House of Lords - Economic Affairs Committee

Banking Supervision and Regulation - Economic Affairs Committee Contents

Memorandum by Dr. Kern Alexander

1. UK banking supervision and regulation has come under intense scrutiny as a result of the credit crisis. Before the credit crisis, UK banking supervisors and their practices were universally esteemed and their regulatory regime of principles-based regulation was emulated across many countries. The credit crisis, however, has exposed major weaknesses in UK banking supervision and regulation. It is the purpose of these written comments to set forth the main principles of prudential bank regulation and supervisory practice, and to comment on the weaknesses in the UK regulatory regime which contributed to the recent financial crisis.

BANKING AND PRUDENTIAL REGULATION

2. The role of banks is integral to any economy. They provide financing for commercial enterprises, access to payment systems, and a variety of retail financial services for the economy at large.[1] Some large banks have a broader impact on the macro economy by facilitating the transmission of monetary policy and making credit and liquidity available in difficult market conditions.[2] The integral role that banks play in the national economy is demonstrated by the almost universal practice of states in regulating the banking industry and providing, in many cases, a government safety net that compensates depositors when banks fail and lender of last resort facilities for banks when they have difficulty accessing credit and liquidity.[3]

3. The main rationale of prudential bank regulation has traditionally been the safety and soundness of the financial sector and protection of depositors.[4] A safe and sound banking system requires the effective control of systemic risk.[5] Systemic risk arises because banks have an incentive to underprice financial risk because they do not incur the full social costs of their risk-taking.[6] The social costs of bank risk-taking can arise from the solvency risks posed by banks because of imprudent lending and trading activity, or from the risks posed to depositors because of inadequate deposit insurance that can induce a bank run.[7] Systemic risk can also arise from problems with payment and settlement systems or from some types of financial failure that induce a macroeconomic crisis.[8] Prudential regulation and effective supervision therefore aim to reduce the social costs which bank risk-taking creates by adopting controls and incentives that induce banks to price financial risk more efficiently.[9]

4. Prudential regulation mainly includes capital adequacy requirements, asset composition and concentration rules, fit and proper standards for bank officers, senior management and board members and internal controls for bank operations. Effective supervision involves surveillance of individual bank risk-taking along with overall leverage levels in the financial system. It also involves enforcement actions which can take the form of authorisation and licence revocations and administrative penalties and civil sanctions imposed against firms and individuals who violate regulatory rules. Capital adequacy has attracted the most regulatory attention in recent years because of the adoption of the Basel II international capital adequacy standards. UK capital adequacy rules are found in the FSA Handbook and derive through secondary legislation from the EU Capital Requirements Directive (2006), which implements Basel II into EU law.[10]

5. Basel II's main aim is to make bank regulatory capital more sensitive to the economic risks which individual banks face, while ignoring the larger social risks which bank risk-taking poses to the financial system. Basel II permits banks to use their own economic capital models to measure credit, market and operational risk and to estimate lower levels of regulatory capital than what regulatory rules would normally require. An important weakness of Basel II is that fails to address liquidity risk, which precipitated the present credit crisis, and allows banks to hold lower levels of regulatory capital for assets which banks securitise into special purpose vehicles in the wholesale debt markets. Moreover, another weakness of Basel II is that it is procyclical because regulatory capital calculations are based on the riskiness of assets on the bank's balance sheets. Rather, regulatory rules should impose counter-cyclical capital requirements, such as higher capital charges during an asset price boom and lower charges during a market downturn. Prior to the credit crisis, the FSA had implemented the Capital Requirements Directive which incorporated Basel II principles into the UK regulatory regime. This contributed to the under-capitalisation of the UK banking system and exposed the broader financial system to systemic and liquidity risk that arose from excessive risk-taking in collateralised debt obligations that originated from US subprime mortgages. The FSA has acknowledged its mistakes in its 2008 review of its handling of the Northern Rock collapse and has published a paper containing liquidity risk management principles for UK banks. Despite this progress, UK banking regulation still suffers from many of the flaws contained in the CRD and Basel II. It is now time to amend substantially Basel II and the CRD based on principles that recognise the true social costs posed to the financial system by bank risk-taking.

