PDF Ebook Banking Supervision and Regulation
The City is a major engine of economic growth and London is the world’s leading financial centre. 2007 and 2008 saw the biggest financial crisis since the 1930s. Yet the financial sector has long been more closely regulated and supervised than the rest of the economy. Successive frameworks of regulation have recognised the need to monitor financial institutions carefully in case problems in one spread to others and threaten the financial stability the regulatory system exists to protect.
There is broad agreement about the background to the banking crash. Banks looking for better yields from plentiful, cheap money made much more use of complex financial instruments, without fully understanding the risks to which they were exposing themselves and the financial system. Defaults on subprime mortgages underlying some of the instruments shattered confidence and financial markets seized up. The decision to allow Lehman Brothers to fail created a loss of trust between financial institutions. Governments and regulators took costly, emergency action to avoid collapse of the banking system and limit the impact of the financial crash on the wider economy.
Why did the framework of regulation and supervision, in Britain and elsewhere, fail to fulfil its principal purpose of avoiding or mitigating financial crisis? There are many reasons, including:
• the application of the regulations themselves contributed to the crisis and made it worse when it came because, among other things, they had a pro-cyclical bias, did not pay enough attention to liquidity, had built-in reliance on ratings agency opinions and were wide open to regulatory arbitrage;
• the tripartite authorities in the United Kingdom (Bank of England, Financial Services Authority (FSA) and Treasury) failed to maintain financial stability and were found wanting in dealing with the crisis, in part because the roles of the three parties were not well enough defined and it was not clear who was in charge;
• too little attention was paid in the United Kingdom to macro-prudential supervision (oversight of the aggregate impact on financial stability of individual banks’ actions); only the Bank of England and the FSA were in a position to assess it;
• the FSA concentrated on its responsibility for conduct-of-business supervision (concerned mainly with consumer protection) and did not pay full attention to micro-prudential supervision (the solvency and sustainability of individual banks);
• the FSA had an inadequate understanding of the complexity and limitations of the risk assessment models used by the banks it was supervising.
It seems clear that the causes of the crisis were not simply management failure at some (but by no means all) banks but also commensurate failures in regulation and supervision, together with shortcomings on the part of the ratings agencies.
The lessons of the crisis are being digested around the world. In many financial jurisdictions, the balance between market forces and regulation is under scrutiny.
So is the fitness for purpose of regulatory frameworks. Outcomes may vary. But markets are global and supervision is not. Whatever changes are made, regulation at national and European level needs to remain broadly aligned to help restore international financial markets as an essential underpinning of global growth and development. National supervisors and regulators could help promote confidence by increasing the intensity of consultation and exchange of information in international advisory bodies, notably on macro-prudential supervision.
But there should be no rush to change the rules of the game. Post-shock, banks are again cautious and most are unlikely to embark on new adventures soon. The main thing is to get changes right. Decisions on some issues should be made when the dust has settled, so that the outcome of emergency stabilisation measures can be judged and the market’s response to the crisis is clearer.
Nevertheless, where the need is clear early action must be taken. The Government has already remedied a gap in the legal framework exposed by the crisis. The Banking Act 2009 draws from the failure of Northern Rock the lesson that special resolution provisions are needed for banks since their failure can threaten the whole financial system. The Treasury is already planning further measures in this area.
The Committee recommends that the Government should as a matter of priority revisit the tripartite supervisory system in the United Kingdom. It should return responsibility for macro-prudential supervision to the Bank of England, with executive powers to be exercised through a broader-based Financial Stability Committee (FSC), including substantial representation from the FSA and the Treasury. This arrangement would be consistent with the Bank’s enhanced statutory responsibility for financial stability. The Bank must have adequate institution-specific information to function effectively during a financial crisis. At the same time, the Government should give further thought to where responsibility for micro-prudential supervision should lie.
The Committee also recommends that:
• supervisors and regulators should subject bank risk models to much more rigorous stress-testing;
• Credit Default Swaps (CDSs) should be reported and centrally cleared;
• regulatory capital requirements for assets on banks’ trading books should be substantially increased.
• branches in the United Kingdom of multinational banks should be subject to greater oversight by the British authorities.
The authorities must move rapidly to develop policies on a range of issues highlighted by the crisis to:
• counter pro-cyclicality in existing regulations;
• regulate liquidity;
• remove agency ratings from regulations;
• give ratings agencies an economic interest in the accuracy of their ratings;
• improve the governance of bank boards.
It is still early days in the aftermath of the financial crisis. Bankers, depositors, businesses, regulators and governments are all adjusting in their own ways. All concerned have a role in rebuilding confidence and a robust system. The authorities should move rapidly to establish the right framework for regulation of the financial system, including competition policy and the reach of the state safety net. But there should be no rush to all-embracing new legislation. Changes to the rules must not only strengthen the banking system but reinforce confidence and the competitive position of British banks and the City.
CONTENTS
Abstract
Chapter 1: Introduction
The financial crisis of 2007–2008
Financial supervision and regulation in the United Kingdom
Scope
Chapter 2: The History and Causes of the Financial Crisis
Chapter 3: Complexity in Financial Services
Types of Complexity
Reasons for Increased Complexity in Financial Services
Consequences of Financial Sector Complexity
Chapter 4: Bank capital regulation
Rationale for Capital Regulation
Capital Regulations
Models in Capital Regulation
Operational risk
The Trading Book
Pro-cyclicality
Liquidity Regulation
Chapter 5: Financial Supervision in the United Kingdom
Supervisory Roles
The Tripartite System: Communication and Coordination
Macro-prudential supervision
Conduct-of-business and micro-prudential supervision
Division of supervisory responsibilities in the United Kingdom
International Supervision
Deposit Insurance
Chapter 6: Ratings Agencies
Growing Importance of Ratings
Rating Agency Business Models
Ratings and Regulations
Ratings Process
Chapter 7: Bank Governance
Non-executive directors
Remuneration of Bankers
Government shareholdings in banks
Chapter 8: Auditors
Audit-Generated Information in Regulation and Supervision
Mark-to-market accounting
Chapter 9: Insolvency Regimes
Chapter 10: Financial Institution Scale and Scope
Chapter 11: Conclusions and Recommendations
Appendix 1: Economic Affairs Committee
Appendix 2: List of Witnesses
Appendix 3: Call for Evidence
Appendix 4: Glossary
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