The future approach to banking regulation and supervision requires accepting that the risks involved in performing bank or bank-like functions are different from those involved in non-financial activities, and non-bank financial activities, such as life assurance.

Fundamental changes to capital adequacy, accounting and liquidity policies

Seven key measures, relating to capital adequacy, accounting, and liquidity policies, are required:

1. Increasing the quantity and quality of bank capital

  • Focus on tier 1 and core tier 1 capital for systemically important banks so that the future banking system is better able to absorb shocks
  • Regulatory minima significantly increased from current Basel II regime that will tend to mean lower return on equity, but a lower-risk banking industry

2. Significant increases in trading book capital

  • Major (eg more than three times) increases in capital required against key types of trading risk so that there is a significant reduction in scale of proprietary risk taking
  • Fundamental review of market risk capital regime (eg reliance on Value at Risk ("VaR") measures), which will drive simplification and derisking of the securitised credit model

3. Avoiding procyclicality in Basel II implementation

  • FSA action already in hand to enable 'through the cycle' rather than 'point in time' estimates of credit risk that will reduce the extent to which lending capacity is impaired in an economic downturn

4. Creating counter cyclical capital buffers

  • Capital levels to increase in booms and decrease in recessions will reduce the dangers of banking system instability
  • Variety of options: discretionary versus formula; in calculated capital or in reserve – this will reduce the amplitude of economic cycles

5. Offsetting procyclicality in publishing accounts

  • Countercyclical buffers to be defined in publishing accounts 'Economic Cycle Reserve' – remuneration and management behaviour less influenced by irrational exuberance

6. Introducing a gross leverage ratio backstop

  • Absolute limit on gross assets to some category of capital (eg Core Tier 1) – this guards against underestimation of risks and limits system-wide financial instability risks by limiting aggregate positions

7. Intensification of liquidity regulation and supervision to contain liquidity risks: in individual banks and at the systemic level

  • Action has already been outlined in the Consultation Paper:
    • More detailed information requirements on liquidity mismatches
    • Stress tests defined by regulators and covering systemic effects
    • Detailed mandatory Individual Liquidity Guidance
  • Possible introduction of code funding ratio rule

These changes will improve the future stability of the banking system but will pose additional costs on banks. There must therefore be a way to ensure that bank-like activities do not migrate outside the regulator perimeter in order to escape capital and liquidity requirements.

Institutional and geographic coverage: economic substance not legal form

  • Off-balance sheet vehicles that create substantive economic risk must be treated as if on-balance sheet for regulatory purposes.
  • Prudential oversight of financial institutions should be coordinated in integrated regulators (covering banks, investment banks and insurance companies), reducing the dangers of inconsistency and arbitrage between different authorities within one country.
  • Regulators must have the power to obtain information and identify new forms of financial activity that are developing bank-like characteristics, and if necessary to extend prudential regulation to them, or to restrict their impact on the regulated community.
  • Appropriate approach to hedge funds:
    • Regulators and central banks in the performance of their macro-prudential analysis role to gather more extensive information on hedge fund activities (or other newly evolving form of investment intermediation), and consider the implications of this information for overall macro-prudential risks
    • Regulators need the power to apply appropriate prudential regulation (eg capital and liquidity rules) to hedge funds or any other investment intermediary if at any time they judge that the activities have become bank-like in nature or systemic in importance
  • Offshore centres must be brought within the ambit of internationally agreed financial regulation

Deposit insurance and bank resolution

The system of bank regulation and supervision has already been buttressed by the following arrangements:

  • Deposit insurance – 100 percent coverage of the first £50,000 of retail deposits per legal entity. The FSA is currently consulting on whether the limit should be per legal entity or per brand, and will consult on what arrangements should be made to deal with temporary large balances (eg related to a house purchase or sale). These consultations will be completed by 31 May 2009.
  • Bank resolution – The Banking Act 2009 defines the FSA's role in deciding upon the need for bank resolution, and provides the UK authorities with wide-ranging powers to ensure the orderly resolution of a failing bank.

