House of Commons

Treasury Committee

Macroprudential tools

Written Evidence

Only those submissions written specifically for the Committee for the inquiry into Macroprudential tools and accepted as written evidence are included.

List of written evidence

1 Institute of Chartered Accountants in England and Wales 3 2 Association of British Insurers 10 3 Genworth 16 4 Building Societies Association 21 5 Council of Mortgage Lenders 26 6 British Bankers Association 30 7 Barclays 52 8 Lloyds 58 9 T R G Bingham 64 10 Virgin Money 67 11 HSBC Holding Ltd 79 12 Nationwide Building Society 90 13 Professor Jagjit Chadha, Professor of Economics,

Chair in Banking and Finance, School of Economics, University of Kent 93

14 Sir Andrew Large 101 15 Association for Financial Markets in Europe 110 16 Supplementary written evidence submitted by the BBA 118

Written evidence submitted by the Institute of Chartered Accountants in England and Wales

INTRODUCTION 1. We are writing to provide evidence in response to the call for evidence by the Treasury

Committee on the macro-prudential tools used by the Bank of England. ICAEW would be pleased to provide oral evidence on any aspect of its submission.

WHO WE ARE 2. ICAEW is a world-leading professional accountancy body, supporting over 138,000

Chartered Accountants in more than 160 countries. 25,000 of those members work across the financial services industry from regulated firms to professional services, intermediaries and regulators. We are also a Designated Professional Body for regulating investment business under FSMA 2000, an FSA Accredited Body for retail financial advisers under the Retail Distribution Review, and a Recognised Supervisory Body for auditors.

3. ICAEW’s Royal Charter means that we work in the public interest with governments

regulators and industry to maintain the highest business and ethical standards. EXECUTIVE SUMMARY 4. Our key points: • We support the broad thrust of the proposals around the Financial Policy Committee

(FPC) to pursue economic and financial stability by responding to a build-up of systemic risk.

• It is not clear that these tools would significantly contribute to financial stability if we faced similar circumstances to the 2008 financial crisis.

• The ‘countercyclical capital buffer’ tool is appropriate but we are less convinced about the two other macro-prudential tools requested by the FPC (the leverage ratio and sectoral capital requirements).

• We have expressed concerns to MPs during the passage of the Financial Services Bill about the lack of clarity and transparency around the macro-prudential tools.

• A balance must be struck between financial stability and economic growth when using the tools – as the Chancellor recognised in his recent Mansion House speech.

• Lack of detail on the recommendations the FPC can make could lead to a ‘soft law’ approach from the Bank of England which could be inconsistent with UK law.

• It is essential that the FPC gives guidance on the use of tools before they are implemented to avoid confusion in the markets.

5. Recommendations:

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i) FPC powers of recommendation: • The Financial Services Bill (FS Bill) should be amended in six ways to provide detailed

clarity on the recommendations that the FPC can make. (para. 16) ii) Transparency and accountability: • The public should be consulted on the financial stability strategy. This will make it easier

to get public acceptance of the use of the macro-prudential tools. (para. 19) • There should be clarity in primary legislation (FS Bill) that the maco-prudential tools

themselves will be consulted on initially and when reviewed. (para. 22) • We support those who believe the relevant SIs should be handled through the super-

affirmative procedure. (para. 24) • The financial stability reports should be published by the FPC four times a year (rather

than twice) and include an analysis of the impact of the FPC’s measures on financial stability and the wider economy, including on economic growth. (para. 27)

iii) Guidance on the use of the tools: • Guidance should be published in advance of each tool being used so that the markets have

time to prepare. (para. 29) iv) Bank of England analysis • Prior to the relevant SIs being laid before parliament, the FPC should publish a detailed

analysis of why each requested tool had been selected. (para. 35) • It will be important for the Bank of England to regularly assess and publish information

on the impact of the tools in use at any given time, including seeking to identify any unintended consequences. (para. 36)

CONTEXT 6. The 2008 financial crisis threw up a number of questions as to why the crisis arose and

how we can prevent it from happening again. This has led to a radical shake up of financial services regulation across the EU and UK. The new regulatory structure introduced in the FS Bill could reduce the probability and severity of a future crisis in the UK. However, history suggests that financial crises will continue to emerge from time to time and so we must not assume that any new regulatory body will be able to prevent future crises.

7. The creation of the FPC as a macro-prudential regulator to respond to a build-up of

systemic risk is a concept that we support. The macro-prudential tools that it can use to

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‘control’ financial stability are a new and innovative approach to regulation and must be considered carefully so not to have unintended consequences on financial stability and the wider economy.

DETAIL Appropriateness of the tools requested 8. It appears that the FPC is looking at financial stability from the viewpoint of preventing

future episodes of excessive exuberance. However, the ‘stability’ challenge in the UK and Europe more generally in the next few years is likely to be more to do with trying to ensure that the financial system performs its basic functions despite the stresses on it. That could call for very different tools than those considered in FPC meetings thus far.

9. We note that the three tools requested are all closely linked to the micro-prudential regulatory regime. That has the advantages of promoting clarity as to how these instruments would work and of minimising operational implementation costs for regulated firms. However, it is not clear that such tools would significantly contribute to circumstances in which the micro-prudential machinery hugely underestimated risks, such as in the run up to the 2008 financial crisis.

10. Within the intended new structure of responsibilities for financial stability and

regulation, it is appropriate for the FPC to control the ‘countercyclical capital buffer’ as this instrument has been agreed by the Basel Committee precisely with macro-prudential objectives in mind. However, we are less convinced about the other two tools which the FPC has initially requested: the leverage ratio and sectoral capital requirements.

11. The leverage ratio even as a micro-prudential instrument is a new feature of the Basel

approach to banking regulation (introduced in the Basel III package) and as such is untested in many economies, including the UK. It would be preferable to gain experience of its use in the micro-prudential context before applying it to macro-prudential objectives.

12. As regards sectoral capital requirements, we share the concerns expressed by some FPC

members (see minutes of 16.March 2012 meeting) that these may not be effective in restraining lending which at a buoyant stage of the credit cycle might appear to be very profitable.

FPC powers of recommendation 13. We are concerned at the lack of detail about to whom the FPC can make

recommendations, what the recommendations may be about, and the lack of an accountability mechanism around these recommendations. This could impact on the legal rights of those to whom recommendations are made, and conceivably allow the

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Bank of England to operate a system of ‘soft law’ which had no democratic basis and which might even be inconsistent with UK law.

14. At the same time, there are risks to the credibility of the FPC if its recommendations were

not generally followed. This underlines the need to clarify the status and implications of FPC recommendations.

15. A number of questions remain unanswered as to the scope of the recommendations

including:

• What subjects these recommendations might address • What kind of entities might receive them • How frequently this power would be used • The intended governance and accountability mechanisms around this power • What the status is of these recommendations and what would happen if

recommendations were not followed 16. Recommendations: The FS Bill should be amended to specify: • Who the FPC can make recommendations to, so it avoids unlimited powers of the FPC to

impact firms and individuals. • The recommendations must be published, together with a detailed explanation of how

their adoption would promote financial stability. • The FPC must publish for public consultation its policy for making recommendations

within three months of this power coming into force. • Recommendations may not be issued on matters which could be addressed through the

explicit legal powers of the Bank, PRA or FCA. • A recommendation does not in any way affect the rights and obligations under UK law

and regulation of the recipient. • The extent or otherwise of compliance with a recommendation may not be used in any

court, tribunal or regulatory proceedings, or in making any supervisory judgement.

Transparency and accountability 17. There should be structures in place at three stages of tool formulation and use. The first

stage is when the type of tools to be used is discussed, the second during the process of implementation of the tools, and the third during post-implementation review.

18. The first structure that should be in place is public consultation on the Bank of England’s

financial stability strategy when it is first determined and when reviewed every three years. Currently the FS Bill requires only the FPC and HMT to be consulted on the strategy. We are concerned that if the public is not consulted on the strategy then it will be difficult to get public acceptance of the macro-prudential tools. It will also not be possible to draw on the full range of expertise available in the UK and internationally –

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which the FPC should be utilising in this highly innovative and new area of economic policy making.

19. Recommendation: During consideration in House of Commons Public Bill Committee,

the Financial Secretary said that public consultation would take too long and the Court of the Bank would determine whether consultation was needed. We recognise that the public cannot be consulted if there is an emergency measure which needs to be dealt with quickly. However, a consultation document on the proposed initial strategy could be developed and published in the next few months. And given that the stability strategy will be reviewed only every three years, there is an obvious window during which the public should be consulted towards the end of those three years. Feedback should be sought on the results of the existing strategy, and on what the agenda should be for the next three years. By undertaking public consultation, there would also be time for all affected to prepare for any likely changes in the stability strategy and react in the best interests of their business, customers or household.

20. The second structure needed is around the process of implementing the tools. This

should be done in two ways.

