The FSA's Priorities for 2008
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Speech by Dr. Thomas F. Huertas, Director, Banking Sector
4th European Banking Regulation Conference,
London
29 January 2008
"May you live in interesting times," runs the ancient proverb, and today's times are certainly that. Financial firms and financial markets are under severe pressure.
My objective this morning is to outline the FSA's priorities for 2008. As the title of the conference suggests, my focus will be on banks, but many of my remarks will apply to firms in other industries as well.
In broad terms our priorities for 2008 are to
- Promote orderly, efficient and fair markets
- Help retail consumers get a fair deal
- Improve our business capabilities and effectiveness
These are the same priorities that we had in 2007 and prior years. They have not changed.
What has changed is the environment. We have had a storm of considerable magnitude – analogous, perhaps, to a hurricane. Some leading firms have suffered massive losses and certain capital markets, notably those for mortgage backed securities, are largely closed. Liquidity in certain instruments, especially complex instruments, has dried up, creating valuation challenges and potential losses. Doubts have crept in concerning certain elements at the centre of the originate-and-distribute model of financial services – ratings and monolines are but two examples.
Recently, spreads in the interbank market have come down from the heights reached last year. The question is whether this is the all-clear signal, or the eye of the storm. No one, I submit, can know that answer for certain, and it would, in my view, be foolhardy to take for granted that we have in fact gotten the all clear signal. There are ample signs on the horizon that what we may be experiencing is the eye of the storm. As bad as things are, they could get worse. We all need to plan for that eventuality. In times like these, it is the regulator's job to remind firms that behind every silver lining, there may be a cloud.
The US economy is slowing down, and there may be a recession. Such a slowdown could spread to other countries, including the UK. In such an environment heavily indebted borrowers with low incomes could have trouble paying their debts. That's especially likely to be true for borrowers – be they consumers or businesses - that were sub-prime to start with. And it could become true for many more. An economic slowdown can rapidly increase the population of fallen angels. And, an economic slowdown is not the best environment in which to resuscitate constricted capital markets.
If things do get worse, business models will be even more severely tested, and firms should, in our view, be thinking through now how they would stand up to such a test. Are their business models shaky or robust? If firms were to suffer a significant loss, could they recapitalise themselves quickly? If a source of funding were to dry up, could the firm replace that funding or do without it entirely?
To date, investors have promptly recapitalised a number of firms with robust business models that have suffered losses in the turmoil of the last six months. But investors are a tough jury, and their views of what constitutes a robust business model may change, particularly if economic conditions worsen. So firms need to think through what it will take to succeed in tough times. And, firms need to be sure that they have adequate resources to survive in the tougher times that may lie ahead.
Accordingly, firms should be asking themselves and we are certainly asking firms a few key questions.
The first is, "do firms have adequate capital"? Thanks to the benign economic environment that prevailed for many years prior to August 2007 firms had earned large profits and built up strong capital positions. This has generally provided firms with an ample cushion to offset recent losses and a base from which to seek recapitalisation, if needed. However, important issues remain.
The most immediate is valuation, especially of complex illiquid instruments. Here, greater transparency is needed – about the risks in the instruments themselves and about how firms are valuing the instruments so that investors, regulators and the banks themselves have greater clarity about the value of these instruments. Above all, it is necessary to assure that firms are placing a fair and true value on their positions, including not only those that are marked to market, but also those that are marked to model and those that are marked according to "independent price verification" (or as some wags would put it, "marked to myth").
Fortunately, firms – together with their auditors – are making significant progress in this area. Firms have conducted extensive reviews of their valuation procedures and are making substantial improvements in processes as well as marking their positions more conservatively. This reflects the reduced possibility in the current environment to sell certain positions to third parties. But further progress needs to occur with respect to transparency, particularly of structured financial products such as asset-backed securities, so that investors can more readily assess the risks of the assets that underlie the structure as well as the risks inherent in the way the structure allocates cash flows from those assets.
Although valuation is the most pressing immediate issue, there are also broader issues with respect to capital. In 2008 most banks will be submitting and we will be reviewing their individual capital assessments under Pillar 2 of the Capital Requirements Directive. Here we will be looking to assure that banks have made an accurate assessment of all the risks that they face, including those risks not covered by Pillar 1 capital requirements, and that they have adequate capital to support those risks, including risks that may arise in a stressed environment.
We will also be looking at the quality of capital. CEBS has initiated a review of the definition of hybrids across Member States as a backdrop to EU efforts to achieve more convergence in this area. More generally, we have launched a discussion paper on the definition of own funds as a basis for the more fundamental review of own funds that Basel and the EU will be conducting over the coming years. In this paper we focus on what we call going concern capital – capital that is available to absorb losses prior to any type of insolvency or winding up procedure for the bank. That is the highest quality capital, and that is the type of capital that we believe firms should be especially sure to have in adequate supply and be able to promptly raise, if needed.
But adequate capital is just the start. The second question we are asking is "does the firm have adequate liquidity"? Since August of last year, banks have had to confront severe liquidity pressures. The litany is well known – practical closure of the asset backed securities market, reduced flows in the interbank market, increased demands for withdrawals from retail depositors and an expectation from investors that banks would support the conduits and structured investment vehicles that they had sponsored or managed, even if they were not legally obliged to do so.
