The Supervision of Financial Services: What's next?
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Speech by Thomas Huertas, Director, Banking Sector, FSA
12th Annual BBA Banking Supervision Conference
28 October 2008
Today's conference occurs on the 79th anniversary of the Crash of 1929. And today we are in the midst of a global financial crisis.
Two questions confront us all. How do we contain this crisis, and how do we cure the system, so that crises will not recur in the future?
Containment must be our first priority. We must arrest the downward spiral in finance in order to avoid the devastation of the real economy that would be caused, if the financial system ceased to function effectively. As yet, the real economy has not crumbled. We have had one quarter of mild negative growth. Technically, we are not yet in recession, much less in the depths of depression.
The crisis has many facets, and so must the solution that will contain it. The crisis ultimately had its origins in an extraordinary period of easy money and strong economic growth that prompted a worldwide search for yield and dulled market participants' perceptions of and concerns about risk, particularly liquidity risk, but also credit risk. In 2006 the US housing market began to peak, interest rates rose, and sub-prime borrowers began to prove why they were called sub-prime in the first place: they started to fall behind on their payments.
This led market participants to begin to doubt the quality of assets based on sub-prime mortgages, and then more generally the quality of complex asset-backed securities such as collateralised debt obligations (CDOs), CDO-squareds and other exotic structures, such as CPDOs, created at the height of the boom. Doubts about the underlying quality were magnified by the opacity of the instruments, and market liquidity in such instruments – never very high to begin with – evaporated. Bid-ask spreads widened dramatically, and in some cases, bids fell away entirely.
Although there have been some very learned and at times quite heated debates about proper valuation methods and accounting treatment, it became clear in the latter half of 2007 that banks would have to take extensive write downs on their holdings of complex instruments. This reduced capital, and caused market participants to have concerns about the credit worthiness of banks (as evidenced by the surge in bank CDS spreads) at the same time that the collapse of SIVs and conduits created very significant liquidity demands on the banks that had sponsored and managed such vehicles. These two factors together led to a funding squeeze as evidenced by the increase in the LIBOR-OIS spread and the contraction in the availability of term funding. That in turn constricted credit extension to firms and families and led to a decline in the rate of growth in the real economy.
Failures of financial institutions, and the manner in which those failures were dealt with, further aggravated the situation. In particular, the failure of Lehman Brothers in September reversed expectations created by the earlier rescue of Bear Stearns that large broker dealers would not be allowed to fail. Moreover, the failure of Lehman Brothers brought home to all that global institutions may be global as going concerns but they become a series of local legal entities when they become subject to administration and/or liquidation. The failure of Lehmans caused market participants to review quickly their securities lending arrangements, limit rehypothecation and reallocate free cash balances. That had very significant knock-on effects on other broker dealers.
The failure of Washington Mutual, also in September, compounded these effects. The US authorities failed to keep whole the senior debt holders in the bank. This contrasted markedly with their behaviour in resolving other bank failures. This change in resolution practice caused market participants to revise their estimates of risk in senior, unsecured obligations of banks, further aggravating the funding squeeze.
Other bank failures compounded the problem, including Bradford and Bingley here in the UK, Fortis in Belgium/Netherlands, HRE in Germany, and the collapse of much of the Icelandic banking system. So did the extended debate in the United States about whether and how to enact the $700 billion TARP programme as well as the growing realisation that, even it were enacted, it would take time to implement.
Against this backdrop of deepening crisis, the UK Tripartite Authorities announced on 8 October that they would implement a comprehensive £500 billion plan to support the UK banking system. The plan addressed both capital and funding liquidity together, not one in isolation from the other. The plan:
- Doubled the size of the Bank of England's Special Liquidity Scheme to £200 billion;
- Instituted a guarantee programme (the Credit Guarantee Scheme) of approximately £250 billion for new wholesale debt issuance by banks that either already have or have a plan for raising Tier 1 capital in the amount and in the form the Government considers appropriate;
- Indicated that the Government had allocated £50 billion to act, if need be, as an underwriter or capital provider of last resort (the Bank Recapitalisation Fund) to enable banks to meet the capital standard required for participation in the Credit Guarantee Scheme.
The combination of higher capital and credit guarantees is designed to limit the risks to the taxpayer.
Within the Tripartite structure, the FSA was responsible, albeit in consultation with the other two authorities, to determine the appropriate level of capital for each individual institution. In reaching this determination three factors were taken into account.