Credit rating agencies and the use of ratings

  • Registration of credit rating agencies with financial regulators playing a supervisory role, coordinated at European level via colleges, to ensure that appropriate structures and procedures are in place to manage conflicts of interest and to reinforce analyst independence from commercial revenue maximising objectives. Supervisory oversight should extend to requiring that rating agencies only accept rating assignments where there is a reasonable case for believing that a consistent rating could be produced.
  • Measures to reduce the inappropriate use of ratings – public policy should avoid unnecessary requirements for investing institutions to hold securities of a specific rating

Remuneration: requiring a risk-based approach

The FSA will include a strong focus on the risk consequences of remuneration policies within its overall risk assessment of firms, and will enforce a set of principles that will better align remuneration policies with appropriate risk management. An initial draft Code that sets out these principles has already been published and will be refined next week.

Adherence to the rules will be achieved by:

  • A proposal to make adherence to the first overarching principle of the Code (to ensure that remuneration principles are consistent with effective risk management) an FSA rule, at least for systematically important firms
  • Integrating assessment of remuneration policies into the FSA standard risk-assessment process (ARROW) with required improvements included in Risk Mitigation Plans
  • If necessary, using increases in Pillar 2 capital requirements to compensate for incomplete adherence

The FSA has been involved in a Financial Stability Forum ("FSF") working group seeking to forge international agreement, and the FSF will shortly publish principles. Achieving international agreement on mechanisms to ensure application of the principles by all major supervisory authorities will be a crucial subsequent step.

Netting, clearing and central counterparty in derivatives trading

The Counterparty Risk Management Policy Group Third Report identified the importance of reducing unnecessary multiplication of gross exposures that may be achieved through 'compression,' the netting out of offsetting bilateral positions. Achieving a reduction in net positions outstanding could be achieved via firms closing out existing exposures, but would be greatly assisted by the development of clearing systems with central counterparties, allowing multilateral netting and reducing economic exposures to those outstanding versus the central counterparty.

Macro-prudential analysis

The failure to undertake macro-prudential analysis and to take appropriate action was one of the crucial failures of the years running up to the financial crises. Previously, the Bank of England tended to focus on monetary policy that did not result in policy responses to offset the risks identified, whilst the FSA focused too much on the supervision of individual institutions, and insufficiently on wider sectoral and system-wide risks.

Macro, sector-wide and firm-specific analysis needs to be done by both the Bank of England and the FSA, with the analysis debated between the two authorities. The relationship could include:

  • The Bank of England being the ultimate arbiter of judgements relating to the position in the economic cycle and the definition of macro-prudential risks, but with the FSA making decisions about which regulatory levers to adjust and by how much
  • The Bank of England should also be able, at the limit and in the absence of agreement, to require the FSA to take specific macro-prudential measures
  • The Financial Stability Committee being designed as a joint committee of the Bank of England and the FSA, with the committee making the final judgement as to the macro-prudential conditions and final decisions as to appropriate policy responses

The FSA's supervisory approach

A new 'intensive supervision' approach, as introduced through the Supervisory Enhancement Programme("SEP") (launched April 2008), will involve:

  • An increase in the resources devoted to the supervision of high impact firms (high impact and complex banks in particular) with an increase in the frequency of comprehensive risk reviews (ARROWs) from a maximum of three to a maximum of two years, and fewer for firms facing particularly risky issues
  • A shift in supervisory style from focusing on systems and processes, to focusing on key business outcomes and risks, and on the sustainability of business models and strategies that will imply a greater willingness to vary capital and liquidity requirements, or to intervene more directly if the FSA perceives that specific business strategies are creating undue risk to the bank itself or to the wide system
  • A shift in the approach to the assessment of approved persons, with a focus on technical skills as well as probity
  • An increase in resources devoted to sectoral and firm comparator analysis, enabling the FSA to better identify firms that are outliers in terms of risks and business strategies, and to identify emerging sector-wide trends that may create systemic risk
  • Investments in specialist skills (eg in the analysis of liquidity risks), with supervisory teams able to draw on enhanced central expert resources
  • A more intensive analysis of information relating to key risks, with, for instance, more detailed information requirements relating to liquidity already outlined in the December Consultation Paper
  • A focus on remuneration policies, and the integration of oversight of remuneration policies into overall assessments of risk

Two further changes are needed:

  • Macro-prudential as well as sectoral analysis – sectoral analysis must be used to identify outlier business models and strategies, and to help build an overall picture of macro-prudential risks
  • Shift in the role the FSA plays in relation to published accounts and accounting judgements (with far more intense contact with bank management and auditors on these issues) – The FSA should undertake comparative reviews of the judgements made by different banks, and hold meetings with management and auditors to explore the reasons for outlier positions.

