Changes to the Uk Regulatory System

7/31/2019 Changes to the Uk Regulatory System

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Changes to the UK regulatory system 5

Changes to the UK regulatory system

At the Mansion House on 16 June, the Chancellor of theExchequer announced plans to change the system of UKfinancial regulation. A further statement was made by theFinancial Secretary in Parliament on the following day.(1) AGovernment policy document for public consultation will bepublished before Parliaments summer recess.

ThisReport, which was prepared largely ahead of theseannouncements, focuses on the Banks assessment of conjunctural risks and aspects of the broader internationalfinancial stability policy agenda, rather than the proposedchanges to UK regulatory arrangements.

The changes will move the United Kingdoms regulatory

framework towards a twin peaks model of financialregulation, with prudential regulation of banks separated fromoversight of consumer protection and market conduct. Thechanges will also give the Bank a new responsibility formacroprudential regulation of the financial system. Theprocess will be completed in 2012.

Prudential Regulation AuthorityThe Government plans to legislate to create a new PrudentialRegulation Authority (PRA) as a subsidiary of the Bank toconduct prudential regulation of sectors such asdeposit-takers, insurers and investment banks. The PRA will bechaired by the Governor. The Chancellor announced thatHector Sants will remain at the FSA to oversee the transitionand will become Chief Executive of the PRA and a new DeputyGovernor of the Bank in due course. Andrew Bailey, the BanksChief Cashier, will be Deputy in the new regulator, and willhelp with the transition. The Deputy Governor for FinancialStability will also sit on the PRA Board.

In addition to the PRA, there will be a new ConsumerProtection and Markets Authority (CPMA), separate from theBank, to regulate the conduct of all financial firms, includingthose prudentially regulated by the PRA. The CPMA will alsohave responsibility for the Financial Services CompensationScheme.

Financial Policy CommitteeThe Government also announced that it will legislate tocreate a Financial Policy Committee (FPC) in the Bank, whichwill be placed in charge of macroprudential regulation. It willhave responsibility to look across the economy atmacroeconomic and financial issues that may threatenstability and will be given tools to address the risks it

identifies. It will have the power to require the new PRA toimplement its decisions by taking regulatory action withrespect to all firms.

The Governor will chair the FPC. Its members will include theDeputy Governors for monetary policy and financial stability,the new Deputy Governor for prudential regulation, the Chairof the CPMA, as well as external members and a Treasuryrepresentative. The Committee will be accountable toParliament, as is the case with the Monetary PolicyCommittee, and to the Banks Court of Directors.

Speaking at the Mansion House, the Governor said: It is notdifficult to see what role such a macroprudential regime mighthave played in the run-up to the crisis. A progressivetightening of capital standards, for example, would havehelped rein in the near-tripling of UK bank balance sheetsbetween 2002 and 2007But a macroprudential regime alsohas a key role to play in the downswing phase of the cycle.Since 2008, credit conditions have tightened, jeopardising the

recovery and, in turn, threatening renewed losses for banks. Byallowing banks to draw on their macroprudential capitalbuffers, while credit conditions remain tight, the system iscountercyclical. In other words, a credible macroprudentialregime could help forestall both excessive exuberance andunnecessary caution.

It is intended that an interim FPC will be set up by the autumnin advance of the passage of primary legislation.

(1) The Chancellors speech is available at www.hm-treasury.gov.uk/press_12_10.htm.The statement by the Financial Secretary is available atwww.hm-treasury.gov.uk/statement_fst_170610.htm.


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Overview 7

Overview

A near-term challenge

Banks operating environment has become more challenging.Since the December 2009Report, markets have focusedincreasingly on strains placed on sovereign balance sheets. InApril, concerns about the sustainability of the Greek fiscalposition became acute and spilled over to a number of otherEuropean economies (Chart 1 ). Amid increased marketuncertainty (Chart 2 ), corporate debt issuance dried upand investors sought safer assets (Chart 3 ), such asUS Treasuries. Concerns about banks sovereign debtexposures contributed to a marked tightening in fundingmarket conditions. In the face of heightened systemic risk, theIMF and European authorities put in place a substantialpackage of support measures (Table A ), which helped tostabilise key markets.