21. Firstly, clarity is needed in primary legislation that the macro-prudential tools themselves will be consulted on both initially and when reviewed. HMT has confirmed that they will consult on the Statutory Instrument for the toolkit but that does not go far enough in ensuring that the measures are accountable, transparent and command a reasonable degree of public support.

22. Recommendation: We would like to see this reference made statutory in the FS Bill. It is

also likely that in the future new macro-prudential tools will be needed that have not currently been discussed or consulted on. To ensure transparency in how these new tools are determined, we suggest that all future SIs on the tools are also consulted on.

23. Secondly, it is important that there is adequate parliamentary scrutiny during the process

of implementing the tools.

24. Recommendation: We support those who believe the relevant SIs on creating the macro-prudential tools should be handled through the super-affirmative procedure.

25. The third structure which should be implemented is around accountability and how the

FPC should report. As set out in the FS Bill, the FPC must publish financial stability reports twice a year. We believe that more frequent FPC reporting would make the FPC’s work and decisions more transparent and accountable.

26. The stability reports are also not required to include an assessment of the impact of the

FPC’s measures on the wider economy. That information is essential if the macro-prudential tools are to strike a balance between financial stability and economic growth.

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27. Recommendation: We support the Chancellor’s recent announcement that the FPC will need to have an economic growth objective as well as a financial stability objective. The FPC could achieve that goal by publishing financial stability reports more regularly (four instead of twice a year, around the time of each quarterly FPC meeting) and include in the report an assessment of the functioning of financial markets and the wider economy.

Guidance on the use of the tools 28. It is essential that the FPC gives guidance on the use of its tools. Without guidance there

could potentially be confusion in the financial markets and wider economy about both the general issue of when tools might be used, and to what end, and about the detailed implementation and impact of individual levers. Such confusion could have a material negative impact on economic growth.

29. Recommendation: Guidance should be published in advance of the tool being used. This

would allow the markets to prepare for the changes. The FS Bill requires the FPC to maintain public statements on how it would intend to use the macro-prudential tools. We recommend that this is published initially for public consultation. But it is likely to be necessary to amplify this with guidance, so as to minimise uncertainty about matters such as the FPC’s decision-criteria, and how the FPC would expect individual tools to work in practice.

Symmetry of the tools 30. The tools should be symmetrical as the objective of their use is to ensure economic and

financial stability and so therefore the tools need to achieve a balance (as discussed above in our third transparency recommendation).

31. There will be some constraints on symmetry, because many prudential requirements are set out in global agreements or EU law, and the UK cannot reduce these below the specified minimum. However, to the extent that macro-prudential tools are used in the UK to lean against boom conditions, it would of course be possible to relax such requirements as the economy moved into a downswing.

32. There does need to be caution when using these macro-prudential tools, because they are new and un-tested. For example, there are already concerns from senior regulators at the Bank of England that new liquidity micro-prudential rules for banks are damaging economic recovery.

Bank of England analysis

33. The FPC’s request for three specific tools appears at present to be made in the minutes of

its 16 March 2012 meeting. We do not believe that the relatively brief (8 pages) discussion

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in that document gives parliament a sufficient basis for it to decide whether to grant these powers, and to hold the FPC to account for their use.

34. It also appears that the Bank of England has not published an analysis of public responses

to its paper on The Instruments of Macroprudential Policy (December 2011). This is a gap in transparency, which needs to be rectified in order for parliament and the public to have a clear view of the issues.

35. Recommendation: Prior to the relevant SIs being laid before parliament, the FPC should

publish, initially for public and external-expert comment, a detailed analysis of why each requested tool had been selected, how each requested tool would be expected to work, the benefits to financial stability anticipated, and the associated costs (such as any adverse impact on growth). The FPC should also indicate broadly the extent to which a tool would be expected to be used. The impact of a tool could range from being a relatively minor adjustment to something with potentially major macro-economic consequences, depending on the extent to which different tools were used. In addition, where other tools were considered but rejected a full analysis of the reasons should be made public.

36. Recommendation: It will be important for the Bank of England to regularly assess and

publish information on the impact of the macro-prudential tools in use at any given time, including seeking to identify any unintended consequences. The appropriate baseline would be one in which the macro-prudential tools were not being used, and the ‘regulatory’ framework comprised just the ‘standard’ micro-prudential requirements.

June 2012

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Written evidence submitted by the Association of British Insurers

1 The UK Insurance Industry

1.1 The UK insurance industry is the third largest in the world and the largest in Europe. It is a vital part of the UK economy, managing investments amounting to 26% of the UK’s total net worth and contributing £10.4 billion in taxes to the Government. Employing over 290,000 people in the UK alone, the insurance industry is also one of this country’s major exporters, with 28% of its net premium income coming from overseas business.

1.2 Insurance helps individuals and businesses protect themselves against the everyday risks they face, enabling people to own homes, travel overseas, provide for a financially secure future and run businesses. Insurance underpins a healthy and prosperous society, enabling businesses and individuals to thrive, safe in the knowledge that problems can be handled and risks carefully managed. Every day, our members pay out £147 million in benefits to pensioners and long-term savers as well as £60 million in general insurance claims.

2 The ABI

2.1 The ABI is the voice of insurance, representing the general insurance, protection, investment and long-term savings industry. It was formed in 1985 to represent the whole of the industry and today has over 300 members, accounting for some 90% of premiums in the UK.

2.2 The ABI’s role is to:

- Be the voice of the UK insurance industry, leading debate and speaking up for insurers.

- Represent the UK insurance industry to government, regulators and policy makers in the UK, EU and internationally, driving effective public policy and regulation.

- Advocate high standards of customer service within the industry and provide useful information to the public about insurance.

- Promote the benefits of insurance to the government, regulators, policy makers and the public.

3 Overall Comments

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3.1 We welcome the opportunity to provide our views to the Treasury Committee’s inquiry into the interim Financial Policy Committee’s (FPC) macro-prudential tools.

Application to Insurers 3.2 Our main concern in relation to the FPC’s toolkit is its potential application to

insurers. In its statement from its policy meeting on 16 March 2012 the FPC makes clear that ‘in addition to banks, the range of institutions to which these [macro-prudential] tools would apply could include building societies, investment firms, insurers and a variety of funds and investment vehicles’. We agree that the FPC’s remit should cover insurers and that, where appropriate, macro-prudential tools should be applied in order to address problems that might arise in the insurance sector. However, to date the work of the FPC has been almost exclusively focused on the banking sector.

3.3 In order to effectively address insurance issues the FPC needs to recognise the fundamental differences between the insurance and banking business models and the different macro-economic impact of a failure in the insurance sector compared to banking and develop sector specific tools to tackle issues that might arise. As a result we believe that it would be counter-productive to attempt to apply to insurers tools developed in a banking context.

3.4 In order to ensure that appropriate macro-prudential regulation is applied across

the financial sector we agree that the Committee should, when developing its toolkit, consider whether a particular tool could have application across sectors and the impact of its use on different parts of the industry. Where appropriate, sector specific tools should be developed.

Relationship to EU and International Requirements

3.5 It remains unclear to us how the FPC will operate in the wider context of the systemic risk arrangements being put in place internationally. In particular we believe that the FPC, Bank of England and HM Treasury need to explain what the FPC’s relationship with the European Systemic Risk Board (ESRB) will be and the role of the FPC in addressing cross-border systemic issues.

3.6 It is also unclear the extent to which some of the tools proposed by the FPC will be compatible with EU law (for example the Capital Requirements Directive and Solvency II). The FPC itself recognises the potential issues involved but has, for the moment, set aside these concerns in framing its advice to HM Treasury (Paragraph 8 of the note of the 16 March meeting).

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3.7 We believe that these issues concerning the operation of the FPC in the wider international context and any limitations on its powers arising from this should be considered as a matter of urgency. Otherwise there is a danger that structures could be put in place which are ultimately found to be unworkable.

Specific Questions

3.8 Our response to specific questions raised by the Committee is set out in the attached annex.

ANNEX

Questions for Consultation 1. Whether the interim FPC has requested the most appropriate tools over which the FPC should be given the power of direction. 2 Whether additional tools should be given to the FPC (these may include tools rejected by the FPC, not considered by the FPC or that use the balance sheet of the Bank of England). We agree that the tools selected (countercyclical capital buffers, sectoral capital requirements and a leverage ratio) appear appropriate tools for the FPC to have powers of direction over in respect of the banking industry. However, as noted in our general comments it is not clear to us that these tools will necessarily be appropriate or effective if applied to insurance or other sectors. While, in principle, countercyclical capital buffers and specific capital requirements might be applied to insurers the major differences between the business models and regulatory requirements of the banking and insurance sectors means that these tools could only be sensibly applied to insurers if they are structured so as to fully take account of the specific requirements of insurance sectoral regulation. The proposed leverage ratio is unlikely to be relevant to insurers. We note that the FPC considered a number of other tools which it would consider seeking powers of direction over at some future date (a liquidity tool, disclosure requirements and loan-to-value/loan-to-income ratios). Some of these may be appropriate in the banking environment (although the proposed loan-to-value/loan-to-income ratios tool would raise significant issues about the impact of the FPC’s decisions on the wider economy). However, with the exception of the proposed disclosure tool, it is unlikely that these particular tools would be relevant to the insurance sector.

