The future of financial regulation
Speech by Hector Sants, Chief Executive, FSA
The Building Societies Association Conference
7 May 2008
I am delighted to be able to talk to you today. There are a number of key issues for the building societies industry which have been highlighted by the recent market developments and I hope, and believe, you will find my observations on these topics of interest.
I would, however, like to start by making a few remarks about the long term importance of the building society movement within the overall financial system. As mutuals, your core business model, or ‘principal purpose’, has a different emphasis to many other models. In particular, the fact that your sole focus can be on your customers rather than on customers and shareholders as required for companies should mean you are well placed to build a sustainable business over the long term. This has to be beneficial for savers and borrowers. For these reasons, mutual building societies add a welcome element of diversity within the financial sector and, whilst we at the FSA do not endorse any specific model, we certainly encourage diversity as a way of adding strength and stability to the system and to encourage beneficial competition. I am therefore happy to make clear we are keen to see a successful and growing building society movement.
Current market conditions
Turning now to more immediate issues arising from the recent market conditions, can I begin by addressing the question as to whether the FSA’s policy on appropriate liquidity and funding has changed. The short answer is no. As a principles-based regulator, the key underlying principle has always been that societies need to meet our threshold conditions by having a credible and sustainable funding model. As set out in our existing guidance, a society needs "to ensure that it can meet its obligations as they fall due, a society should … keep an appropriate amount and mix of liquidity to meet any sudden adverse cash flow; the level of liquidity held should be sufficient to maintain public confidence that the society can meet its commitments." This has not changed, although there are no doubt some lessons to be learned for the future.
What is currently the case? As you would expect, in these more difficult financial markets, in our view, firms do face increased financial funding risk which needs to be taken into account. We have therefore been collecting additional information on your liquidity arrangements and funding plans. I do, by the way, recognise that such an increased information flow is a demand on your time and resources and we are grateful for the understanding and support you have shown.
There have been some reports in the press that, as a result of this more intensive monitoring, we have required some firms to increase liquidity ratios to 35%. I would like to make clear today that is simply not true – we have never said that. Our historic numeric limit continues to apply: that societies should hold 8 day liquidity in excess of 3½% of the total funding liability. There have also been reports that we have set a new minimum liquidity requirement of 20%. These reports suggest this has had the effect of reducing mortgage lending capacity by several billion pounds, assertions that are also incorrect. What is true is that 20% liquidity has been the overall sector average for a number of years, with many societies themselves choosing to hold liquidity above that level.
Against that background, if firms are below this level, it has been a trigger for us to initiate a more intensive dialogue with that society on its funding model. 20% is therefore not a minimum requirement, it is a trigger for discussion. To summarise on this important issue, at no point are we seeking to apply specific restrictions on lending by societies, what we are doing is what is expected of us as an effective regulator, namely ensuring that firms’ funding models and balance sheets are sustainable and that societies can give us the necessary reassurance that allows us to know that depositories can have confidence that their money is safe.
I hope I have made clear our approach to addressing the current market conditions. We are, however, giving consideration to improving our liquidity policy framework for the long term. This work was in hand prior to the recent step changes in market conditions, though events have undoubtedly caused us to accelerate our work in this area. In December of 2007 we published a Discussion Paper on improving our liquidity framework for banks and building societies and we will be taking this work forward over the next twelve months.
Recent events have, however, already helped us draw some preliminary views. Notably, a simple figure of 20% does not in itself ensure that liquidity is adequate. The current regime was designed when societies held even lower levels of wholesale funding and the main objective was for them to hold a stock of assets which could quickly be turned into cash in the event of sudden retail outflows. The problem now is that such outflows could be either wholesale or retail and the stock of liquidity held, in many cases, has proved less liquid than the regime envisaged. No doubt you are already considering these points so I thought I might add a few observations on this important topic.
Liquidity
First, the ‘stock’ approach to liquidity, adapted for building societies and the clearing banks, takes no account of how that stock is financed. A society could borrow cash for a week, invest that cash for a week in a qualifying deposit, and call the deposit ‘liquidity’. This process increases the reported stock of liquidity, but does not leave you with usable cash to cover retail withdrawals, nor to meet wholesale maturities. This cannot be sensible, as the original loan will use up valuable funding lines and the whole round trip may involve a negative carry. So, to be any use as liquidity, investments or placements in the market must be financed by funding of longer duration than the period over which the liquidity may need to be relied upon.