Sovereign risk had been highlighted previously, including in theDecember 2009 FSRand by market participants in the BanksSystemic Risk Survey (Table B ). But the speed with whichGreeces problems were transmitted to other countries andmarkets highlighted persisting fault lines in the global financialsystem. A lack of transparency about sovereign exposuresamplified counterparty risk concerns, affecting funding

Since the December 2009 Report, markets have focused increasingly on strains placed on sovereignbalance sheets. In April, concerns over Greek sovereign risk spilled over to other European countriesand developed rapidly into a generalised retreat from risk-taking. Inadequate transparency aboutsovereign exposures led to counterparty concerns and renewed strains in bank funding markets. Inresponse, the IMF and European authorities put in place a substantial package of support. Whilethese measures helped to stabilise conditions, market pressures have not yet abated. EU leadersalso recently announced plans to publish the results of stress tests conducted on the largestEuropean banks; this will be another important step.

UK banks have raised their capital and liquidity buffers substantially, which has helped themweather recent tensions. But, in common with their peers, they face a number of challenges in theperiod ahead. UK banks need to maintain resilience in a difficult environment, while refinancingsubstantial sums of funding; they have a collective interest in providing sufficient lending to supporteconomic recovery; and they will need over time to build larger buffers of capital and liquidity tomeet more demanding future regulatory requirements. The new Basel regulatory regime will beagreed in the autumn. An extended transition to this new regime would enable banks to build

resilience through greater retention of earnings, while sustaining lending.

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Sources: Thomson Reuters Datastream and Bank calculations.

(a) Spread of ten-year government bond yields over German bunds for selected countries.Data to close of business on 10 June.

(b) December 2009 Report .

Chart 1 European sovereign spreads(a)


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8 Financial Stability Report June 2010

markets internationally. And strains in foreign exchange swapmarkets revealed the continued heavy reliance of manyEuropean banks on short-term dollar funding from wholesalemarkets (Chart 4 ).

UK banks have increased their resilienceUK banks strengthened their resilience during 2009. Capitalincreased significantly (Chart 5 ), with average ratios now attheir highest level in more than a decade. This is a strongcapital platform. In addition, leverage declined sharply(Chart 6 ), reflecting equity issuance and reductions in assets inroughly equal measure. Those asset reductions werepredominantly falls in intrafinancial sector exposures,including derivatives, rather than lending to the real UKeconomy.

But, like their peers, UK banks as well as building societies(see box on pages 4849) face significant challenges. Theyneed to remain resilient in a difficult environment, whilerefinancing substantial sums of funding in coming years. Theyhave a collective interest in supporting lending, given thecontinued dependence of small and medium-sized businesseson bank credit and signs of more difficult capital marketconditions for larger companies. And they need to plan theiradjustment to tighter future regulatory requirements.

building up a buffer against sovereign concernsAlthough UK banks have limited holdings of sovereign debt ineconomies where fiscal concerns have been most acute(Section 2), they have counterparty relationships withEuropean banking systems that have larger exposures(Chart 7 ). These banks face further write-downs in 2010,according to the IMF and ECB.

If undiminished, sovereign concerns could also affect UK banksthrough their impact on global financial markets (Section 3).Renewed concerns about counterparty risk could furtherreduce the availability of bank funding. And funding strainscould be exacerbated by any falls in the perceived value of

government support for banks. Deteriorating investorsentiment could also trigger further falls in asset prices.Market participants currently appear to place increased weighton such a tail scenario for asset prices (Chart 8 ).

Sovereign risk concerns in Europe might lead to a further shiftin investors demand both geographically (from European toAsian and US assets) and across the risk spectrum (from riskyto safer assets). That redistribution of risk capital would weighon prospects for growth in Europe. It would also intensify theslower-fuse risk of overheating in some emerging Asianeconomies (see box on pages 2829).

International authorities have taken action to mitigate theimmediate market consequences of perceived sovereign risks.On 9 May, the EU announced the creation of a European

Chart 3 Indicators of risk appetite(a)(b)

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Credit Suisse

State Street

Standard deviations from mean(c)

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Sources: Bloomberg, Credit Suisse and Bank calculations.

(a) Indices are adjusted so that positive numbers in both series indicate increased risk-taking andnegative numbers indicate reduced risk-taking.

(b) Data to close of business on 14 June 2010.(c) Mean and standard deviation calculated from 28 July 2004.