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3. The extent to which the FPC's powers of recommendation are appropriate, and how they will work with the powers of direction. It is appropriate for the the FPC to have powers of recommendation in relation to the Bank of England, HM Treasury, PRA and FCA. In many cases the most appropriate method for dealing with concerns raised by the FPC will be for the relevant regulatory authority to take action using its more detailed knowledge of individual firms to determine where and when to intervene. In these circumstances a comply or explain approach would appear to give the necessary flexibility. We are more concerned about the provision in the Financial Services Bill which gives the FPC a general power to make recommendations to other persons or bodies. It is not clear to us the circumstances in which such a power might be used, the class(es) of person to whom such recommendations might be addressed or the implications of compliance/non-compliance with the recommendation. We believe that it would be more appropriate for the Bill to set out clearly which groups and organisations the FPC can address recommendations. 4 What structures should be created to provide the necessary transparency and accountability structures for the use of the tools. In many respects the accountability structures set out in the Financial Services Bill are, in our view, sufficient to ensure the necessary transparency in the design and use of the tools. We do, however, have a number of concerns that we believe should be addressed:

- The current proposal is for the FPC to have ten members. Four will be Bank of England executives, one will be the Chief Executive of the FCA and one will represent the Treasury. Only four will be independent. We believe that there should be a majority of independent members on the FPC to guard against official ‘groupthink’, ensure that the wider interests of the UK economy are represented and provide the FPC with access to the widest available pool of talent. We, therefore, propose that the number of independent members should be increased to six.

- We believe that the FPC should draw on a wide range of experience and expertise including from the financial sector (and in particular from the insurance sector). We are concerned that the current membership of the ‘interim FPC does not draw on a sufficiently wide pool of expertise (the independent members consist of an ex-Bank of England official, two retired bankers and a retired overseas central banker). We suggest that the Financial Services Bill should be amended to ensure that the FPC includes members with relevant experience beyond banking – this is necessary given the wide

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ranging remit of the FPC and the potential impact of its decisions on the wider economy.

- We are concerned that the requirement to comply with a direction will enable the PRA and FCA to dispense with consultation and other due process requirements that it would be otherwise required to undertake. We believe that the FCA and PRA should normally be required to consult on how they will implement directions (if this is impossible because of the urgency of the situation then existing FSMA requirements enabling consultation to be dispensed with or circumscribed can be invoked).

5. Whether the FPC should provide guidance on the use of the tools, and if so, what form that guidance should take. 7. What further analysis should be provided by the Bank of England before the macroprudential tools are granted to the FPC, and what analysis should be periodically produced by the Bank of England once any tools have been introduced. The Financial Services Bill requires the FPC to issue a statement of policy in respect of each macroprudential tool. In addition each direction to the FCA or PRA may include recommendations as to how and when the direction is to be implemented. These requirements appear to be sufficient to provide any analysis and guidance needed while allowing the FCA and PRA some flexibility as to how they implement the measure. It is, however, important that the FPC makes clear to what sector(s) each of its tools will apply. Wherever necessary it should calibrate each tool to take account of differences in sectoral regulation so that any measures taken can be applied appropriately. 6. Whether the tools requested, taken as a whole, should be symmetrical, that is, the extent to which they should ameliorate downturns as well as upswings in credit cycles. In principle we would agree that this should be the case. To some extent this will happen as directions are removed as circumstances change. For example, if additional capital requirements are placed on certain lines of business in order to dampen down an upswing then the removal of these requirements as business conditions deteriorate will ameliorate the downturn. However, there will be limitations on the ability of the FPC to act in a wholly symmetrical manner given the existence of minimum capital and liquidity requirements in UK and international regulation.

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More generally we would support the view that the FPC should be required to take into account the implications for economic growth, as well as for financial stability, of its proposals. We would also suggest that consideration should be given to requiring the PRA and FCA to also take account of the wider economic impact of their policy proposals. June 2012

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Written evidence submitted by Genworth

Genworth welcomes the opportunity to submit comments in writing to the Treasury Select Committee for its inquiry into the Bank of England’s proposed macro-prudential policy tools.

Genworth is the largest globally active private sector provider of mortgage indemnity insurance. In Europe, Genworth offers mortgage indemnity insurance in the United Kingdom, Ireland, Spain, Italy, Portugal, Sweden, Finland, and Germany. Our US Headquarters are in Richmond, Virginia and our European Headquarters are in London. Genworth is regulated by the FSA in the UK and will be under the Solvency II regulatory framework once it is implemented.

Mortgage insurance provides protection to financial institutions against losses arising from borrower default on high loan-to-value (HLTV) residential mortgage loans. Mortgage insurance, where effectively regulated and well-capitalized for the nature of the risk involved, is designed to be a capital-buffer or “shock absorber”. Its liquid, diversified capital base can be applied across the banking system wherever losses emerge.

We responded to the Bank of England’s consultation on macro-prudential tools, and, in focusing on the countercyclical capital buffer, a sectoral capital requirement, and a leverage ratio we feel the Bank has considered the right tools.

Variable risk weights are more effective than loan to value limits High Loan to Value loans (where the borrower contributes a lower deposit, and the mortgage provider contributes – for example - over 80% of the value of the property) carry a different risk profile from lower loan to value loans. This is because the severity of the loss for the lender is higher, and also because the borrowers’ willingness to pay under stress may be affected if they have less ‘skin in the game’. HLTV is not a measure of affordability or overindebtedness, which is better measured by assessing the size of the monthly payment relative to the borrower’s income. Put simply, the lack of a substantial deposit, which will be particularly high in areas with high property values, does not indicate that the borrower cannot afford the repayment. However, high loan to value lending is required to ensure that the financial system adequately serves moderate income homebuyers, especially families who are first time homebuyers, or those living in highly populated urban areas where house prices are higher. The higher risks associated with this category of lending explain why strict underwriting criteria and counter-cyclical buffers are so important, and also why it is crucial that lenders set appropriate levels of capital aside to mitigate this risk. We agree with the interim FPC’s request for the power to adjust risk weights if the market overheats. Risk weights measure the ‘riskiness’ of loans and are based on the likely frequency and severity of losses in a stress economic scenario. In turn, they drive the minimum capital requirement. We therefore strongly support an increase of risk weights for all mortgages, and in particular HLTV lending (sectoral capital requirement instruments), in preference to imposing LTV limits.

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This prudential tool will ensure continued availability of HLTV mortgages to borrowers with good credit quality whilst establishing prudent lending practices. An ongoing increase in capital requirements for high loan to value would be more effective than increasing requirements once a problem has already emerged We would go further and suggest that more capital is set aside to mitigate against the risks of high loan to value lending on an ongoing basis (as opposed to only to be used as a lever). In fact, supervisors in various jurisdictions have expressed concern that the risk weight values that are currently being used by lenders do not capture the true risk of HLTV loans. This is particularly important for the larger UK banks (which do the majority of mortgage lending), which use the ‘internal model’ to assess their capital requirements. The ‘internal model’ allows for more flexibility in calculating capital, and carries the risk of under-estimating the potential severity of the loss for HLTV lending if there is a significant market downturn. We would recommend a supervisory review of the ‘internal model’ (IRB) models, along with (as an interim measure) a minimum capital requirement for high loan to value lending through the introduction of a higher floor for loss severity. Currently, loss given default (LGD), which is the measure of loss severity and a primary driver of RW and hence minimum capital requirement, has a floor of 10%. Whilst this 10% floor is adequate on a low LTV portfolio, it is grossly insufficient for high LTV loans. As high LTV loans experience higher losses, especially in a downturn where combination of house price decline and quick sale adjustments could mean significantly low rates of recovery of property value (c. 70% of property value as seen recently across countries most impacted by the credit crisis). As lenders do not often use conservative assumptions, supervisory intervention becomes necessary. Imposing a higher loss severity (Loss Given Default) floor, say 20% on HLTV loans (above 80% LTV) will align the ‘internal model’ capital calculation that the bigger banks use, with loss experience during the recent crisis. Using conservative risk weights ensures an ongoing level of prudent capital in the system rather than ad hoc tools such as LTV caps. The latter is a reactive tool and introduces volatility in the capital requirement, putting banks under additional pressure in times of stress. On the other hand, higher risk weights result in a prudently high capital base and are a proactive tool to manage financial stability. Loan to value limits are a ‘blunt’ tool and there are more effective alternatives Consideration was also given by the Bank of England to Loan to Value (LTV) limits as a macro-prudential tool, but the interim Financial Policy Committee has not requested LTV limits for the ‘toolbox’, partly because there had been insufficient public debate on this point.

