Presentation on theme: "THE UK FINANCIAL SECTOR, REGULATION AND THE FINANCIAL CRISIS"— Presentation transcript:
1 THE UK FINANCIAL SECTOR, REGULATION AND THE FINANCIAL CRISIS Course on Financial Instability at the Estonian Central Bank,9-11 December 2009 – Lecture 5E Philip DavisNIESR and Brunel UniversityWest Londongroups.yahoo.com/group/financial_stability
2 Overview What is a bank – how do they fail? The role and nature of financial regulationHow did the financial crisis impact on the UK?The safety net – issues for the UKPrudential regulationCross border aspectsSome comments on the Turner Review
3 What is a bank – why do they fail? Traditional bank
5 The role and nature of financial regulation Aims to protect against market failuresInformation asymmetryExternalityMonopolyTwo aspects of regulationThe 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 EnglandFinancial 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
10 Major elements of UK crisis Freezing of interbank markets from August 2007 requiring liquidity assistance by Bank of EnglandRetail and wholesale customer run on Northern Rock, failed in September 2007Bradford and Bingley, Alliance and Leicester had to be taken overNeed to nationalise and recapitalise RBS and HBOS with massive, partly covert, state assistance in October 2008UK 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” regulatorsSerious 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 fundingLongest 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 ProgrammeMoved between FSA divisions three times in as many years – and division mainly responsible for Northern Rock had suffered staff cutsRecords of supervisory meetings were often not keptIn 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 recapitalisationMajor burden on fiscal policy, to add to cyclical swingHow realistic to expect 2007 maintained?Keeping public support for recapitalisationThe poor performance of public banksDeposit insurance shown to be inadequateIncrease in limits to £50,000 and 100%Ability to access in 7 daysShould 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 RockHow to exit from the high level of liquidity support?Is “stigma” adequately dealt with?Special resolution regime institutedBanks can be put into resolution when not technically insolvent, in interests of financial stabilityA step forward from Northern Rock….….but need for numerical prompt correction action targets (link to capital and liquidity) to avoid forbearanceCould Bank of England be overburdened?
14 Lessons for prudential regulation Capital adequacy failed to prevent crisisThe 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 intermediationBut reduces incidence of financial instabilityCapital adequacy and procyclicalitySpanish approach conflicts with accounting rules…….but other are just theoreticalLeverage 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 centreNeed for an aggregate quantitative target?Equal attention to liability management?Other prudential regulation had let banks take unwarranted risksLimits on LTVs needed for mortgages and commercial propertyEnsuring remuneration covers the lifetime of productsIs there a need to divide commercial and investment banking again? Reduce bank size?Caution in government guaranteeing securitisationsRegulation 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 supervisionDid the UK’s “light touch” fail?Specific issues with Northern RockGeneral issues allowing risky lending, wholesale funding, inadequate assessment of takeoversStructure of regulation – more dual key to avoid underlapOr even moving LCFIs back to the Bank?
17 Cross border aspectsHow far ahead can the UK go alone – does the “City” concern dilute desirable regulation?Problems of Basel 2 – back to the drawing board?Rating agenciesRisk modelsWhy no global agreement on liquidity?Learning from Iceland – institutions that are “too big to save”, branching and cross border LOLRIcelandic bank deposits unprotected – use of anti-terror law to seize assetsBroader 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 issuesVery 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 ReferencesDavis E P (2009), “Banking on prudence”, chapter of OECD Report on the UK Economy, OECD Economics Department Working Paper