Second, the building society regime allows certain financial instruments as prudential liquidity provided boards and management are satisfied there is a secondary market into which they can be sold easily and without significant capital loss, i.e. they are genuinely liquid. A year ago, no doubt, you would have thought that longer term instruments such as FRNs and even MBS came into this category, but this cannot be said today for a number of these instruments. I hope that you will have already reviewed your policies to exclude purchases of new instruments that would fail the liquid market test if you intend to hold these as prudential liquidity.
Third, the growth of the housing finance market, in which you all play such an important part, brought with it structural issues that are now clear but which will be problematic to resolve. Broadly, the mortgage lending demand of 10 years ago was largely financed by liquid retail savings. In the last 10 years, borrowing levels have increased to the point where liquid savings can no longer finance demand. The gap has been filled by wholesale funding and in particular securitisation.
This was the structural problem of Northern Rock’s business model, and although building societies do not operate the Rock’s combination of high growth and over-reliance on wholesale funding, including securitisation. We, nevertheless, believe there are lessons here for all banks and societies. If wholesale funding is being utilised, it should be in a proportionate manner and the overall funding model sensibly diversified. In particular, the wholesale component should be diversified in term and maturity. We are also fully aware that your mortgage pricing reflects, among other things, the composite cost of your funding – a mix of retail deposit rates and a variety of wholesale funding costs. Nor do you largely fund yourselves at the Bank of England’s ‘Bank Rate’ and your pricing is rightly influenced by your perception of credit risk.
So what does this mean for future policy? Well, as we said in our Discussion Paper, we are looking to build in both a stock of assets that can be turned into cash if needed for a short term-retail outflow, and a longer term mismatch ladder that shows inflows against worst case outflows. Whether or not we set hard quantitative limits is still under debate, not just in the UK but in Europe and across the world. But you must set your own internal limits for mismatch, stock, instrument concentrations and so on. Indeed, I assume you already do. We will undoubtedly continue to ensure you have policies and procedures to manage liquidity risk, and to perform regular stress testing of these.
On stress testing, experience to date shows many of you generally have not modelled sufficiently extreme stress scenarios. Most of the stress testing performed before last August was based on a firm-specific rating downgrade and, even where firms modelled the closure of some wholesale markets, it was assumed these would reopen quickly. I would like to underline that your stress testing assumptions need to be much more robust and, in particular you must also have robust operational contingency plans, which means looking at the practical operational issues such as internet site capacity and branch transaction processing. In my view a constructive approach for boards to this question would be to ensure they understand the circumstances both financial and operational under which their institution would fail and determine whether that is an appropriate risk to take. Understanding the limitations of your business model is, in my view, an essential discipline for any board.
Capital adequacy and credit
I would now like to move on to the linked topics of capital adequacy and credit risk. Can I say firstly how much we appreciated the efforts of the BSA in organising your series of training seminars for societies on Basel 2 and CRD in 2006 and 2007, which we were happy to support. I thought it would be useful to say a few words now about the overall capital position of the building society sector and future prospects.
Broadly, you current ratios are adequate and this is, in some part, due to the more favourable treatment of your core retail mortgage business under both revised standardised and internal ratings approaches. However, you should not be complacent. As building societies, you, as you know, do not have recourse to rights issues or equity injections from sovereign funds. The outlook for your capital is based much more on the interplay of retained surplus and asset growth. Surplus will be under threat for two reasons this year – from higher funding costs and from the impact of provisions for bad debt. In your case, in the retail mortgage market, these provisions may be slower to emerge than some of the write downs that the large investment banks have posted recently, but the impact will last longer. And those firms operating in the sub-prime or buy to let market, where typically the personal covenant of the borrower is weaker, can expect heavier losses.
This leads me on to the wider importance of managing credit risk well. Capital adequacy is not the main answer – by the time you need the capital to absorb mortgage losses, the damage has been done. We have never said that a building society cannot make a loss, or cannot survive a loss, but the process is still painful as some firms are now discovering. Some level of arrears, bad debt and write off is unavoidable, as mortgage loans can become impaired through changes in the borrowers circumstances. But the riskier forms of lending will be fully exposed when markets turn. We do not advocate exaggerated pro-cyclicality: over-reacting as the market is turning will not stop the losses that may emerge from earlier poor lending practices. However, you may feel following a review of your lending policy that criteria should be tightened.