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High loan to value lending is necessary for first time buyers, and is particularly important for new build property (which can often be reliant on first time buyers). Lack of high loan to value lending therefore has a negative economic impact on housebuilding, which is an important driver of economic recovery and growth. Strict loan to value limits also have a negative impact on social mobility, with borrowers who can rely on parental guarantees or parental assistance with a deposit being unfairly advantaged. Case study from Sweden: LTV limits have led to rise in unsecured lending Most importantly in the context of systemic risk, Loan to Value limits encourage the use of unsecured ‘top up’loans, which are higher risk than high loan to value lending, both for borrowers and for the financial system. One of the consequences of ‘hard’ loan to value limits in other jurisdictions has been an increase in unsecured top-up loans to bridge the gap between LTV limits and property prices. This has made LTV limits an ineffective tool in managing over-indebtedness, and has increased and not reduced the macro-prudential risk, since the performance of loans with this ‘top up’ element is worse than the performance of high loan to value lending. The Swedish regulator commented as follows: ‘Some banks offer their customers unsecured loans in conjunction with mortgages. The majority of the banks still divide their mortgages into "top loans" and "bottom loans". They allow the bottom loan to be fully collateralised by the home for up to between 75 and 85 per cent of the market value…. Most, but not all, of the banks offer unsecured loans for the portion of the loan-to-value ratio that exceeds 85 per cent.‘ (The Swedish mortgage market, March 2011, Finansinspektionen) One of the consequences is that borrowers need to pay a much higher rate on the unsecured part of the loan, which also has to be paid off over a much shorter period of time. The graph below, based on data from ‘Statistics Sweden’ (www.scb.se) demonstrates the growth in unsecured credit to households, post the LTV cap.

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Unsecured credit by Monetary Financial Institutions (MFIs) to Households

85% LTV cap iimposed

Increase in unsecured credit since

LTV cap

This issue has also been raised in other jurisdictions. In a speech on Housing markets and financial stability at the National University of Ireland, Galway, 20 April 2012, Mr Stefan Gerlach, Deputy Governor of the Central Bank of Ireland, noted: “However, the narrow focus may enable borrowers and lenders to seek to circumvent the restrictions. For instance, Crowe et al. (2011a) report that, in Korea lower LTV limits were implemented for loans of less than 3 years substantially increasing the popularity of loans of three years and one day. Furthermore, LTV limits have been circumvented by taking out a personal loan to cover a portion of the house price. International precedent for combining LTV limits with mortgage insurance Mortgage Insurance is currently in use in many countries across the world (40 countries globally). There is widespread use in countries such as Canada, Italy, Australia, Hong Kong and Mexico, where the regulatory framework actively encourages its use for some of the reasons outlined in the reports above. Many of those countries fared better during the global financial crisis since wide use of Mortgage Insurance had helped to embed prudent lending practices. In many countries, for example Canada, LTV limits have successfully been combined with mandatory mortgage insurance. In Canada’s case, all loans with a loan to value level of 80% or more a required to be covered by a credit risk mitigant such as mortgage insurance up to 95%. Borrowers are required to make a down payment of 5%. Canada’s housing market provides a stark contrast to that of its neighbour the USA. Loan payment arrears rates in Canada have remained under 0.5% .

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To conclude, we firmly believe that LTV limits are too blunt an instrument and will not lead to more prudent lending, as international examples have shown. Instead, policymakers in the UK should consider adjusting the risk weights linked to high loan to value mortgages. These risk weights should take into account the use of credit risk mitigants such as mortgage insurance. Please do not hesitate to contact me if you have any further queries. Yours faithfully, Angel Mas, President, Mortgage Insurance Europe June2012

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Written evidence submitted by the Building Societies Association

Executive Summary

1. The Building Societies Association (BSA) recognises that the Financial Policy Committee (FPC) at the Bank of England does require its own policy instruments to be able to mitigate risks to the stability of the UK financial system.

2. However, we are concerned that some of the tools proposed by the Interim FPC to be subject to powers of direction may have significant detrimental side effects. In particular, use of an unweighted leverage ratio disadvantages firms whose balance sheets are predominantly made up of low-risk assets, such as residential mortgages, restricting their ability to lend. And sectoral capital buffers applied to high loan-to-value lending are, in their effects, almost the same as explicit LTV limits, which the Interim FPC decided against recommending to the Treasury.

3. The unlimited range of levers that could be subject to powers of recommendation leads to considerable policy uncertainty for firms. This concern is acute because it is not conceivable that the PRA or FCA would, in practice, reject a recommendation made by the FPC. The powers of recommendation are therefore wide in scope, not well defined and likely to be strictly applied.

4. The FPC aims to reduce risks to the financial system as a whole. Therefore, it would make sense if the use of many of its policy instruments was limited to systemically important firms. It will often be disproportionate, from the viewpoint of risks to the stability of the system as a whole, to impose the cost of compliance with these directions and recommendations on simple, small firms. The specific effects of the instruments on firms with different business models should also be considered to determine if they have a disproportionate impact on certain types of firm, such as mutuals.

5. Some of the uncertainty comes from not knowing how active the FPC will be in the use of its powers in the future. To reduce the uncertainty, the Bank should conduct and communicate detailed analysis of how and when the tools are likely to be used and the expected consequences of using them. This is essential as other concurrent regulatory changes will have an impact on the effectiveness of the proposed macroprudential instruments. Further analysis should review the full effects of any tools after they have been used.

Introduction

6. The Building Societies Association (BSA) represents mutual lenders and deposit takers in the UK including all 47 building societies. Mutual lenders and deposit takers have total assets of over £375 billion and, together with their subsidiaries, hold residential mortgages of nearly £240 billion, 19% of the total outstanding in the UK. They hold more than £250 billion of retail deposits, accounting for 22% of all such deposits in the UK. Mutual deposit takers account for 34% of cash ISA balances. They employ approximately 50,000 full and part-time staff and operate through approximately 2,000 branches.

7. The BSA recognises that following the financial crisis there is a role for a body which is responsible for surveying the outlook for risks to the financial system as a whole, and appreciates that it is necessary for this body to consider policy instruments that it can use (or suggest be used by other bodies) to mitigate these risks. The FPC is the new body tasked with fulfilling this role, and is due to have powers to direct the PRA or FCA to take action against urgent risks to the system, as well as powers to make recommendations to the PRA or FCA to act. In addition the FPC will be able to make public pronouncements and

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warnings. The BSA has some concerns about the macroprudential instruments that have been proposed by the Interim FPC, and we highlight the importance of communications to reduce uncertainty about how it will use its powers. The FPC should be open to consultation with financial service providers to understand the impact of its instruments in practice.

Proposed powers of direction

8. BSA members have concerns relating to some of the macroprudential instruments to be open to powers of direction, as proposed by the Interim FPC in its statement following its March 2012 meeting.

i) Leverage ratio

9. A minimum leverage ratio (bank equity as a percent of total assets) set at 3% forms part of the Government’s proposed implementation of the ICB report recommendations, as announced on 14 June, and in line with that agreed internationally under Basel III. But it is noteworthy that the Government held back from applying a higher ratio, in particular because this might impact badly on institutions that performed well during the crisis, such as the building society sector (specifically mentioned by the Secretary of State in a radio interview on 14 June1). Increasing a single non-risk weighted leverage ratio would penalise otherwise well-capitalised and well-managed organisations which hold large volumes of residential mortgages which are demonstrably low risk assets. Such assets have been seen to be low risk through the financial crisis and recession, with low levels of arrears. Over the last decade annual mortgage write-offs across all monetary financial institutions have averaged just 0.04% of average mortgage balances, and peaked at 0.11% of average balances in 20092. Increasing the leverage ratio could result in other risks to financial stability if it leads these organisations to increase the riskiness of the assets on their balance sheet, or alternatively it may cause them to reduce the amount of low risk mortgages they hold, to the detriment of the housing market.

10. The principal source of new capital for mutuals will continue to be retained profits generated from their low risk, low return businesses. It is therefore challenging for them to raise new capital rapidly should the FPC direct that the minimum leverage ratio be raised rapidly. However, simple, low risk business models such as those of mutual lenders help wholesale creditors to understand the business and builds trust, helping mutuals to access liquidity and funding. This is not readily identified solely by looking at a single leverage ratio. It should therefore be recognised that a single leverage ratio is a crude measure that does not take into consideration differences between business models, and we therefore do not believe it is appropriate to apply increases in that single ratio universally as a macroprudential tool. A better approach has been pioneered in the European Parliament during its legislative consideration of the Capital Requirements Regulation that implements Basel III in the EU. Amendments from the relevant Committee of the Parliament replace the single leverage ratio with a differentiated ratio in three tiers according to the riskiness of a bank’s business model: for low-risk business models, suggesting an indicative leverage ratio of 1.5%, for average-risk models an indicative ratio of 3%, with a 5% leverage ratio for the highest-risk business models3. Such an approach takes into account the important differences in relative risk. And it might then be more appropriate for any increase in leverage ratios for macroprudential purposes to be stated as a percentage increase of the base leverage ratio for each institution – so, a 10% uplift in leverage ratios would then move low-risk banks to 1.65%, medium-risk banks to 3.3%, and high risk banks to 5.5%. 1 Secretary of State for Business, Innovation and Skills speaking on The World at One, BBC Radio 4, 14 June 2012 2 Source: Bank of England (Series codes: RPATFHD; LPMB3TA) Annual sterling write offs of loans secured on dwellings to individuals as a percentage of average mortgage balances outstanding. 3 See Article 482 “Differentiation of leverage ratios according to business models” in the compromise text of CRR adopted by the Economic and Monetary Affairs Committee of the European Parliament in May 2012.

