On July 8 the UK government published proposals for the reform of banking regulation. These proposals were announced by Alistair Darling, the Chancellor of the Exchequer (the UK finance minister), and contained in a report prepared by the UK Treasury. The report had been widely anticipated, and adopted many of the recommendations contained in the review prepared earlier this year by Lord Turner, the chairman of the Financial Services Authority (FSA), on the proposed regulatory responses to the banking crisis.
Some of the principal issues addressed by the Treasury's report are outlined below.
The tripartite structure
The Treasury's report does not envisage a fundamental change to the structure of UK banking regulation. The current structure, known as the tripartite system, divides responsibilities between the Treasury, the Bank of England, and the FSA. Under this system, the Treasury's primary role is in relation to the formulation of the domestic legislation which governs UK financial services, the Bank has general responsibilities concerning the maintenance of the stability of the financial system as a whole, and the FSA has responsibility for the regulation and supervision of particular banks.
Regulators around the world have been criticised for not doing more to predict and prevent the recent financial crisis, and the tripartite system has been seen by many as failing in this respect. Until 1997, the Bank of England regulated UK banks, but most of the Bank's regulatory functions were then transferred to the FSA. Many, including the opposition Conservative party, would like to see the Bank given significantly more power at the expense of the FSA, which they view as not having dealt adequately with the recent problems faced by UK banks. George Osborne, the Conservative shadow chancellor, has specifically stated that the prudential supervision of banks would be transferred to the Bank of England should the Conservatives come to power.
The government, however, wishes to retain the tripartite structure, but at the same time wishes to strengthen regulation. They intend to achieve this primarily by providing greater powers and increased resources to the FSA.
Council for Financial Stability
Nevertheless, reflecting criticisms of the tripartite system, the government intends to put in place new arrangements to improve the coordination of the three authorities by the creation of a new Council for Financial Stability, to be chaired by the Chancellor of the Exchequer. The Council will have regular meetings to analyse and assess potential risks to the financial system and to consider appropriate responses to such risks.
The FSA has recently announced that it will carry out an internal reorganisation designed to deal more effectively with the most important issues it faces. One of the key reforms is the bringing together of the FSA's risk specialists into a risk business unit, which will also concentrate on wider systemic risk issues. This reorganisation reflects the analysis in Lord Turner’s review, in which he recognised that the FSA had not in the past placed sufficient emphasis on analysing the systemic risks facing the banking sector and the sustainability of whole business models, but had concentrated too much on the narrower specific regulation of individual banks.
New financial stability statutory objective for the FSA
To complement the FSA’s increased emphasis on identifying systemic risk through its internal reorganisation, the Treasury report announces that the government will extend the powers of the FSA by providing it with a formal statutory objective for maintaining and enhancing financial stability, and by extending its rule-making powers to give it clearer legal authority to set rules whose purpose is to protect wider financial stability. These changes will make clear that the FSA can take regulatory action where there are risks to the financial system as a whole.
Banks’ remuneration practices
Banks’ remuneration practices have been one of the primary areas of public concern. The Treasury report states that it is clear that banks' remuneration practices were an important factor in the crisis, in that they tended to encourage risky conduct which produced short term gains, without properly taking account of the long term risks. The FSA has prepared a code, which is due to come into effect later this year, designed to ensure that banks have remuneration policies which are consistent with effective risk management. The Treasury report announces that the FSA will produce annual reports on remuneration practices and the risks they pose to financial stability, and that bankers' remuneration will be a subject discussed at the first meeting of the new Council for Financial Stability.
Are some banks too big to fail?
There has been much discussion about whether some banks are too big to fail. Recently, the governor of the Bank of England, Mervyn King said: "If some banks are thought to be too big to fail, then, in the words of a distinguished American economist, they are too big." However, it could also be argued that even quite small banks are too important to fail because of their role in the financial system. Consequently, the government does not support putting arbitrary limits on the size of banks. Instead, complex banks which pose the greatest risk to the financial system will face higher capital requirements.
Should traditional retail narrow banking be separated from the investment banking side of banks?
Similarly, it has been suggested that traditional narrow banking should be separated from investment banking, adopting a Glass-Steagall type approach. However, the government believes that there is no evidence that insulating the deposit-taking business of banks from their other activities would have made them less likely to fail during the recent crisis or that the systemic impact of any failure would have been reduced.
The government therefore does not favour a Glass-Steagall type separation, but believes that regulation should be focused on firms which would have a high impact on the financial system were they to fail. These regulatory measures will include requirements that such firms hold capital and maintain liquidity to reflect both the likelihood of their failure and the impact that this failure could have on the system as a whole. However, the Treasury also notes the importance of an internationally agreed approach to the development of such requirements.
Increasing the quality and quantity of capital
Following on from the recommendations in the Turner review, the government supports the FSA’s proposals to increase the minimum levels of capital required for banks significantly above those required under the current Basel II rules.
As well as increasing the quantity of capital, the government has emphasised the importance of banks building buffers of high quality capital, in particular shareholder equity (as opposed to other forms of capital such as subordinated debt), as affording protection by being better able to absorb losses.
Proposals for counter-cyclical capital requirements
The current Basel II capital regime has been criticised as being pro-cyclical in that it exaggerates swings in the economic cycle, with capital requirements tending to fall in periods of growth, so accentuating the boom, and rising in recessions, which can lead to banks cutting back on lending and so making the recession worse. The government therefore agrees with the objective of creating a counter-cyclical capital regime, with capital buffers increasing in economic upswings and decreasing in recessions. It, however, notes that these changes need to take place after international agreement.
The report notes the importance of maintaining adequate levels of liquidity, especially in times of financial crisis. The government supports the FSA's proposals to reform liquidity standards in the UK, but again notes that internationally agreed standards are needed in this area.
The UK has recently introduced legislation (the Banking Act 2009) designed to ensure the effective resolution of banks in the event of their failure. To supplement this, the government believes that the banks themselves should have clear contingency plans, which could be implemented at short notice, for action in times of failure. The FSA will work with “high impact” firms to ensure they have such plans in place.
Pre-funding to be introduced in the Financial Services Compensation Scheme
A further proposal to protect depositors is to improve the Financial Services Compensation Scheme, which is financed by the industry, and which reimburses depositors in failed banks. Since bank failures can be expensive, the Scheme cannot always meet the full costs of a substantial failure immediately by raising levies from the industry. The government therefore believes that, in the future, there should be a pre-funded element in the Scheme; the idea of pre-funding being that it will enable the costs to be spread before a major failure occurs. UK banks, however, are concerned at the increased costs they will face as a result of these proposals.
The government's proposals do not amount to a fundamental reform of the way in which UK banking regulation will be structured, but they do move the emphasis towards identifying risks to the financial system as a whole, rather than concentrating on the narrow supervision of individual banks. The government, however, recognises the limits on its ability to regulate, given that many of the key issues affecting UK regulation, such as capital and liquidity requirements, first need to be agreed internationally, and given that many of the decisions affecting UK banking regulation are made at the European Union level.