I would like to draw particular attention to three risk areas that we have come across in our supervision of individual societies over the last year: excessive concentration in the buy to let market; continued acquisition of mortgage books, even when routine funding was becoming problematic; and poor understanding of the extra risk of major exposures to commercial borrowers.
The common theme across all three was that there were many cases where there was an inadequate understanding of the downside risks. Before coming here I looked back at the speech given by my predecessor John Tiner when he addressed your conference in May 2004 and was struck by what he had to say on this – I quote:
“However, it is far from clear to us that all societies operating in the commercial buy to let, equity release, sub-prime and self certified markets have properly assessed the additional risks that inevitably go with the higher margins available …. When we see the board papers proposing a move into new areas of more risky lending, we frequently find that the authors place great emphasis on the additional income that can be earned but hardly mention the increased costs and risks that arise at the same time. But if those are not identified and priced into the product, it is far from clear how a board can be taking a fully informed decision.”
Four years after these warnings, we still find unacceptable practices during our visits to some firms. I must therefore emphasise again, it is the responsibility of the Board to test and challenge such proposals from management. A simple rule of thumb for boards is not to take on the risk of products they do not understand.
Treating Customers Fairly
I now want to say a few words on Treating Customers Fairly, which underpins the delivery of our statutory consumer protection objective and is of key importance in these times of market turbulence when consumers need protection the most. It is, therefore, vital that you do not lose sight of your TCF strategy in the current conditions. In this ever more challenging economic environment, arrears and possessions are set to increase significantly, albeit from a very low base and concentrated in specific sectors of the market. We do expect lenders to meet the requirements on the treatment of customers in payment difficulties set out in our mortgages conduct of business sourcebook. Firms must have in place, and operate, a written policy and procedures for dealing fairly with customers in arrears.
We have set out a number of factors which we consider are likely to be central to such policy and procedures, including using reasonable efforts to reach agreement with the customer; adopting a reasonable approach to the time over which any shortfall in payments can be made good; and only repossessing a property where all other reasonable attempts to resolve the position have failed. The rules, which consolidated good practice standards in the industry when we introduced our mortgage regime, were drafted in a high level way to give firms the flexibility to respond to the individual circumstances of customers in payment difficulties.
The impact of poor arrears handling practices can be substantial for the borrowers affected. There will be cases where the borrower has no realistic prospect of getting back on track, so dealing with the inevitable sooner rather than later will be in everyone’s best interests. However, in other cases inflexibility and resorting hastily to court action may lead to properties being taken into possession when a less drastic solution was realistic and would have led to a better outcome for both the borrower and the lender.
Thematic work on intermediaries has found failures in relation to mortgage business which was being directed to lenders. We have to ask what happened when those applications were reviewed by the lenders. I know that many of you do have the necessary systems and processes in place to assess and determine the applications you receive. My message today is clear:
For new mortgages, you must, as always, consider the borrower’s ability to repay before agreeing to lend money. And what my predecessor said at this conference four years ago about assessing affordability remains valid. Also, it is worth bearing in mind that even on a broker introduced mortgage, you are required to take account of the customer’s ability to repay. As a building society, it is surely in your firm’s own interest to make sure a borrower can meet repayments, not least as now is not the time to take on future arrears problems. I should also say, finally, that we fully recognise that borrowers too have personal responsibility for providing accurate information which you can rely on and themselves consider what they can afford. This does not, however, modify or lessen your responsibilities as lender.
I would also like to mention that we are becoming increasingly aware of changing market dynamics that are putting pressure on mortgage intermediaries as some lenders are only offering certain deals directly to customers. We have been approached by a number of intermediaries asking whether this practice is fair under TCF. Our response is that lenders are not obliged to deal through brokers. How they choose to price and distribute their products is a commercial matter. There have always been certain lenders who choose not to offer their products through brokers, and others who differentiate pricing depending on the channel, for example those offering ‘exclusives’ to certain mortgage clubs or special interest-only rates. It follows from this that not every product on the market will necessarily be available to any one broker – something which our definition of whole of market takes into account. If certain lenders decide to offer their direct customers cheaper deals, we do not see that customers’ best interests would be served by preventing this.
However, we believe that a healthy market is one where consumers have a choice in how they purchase a mortgage, either direct or via an intermediary who can shop around and advise the customer to help get the right deal. We hope that the current market developments do not make it harder and more expensive for customers to get advice on what is one of the most important decisions of their lives.
