Dialogue on Financial Stability: How is bank risk to be managed?
Speech by Hector Sants, Chief Executive, FSA
Associate Parliamentary Group on Business Finance & Accountancy Banking Reform
14 October 2008
I am pleased to be here today to outline for you the work that the FSA is undertaking to support financial stability and depositor protection.
The measures announced this week and last to support the banking system are a significant and comprehensive package, which we welcome. We will work with firms, Treasury and Bank of England to maintain financial stability. All the measures are important; together they address liquidity provision, capital, and future funding needs. As the banking supervisor we will work with banks and building societies to ensure that they maintain very strong capital and liquidity.
This package is an important step in dealing with the immediate issues that we all face. Clearly, we also need to prevent the recurrence of such extreme events and to ensure that the authorities are better equipped to deal with banks and building societies in the event we were again to encounter severe difficulties.
The authorities published the first discussion paper on banking reform last October. Since then we have consulted widely to turn ideas into concrete proposals. Many stakeholders have assisted that process, including of course the Treasury Select Committee.
I would like to focus my remarks today on three issues with respect to the FSA’s role in this framework. Firstly, our regulation in the prevention of failure, secondly the concept of ‘heightened supervision’, the name given to our activity when failure appears possible, and finally our role when a failure occurs. I will also touch on the work we are undertaking to review depositor compensation arrangements.
Prevention is better than cure
Turning first to our role as a regulator. The changes that are being made – a regime to deal with failing banks and reform to aspects of the compensation scheme – are tools intended for the very worst case scenario. They are the last resort, not the first. Firms must of course continue to focus on meeting their regulatory obligations on an ongoing basis.
As a regulator our focus is on preventing bank failures. Management remain responsible for their own institutions, but there is clearly a need for the authorities to reflect on the lessons that we should learn from recent events. There is no question that this has been a global failure and that all elements of the framework, need to be looked at. We will play our role, working closely with colleagues around the world, to look again at the overall regulatory framework and the standards expected on capital, liquidity and risk management. We will be publishing a discussion paper next year to set out FSA’s views on the right global framework going forward.
We also support the current accounting framework, but we see a need for an ongoing debate on the nature of fair value – will it in future be possible to say that fair value is always at an exit price? But we do not think that rushing to change accounting standards during a crisis, while markets evolve, is appropriate.
The FSA also has an important role – alongside Treasury and the Bank – in contributing to financial stability. As supervisor of individual institutions we must ensure that we are able to identify systemic risks posed by the banks we regulate, and respond to those on a bank-by-bank basis and, with our Tripartite colleagues, look at the financial system as a whole.
Supervisory Enhancement Programme
Recognising this is a global crisis with its origins in a set of global circumstances over which a national regulators influence is limited, there are however, undoubtedly lessons we can learn. It is clear that a number of banks, notably those that became dependent on wholesale funding, went into the crisis with business models ill-equipped to survive a stress of this severity, and we could have done more to minimise this, a fact that we regret. We have introduced a Supervisory Enhancement Programme (SEP) to address this issue. We have already made many of the necessary changes, and we will complete SEP by the end of the year.
We will have a minimum supervisory resource for all high impact firms, to ensure the necessary focus and continuity. We need a culture that attracts and retains quality individuals, and which encourages decisive yet considered judgments. This can only be built through time and concerted action. We have also been clear that we need the right people in the right jobs: the right mix of career regulators and experienced market practitioners.
I believe that the performance of the FSA, in the period since these issues arose, demonstrates how effective the organisation can be. It is my belief that the organisation has done its utmost to mitigate the effects of the crisis on the institutions it regulated over the last 15 months. If I may say so I am also immensely proud of the tireless way the staff have worked in the last 15 months.
“Heightened supervision”
Over the last year we coined the phrase “heightened supervision” to convey the fact that a bank could expect our supervisory approach to change in response to an increase in the risk that a bank posed. Normally there would not be a cliff edge over which a bank dropped from so-called ‘normal’ supervision into the resolution regime.
Heightened supervision is not a separate supervisory regime or set of powers. The Banking Bill does not propose that the FSA be given additional powers that it does not already have to create a separate regime of “heightened supervision”. The term is a colloquialism that reflects the fact that we adopt a risk-based approach. As the risks a bank poses increase – particularly where a firm’s ability to meet the Threshold Conditions is threatened – we will intensify our supervision. This could involve an increase in the number of staff looking at that bank; in the number of visits and meetings (especially with senior management); or a change in the frequency (or type) of information that they provide to us. All these are aspects of our supervisory regime already. And there will be closer cooperation with our tripartite colleagues and the FSCS. In particular we will ensure the Bank of England has access to all necessary data and has the required direct contact with the firms.
