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THE UK FINANCIAL SECTOR, REGULATION AND THE FINANCIAL CRISIS

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THE UK FINANCIAL SECTOR, REGULATION AND THE FINANCIAL CRISIS Course on Financial Instability at the Estonian Central Bank, 9-11 December 2009 Lecture 5 – PowerPoint PPT presentation

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Title: THE UK FINANCIAL SECTOR, REGULATION AND THE FINANCIAL CRISIS


1
THE UK FINANCIAL SECTOR, REGULATION AND THE
FINANCIAL CRISIS
Course on Financial Instability at the Estonian
Central Bank, 9-11 December 2009 Lecture 5
  • E Philip Davis
  • NIESR and Brunel University
  • West London
  • e_philip_davis_at_msn.com
  • www.ephilipdavis.com
  • groups.yahoo.com/group/financial_stability

2
Overview
  • What is a bank how do they fail?
  • The role and nature of financial regulation
  • How did the financial crisis impact on the UK?
  • The safety net issues for the UK
  • Prudential regulation
  • Cross border aspects
  • Some comments on the Turner Review

3
What is a bank why do they fail?
  • Traditional bank

4
  • Modern bank

5
The role and nature of financial regulation
  • Aims to protect against market failures
  • Information asymmetry
  • Externality
  • Monopoly
  • Two aspects of regulation
  • The safety net lender of last resort and
    deposit insurance - ultimately recapitalisation/na
    tionalisation the current issue
  • Prudential supervision capital adequacy and
    supervisory monitoring and macroprudential
    analysis the future issues

6
UK regulatory framework
  • Tripartite system of Treasury, FSA, Bank of
    England
  • Financial Services Authority (FSA) is responsible
    for financial and banking regulation
  • Bank of England contributes to the stability of
    the system through monetary policy, its lender of
    last resort operations and macroprudential
    surveillance
  • Treasury is responsible for the overall
    architecture of the system and aspects affecting
    the public finances

7
Size of UK banking sector
8
FSIs for UK banks
9
Customer funding gap
10
Major elements of UK crisis
  • Freezing of interbank markets from August 2007
    requiring liquidity assistance by Bank of England
  • Retail and wholesale customer run on Northern
    Rock, failed in September 2007
  • Bradford and Bingley, Alliance and Leicester had
    to be taken over
  • Need to nationalise and recapitalise RBS and HBOS
    with massive, partly covert, state assistance in
    October 2008
  • UK bank losses estimated at 36 bn in October
    2008, initially mainly US securities, later UK
    defaults. Many losses from poorly capitalised
    subsidiaries (SIVs and conduits) whose size
    surprised regulators
  • Serious collapse of real economy ensued

11
Northern Rock failure of supervision
  • Asset risk - made up to 125 mortgages, and
    liability risk high dependence on wholesale
    funding
  • Longest regulatory periods between formal ARROW
    assessments (36 months) and lowest number of
    close and continuous regular surveillance
    meetings, only high impact firm without a Risk
    Mitigation Programme
  • Moved between FSA divisions three times in as
    many years and division mainly responsible for
    Northern Rock had suffered staff cuts
  • Records of supervisory meetings were often not
    kept
  • In Spring 2007 allowed to pay a large dividend
    and reduce its capital adequacy target, although
    FSA already concerned about liquidity

12
Lessons for the safety net
  • Huge cost of recapitalisation
  • Major burden on fiscal policy, to add to cyclical
    swing
  • How realistic to expect 2007 maintained?
  • Keeping public support for recapitalisation
  • The poor performance of public banks
  • Deposit insurance shown to be inadequate
  • Increase in limits to 50,000 and 100
  • Ability to access in 7 days
  • Should the system be prefunded?
  • Should there be risk based premia?

13
  • Lender of last resort overburdened
  • Successful covert lending to HBOS and RBS after
    failure with Northern Rock
  • How to exit from the high level of liquidity
    support?
  • Is stigma adequately dealt with?
  • Special resolution regime instituted
  • Banks can be put into resolution when not
    technically insolvent, in interests of financial
    stability
  • A step forward from Northern Rock.
  • .but need for numerical prompt correction action
    targets (link to capital and liquidity) to avoid
    forbearance
  • Could Bank of England be overburdened?

14
Lessons for prudential regulation
  • Capital adequacy failed to prevent crisis
  • The FSAs trigger ratio system is helpful but
    should targets be published (also ARROW,
    liquidity)?
  • Banks should be required to hold adequate capital
    for offbalance sheet risks, so as to counter
    regulatory arbitrage and reputational risks.
    Accounting treatment of offbalance sheet assets
    should be aligned with the underlying risks.
  • Higher capital across the board (banking and
    trading books)?
  • Raises the cost of intermediation
  • But reduces incidence of financial instability
  • Capital adequacy and procyclicality
  • Spanish approach conflicts with accounting rules
  • .but other are just theoretical
  • Leverage ratio warrants consideration (NIESR work
    shows effect on crisis probability)

15
  • Liquidity regulation had been forgotten
  • The new UK proposals a marked advance given
    narrow liquidity had fallen to 1likely to raise
    government bonds from 5 to 10 of assets
  • but how compatible with maintaining the City as
    a financial centre
  • Need for an aggregate quantitative target?
  • Equal attention to liability management?
  • Other prudential regulation had let banks take
    unwarranted risks
  • Limits on LTVs needed for mortgages and
    commercial property
  • Ensuring remuneration covers the lifetime of
    products
  • Is there a need to divide commercial and
    investment banking again? Reduce bank size?
  • Caution in government guaranteeing
    securitisations
  • Regulation of innovations needed like drugs?

16
  • Macroprudential analysis had failed to provide
    effective warnings
  • How to act if macroprudential warnings are given
    speeches or action?
  • Ensuring macroprudential considerations enter the
    ARROW process and individual supervision
  • Did the UKs light touch fail?
  • Specific issues with Northern Rock
  • General issues allowing risky lending, wholesale
    funding, inadequate assessment of takeovers
  • Structure of regulation more dual key to avoid
    underlap
  • Or even moving LCFIs back to the Bank?

17
Cross border aspects
  • How far ahead can the UK go alone does the
    City concern dilute desirable regulation?
  • Problems of Basel 2 back to the drawing board?
  • Rating agencies
  • Risk models
  • Why no global agreement on liquidity?
  • Learning from Iceland institutions that are
    too big to save, branching and cross border
    LOLR
  • Icelandic bank deposits unprotected use of
    anti-terror law to seize assets
  • Broader cross border issues of home/host
    unresolved coming at express speed in Eastern
    Europe

18
Some comments on the Turner Review.
  • Long run solutions not current issues
  • Very negative on market discipline but do the
    regulators really know best?
  • The boundary problem how easy to regulate the
    unregulated?
  • Institutional co-operation or conflict in
    macroprudential surveillance?
  • New EU regulator but what role?
  • Desire for cross border operations as self
    capitalised subsidiaries - major challenge to the
    current passporting procedure.

19
and the possible downgrading of the FSA
  • Does the Bank of England want to regulate banks
    what are the costs?
  • What is the middle ground can the Bank have
    macroprudential levers?
  • What sort of institution will the FSA be as a
    consumer protection regulator?
  • Could there be dangers in the transition?

20
References
  • Davis E P (2009), Banking on prudence, chapter
    of OECD Report on the UK Economy, OECD Economics
    Department Working Paper
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