- Ensuring the aggregate amount of capital restored confidence in the banking system as a whole.
- Ensuring that the amount of capital for each institution would sustain confidence in that institution.
- Ensuring that each individual institution would be able to have sufficient Core Tier 1 Capital, even after absorbing losses that might ensue from a severe recession. Each individual stressed scenario was of a standard type, but the overall weightings were, of course, tailored to the specific institution.
It is important to recognise that this approach has been adopted in the context of implementing the Tripartite's support package. The approach included a 'confidence premium' and it should not be presumed that this represents the FSA's view of the right long term capital framework for deposit taking institutions. As the FSA has already announced, it will be publishing its views on these issues through a discussion paper in the first quarter of 2009, the expectation being that this document will form part of the wider review of the global regulatory environment, which the FSA along with the other regulatory authorities, will be participating in.
In order to facilitate firms' reaching the standard required to support the guarantee, the Government offered to act as underwriter or purchaser of last resort for any new capital issuance that the institution might require. For institutions that availed themselves of the Government's offer to subscribe to new capital, the Government imposed additional institution-specific conditions relating to dividends, executive compensation, board representation, management and strategy (including commitments with respect to lending to individuals and SMEs in the UK).
The prompt translation of the plan into action has initially had a calming effect on markets, particularly since other countries such as France, Germany, the Netherlands, Switzerland and the United States quickly followed with the implementation of similar measures. In addition, central banks have taken supplemental measures to reduce interest rates and to improve liquidity. In the UK the Bank of England has revised its Red Book to expand the range of eligible collateral and to reduce the pricing for its Standing Facilities. CDS spreads have narrowed, LIBOR rates have stabilised, and liquidity is beginning to return.
Although it is too early – as our next speaker, Sir John Gieve, will, I am sure, explain when he presents the Bank's view on financial stability -- to be completely confident that the crisis has been contained, it is not too early to think about the cures that might be developed to assure that the system does not again go awry. Indeed, the G-20 will be meeting in Washington on 15 November to progress this, and the EU has formed a group of wise persons, headed by Jacques de Larosiere, to consider the same subject in a European context. The UK Government has advocated implementation of supervisory colleges for the top 30 financial institutions globally – a measure that the Financial Stability Forum has embraced, and that the UK and its EU partners are well on the way to putting into practice.
These summit initiatives come on top of legislative and regulatory proposals that are already under consideration at national and EU level. This morning's speech is not the time to go into great detail, but a few elements are perhaps worth bearing in mind as these discussions intensify.
First, financial stability is not solely a regulatory and supervisory task. It depends critically on macroeconomic stability as well. That has been all too apparent in the downturn, but it is critical in my personal view that we consider what the monetary and fiscal authorities should be doing to assure financial stability. What central banks do with respect to interest rates, reserve requirements and the interest payable on reserves, and liquidity policy (including collateral eligibility, haircuts and rates charged for borrowing) has significant effects on financial stability. Can these classic central bank tools really be used effectively to puncture asset price bubbles before they get out of hand? If so, financial stability will in my view be much enhanced.
Second, when things go wrong at a financial institution, it is important to have in place a framework that allows the institution in question to be resolved quickly so that consumers are protected, assets are liquidated in an orderly manner that respects the rights of creditors, and shareholders suffer first loss. Until 2008 we did not have such a framework in the UK, and its absence hindered the resolution of Northern Rock. The Banking Special Provisions Act has been an effective stop gap measure that has facilitated the resolution not only of Northern Rock, but also of Bradford and Bingley and the UK subsidiaries of failed Icelandic banks, but this Act will expire in February 2009. To replace it, the Government introduced on 7 October a Banking Bill that will establish a permanent resolution regime for UK banks and building societies and greatly strengthen the UK deposit guarantee scheme. The Banking Reform Bill is very much a product of joint work by the three Tripartite authorities and the FSCS as well as a reflection of the extensive consultation that has been conducted with industry and other stakeholders, including the BBA. The Bill's prompt enactment is essential to preserve financial stability.