Corporate governance
I would like to finish with a few words about corporate governance. There are three reasons for doing this. Firstly, we have seen inadequate review, assessment and challenge of proposed new initiatives. As I have already highlighted, we have particularly found this around the liquidity and funding issues with which societies have been confronted. Some societies have been very slow to appreciate the nature and scale of the market turbulence or react prudently.
Secondly, if a building society is to survive, prosper, and bring real benefits to its members, it must have a good quality board. A board, together with the senior management team, has to lead their society through these challenging, competitive and more complex times.
And thirdly, because, as you will be aware, we have maintained the guidance that says that building societies should have regard to the Combined Code when establishing and reviewing their own corporate governance arrangements. To this point may I highlight two matters that are set out in the Combined Code: That the board should undertake a "formal and rigorous" annual evaluation of individual directors and that non-executive directors should scrutinise the performance of management in meeting agreed goals and objectives.
I would ask you to consider whether this is a process which is well established at your society; and, in particular, is it "formal and rigorous". Do your Boards act on the results of the evaluation? In most cases there may only be behavioural changes to make. But in exceptional cases this might mean going further and questioning whether the person is still right for the role. Most societies do evaluate their executive directors, and many have processes that could be regarded as clearly demonstrating best practice, but in some cases we have seen this does not involve a structured process with, for example, agreed objectives and performance criteria against which the assessment is made. Such processes look neither "formal" nor "rigorous".
I would now like to say a few words about succession planning. This is, I am afraid, another area where we believe improvements should be made. I am sure you will agree it is vitally important for the long term health of a society that it has management depth and a credible management development and succession planning process. I am afraid that we do not believe that the practice in this area is always at the level we would expect.
Such deficiencies can carry considerable risk for a society, not least of which is the risk of stagnation and lack of focus which can result from a lengthy transitional period. May I thus use this opportunity to remind boards and non-executives in particular of their responsibilities in this area. This will be a theme we shall be returning to in the future.
In conclusion on governance, I would just like to underline the importance of boards focussing on what we say in the Building Society Regulatory Guide, namely “Society boards and management have a special responsibility to protect the interests of their members through the highest standards of corporate governance.” Public companies have the added pressure of institutional shareholders you are not subject to this additional scrutiny and thus must be extra diligent. I am sure you are all aware of this point, but I feel it bears repeating.
In conclusion, today I have sought to deliver five main messages. Firstly, and critically, the FSA recognises the value you bring to the financial industry and the benefits you provide to savers and borrowers. You should not therefore doubt our determination to work with you to ensure the movement thrives and grows.
Secondly, the recent, more difficult, financial conditions have, as you would expect, increased the intensity of our supervisory engagement with you and we are grateful for your understanding in this respect. However, I wish to make clear we have not set some new general minimum liquidity requirements. Nor indeed are we aware of any material disagreements about the appropriate balance between liquidity and mortgage lending with any society. We believe that our approach aligns with good risk management practices and these are supported by the industry.
Thirdly, it is clear that the liquidity regime will benefit from modernisation and I have outlined some of the current thoughts which are already influencing our supervisory approach.
Fourthly, given the increased focus on financial risks, it is critical not to lose sight of the customer and the importance of fair treatment. In particular, on the matter of arrears, a thoughtful and considered approach to individual cases will, I believe, be of mutual benefit to industry and borrowers alike.
Finally, I would also encourage you to focus on the importance of good governance and the importance of Boards fully discharging their responsibilities. This last point is arguably the most important. A successful building society movement ultimately rests on the quality of judgement and engagement of its Boards. A fact I am sure is acknowledged by all of us.
Also, I would like to take this opportunity while speaking at the BSA Conference to thank the BSA for the engagement and support that have provided over the past year. I have already mentioned an instance where the BSA has done an excellent job on behalf of its members, and in collaboration with us, namely the Basel 2/CRD seminars. Can I also mention the various TCF seminars the BSA has run and its adaption of the Combined Code on corporate governance for the difference circumstances of building societies. These are just three examples that illustrate what an effective and responsible body the BSA is. And behind the scenes we are very aware of the technical excellence and diligence in representation that the BSA secretariat team demonstrate in their regular and constructive interactions with us.
I hope you have found these remarks useful and look forward to taking questions now and continuing a dialogue over the coming year and work together to ensure the continuing health of the movement. Many thanks for your attention.