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
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