Table A European sovereign concerns timelineRecession and public sector support for banking sector lead todeteriorating scal positions

2008/2009

Newly formed Greek Government revises estimate for 2009 budget decitfrom 3.7% to 12.5%

Oct. 2009

Greek sovereign debt ratings downgradedOct.-Dec. 2009

Council of the European Union gives notice to Greece to correct its decit by2012

Feb. 2010

ECB announces that it will keep the minimum credit rating threshold foreligible collateral at BBB- beyond 2010

Apr. 2010

Deterioration of Greek sovereign and bank funding market conditions spreadsto a number of other European countries

Apr.-May 2010

110 billion support package for Greece is announced with30 billion to be contributed by the International Monetary Fund and theremainder by euro-area Member States

2 May 2010

ECB suspends the application of the minimum credit rating threshold foreligible Greek collateral

3 May 2010

IMF and European authorities announce a wide-ranging set of measures tosupport European nancial stability

9 May 2010

Spain and Greece sovereign debt ratings downgraded.Governments in Germany, Greece, Italy, Portugal, Spain and theUnited Kingdom announce accelerated plans for scal consolidation

May-June 2010

Chart 2 Market uncertainty (a)

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300Equities (left-hand scale)

Currencies(left-hand scale)

Interest rates(right-hand scale)

CDS premia (right-hand scale)

Per cent Basis points

Sources: Bloomberg, British Bankers Association, Chicago Mercantile Exchange, Euronext.liffe, JPMorgan Chase & Co. and Bank calculations.

(a) Three-month option-implied volatilities. For further details, seeChart 3.3 .


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Overview 9

Stabilisation Mechanism, with the IMF providingcomplementary financing arrangements. In parallel, the ECBhas undertaken a range of measures, including purchases of euro-area public debt and, in co-ordination with other centralbanks, resumption of US dollar liquidity operations. Theforthcoming stress test for European banks will be anotherimportant step.

and losses from legacy exposures to overextended borrowers.UK banks are exposed to domestic borrowers, some of whomoverextended their balance sheets in the build-up to the crisis.To date, a combination of low interest rates and forbearance orrestructuring of loans by banks has helped to contain stress tohouseholds and businesses. But weaker-than-anticipatedgrowth or a pickup in market interest rates could increase

financial pressures on those sectors and on banks. Corporateliquidations, including in the commercial property sector,could increase if banks become less willing or able to allowbreaches in loan covenants (see box on pages 3233).

US exposures account for around a quarter of UK banksforeign claims. While the US economic outlook has improved,there are downside risks to the US housing market, reflectingan overhang of supply and the potential for a rise inforeclosure rates as official sector support is unwound. Thatcould increase losses on US household lending, where around aquarter of mortgagors are currently in negative equity (see boxon pages 2627).

Banks face a substantial refinancing challenge,Banks internationally face a substantial refinancing challengeover the coming years, as private sector funding matures andextraordinary public support is withdrawn. Globally, banks areestimated to have at least US$5 trillion of medium tolong-term funding maturing over the next three years(Chart 9 ). In the United Kingdom, the largest banks willneed to refinance or replace around 750 billion800 billionof term loans and liquid assets by the end of 2012. That

equates to over 25 billion each month on average, morethan double the average monthly issuance achieved so far this year. UK banks also need to extend the maturity of theirwholesale funding, around 60% of which falls due withinone year.

need to have credible plans in place,The UK authorities are working with the UK banks to assess theindividual and collective credibility of their funding strategies.In aggregate, banks might make optimistic assumptions abouttheir ability to attract retail deposits, domestically andinternationally, at a time when both they and non-banks arecompeting aggressively for inflows. That underlines theimportance of some front-loading of efforts to term outfunding, despite its relatively greater cost given the currentslope of the yield curve.

Table B Systemic Risk Survey results: key risks to the UK financialsystem (a)

Risks mostKey risks challenging to manage

May 2010 Nov. 2009 May 2010 Nov. 2009

Sovereign risk and/or concernsabout public debt 69 24 43 3

Economic downturn 67 68 43 41

Regulation, taxes on banks 41 49 33 35

Funding and liquidity problems 33 35 20 30

Financial market disruption/dislocation 28 30 20 19

Property price falls 28 27 6 5

Tight credit conditions 20 24 7 11

Household and corporate defaults 17 49 11 22

Election uncertainty 17 0 0 0

Financial institution failure/distress 15 11 11 14

Sources: Bank of EnglandSystemic Risk Surveysand Bank calculations.

(a) Per cent of respondents citing each risk. Market participants were asked to list (in free format) the five risksthey believed would have the greatest impact on the UK financial system if they were to materialise, as wellas the three risks they would find most challenging to manage as a firm. Risks cited in the previous surveyhave been regrouped into categories used to describe the latest data.