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ii) Sectoral capital requirements

11. The Interim FPC rejected limits on mortgage terms and conditions, such as direct restrictions on loan-to-value (LTV) and loan-to-income (LTI) ratios. The reason for this decision was that the debate necessary to achieve public acceptability was not suitably advanced. The Interim FPC also state that “unlike the other instruments proposed, these instruments would directly affect how much individuals and businesses may or may not be able to borrow”4. However, in the following paragraph the FPC states that it “noted that other tools, such as the ability to vary sectoral capital requirements, and particularly those relating to residential mortgages by LTV or LTI, might be able to deliver at least some of the same financial stability benefits”. Therefore, the Interim FPC appears to believe that sectoral capital requirements are similar in their effect to direct restrictions on mortgage terms.

12. We made this point in our response to the Bank’s initial discussion paper, and argued that raising capital requirements on these loans could lead to similar problems to restrictions on LTV and LTI ratios. Such limits would unfairly penalise individual borrowers who were genuinely able to repay these loans and who pose little threat to financial stability, as the restrictions do not take individuals’ circumstances into account. Furthermore, such limits might lead to other risks arising if they incentivise consumers to use other secured or unsecured borrowing to raise the total amount they borrow, while satisfying the restrictions on mortgage terms. While sectoral capital requirements would not prohibit loans above certain LTVs or LTIs, they would still cause the supply of these loans to be restricted and could lead to the above problems, including risks shifting to other types of lending.

Powers of recommendation

13. Most of the focus on the FPC’s role has been on the powers of direction, as the tools under these powers are to be prescribed in legislation. However, the FPC’s powers to recommend action by the PRA or FCA will be far more wide-ranging in scope, covering the exercise of the entire respective functions of the two regulatory authorities. The FPC could therefore make recommendations affecting various aspects of financial services providers’ businesses including capital, liquidity, terms and conditions of transactions and products (such as LTVs and LTIs) and restrictions on distributions of profit. The potential for recommendations to be made on such a wide scope increases the policy uncertainty for firms. It is therefore essential that consultation with firms takes place before recommendations are enacted so that unintended consequences can be avoided. The Interim FPC has said that the choice between recommendation and direction will depend on the nature of the risk, the degree of urgency and whether there are benefits to a more flexible implementation by the FCA and/or PRA under a recommendation.

14. Recommendations will be made on a “comply or explain” basis. However, it is difficult to envisage circumstances where FPC recommendations will not be enacted by the microprudential regulatory bodies, particularly as senior FCA and PRA officials are likely to sit on the FPC itself (The Financial Services Bill requires the Chief Executive of the FCA to sit on the Committee, and the FSA Chairman and Chief Executive currently sit on the Interim FPC, and the incoming Head of the Prudential Business Unit will take the Chief Executive’s place on his departure). As the FPC’s recommendations will all be published in minutes of the meetings, it would be surprising if the FPC recommended action that was subsequently wholly rejected by the microprudential or conduct regulators. Therefore the FPC’s recommendations are likely to be extremely powerful.

Proportionate use of instruments

4 FPC Statement 16 March 2012

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15. The FPC’s purpose is to identify, monitor and act to remove or reduce risks that threaten the UK financial system. This focus on systemic risks means that that the FPC should concentrate its directions and recommendations on firms that are systemically important, and should consider the burden on of firms of different size and organisational form such as mutually owned firms. In many instances the risks to the system as a whole will not be affected significantly by the actions of small, simple firms.

16. A good example is that of disclosure requirements. The Interim FPC was not able to advise the Treasury to grant powers of direction to disclosure because this could not be narrowly defined. Disclosure is thus likely to be one of the most commonly used tools by the FPC under its powers of recommendation. The costs to firms of collating and analysing this data, particularly if it is not already collected or changes frequently, may outweigh the benefit. This is especially true for requiring additional disclosures by small firms which are likely to be of little importance to the stability of the financial system as a whole. Such requirements could be focussed on the largest firms and still be effective.

17. We have also mentioned above the disproportionate effect of a non risk-weighted leverage ratio on firms with simple balance sheets. The FPC should consider whether its recommendations or directions have disproportionate effects on firms with different business models as this could distort competition unfairly.

FPC analysis and communications

18. The Government identified the lack of a single, focused body with responsibility for protecting the stability of the financial system as a whole as one of the main shortcomings of the regulatory system before the financial crisis5. Therefore, it would seem to be sensible for the FPC to use historical data to model what action it would have taken and to see how effective its proposed tools would have been in averting the financial crisis by themselves, and also in combination with the other subsequent and planned regulatory reforms.

19. As mentioned above, there could be considerable uncertainty for firms arising from the wide scope of the FPC’s powers, but also from not knowing how active the FPC will be in making recommendations. Of course it will depend on the prevailing circumstances, but it is currently unclear whether several recommendations will be made each quarter, or whether there will be extended periods where the FPC assesses the risks but does not deem any action necessary.

20. To reduce the uncertainty for firms so that they can plan for the future, it is essential that the FPC communicates as much as is practicable how it envisages using its tools and under what circumstances, and the effects it expects them to have on different types of firm and the market overall. Recommendations by the FPC, as opposed to directions, will give more time for analysis and consultation with firms operating in the market to ensure the instruments produce the required results. The FPC should also analyse the likely interaction of its instruments with other ongoing regulatory reforms, including those stemming from Europe. After an instrument has been applied, the FPC should publish a review into its effectiveness to improve its future application.

21. The importance of good communication is highlighted in relation to ad hoc disclosure requirements. Rather than adding to market discipline there is a risk, particularly at times of market stress, that frequently changing disclosure requirements could undermine confidence in a pro-cyclical way. The additional information could be misinterpreted and crystallise problems, whether real or merely perceived. The purpose of FPC recommendations for ad hoc disclosures therefore needs to be carefully communicated and explained. Through-the-

5 HM Treasury, A new approach to financial regulation, Paragraph 1.25, June 2011

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cycle disclosure requirements might reduce this risk, while the EU Capital Requirements Regulation (continuing the approach to disclosure – Pillar 3 – under the existing directive) will extend and codify disclosure requirements with maximum harmonising effect – i.e. the EU rules will be exhaustive, so it is not clear whether any other disclosures – on any of the topics covered by CRR Pillar 3 – can be required by national authorities. The EU package6 will also continue (from the existing directive) the strict prohibition on regulators disclosing supervisory information, indicating the potential challenges arising from the interaction of macroprudential policy and other concurrent regulatory reforms.

June 2012

6 Capital Requirements Directive, Article 54 et seqq in Commission proposal text, July 2011

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Written evidence submitted by the Council of Mortgage Lenders Introduction The CML is the representative trade body for the first charge residential mortgage lending industry, which includes banks, building societies and specialist lenders. Our 111 members currently hold around 95% of the assets of the UK mortgage market. In addition to lending for home-ownership, the CML’s members also lend to support the social housing and private rental markets. We are grateful for the opportunity to submit evidence to the Treasury Committee’s inquiry into the macroprudential tools that will be available to the Bank of England’s Financial Policy Committee (FPC). Our main concern is that the significant increase in the powers of the Bank have not been matched by a commensurate increase in transparency and accountability. In addition to responding to the questions in the call for evidence we have outlined the importance of the FPC having a clear process to deliver transparency and accountability and have outlined the key points in the discussion about LTV/LTI caps. Transparency and accountability The FPC will have broad ranging powers to direct and recommend actions for both the Prudential Regulation Authority (PRA) – a subsidiary of the Bank of England – and the Financial Conduct Authority, an independent regulator. These powers, when used, will have an impact on firms’ ability to lend thereby limiting consumer access and choice. If there is a lack of clarity about when or how the FPC’s powers can be used, it is likely to have an impact on the behaviour of both regulators and firms. The shadow-FPC has recognised that its decisions have the potential to be controversial. Its decision not to recommend the power to direct loan-to-value (LTV) or loan-to-income (LTI) caps was primarily taken because it would have a significant impact on consumers. We think that this is symptomatic of the challenges facing the FPC, the greater the impact its actions have on consumers and the ‘real economy’ the more it will need political legitimacy, as well as sound economic reasoning, to the actions it does. Political legitimacy can only be maintained if the FPC is seen to be accountable to government (and Parliament) and its processes are as transparent as possible. A key part of this process should be a duty to consult upon and publish a framework of how and when the FPC may use its power. When the powers of direction have been used, the FPC should have to publish the reasons why they have been used, including an ongoing assessment of the impacts. The powers of recommendation – whilst not binding – will be significant and therefore we believe that the FPC should be required to outline the measures it is likely to recommend and what it would to achieve by its recommendation. We can see the benefit in the FPC have flexibility about the recommendations it makes, but as regulators, firms and consumers require a degree of certainty to be able to operate effectively.