Third, regulation has a significant contribution to make to financial stability. Reform will focus above all on two things: liquidity and capital. In the UK we are about to reform liquidity regulation and supervision significantly. As mentioned earlier, the Bank of England has revised its Red Book to expand the range of eligible collateral and reduce the pricing on its Standing Facilities. The FSA will shortly be issuing a consultation paper to introduce a new liquidity regime. This builds on international work undertaken by the Basel Committee and in CEBS. Under this regime each deposit taking institution will be required to undertake an individual assessment of its liquidity risks. These risks include those that could crystallise as a result of a name-specific stress, a market-wide stress and a combination of the two. The regime will also require a bank to manage its liquidity risk – either by managing its assets and liabilities to reduce possible liquidity demands or to hold truly liquid assets to offset possible liquidity demands. The objective is to minimise the possibility that the institution will require emergency liquidity assistance from the central bank, and we anticipate that the new regime, coupled with the possibility for banks to issue longer term liabilities under the government's credit guarantee programme, will lead to a reduction in reliance on overnight funding.
On capital, there will be a review of capital requirements by the Basel Committee and in the EU, particularly with respect to requirements for the trading book. The broad assumption underlying the Basel Capital Accord – that regulators around the world could rely on firms' own risk models as the basis for capital requirements – has not turned out to be correct, at least for the trading book. Losses in trading books have been several orders of magnitude larger than the capital which the models said had to be held against those risks.
This does not mean, in my view, scrapping Basel 2. The general principle of tailoring capital requirements to risk remains valid. What has, however, become apparent, is that risks are far greater than previously anticipated, and that capital levels will have to reflect the risks that have actually occurred and could occur again. But we will need to change regulation in a manner that avoids unintended consequences and avoids creating new opportunities for regulatory arbitrage.
The net effect will, I suspect, almost certainly be a significant increase in capital requirements. At a minimum, revisions to capital requirements will, in my view, have to take into account the volatility that we have seen over the past year, so that firms would be capable of withstanding extreme events. It would also mean taking into account the possible evaporation of market liquidity. Current proposals for an incremental risk charge, including a charge for event risk, on the trading book point in my view in the right direction.
In addition, regulators will consider means to reduce the potential pro-cyclicality of capital requirements, specifically to counter the reduction in capital requirements that could arise in a boom, when mark-to-model methods say that capital has increased and volatility has subsided. Certainly authorities will consider steps such as dynamic provisioning as well as the introduction of a leverage ratio. However, it should be noted that the leverage ratio employed in the US did not prevent firms from suffering very large losses on large concentrations of sub-prime assets. Nor did the leverage ratio prevent firms from sponsoring SIVs and conduits – vehicles that ultimately contributed to severe liquidity pressures.
There will also be a hardening in the quality of capital. In the current crisis attention has increasingly focused on capital that is unequivocally and immediately available to bear losses. I would expect this focus to continue, and for requirements to be increasingly framed in terms of Core Tier I capital.
Fourth, supervisors will tackle remuneration policies. Firms themselves have admitted that remuneration policies may have been a contributory factor to the financial crisis. We concur, and have therefore written to the CEOs of major firms to assure that firms' remuneration policies are consistent with sound risk management. We will also work with other regulators in bodies such as the Financial Stability Forum to assure that this problem is tackled on a global basis.
Our concern is not with the level of pay. We have no objection to people earning high compensation, provided they earn it in a manner that is consistent with sound risk management. We do object to remuneration policies that stack the deck in favour of the executive. Such an example might be a bonus system in which the current year bonus is based entirely on revenues, not profit, where the executive in question has a strong influence over determining revenue recognition, where estimates of future profit can be front-loaded into current year revenues, and where the entire bonus is paid to the executive immediately in cash. Such bonus systems can be a one-way ticket to disaster, and firms will need to eliminate such practices.
We have followed up the Dear CEO letter by asking major firms to supply us with information on their remuneration policies, and we will be meeting them individually between now and Christmas to discuss them. In the New Year, we will give feed back to the firms, and hold further discussions where necessary. We will also publish a more general review of remuneration policies in the London market, with a revised statement of what we consider to be good practice.
Fifth, firms must conduct their business properly. They must be vigilant against market abuse, they must treat their customers fairly, and they must guard against letting their institutions be used for financial crime.
This is a massive agenda for firms, for supervisors and policymakers in general. At the FSA we are implementing a supervisory enhancement programme to enable us to meet these challenges. Through recruiting and training we have improved the supervisory teams, and we have been extremely pro-active in terms of getting firms to mitigate the risks that they face in these turbulent times. And we have worked closely with our Tripartite partners and the FSCS as well as with regulators in other countries to resolve problems quickly.
This will continue so that we can contain this crisis and design a cure to prevent future crises.