By extension, the term “heightened supervision” does not imply a separate set of objectives for the FSA. Our goal remains the same: to reduce the risks to our four statutory objectives in FSMA, and that the bank should continue to meet its Threshold Conditions. Those objectives are the basis of our regime.
FSA role in resolution
The Banking Bill, published last Tuesday and due for its Second Reading today, will give the Authorities a range of tools: to direct transfers of a bank’s business to a private sector purchaser, temporarily to a Bank of England controlled bridge bank, or into Temporary Public Ownership . Our role in a resolution is, as banking supervisor, to take the regulatory decision that a bank is failing the test to continue to be an authorised bank – the Threshold Conditions - and that it is not reasonably likely that the bank can bring itself back into compliance. And we will have a role in recommending to the Bank of England which of the resolution tools would be appropriate. Once a bank is placed into the resolution regime, the FSA will continue to supervise it in our usual risk-based way.
The Bill puts on a statutory basis the Bank of England’s role in contributing to financial stability, and we will continue to work closely with the Bank and Treasury given that we each have a role in supporting financial stability. The FSA and the Bank have worked closely and constructively during the period of the crisis, most recently on the bank recapitalisation plan and on addressing the problems with Icelandic banks. Key to this successful partnership has been clarity of responsibility: the FSA for supervision of and decision-making in relation to individual firms and for seeking private sector solutions. And the Bank for the provision of liquidity and, increasingly, for the resolution of banks once the Treasury has decided to use powers under the Banking (Special Provisions) Act. This experience will provide a solid foundation for the future once the new banking legislation comes into force.
A word on the issue of ‘two triggers’ and the division of responsibility between the Bank and FSA. The FSA is supportive of the allocation of roles set out in the Bill. It was never the FSA view that it should be responsible for managing failed banks; this would clearly be incompatible with the role of supervision of such institutions. For the FSA the key issue was to retain the clear responsibility for supervision and not to be placed in a position of accountability without authority. The Bill ensures this through clearly recognising the importance of a single supervisor making the judgement of whether a bank is a going concern. It is in no ones interest to have overlap and duplication of supervision.
Until recently most banking failures have been of banks whose activities have been wholly or predominantly confined to a single country. The collapse of Lehman and of the Icelandic banks has demonstrated how much more challenging it is to handle a failure with significant cross-border consequences. We had thought this was going to be a challenge: we now know it is. The answer, at least now, is not a debate about the need for greater harmonisation of powers, or reform of national insolvency laws. Instead, we should concentrate on what we can do quickly - to learn the lessons from these events, act on them and incorporate them into initiatives at the European and global levels to improve crisis management preparedness.
Compensation arrangements
There must be effective compensation arrangements for depositors. These are a key part of protecting consumers and enhancing confidence in the banking system. We are looking at three aspects: compensation limits; fast payout of compensation; and consumer awareness.
We set the monetary limits up to which compensation is payable by the FSCS when a regulated firm is declared in default. Last October the FSA increased cover for deposits to 100% of the first £35,000 of each depositor’s claim. And from last Tuesday we raised the limit to £50,000.
We have also been looking at depositor protection by banking ‘brand’. This is an issue because consumers do not always understand that the maximum compensation they can claim will be limited to each individually authorised bank, regardless of the number of brands it uses. There are, however, practical issues which would need to be overcome: that a brand has no legal basis and is defined by the bank primarily for marketing purposes, and whether there should then be control of the number of brands or regulation of the way in which a bank uses its brands.
From the consumer’s perspective, the speed with which any compensation is paid is as important as knowing that there will be some compensation in the first place. We remain committed to a target of seven days for providing the depositors of a failed bank with access to at least a proportion of their funds, and the balance within the following few days. A number of changes to support this require passage of the Banking Bill. We recognise there will be significant logistical challenges for banks in providing the information that would be needed, and that changes to large, complex systems come at a significant cost to firms. So we are undertaking research jointly with the BBA and FSCS. We will use this to ensure that we achieve the right outcome that is workable and that gives consumers confidence.
We are undertaking research into consumer awareness of compensation issues to understand what consumers want to know and how best to deliver any messages to them, again, to support consumer confidence in the banking system as a whole. We will consult on all these issues in January.
I want to end by noting that the events of the past year have highlighted that change is needed in how bank risk is managed: in the first place by banks themselves, but also by the authorities changing the framework where needed. We need to pursue vigorously a range of measures, which we will do working with stakeholders and with our Tripartite colleagues.