THE UK FINANCIAL SECTOR, REGULATION AND THE FINANCIAL CRISIS

1. 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 e_philip_davis@msn.com www.ephilipdavis.com groups.yahoo.com/group/financial_stability

2. 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

3. What is a bank – why do they fail? • Traditional bank

4. “Modern” bank

5. 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”

6. 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

7. Size of UK banking sector

8. FSIs for UK banks

9. Customer funding gap

10. 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

11. 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

12. 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?

13. 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?

14. 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)

15. 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?

16. 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?

17. 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 anti-terror law to seize assets • Broader cross border issues of home/host unresolved – coming at express speed in Eastern Europe……

18. 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.

19. …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?

20. References • Davis E P (2009), “Banking on prudence”, chapter of OECD Report on the UK Economy, OECD Economics Department Working Paper