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We do not believe that the accountability and transparency proposals in the Financial Service bill are sufficient and have made similar points when responding to HM Treasury’s consultations and in our briefing note for MPs. Powers of Direction: A discussion on loan-to-value and loan-to-income caps We agree with the conclusions of the shadow-FPC, that LTV and LTI caps for mortgages have the potential to be controversial due to their impact on society. They risk being a rough and ready measure that directly impacts at an individual consumer level, by restricting the accessibility of the housing market, in particular it would adversely impact those borrowers who can afford the repayments for a mortgage with an LTV or LTI that was prohibited. This would create particular problems for first-time buyers entering the market – which has knock-on impacts for those already on the housing ladder by making it more difficult to start a ‘chain’, this would put pressure on the private and social rented sectors. It would instantly create ‘mortgage prisoners’ for those borrowers whose LTV/LTI is above the threshold, as they would not be able to remortgage to a new lender or to move (unless they are downsizing or moving to a cheaper property). The mortgage and housing markets are of significant economic and political importance in the UK and any decision to restrict or restrain the market would have to be well founded and carefully assessed in order to be acceptable to the public. It has been argued the similar LTV/LTI caps have been used with success internationally, but the markets they have been deployed in are either significantly different to the UK market, either in size or structure (such as Hong Kong or Canada). We are aware that LTV caps are in place in both the Netherlands and Sweden, but it is too early to assess the full their impacts. Anecdotally, we are aware that borrowers in the Swedish market are using unsecured loans to help fund the increased deposits required, which is potentially not the best outcome for consumers. Additionally, and perhaps more importantly, the three powers of direction that the shadow-FPC has advised HM Treasury that it should have available going forward (the countercyclical capital buffer, sectoral capital requirements and a leverage ratio) would all serve to put the brakes on an overheating mortgage market, as they would generally make it more expensive for lenders to offer ‘riskier’ products, therefore reducing their supply and negating the need for LTV/LTI caps. The interim FPC has indicated that it might differentiate secotral weights according to LTV or LTI. If this turns out to be the case, then the FPC may already have the power to effectively lean against high LTV lending. We need a better understanding of what the FPC intends. The changes in the UK mortgage market after the financial crisis have demonstrated the impacts that these three prudential measures can have. The reduction in the availability, combined with increased costs, of funding and significant changes in the capital and liquidity regimes governing UK lenders have resulted in the withdrawal of higher LTV products (with a marginal recovery over the last few months in the 90 -95% LTV bracket).

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It should also be noted that Financial Services Authority’s mortgage market review (MMR), although focussed on conduct of business regulation, has and will reduce elements of high risk lending. For example the self-certification of income will be prohibited and regulation governing the assessment of affordability will be significantly enhanced. In addition to the changes in the MMR the Financial Stability Board has published principles for sound underwriting of residential mortgages and the EU mortgages directive is progressing through the legislative process. Both of these cover similar ground to the FSA’s review and reinforce the requirements to robustly assess affordability. Taken as a whole we strongly believe that the changes in both prudential and conduct regulation, combined with the FPC’s powers of direction should ordinarily be more than sufficient to dampen an overheating housing and mortgage market. LTV/LTI caps then would only be needed once all of the other checks and balances had failed. Therefore, given the political implications of using such caps and their unproven performance in a market of the size and complexity of ours, we agree with the shadow-FPC that further consideration is needed about whether such a power is warranted and, if so, a clear understanding of the context which it would be used. Response to questions We have provided answers to the questions that are relevant to our members and the mortgage market. 1. Whether the interim FPC has requested the most appropriate tools over which the FPC should be given direction?

As outlined above, we believe that the tools that the shadow FPC has requested are sufficiently wide-ranging to be able to address an overheating mortgage market. However, given the breadth of the powers further clarification from the FPC is necessary to determine how and when it may use those powers. For example, the ability to apply differential capital requirements to different sectors, may mean that the FPC increases across all products, or that it targets specific parts of the market that are overheating – in the mortgage market higher LTV mortgages would probably be the focal point.

Therefore, given the scope of the powers requested by the FPC, they appear to be appropriate, but without further clarification regarding how and when these powers will be used, it is difficult to say for certain.

2. Whether additional tools should be give to the FPC (these may include tools rejected by the FPC, not considered by the FPC or that use the balance sheet of the Bank of England)?

In our introductory comments and response to question one, we believe that for the mortgage market, the FPC’s powers and the broader changes in regulation are likely to be sufficient.

3. The extent to which the FPC’s powers of recommendation are appropriate, and how they will work with the powers of direction?

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In principle we agree that the FPC should have a degree of flexibility in the powers at its disposal, in order to respond to unforeseen events. The powers of recommendation provide the FPC with flexibility, but in order to give stakeholders a degree of certainty; we believe that it is important that the Bank outlines when it is likely to make recommendations and what form these may take.

4. What structures should be created to provide the necessary transparency and accountability structures for the use of the tools?

As outlined above we believe that the FPC should have a duty to consult upon and publish a framework outlining the purpose of its powers and their likely impacts.

Additionally, the FPC should be required to publish the Minutes of its meetings and to write to the Chancellor of the Exchequer if it decides to use any of its tools, setting out what the actions are and why they are being used.

5. Whether the FPC should provide guidance on the use of the tools, and if so, what form that guidance should take?

We strongly support that the FPC outlines when and how its tools of direction are likely to be used, as we have outlined above, the tools it has requested a very broad in their scope and could be employed in a number of ways.

6. Whether the tools requested, taken as a whole, should be symmetrical, that is the extent to which they should ameliorate downturns as well as upswings in credit cycles?

This question has been answered by the Chancellor of the Exchequer in his Mansion House speech on 14 June, where he stated that ‘the Government will amend the Financial Services Bill to give the FPC a secondary objective to support the economic policy of the Government. I will make it a legal requirement for the FPC to report, for every action it takes, how that action is compatible with economic growth as well as stability.’

We welcome this additional requirement on the FPC but as with all its powers, what this means for the practical workings of the FPC remains to be seen. We would encourage the FPC to have an open dialogue with stakeholders to discuss how to balance its two statutory objectives.

June 2012

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Written evidence submitted by the British Bankers Association

Executive Summary

The British Bankers’ Association welcomes the opportunity to provide evidence to the Treasury Committee’s inquiry into the macroprudential tools under consideration for the Financial Policy Committee.

1. The BBA has been strongly supportive of the development of a macroprudential regime and has taken a keen interest in the proposed framework through which the FPC will operate and the international discussion on the instruments which should be utilised to deliver macroprudential supervision. In responding to the questions set by the Committee, our evidence makes the following fundamental points:

• Macroprudential policy should not simply duplicate microprudential supervision or be used to impose undifferentiated capital surcharges in an effort to mitigate all potential risks to financial stability. To be successful macroprudential supervision should be broader and consider wider financial stability and the drivers of financial instability; and

• Transparency and accountability are of paramount importance: this includes the manner in which the FPC operates, how it assesses financial stability and accounts for its actions. It also extends to how Parliament authorises the tools, assesses their effectiveness and the degree to which the effects of FPC decisions are visible to consumers.

2. In this context, we welcome the announcement made by the Chancellor in his Mansion

House speech that the Government intends to “amend the Financial Services Bill to give the FPC a secondary objective to support the economic policy of the Government”. This is something we have long advocated and, together with the suggested requirement for the FPC “to report, for every action it takes, how that action is compatible with economic growth as well as stability” look to be important enhancements to the statutory footings on which the FPC will be established.

3. As a final point, we observe that the development of a macroprudential capability on the part of the Bank of England is still seen as a technical mechanism; given the potential implications of the powers the FPC will have at its disposal we believe this must change and the FPC must be viewed for what it is, a counterpart to the Monetary Policy Committee whose decisions will influence directly on businesses and households.

4. Below we respond to the questions set by the Committee. Our evidence is supported by a number of annexes which consider in some detail the suitability of a range of macroprudential tools. 1. Whether the interim FPC has requested the most appropriate tools over

which the FPC should be given the power of direction

5. Our starting point is that we believe the choice of macroprudential tools should be guided by firm criteria against which to assess their suitability. In this regard, we see the

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criteria identified by HM Treasury and the FPC as being broadly appropriate. In particular, we are supportive of the requirements set by HM Treasury that:

• FPC directions be focused on system-wide, rather than firm-specific characteristics;

• directions must be confined to areas where the UK has sufficient national discretion; and

• tools or instruments should be specific, rather than broad or open-ended, so that powers of direction apply only to measures that are defined precisely.