In line with the deterioration of market conditions, we have stepped up the frequency and intensity of our reviews of the liquidity of all banks in the UK and we will continue this supervisory focus in 2008 and beyond. For those interested in the approach taken in these reviews, I recommend reading our discussion paper on liquidity published in December 2007. This takes a "belt-and-braces" approach to liquidity. The belt is a comprehensive view by the bank of the inflows and outflows that the bank expects to incur over the coming time horizon – in other words, what are the liquidity pressures that it expects, both under normal and stressed conditions. And, the buckle on the belt is the plan that bank has in place to counteract larger than expected outflows, including, for example, contingency plans for websites, call centres, branches and communications if the bank were to experience a surge in retail deposit outflows. Experience has shown that assumptions that firms have made with respect to these outflows have not been sufficiently robust compared to the actual outflows that have occurred.
The braces are a stock of highly liquid instruments – cash or items that can be readily and immediately turned into cash via sale or repo at a minimal haircut.
Ordinarily in a discussion document, we put it out for comment, we wait for the comments to come in, we then evaluate things. I will tell you, with respect to liquidity we have, and will continue to have, quite detailed discussions with firms, with banks, as to how they are actually managing their liquidity. In times like these it is especially important that banks are wearing both belt and braces.
A third question concerns systems and controls. Are they adequate? "Could it happen to us? If not, why not?" are the first questions that CEOs of banks would have been asking in response to the news that SocGen had lost €5 billion as a result of control failures. Our supervisory response was to ask firms whether or not they were in fact asking themselves that question and to request a copy of the response. Based on the responses that we receive, we may take further supervisory action.
Contrary to reports in the press over the weekend, we are not planning new rules and regulations in this area. We are operating in a principles and risk-based manner. If there are deficiencies at a particular firm, we will work with that firm to remedy them. If there are broader lessons to be learned from the overall responses, we will convey them to the industry and build the lessons into our supervisory reviews.
The fourth question concerns staffing and resources? Are they adequate? We all know that the front office is where the glamour and the revenues are. We all know that the front office has a great deal of influence. But, I would submit, you cannot be driving at speed unless you know that the brakes and the steering wheel are in order. Skimping on control staff and systems is penny wise but billions of pounds foolish. In our dialogue with banks we want to be sure that they are in fact adequately staffing their control areas, both in terms of quality and numbers of people.
Let me now turn to conduct of business issues. Business models need not only to be robust; they also need to be what I would call decent. Accordingly, firms should be asking themselves a few key questions, and we are certainly asking firms these questions.
First, do firms treat their customers fairly? Have they embedded this in their business practice, from product design, through to distribution and complain handling? Although firms have made significant progress in this area in recent years, some firms have exhibited weaknesses or shortcomings in certain areas, such as the sale of payment protection insurance. The question of fairness also encompasses unauthorised overdraft charges and a number of other areas, so there is substantial work for banks in this area.
More generally, both we and the banks are reviewing the Banking Code. In particular, there is a discussion as to whether the Banking Code should contain an overarching fairness provision. We think that that is a very good idea, and our review of situation will pay close attention as to whether the revision of the Banking Code does in fact incorporate such a provision.
The second question that firms should be asking themselves, and that we are certainly asking firms, is: Do they adhere to proper standards of market conduct? Are they taking sufficient precautions to guard against market abuse? Last year, for example, we conducted a study with respect to the practices on mergers and acquisitions. The study established that firms had huge numbers of people classified as insiders on each deal that they were working on. Does a firm really, really need two hundred-plus people on the insider list? We think not, and we are asking firms why the numbers need to be so large, and why each of the people on the list actually needs to have access to confidential inside information.
We have also instituted increased surveillance of market transactions, and have built up our technology to enable us to do so. Finally, we have also instituted criminal prosecutions, so that anyone engaged in market abuse can have the opportunity to be a long-term guest of Her Majesty in one of her correctional facilities.
A third conduct question concerns financial crime. Are firms taking sufficient precautions, sufficient steps, to protect against financial crime and to protect against the possibility that their institution could be used by others for financial crime? Are firms taking a risk-based approach with respect to controls on money-laundering? Are firms doing enough to protect customer data? These and other questions are what we will be asking firms.
We frequently hear that we may have gotten incorrect the balance between prudential and conduct of business supervision. They have to be able to maintain adequate prudential standards and they have to maintain correct conduct of business practices. In other words, firms have to walk and chew gum at the same time.
Finally, let me turn to roles and responsibilities. It is a bank's responsibility, not the FSA's, to select a strategy and run the business. We are not, and should not be, shadow directors of the bank. It is the firm's responsibility to make sure that the firm adheres to the FSA's principles and rules. Banks should take risks. That is how they help borrowers and savers and how they contribute to economic growth. If they succeed, firms and their shareholders should get the rewards. If firms do not succeed, shareholders should stand first in line to bear the loss, and shareholders should face the loss of their entire investment before anyone else loses one penny of theirs.
The FSA's role is to supervise firms' adherence to the FSA's principles and rules. We should enforce minimum standards, including minimum standards on capital and liquidity. We should take a view on whether firms' business models are shaky or robust, whether firms pose a risk to our statutory objectives, and to assure that firms put in place appropriate risk mitigation programmes.
So what about Northern Rock? As we have previously announced, we are drawing lessons from the events of 2007. We are reviewing and strengthening our supervisory practices, including strengthening our banking sector team to act as a risk unit. And we are working closely with HM Treasury and the Bank of England to preserve financial stability. There are ongoing efforts with respect to supervision of individual firms and markets, and I would submit that in this area, no news is literally good news.
And, we are working quite intensively with HMT and the Bank of England on proposals for reform of the deposit guarantee scheme and for tools to facilitate the resolution of troubled banks - Joint Consultation paper: Financial Stability and Depositor Protection [PDF]. These will be laid before the House tomorrow, and we plan an active consultation with industry and other stakeholders. So please be both thoughtful and forthright.