Transcript On Financial Regulation and the Financial Crisis

THE UK FINANCIAL SECTOR,
REGULATION AND THE
FINANCIAL CRISIS
Course on Financial Instability at the Estonian Central Bank,
9-11 December 2009 – Lecture 5
E Philip Davis
NIESR and Brunel University
West London
[email protected]
www.ephilipdavis.com
groups.yahoo.com/group/financial_stability
Overview
• What is a bank – how do they fail?
• The role and nature of financial regulation
• How did the financial crisis impact on the
UK?
• The safety net – issues for the UK
• Prudential regulation
• Cross border aspects
• Some comments on the Turner Review
What is a bank – why do they
fail?
• Traditional bank
Assets
Liabilities
Liquid assets
Capital
Retail deposits
Illiquid loans
• “Modern” bank
Assets
Liabilities
Liquid assets
Capital
Illiquid loans
Retail deposits
Illiquid securities
Wholesale deposits
Loans being securitised
Illiquid securities
Illiquid securities in SIV/conduit
Asset backed commercial paper with bank back
up line of credit
The role and nature of financial
regulation
• Aims to protect against market failures
– Information asymmetry
– Externality
– Monopoly
• Two aspects of regulation
– The safety net – lender of last resort and deposit
insurance - ultimately recapitalisation/nationalisation
– “the current issue”
– Prudential supervision – capital adequacy and
supervisory monitoring – and macroprudential
analysis – “the future issues”
UK regulatory framework
• Tripartite system of Treasury, FSA, Bank of
England
– Financial Services Authority (FSA) is responsible for
financial and banking regulation;
– Bank of England contributes to the stability of the
system through monetary policy, its lender of last resort
operations and macroprudential surveillance;
– Treasury is responsible for the overall architecture of
the system and aspects affecting the public finances
Size of UK banking sector
Panel A. Resident banking–sector assets (multiples of GDP)
Country
2007
2008
UK
5.0
5.5
Euro area
US
3.3
0.9
3.5
1.0
Panel B. UK resident banking–sector assets by currency (multiples of GDP)
Bank ownership
UK
Other European Union
American
Japanese
Other developed
Other
Memo: building societies
£ assets
1.40
0.47
0.08
0.01
0.16
0.01
0.26
Foreign
currency
assets
1.05
1.05
0.44
0.11
0.65
0.05
0.02
Total
assets
2.45
1.51
0.52
0.12
0.81
0.06
0.27
FSIs for UK banks
Major banks tier 1 capital ratios – median
Bank capital to assets – median
Bank non-performing loans to total loans
Bank provisions to non-performing loans
Bank return on assets
Bank return on equity
2003
8.1
26.7
2.5
69.8
0.6
8.6
2004
8.0
26.6
1.9
61.5
0.7
10.9
2005
7.9
30.4
1.0
54.0
0.8
11.8
2006
8.0
30.8
0.9
54.6
0.5
8.9
2007
7.7
31.2
0.9
0.4
6.2
20081
7.9
34.1
Customer funding gap
Major elements of UK crisis
• Freezing of interbank markets from August 2007
requiring liquidity assistance by Bank of England
• Retail and wholesale customer run on Northern Rock,
failed in September 2007
• Bradford and Bingley, Alliance and Leicester had to be
taken over
• Need to nationalise and recapitalise RBS and HBOS with
massive, partly covert, state assistance in October 2008
• UK bank losses estimated at £36 bn in October 2008,
initially mainly US securities, later UK defaults. Many
losses from poorly capitalised subsidiaries (SIVs and
conduits) whose size “surprised” regulators
• Serious collapse of real economy ensued
Northern Rock – failure of supervision
• Asset risk - made up to 125% mortgages, and liability
risk – high dependence on wholesale funding
• Longest regulatory periods between formal ARROW
assessments (36 months) and lowest number of close and
continuous regular surveillance meetings, only high
impact firm without a Risk Mitigation Programme
• Moved between FSA divisions three times in as many
years – and division mainly responsible for Northern
Rock had suffered staff cuts
• Records of supervisory meetings were often not kept
• In Spring 2007 allowed to pay a large dividend and
reduce its capital adequacy target, although FSA already
concerned about liquidity
Lessons for the safety net
• Huge cost of recapitalisation
–
–
–
–
Major burden on fiscal policy, to add to cyclical swing
How realistic to expect 2007 maintained?