6. In addition, effective supervision and regulation require banks to have robust corporate governance arrangements that incentivise bank management and owners to understand the risks they are taking and to price risk efficiently in order to cover both the private costs that such risk-taking poses to bank shareholders and the social costs for the broader economy if the bank fails.[11] Corporate governance plays an important role in achieving this in two ways: to align the incentives of bank owners and managers so that managers seek wealth maximisation for owners, while not jeopardising the bank's franchise value through excessive risk-taking; and to incentivise bank management to price financial risk in a way that covers its social costs. The latter objective is what distinguishes bank corporate governance from other areas of corporate governance because of the potential social costs that banking can have on the broader economy.[12]

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

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

BANK SPECIAL RESOLUTION REGIMES

9. The social costs that banks pose for the economy also demonstrate the need for a special resolution regime for banks that provides a legal framework for the regulator to decide whether to attempt to save a bank by recapitalisation or other restructuring pre-insolvency, and if this fails, to oversee in insolvency the unwinding of the bank's multiple positions and to sell off its viable assets to other banks or investors.[13] For many countries, including the UK,[14] ordinary insolvency law procedures have applied to the administration and liquidation of a failing bank. Generally, corporate insolvency law applies an elaborate framework to rank the economic claims of creditors and other stakeholders against a firm which is unable or unwilling to honour its financial obligations. Insolvency law may prove socially costly, however, for certain firms, such as banks, because insolvency procedures may result in restrictions on a bank performing its essential function as a financial intermediary in the economy.[15] The inadequacies of general insolvency law to address the risks which banks pose to the broader economy has led many countries to enact special bank resolution regimes.

10. An important element of these resolution regimes is that they permit the regulator to take certain measures pre-insolvency which may alter or reduce shareholder rights and the claims of third parties in order to protect depositors in the weakened bank and to maintain overall financial stability. The rationale for a pre-insolvency intervention regime is that the regulator should have the authority to take certain measures in response to a rapid loss of market confidence which may result in the bank losing access to the short-term inter-bank loan market and wholesale capital markets which may result in increased systemic risk in the banking system. Through regulatory intervention, a market-based solution may become possible. If a market solution is not possible, however, the intervention may be the first step by the regulator or central bank taking control of the failing bank and transferring its shares and other property, including contractual rights and obligations, to a state-owned bridge bank or a private purchaser. Further steps may involve the bank being declared insolvent and being subject to administration or liquidation.

11. The credit crisis of 2007-09 has demonstrated the importance of bank special resolution regimes and the need to balance the competing interests of shareholder rights with the regulatory objectives of financial stability and depositor protection. The constraints of corporate insolvency regimes can be too cumbersome for effective resolution of a banking enterprise, especially during a financial crisis when a failing bank needs to maintain open lines of credit with other financial institutions and to manage its balance sheet while achieving regulatory objectives. Bank resolution regimes must be designed not only to protect shareholders and creditors, but also to achieve other regulatory objectives that are vital for the efficient operation of the economy. The UK Banking Bill 2009 contains a special resolution regime that seeks to achieve these objectives by granting the Treasury and the Bank of England sweeping powers to restructure a failing bank and to transfer its shares and property to a government-owned bridge bank or to a private purchaser. Although the stabilisation regime provides a comprehensive framework for bank corporate restructuring and insolvency, it suspends corporate governance rules for shareholders and thus interferes with shareholder rights. This raises important issues under EU company law and the European Convention on Human Rights regarding the protection of property rights and interests in a bank that is undergoing restructuring to achieve regulatory objectives.

THE UK TRIPARTITE SYSTEM

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

February 2009