Chart 5 Tier 1 capital ratios for selected European

banking systems(a)(b)

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Average 20050720082009

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KingdomSources: Capital IQ, Moodys Investors Service, published accounts and Bank calculations.

(a) Includes banks with total assets of more than US$100 billion.(b) Aggregated from individual banks, weighted by total assets.

Chart 4 Euro-dollar basis swap rates(a)(b)

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(a) Additional rate over three-month Euribor to swap US dollars, which pay three-month dollarLibor, for euros for one year.

(b) Data to close of business on 14 June 2010.


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and support lending to the real economy,Banks have a collective interest in supporting economicrecovery through their lending activities. Credit availabilityremains tight for some sectors, despite recent improvements.And the recent retreat from risk by unleveraged investorsmight have increased those pressures. There is a risk thatbanks alleviate their own funding pressures by furtherconstraining credit conditions for customers. That would denteconomic recovery and so raise credit risk for all banks.

Over time, UK banks have the capacity to provide greatersupport to creditworthy customers while meeting fundingrequirements and remaining resilient by adopting moreconservative retention policies. Banks have slightly reducedpayout ratios. But, while profits remain buoyant, furtherreductions in discretionary distributions to staff and

shareholders could raise substantial amounts of new capital(Chart 10 ).

during an extended transition to new regulatory requirements.While more prudent international regulatory standards arerequired, the transition to the new regime should take dueaccount of the economic environment. An extended transitionwould make it easier for banks to build resilience throughprofit retention, while sustaining lending. Lengthening thetransition timetable should not, however, detract from theneed to agree internationally the shape and calibration of thenew Basel regulatory regime during the autumn, to reduceinvestor and management uncertainty.

Safeguarding stability

More prudent regulatory standards will be required wheneconomic conditions improve.The Basel Committee for Banking Supervision (BCBS) iscurrently developing a package that will require banks to holdlarger buffers of resiliently liquid assets and loss-absorbing

capital. The required level of capital in the system depends ontwo key judgements. First, the amount of capital that bankswould be expected to hold when credit supply is neitheroverly exuberant nor overly conservative. This must balancethe costs of higher capital, such as any adverse impact on thecost of credit, against the benefits of fewer or less severefuture financial crises (see box on pages 5860). Thesecond judgement is the split of total capital between acredible hard minimum (below which the authorities wouldtypically take action, such as placing a bank in resolution) anda usable buffer (Chart 11 ). The latter buffer should bematerial. As the Governor set out at the Mansion House,(1) itmight also vary over the credit cycle, as part of the

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Sources: Bank for International Settlements (BIS), European Central Bank and Bank calculations.

(a) Chart shows exposures of each country to the public sectors of other selected countries andto its own public sector. All claims are as a fraction of 2008 aggregate shareholder equity.

(b) All claims exclude guarantees and derivatives. Claims of German banks are not adjusted forrisk transfers.

(c) Exposures to own public sector.

Chart 7 Selected BIS banks claims on public sectors(a)(b)

Chart 8 Market-implied probability distributions of S&P 500(a)

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March 2009trough(b)

April 2010 peak(c)

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Sources: Chicago Mercantile Exchange and Bank calculations.

(a) One year ahead. For further details, see footnote (a) in Chart 3.15 .(b) Taken as 10 March 2009.(c) Taken as 23 April 2010.

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Leverage ratio

CapitalDerivativesSecuritiesLoans to banks and OFCs(c)

Average leverage

Sources: Bank of England, published accounts and Bank calculations.

(a) Bank of England estimates used to correct for a change in the reporting basis of loans to UKhouseholds see Bank of England:Monetary and Financial Statistics (May 2009), Table A4.1and footnotes.

(b) Gross leverage is calculated as total assets divided by total equity. By accounting forderivatives positions on a gross basis, this measure best captures the risks around theassociated counterparty exposures.

(c) Other financial corporations.(d) Private non-financial corporations.

Chart 6 Changes in major UK banks gross leverageratio(a)(b)

(1) At the Mansion House on 16 June, the Chancellor of the Exchequer also announcedplans to change the system of UK financial regulation. See the box on page 5 forfurther details.


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Overview 11

macroprudential toolkit. Following the passing of adverseshocks, banks could drain the buffer to absorb losses withoutan unnecessary tightening of credit conditions.