A major increase in FSA resources devoted to bank supervision, beyond that already planned in the SEP, is not essential to more effective regulation and supervision. Crucial changes in the FSA's approach are therefore likely to be:

  • The changes in supervisory approach already planned and being implemented, significantly increasing the intensity of supervision but without progressing to a bank examiner model
  • Further steps to intensify supervision in particularly high impact areas, eg oversight of accounting judgements
  • More macro-prudential analysis, and more analysis of and willingness to make judgements on business models
  • The more effective design and use of a small number of high impact prudential levers, in particular those relating to capital, liquidity and accounting policies

Risk management and governance

The FSA proposals for required improvement in risk management and governance will await the outcome of the Walker Review (October 2009), but are likely to be:

  • Improved professionalism and independence of risk management functions – the FSA will play a more active role in assessing the competence of senior managers
  • Risk management considerations embedded in remuneration policy
  • Improvements in the skill level and time commitment of non-executive directors
  • Shareholder discipline over corporate strategies

Regulation of large complex banks

Large commercial banks enjoy the benefits arising from retail deposit insurance, lender of last resort access, and an implicitly understood 'too big to fail' status. These benefits can be used to support proprietary trading activities that create risks for the institution and system. Future regulation to prevent this will include:

  • A regulatory regime for trading book capital that combines significantly increased capital requirements with a gross leverage ratio rule that constrains total balance sheet size
  • Intensification of the supervision of liquidity risks that will limit the ability of banks to hold potentially illiquid assets funded by short-term liabilities
  • Remuneration principles that will include a requirement for the calculation of profits to include adequate allowance for the different riskiness of different activities

Regulation and supervision of cross-border banks

The likelihood of large cross-border failures can be reduced by greater international coordination and actions focused on specifically national concerns.

Increased international cooperation: The Financial Stability Forum has defined the objective that all major cross-border financial institutions should be covered by a 'college of supervisors.' However, whilst colleges of supervisors can ensure better flows of information between national supervisors and can achieve the voluntary coordination of national supervisory actions, they cannot deliver fully integrated global supervision, since legal powers of intervention are national in nature, and since national governments look to national supervisors to protect national interests.

Increased national focus: Group liquidity supervision will involve gathering far more extensive information from banks and from home country supervisors on the whole bank liquidity of banks operating in the UK, with the power to impose tougher local liquidity requirements on branches and subsidiaries if the FSA has any concerns about the quality of information available or the implications of that information. In addition, the FSA will be more willing to use its powers to require major international banks to operate as subsidiaries in the UK, to increase capital requirements on local subsidiaries, and to impose other restrictions on business operation.

The European single market

The current European framework, combining branch passporting rights, home country supervision, and purely national deposit insurance, are not a sound basis for the future regulation and supervision of European cross-border retail banks. Sounder arrangements require either increased national powers, implying a less open single market, or a greater degree of European integration.

The FSA Discussion Paper expresses a current preference for:

  • The creation of a new European Union institutional structure, which would replace the Lamfalussy committees (CEBS, CESR and CEIOPS). This body would be an independent authority with regulatory powers, a standard-setter and overseer in the area of supervision, and would be involved, alongside central banks, in macro-prudential analysis, while leaving the primary responsibility for supervision at member state level.
  • The reinforcement of host-country supervisory powers of liquidity, and the right of host-country supervisors to demand subsidiarisation, and to impose adequate capital requirements and restrictions on local business activity

Click here for comments by Jacqui Hatfield (regulatory services partner in the FIG group) on the Turner Review