6. In considering the tools which should be made available, we note the FPC also assessed

the various possibilities against the principles of effectiveness, efficiency, transparency, coverage and independence. In our view there would be merit in adding the following to this list:

• a preference for simplicity; • an element of predictability; • proportionality; and • international coordination and reciprocity.

7. These are largely self-explanatory. International coordination relates principally to the

relationship between the FPC and the European Systemic Risk Board; as the Bank of England’s recent discussion paper noted, the FPC will be required by European Union law to take account of the potential implications of its actions on European-wide stability and so this should be reflected in the selection criteria. Reciprocity refers to the need for home country regulators to agree to apply macroprudential tools to EEA firms operating in the UK market on a passported-in basis, at a minimum, in order for macroprudential policies to be effective as they can be without so-called ‘leakage’. Global agreement via the G20/Financial Stability Board/Basel Committee is necessary for macroprudential policy to be truly effective.

8. We include an assessment of various tools against these different criteria in the Annex to this evidence. A key point which emerges from this analysis is that it is vital to understand the transmission mechanism behind the tools. This is both important to assess the degree to which the tool will meet the objective set but also to identify the level of work required to make the tool operational. Countercyclical capital buffer

9. We have been supportive of the development of the CCB and agree that it should be included within the FPC’s initial toolkit. Its main strength is the international reciprocity arrangements under the Basel III agreement which should minimise the degree of possible ‘leakage’, something we view as one of the main barriers to the FPC meeting its objectives. However, we must underline that the CCB cannot be seen as a panacea. Whilst an increase in the buffer rate would have a direct effect on loss absorbing capacity, these changes will not focus directly on specific sectors or be applied to the unregulated sector and could give rise to perverse incentives to increase exposure to ‘riskier’ assets in an effort to maintain adequate returns. Fundamentally, we would not wish to see macroprudential supervision reduced to an attempt to combat all possible

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risks to financial stability via the introduction of undifferentiated capital buffers in the regulated sector.

10. As a final point, we must underline that the CCB has to be used counter cyclically. This means that the FPC must be willing to determine publically the point at which in the cycle the buffer can be drawn down. Whilst we are supportive of this aspect of the framework, it remains to be seen how the market would react to an announcement that banks could draw down the buffer at the appropriate point in the cycle. We fear that in reality there will be pressure to maintain unduly high levels of capitalisation which may impede the effectiveness of the tool and limit the ability of banks to support their customers and the economy during the recovery from a shock to financial stability. Sectoral capital requirements

11. In principle, sectoral capital requirements could be used to increase the cost (and therefore reduce the quantity) of lending to specific sectors and thus act in a more targeted way than the CCB. Whilst this is positive it raises a number of questions, including whether it is possible to identify risky sectors and to determine the appropriate change in risk weighting as well as how an unduly activist approach to fine tuning could be avoided.

12. Beyond these questions, we are concerned that the FPC may have opted to request this tool as a means of achieving broadly the same effects as Loan-to-value or Loan-to-income powers but without the same degree of visibility that these tools would imply. We note in the 16 March 2012 record of the FPC’s meeting, the FPC argues that changes in sectoral risk weightings would have more ‘transparent distributional consequences’ than changes in aggregate capital levels. Whilst this may be so, the effects are much less transparent than LTV caps and we are concerned that the use of this tool could be subject to a lesser degree of political accountability than would be the case with LTVs (although this is not to say that LTVs should be seen as a panacea). At the very least, the ‘signalling’ effect of utilising the tool for consumers will be much lower as it is much more difficult to communicate.

13. As a final point, it is worth highlighting that at the time of writing Article 119 of the Presidency compromise for the Capital Requirements Regulation grants Member States the ability to vary risk weightings attached to mortgage lending for reasons of ‘financial stability’. The text grants the ability to set the risk weight for residential mortgages between 35 and 150 per cent and between 50 and 150 per cent for commercial mortgages. The EBA is tasked with developing technical standards to be used to identify criteria which can justify adjustments. Importantly, the current form of the proposals envisages reciprocity between Member States. It does not, however, consider the position of international banks and how the provisions might be applied to the UK branch of a third country bank. A summary of the macroprudential flexibility under the CRR is provided in Annex 5. Leverage ratio

14. We are supportive of the concept of the leverage ratio as a backstop to other forms of supervision but are uncertain of its suitability as a macroprudential tool to be published and varied overtime. To be effective, the tool must be used, as the Basel Committee

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suggests, in combination with other supervisory tools to mitigate, for example, making it the primary capital constraint on banks, or incentivising changes to the composition of balance sheets to maintain returns in response to other requirements. The design of the leverage ratio is also complex which reduces its utility for market participants who will seek to use it to assess the relative positions of banks across jurisdictions. For instance, differences in IFRS and US GAAP lead to different approaches to the consolidation, derecognition and netting of balance sheets which complicates the comparability of leverage between European and US banks. International coordination of the level and use of a leverage ratio is therefore important. Disclosure requirements

15. We fully recognise the importance of banks providing high-quality, decision-useful disclosures about their activities. Indeed, our members have worked with the FSA to develop the principles-based BBA Disclosure Code under which they are committed to enhancing the quality and consistency of the disclosures they provide at each reporting period. As part of this process, due regard has been given to recommendations made by the FPC on areas where enhanced disclosure could prove beneficial but in the context of the practical realities of the time it takes to access data and develop disclosures which meet strict standards of reliability. We therefore do not believe a case has been made to support the FPC’s decision to request a broad power to set disclosure requirements and suggest that the imposition of common templates for financial reporting disclosure would be counterproductive given that it is highly doubtful whether robust, decision-useful templates could be produced by the PRA in the necessary timescales. Indeed we fear that if templates were mandated there would be a consequent reduction in the current high-quality disclosure provided by banks. Rather than seeking a broad power of direction, we therefore encourage the FPC to maintain an open dialogue with the FSA (PRA) and industry so there is an awareness of the risks the FPC is monitoring and an understanding on the FPC’s part of the practicalities and time scales required to provide new and innovative disclosures for groups which operate in multiple jurisdictions. 2. Whether additional tools should be given to the FPC (these may include

tools rejected by the FPC, not considered by the FPC or that use the balance sheet of the Bank of England)

16. Given the early stage in the development of macroprudential policy and the concerns

around accountability it would seem appropriate to us to grant the FPC a relatively narrow set of directional powers, at least initially. Taken together, the tools requested by the FPC are potentially very significant in their scope and intrusiveness and the consequences of their use are unknown. We would favour an approach under which the range of tools available to the FPC increases as its knowledge and sophistication grows.

17. A significant element of this will relate to the articulation of the meaning and preferred

outcomes of financial stability. We believe that financial stability is closely bound up with, but not exactly the same as, stability of the supply of credit to the economy and possibly also its price to the extent that stability of both can be achieved at the same time. In our view, financial stability is concerned with the integrity, resilience and sustainability of the supply of payments services, maturity transformation, risk pooling and risk transfer. A preferred definition of financial stability should therefore include,

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but not be limited to, the stable supply of finance to support economic activity and therefore implicitly include an outcome in terms of economic activity and that there may be a trade-off between economic activity and resilience.

18. The analysis provided in the annex includes our views on the merits of other macroprudential tools which could be considered in future. We also include a table giving examples of additional ways that the FPC could seek to apply macroprudential supervision through the existing microprudential toolkit.

19. As a final point, it should not be forgotten that the power of direction is just one available to the FPC. Just as important are the powers of suasion, public pronouncement and influence over the microprudential regulators. Fundamentally, if the FPC’s analysis is well-reasoned and it clearly communicates its concerns then it is likely to gain traction without the need to resort to the power of direction. 3. The extent to which the FPC’s powers of recommendation are appropriate,

and how they will work with the powers of direction

20. We note the FPC’s statement that it does not believe that there should not be rigid sequencing of the use of recommendations and directions, and can largely agree with this for the reasons outlined in the 16 March 2012 minutes. It is right that once Parliament has granted the powers of direction to the FPC it has the flexibility to decide which tool is most appropriate for combating the concern it has identified, albeit within the context of predetermined norms.

21. Notwithstanding this, we believe there needs to be a culture change around how the FSA (and PRA/FCA) respond to recommendations from the FPC. In our experience to date, the FSA has treated recommendations like directions and has implemented them unquestioningly. Whilst we believe there are grounds for a degree of due process around the implementation of directions, we strongly believe that this must be the case for recommendations and that the relevant authority should consult on how and when it should comply. Fundamentally, we continue to view consultation with the industry as a necessity to enhance communication between the FPC and the outside world which to date has sadly been lacking. 4. What structures should be created to provide the necessary transparency

and accountability structures for the use of the tools

22. The accountability mechanisms for the FPC remain of paramount importance to us. Whilst we recognise that the different sources and amplifiers of systemic risk do not lend themselves to a single indicator for financial (in)stability, as is the case for monetary policy, in our view the FPC should develop a range of agreed indicators which can be used for justifying macroprudential decisions. It would seem appropriate to us that when implementing a macroprudential tool the FPC should issue a statement – either through its minutes or the Financial Stability Review – explaining the factors which drove it to act, what it hopes to achieve and a cost/benefit analysis. Issuing a statement of this type will not only draw attention to the risks the FPC’s perceives in the financial system and help the market to understand them; it will also provide a basis on which Parliament can at a later stage hold the FPC to account for its actions.

