The FSA has published a speech by David Strachan (Director, Financial Stability, FSA) entitled The regulatory response of the G20 to the financial crisis.
Mr Strachan covers three topics:
- Counter-cyclical requirements.
- The scope of regulation.
- International regulatory co-operation.
He discusses these topics around The Turner Review and Discussion Paper 09/2: A regulatory response to the global banking crisis.
On counter-cyclical requirements Mr Strachan starts by stating that there is now a widespread acceptance that the Basel II framework needs to be revised to include stronger counter-cyclical elements.
With regards to Pillar 2, Mr Strachan states that there are three lessons that need to be kept in mind when designing a better counter-cyclical framework and these are:
- The current approach highlights some of the drawbacks of a discretionary framework.
- Although there was a counter-cyclical provision in the Basel II framework, much of the detail was left to national implementation which meant that international comparability was difficult to achieve.
- All this was part of the Pillar 2 framework, which is bank-specific and where the results are not published. This made it impossible to judge how this provision was being implemented in practice.
Mr Strachan then discusses counter-cyclical capital buffers. He states that clear agreement is needed for stronger counter-cyclical capital buffers to be part of the Basel II framework. He then looks at general and specific design issues. Four general design issues which need to be considered are:
- Should the counter-cyclical capital buffer be accumulated through a discretionary approach, or should there be some type of formula that operates as an “automatic stabilizer”?
- There is no point in accumulating a capital buffer above the minimum if the market comes to regard this higher level as the new minimum.
- The buffer must be able to absorb losses on a going concern basis which in turn means that it must comprise the highest quality capital, most likely equity and retained reserves.
- The buffer cannot count as capital while it is being accumulated, otherwise banks will be able to gear up on it such that the buffer will become built into the regulatory minimum and not be available to absorb losses in the downturn.
Two specific design issues are then mentioned. Firstly, the need for accurate measurement of the long-run default rate, over the cycle. The FSA knows from experience of implementing the internal ratings based approaches to Basel II that this is not straightforward. Secondly, the measurement of the duration of the cycle.
Mr Strachan then states that the accounting treatment of a counter-cyclical capital reserve is important. However, he does not believe that it is impossible to make any progress unless and until the accounting treatment is changed to enable more forward-looking subjective provisioning.
Mr Strachan then discusses discretionary capital add-ons. He states that supervisors (and central banks) will need to be ready to translate the outputs from both micro- and macro-prudential assessments into mitigating action. In some cases the mitigating actions may come in the form of further “discretionary” capital add-ons, at the level of individual firm, class of firm or firms generally. In others, the right response may be in the form of concentration limits or other types of macro-prudential tool.
He also mentions other tools, and sets out two recommendations from the Turner Review:
- A leverage ratio. The FSA believes that a leverage ratio should complement the risk-based capital regime as a regulatory back-stop.
- A core funding ratio. The FSA believes a core funding ratio could play a role in a new capital and liquidity regime.
On the scope of regulation Mr Strachan states that agreement is needed, internationally, that regulation should focus not on legal form but on the economic substance of activities carried out by the entity. In order to achieve this Mr Strachan states that all authorities across the world need to be able to understand, and act upon where appropriate, the following:
- Unregulated activities within otherwise regulated groups.
- The exposures between the regulated and unregulated firms
- Risks developing in the unregulated sector to financial stability and the regulated sector itself.
In the final part of his speech Mr Strachan discusses international supervisory cooperation. Re-establishing an effective global framework will be absolutely crucial if an effective regulatory system for financial stability is to be created. As part of this the international system needs to be able to monitor growing risks to stability and challenge national authorities, who ultimately take the action and bear the costs of crisis. The mechanisms of international cooperation must be improved. Effective international standards need to be agreed within a reasonable period and be implemented properly. Effective and practical colleges of supervisors need to be operating, bringing together the key players for large global groups. Crisis management arrangements need to be thought about, discussed and articulated during good times, so that, if and when a crisis breaks, authorities have a clearer picture of what challenges they will face and can address them quickly and more effectively.
View FSA speech - The regulatory response of the G20 to the financial crisis, 1 April 2009