Keeping public support for recapitalisation
The poor performance of public banks
• Deposit insurance shown to be inadequate
–
–
–
–
Increase in limits to £50,000 and 100%
Ability to access in 7 days
Should the system be prefunded?
Should there be risk based premia?
• Lender of last resort overburdened
– Successful covert lending to HBOS and RBS after
failure with Northern Rock
– How to exit from the high level of liquidity support?
– Is “stigma” adequately dealt with?
• Special resolution regime instituted
– Banks can be put into resolution when not technically
insolvent, in interests of financial stability
– A step forward from Northern Rock….
– ….but need for numerical prompt correction action
targets (link to capital and liquidity) to avoid
forbearance
– Could Bank of England be overburdened?
Lessons for prudential regulation
• Capital adequacy failed to prevent crisis
– The FSA’s trigger ratio system is helpful – but should targets
be published (also ARROW, liquidity)?
– Banks should be required to hold adequate capital for off–
balance sheet risks, so as to counter regulatory arbitrage and
reputational risks. Accounting treatment of off–balance sheet
assets should be aligned with the underlying risks.
– Higher capital across the board (banking and trading books)?
• Raises the cost of intermediation
• But reduces incidence of financial instability
– Capital adequacy and procyclicality
• Spanish approach conflicts with accounting rules…
• ….but other are just theoretical
• Leverage ratio warrants consideration (NIESR work shows effect on
crisis probability)
• Liquidity regulation had been forgotten
– The new UK proposals – a marked advance given
narrow liquidity had fallen to 1%…likely to raise
government bonds from 5% to 10% of assets
– …but how compatible with maintaining the City as a
financial centre
– Need for an aggregate quantitative target?
– Equal attention to liability management?
• Other prudential regulation had let banks take
unwarranted risks
– Limits on LTVs needed for mortgages and commercial
property
– Ensuring remuneration covers the lifetime of products
– Is there a need to divide commercial and investment
banking again? Reduce bank size?
– Caution in government guaranteeing securitisations
– Regulation of innovations needed – like drugs?
• Macroprudential analysis had failed to provide
effective warnings
– How to act if macroprudential warnings are given –
speeches or action?
– Ensuring macroprudential considerations enter the
ARROW process – and individual supervision
• Did the UK’s “light touch” fail?
– Specific issues with Northern Rock
– General issues allowing risky lending, wholesale
funding, inadequate assessment of takeovers
• Structure of regulation – more dual key to avoid
underlap
• Or even moving LCFIs back to the Bank?
Cross border aspects
• How far ahead can the UK go alone – does the
“City” concern dilute desirable regulation?
• Problems of Basel 2 – back to the drawing board?
– Rating agencies
– Risk models
• Why no global agreement on liquidity?
• Learning from Iceland – institutions that are “too
big to save”, branching and cross border LOLR
• Icelandic bank deposits unprotected – use of antiterror law to seize assets
• Broader cross border issues of home/host
unresolved – coming at express speed in Eastern
Europe……
Some comments on the Turner
Review….
• Long run solutions not current issues
• Very negative on market discipline – but do the
regulators really know best?
• The boundary problem – how easy to regulate the
unregulated?
• Institutional co-operation or conflict in
macroprudential surveillance?
• New EU regulator – but what role?
• Desire for cross border operations as self
capitalised subsidiaries - major challenge to the
current passporting procedure.
…and the possible downgrading
of the FSA
• Does the Bank of England want to regulate
banks – what are the costs?
• What is the middle ground – can the Bank
have macroprudential levers?
• What sort of institution will the FSA be as a
“consumer protection” regulator?
• Could there be dangers in the transition?
References
• Davis E P (2009), “Banking on prudence”,
chapter of OECD Report on the UK
Economy, OECD Economics Department
Working Paper