Policymakers plan to tackle fault lines in the regulatory treatment of trading activitiesAhead of the crisis, banks had an incentive to shift assets tothe regulatory trading book where capital charges were oftenmuch lower than in the banking book. But, during the crisis,the majority of losses in banks trading books were linked tocredit positions. The BCBS has started a fundamental reviewof the regulatory regime for trading assets. Two principlescould usefully form building blocks for the eventual regime:consistent treatment of similar types of risk across banksbalance sheets, irrespective of where they are booked; andexplicit allowance for the risk of swings in liquidity premia on

positions that are marked to market.

and strengthen market discipline and risk management.Effective market discipline can contribute to a more resilientfinancial system. Convergence of international accountingstandards would help facilitate comparisons of internationalbanks financial positions. Market discipline would also beaided by improved disclosure by banks, including on thevariation in key balance sheet measures during reportingperiods (see box on pages 6364). Better disclosure mighthave helped to mitigate strains in funding markets in recent

years, which were exacerbated by a lack of informationregarding banks exposures. Banks should also strengtheninternal risk management, with treasury functions executingrisk-based transfer pricing policies and not serving as profitcentres.

Policy action is needed to reduce the distortions created by too important to fail banksPolicy action is needed to reduce the structural problemscaused by banks that are too important to fail (TITF). LargerUK banks expanded much more rapidly than smaller

institutions in the run-up to the crisis (Chart 12 ) and havereceived disproportionate taxpayer support during this crisis.That reflected a misalignment of risks on TITF banks balancesheets, due to implicit guarantees on their liabilities.

The Bank welcomes the Governments establishment of a newindependent commission to review the structure of andcompetition in the UK banking system. Incentives to becomeTITF could also be reduced by restrictions on activities andcapital surcharges on institutions generating systemic risk.And further measures are needed to ensure that banksuninsured creditors face a credible threat of loss. For example,there is international debate about requiring uninsuredcreditors to recapitalise distressed banks through an extensionof the scope of statutory resolution regimes and throughconvertible debt instruments.

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Per cent of average annual issuance 200507 trillions

Sources: Bank of England, Dealogic, ECB, FDIC, Fitch, SoFFin, UK DMO and Bank calculations.

(a) See Chart 4.16 for details.

Chart 9 Bank refinancing requirements internationally(a)

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(a) Lines indicate staff compensation and dividend ratios that would generate various levels of retained capital, and are based on major UK banks 2009 results. Diamonds indicatecompensation to revenue and dividend to revenue ratios for the major UK banks in various years. Diamonds for 200508 are not indicative of capital retained in 200508, as results inthese years differ from the 2009 results used to calibrate the lines.

(b) Compensation to revenue and dividend to revenue ratios were high in 2008, partly due tolower revenue in that year. Though the 2 008 ratios are outside the limits of this chart, theyare presented in Chart 4.20 .

Chart 10 Capital accumulation achievable through lowerdiscretionary distributions by UK banks(a)(b)

Chart 11 Varying capital buffers over the credit cycle

Time-varying overall level

Cycle-neutralbuffer

Minimum requirement (hard oor)

Time

Time-varyingbuffer

Capital requirements (per cent of risk-weighted assets)

Source: Bank of England.


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and to strengthen market infrastructure.The crisis has underlined the importance of ensuring thatemerging shifts in market structure do not result in systemicrisks developing outside the banking system. For that reason,the authorities should monitor carefully the expansion of leverage in exchange-traded funds and in UCITS hedge fundsthat offer ready liquidity to investors. The crisis alsohighlighted the importance of strengthening the infrastructuresupporting capital markets. Initiatives are under way to extendcentral counterparty (CCP) clearing. But this will only improveresilience if appropriate CCP risk management standards are inplace (see box on pages 6970). For example, holdingsufficient resources to meet the default of at least the twolargest member counterparties in stressed but plausiblemarket conditions would help to reduce systemic risks. Theongoing review of international standards for financial market

infrastructures represents an important opportunity to raisestandards for the new markets.

Chart 12 Liabilities of banks and building societies bysize(a)

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(a) Big includes Barclays, HBOS, HSBC, Lloyds TSB and RBS; medium includesAlliance & Leicester, Bradford & Bingley, Nationwide and Northern Rock; small includes allcurrent building societies except Nationwide. Based on subsample of institutions for19982000.

Changes to the Uk Regulatory System

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