham East, Chris Leslie MP and the member for Kilmarnock & Loudon, Cathy Jamieson MP.

Specifically, these amendments relate to the standards of data that will be collected by the proposed Prudential Regulatory Authority(PRA), which in turn would then be available for the Financial Policy Committee (FPC) to base its market interventions on – i.e. its financial stability role. Intellect would argue that by proscribing the data that banks must produce, it will reduce the opacity of the financial system and increase the effectiveness and reduce the risk of unwanted economic fallout, of regulatory market interventions. For reference, the relevant amendments are attached to this email and are numbered 38, 88 and 89. A briefing paper outlining Intellect’s case is attached to this email and provides testimony from a number of stakeholders across the financial system.

As things stand the new regulatory authorities will not be equipped to form an accurate assessment of the current and future risks to the financial system or individual financial institutions because of the poor standard of reporting information that banks submit to regulators. The result is that the regulatory authorities (and the Financial Policy Committee in particular) will not be in a suitable position to make effective, targeted and timely judgements/interventions – as was the case in the financial crisis.

Whilst Intellect acknowledges the Government’s position, re-iterated in the Standing Committee session of the 21st February by the Financial Secretary to the Treasury, that the Financial Services Bill already provides for ‘the power for the FPC or the Bank to request information in pursuit of financial stability’ (page 13 of the Bill and new section 9V to the Bank of England Act 1998-"Directions requiring information or documents" Subsection (2)), we believe that this stance overlooks the key point of an argument espoused by numerous organisations across the financial ecosystem – that the information requested by the FPC from the PRA (or the FCA) will be based upon poor quality data taken from individual banks, that does not accurately reflect the true risk positions of individual financial institutions. In short, it is all very well empowering the regulators to request information from wherever it feels it is necessary, but if this information stems from data that is neither granular, timely, nor accurate – it will not allow the FOC to effectively intervene in the market to head of systemic risks.

Under current conditions, the risk of wider (unintended) economic fallout as a result of FPC market interventions is much greater as there is not the granularity of data to target such interventions on specific instruments or ‘corners’ of the market. The US Treasury Department and Congress have appreciated this reality and acted accordingly to address this failing in the Dodd-Frank Bill by creating the Office of Financial Research. However, it unfortunately appears that the Government and the UK regulatory authorities have yet to do so and the current provisions of the Financial Services Bill does not address this significant oversight.

The amendments put forward on ‘Data Collection’ will go some way to providing the statutory basis upon which reporting standards that banks must adhere to, can be set. Intellect feels that providing the regulatory authorities with the right tools to do their job is not a party political issue, but more one of necessity, common sense and economic prudence.


38

Financial Services Bill, continued

Chris Leslie MP

Cathy Jamieson MP

88

Schedule 12, page 244, line 40, at end insert-

‘In section 165(A) after subsection (10) insert-

"(11)
Data Collection

(a)
The PRA should require the submission of reports from any PRA-

authorised person for the purpose of assessing the extent to which a

financial activity or financial market in which the PRA-authorised person

participates may pose a threat to financial stability in accordance with the

PRA’s general objective. The PRA shall collect, in a manner determined

by the PRA and in consultation with the FPC, financial transaction data

and position data from PRA-authorised person companies.

(b)
For the purposes of (a)-

(i)
financial transaction data shall mean data pertaining to the

structure and legal description of a financial contract, with

sufficient detail to describe the rights and obligations between

counterparties and make possible an independent valuation; and

(ii)

position data shall mean data pertaining to data on financial

assets or liabilities held on the balance sheet of a financial

company, where positions are created or changed by the

execution of a financial transaction and which includes

information that identifies counterparties, the valuation by the

financial company of the position, and information that makes

possible an independent valuation of the position.

(c)
The FCA shall assist the PRA in accordance with Clause 3D to ensure

that the PRA is able to exercise its function as described in (a);

(d)

(i)
To facilitate the effective collection of data, the PRA should

prepare and publish, in a manner that is easily accessible to the

public and in the form of a summary or collection of information

so framed that it is not possible to ascertain from it information

relating to any particular person-

(1)
a database detailing relevant counterparties; and

(2)
a financial instrument reference database; and

(3)
formats and standards for PRA data, including standards

for reporting financial transaction and position data to

the PRA; and

(ii)
Where possible, the PRA shall co-operate with foreign

regulators to the extent required to collect relevant information

on PRA-authorised persons already collected by those foreign

regulators;

(e)
The PRA shall develop and maintain sufficient resources to review the

collection of data referred to in (a) above in order to-

(i)
develop and maintain metrics and reporting systems for risks to

the financial stability of the United Kingdom;

(ii)
evaluate stress tests or other stability-related evaluations of

financial entities overseen;

(iii)
investigate disruptions and failures in the financial markets;

(iv)
conduct studies on the impact of policies relating to systemic

risk;

(v)
promote best practices for financial risk managment to PRA-

authorised persons.

39

Financial Services Bill, continued

(f)
The PRA shall publish a report which compiles the data collected in

accordance with Clause (1) on a periodic basis as determined by the PRA,

which shall be-

(i)
made available to the public in an easily accessible medium; and

(ii)
in the form of a summary or collection of information so framed

that it is not possible to ascertain from it information relating to

any particular person.".’.

February 2012

Prepared 29th February 2012