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23. In terms of the process of approving tools for use by the FPC, we are largely supportive of that envisaged by the Treasury, although we maintain our view that Parliament should include ‘Sunset’ clauses when approving a tool to ensure that the toolkit remains up-to-date. Given the potential scope of the powers considered, we suggest that Parliament may also wish to consider constraining the degree of variation available to the FPC. For example, a power to vary the leverage ratio could be set in a range either side of the figure set by the Basel Committee. Such an approach would also be conducive to requiring the FPC to assess the impact of a variation and to justify the benefits the use of the tool would deliver. 5. Whether the FPC should provide guidance on the use of the tools, and if so,

what form that guidance should take

24. As noted above, we believe there is a case for Parliament to set limits on the degree to which the FPC can use its directional tools to vary supervisory parameters. A decision to exercise a tool outside these parameters could be taken via the emergency ex post approval process contained within the Bill. We also believe that the FPC should explain what it hopes to achieve by utilising a tool and that it should publish a cost/benefit analysis to justify its decision.

25. Beyond this, we see a place for the FPC to produce broad up-front guidelines setting out the circumstances in which it would be likely to use a directional tools and the order and magnitude in which it is probable it will use specific macroprudential tools. Whilst we can accept that there may be circumstances in which the FPC may need to diverge from this, the guidelines would produce a measure of regulatory certainty for microprudential supervisors and the industry. 6. Whether the tools requested, taken as a whole, should be symmetrical, that

is, the extent to which they should ameliorate downturns as well as upswings in credit cycles

26. We believe it is fundamentally important for the tools to be used in a symmetrical

fashion and see this as being at the heart of macroprudential supervision. Whilst we do not wish to see the FPC seeking to manage the economy actively, there is clearly scope for it to use its powers to mitigate the procyclical nature of the financial system. In this regard, we fear that too little attention has been devoted to understanding how the market will react to a loosening of requirements and suggest that, in light of recent experience, the FPC will need to undertake considerable market education to ensure that banks are able to drawdown metrics such as the countercyclical capital buffer. 7. What further analysis should be provided by the Bank of England before the

macroprudential tools are granted to the FPC, and what analysis should be periodically produced by the Bank of England once any tools are granted

27. The Global Financial Crisis has had its greatest impact in developed economies.

However the experience exemplifies and mirrors crises seen in emerging markets over the last 25 to 30 years, in particular the Latin American crises and the Asian Crisis of 1997. Many of these regimes have successfully used marcoprudential levers to address

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their particular crises. The Bank of England and the FPC should consider the lessons which can be learned and implemented from these emerging markets experiences.

28. More specifically, we suggest that the FPC should be asked to provide a policy statement outlining how it will expect to utilise the tools. It would also be useful for the FPC to provide greater clarity on the indicators it will utilise to assess financial stability. The biannual FSR should be used to provide an update on the adequacy of the toolkit as well as to provide details on how the financial stability indicators have moved over the reporting period. If a macroprudential tool has been implemented, the FSR should give an analysis of the degree to which it is achieving the objectives set for it. Clarity in this area is especially important in light of the FPC’s additional objective to support the economic policy of the government. June 2012

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ANNEX 1: Overview of macroprudential instruments Description/Aim Current or future

framework Authority responsible for activation

Possible unintended consequences

Equivalence issues

Counter-Cyclical Buffer

Increase bank resilience and moderate economic cycle Linked to a growth/GDP metric

Basel III and CRD IV CRD IV envisages power to extend buffer beyond 2.5 per cent

National supervisor – FSA (PRA)

Blunt tool, which may lead to banks increasing exposure to riskier sectors to maintain ROE (and thereby withdrawing credit from sectors policy-makers wish to protect). Uncertainty over whether supervisors will permit banks to draw buffer down.

Reciprocity arrangements envisaged by BCBS limit concerns over leakage, although lack of clarity over how these will be applied in practice

Sectoral capital requirements

Increase capital held against sectors of concern to policy makers, disincentivising lending

CRD IV permits EBA to develop technical standards which will permit supervisor to alter certain risk weights. Also possible to implement via capital add-on or IRB scaler

National supervisor – FSA (PRA) EBA to develop technical standards, which will limit Member State flexibility

May shift risk to other sectors EU cross-border reciprocity is envisaged but no equivalent agreement for other markets

Maximum leverage ratio

Limit total (i.e. non risk weighted) assets to equity to limit leverage. Potential to use dynamically.

Basel III (and CRD IV) introduces a maximum leverage ratio from 2018

National supervisor – FSA (PRA) EBA to develop technical standards, which will limit Member State flexibility

May increase incentive to hold riskier asset and the development of complex off-balance sheet arrangements. Could potentially disproportionately affect low risk business models.

Different accounting frameworks hinder comparability. A dynamic ratio would incentivise leakage.

Time-varying Enhance the Provisioning currently Securities regulator – Unless IFRS was amended, UK Cross-border and cross-

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provisioning robustness of banks by requiring the recognition of both expected and unexpected losses to build up general provisions

governed by IFRS, as authorised by the EU.

FSA (FCA) currently responsible for enforcement of IFRS. In Spain, Bank of Spain sets provision levels for specific sectors.

banks’ financial statements would be incompatible with IFRS. Those with listings on foreign markets would be required to reconcile their accounts to full IFRS. The decision-usefulness of financial statements would be reduced, undermining market confidence.

sector leakage both likely to occur

Restrictions on distributions

Incentivises banks to increase capital levels by hindering their ability to make distributions until they do so.

Basel III introduces a Capital Conservation Buffer – which limits ability to make distributions if utilised. Power envisaged goes beyond this to become a more discretionary power, perhaps linked to stress testing/ICAAP.

National supervisor – FSA (PRA) EBA to develop technical standards, which will limit Member State flexibility

May incentivise deleveraging and the longer-term ability of banks to raise capital. More effective as a microprudential tool when a bank is not meeting a minimum requirement. Could have a negative impact disproportionately on banks that are in a strong position and are well managed because equity markets will dry up even for those looking to attempt pre-emptive equity raising.

No reciprocity provisions envisaged.

Counter-cyclical liquidity buffers

Set liquidity buffer requirements over and above micro-prudential standards with a view to

Basel III (CRD IV) introduces two micro-prudential liquidity standards: LCR & NSFR.

National supervisor – FSA (PRA) EBA to develop technical standards on

May encourage risk taking by banks seeking to maintain ROE. Inefficient use of liquid assets may act as a drag on the

Leakage highly likely. Equivalence may be hindered by different definitions or horizons.

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enhancing banks’ resilience to liquidity crises and therefore reducing procyclicality.

Proposal could be implemented via a multiplicative scalar applied to minimum LCR requirement or as a change in the duration of the stress period. Alternative an unweighted liquid asset ratio could be applied and varied. A Core Funding Ratio could be applied and varied as a macroprudential tool to ensure a given portion of a bank’s total funding was from certain sources or of a minimum maturity.

operation of LCR and NSFR, which will limit Member State flexibility

economy.

LTV/LTI restrictions

Enhance the resilience of financial institutions by ensuring minimum levels of collateral are held against mortgages, minimising losses in the event of default. Moreover,

Residential mortgage lending is regulated by FSA Mortgage Conduct of Business Rules and will be covered by forthcoming EU Mortgage Directive.

National supervisor – FSA (FCA)

Some borrowers may be excluded from market. May drive activity to shadow banking system or incentivise consumers to top up deposits for mortgages with other credit products. Could ‘politicise’ FPC.

Any firm passported in to the UK market would be required to comply.

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restricting the availability of credit may temper the property market.

Buy-to-let lending is outside scope.

Margining requirements

Static or dynamic margining requirements could offset procyclicality inherent in margining practices, thereby reducing systemic risk cause by spikes in margin requirements.

BIPRU National supervisor – FSA IOSCO

Minimum requirements may be arbitraged by making greater use of unsecured financing to offset any higher margin that may be required to secured financing

Potential for cross-border leakage unless internationally agreed framework developed

Disclosure requirements

Enhance firms’ disclosure to ensure market discipline operates and to limit the potential for perception-driven contagion

IFRS BIPRU Transparency Directive UK company law BBA Disclosure Code

National supervisor – FSA (PRA) Financial Reporting Council ESMA

Disclosure of certain information may have adverse consequences or may be misinterpreted by the market. Regulator imposed disclosure templates may hinder the decision-usefulness of information provided by failing to allow for business model/mix to be adequately portrayed.

Use of central counterparties

Require regulated institutions to use a CCP to manage risks arising from defined transaction types to overcome private incentives or

G20 agreement to centrally clear all standardised OTC transactions. Implemented via EMIR in the EU.

ESMA and FSA (FCA). Concentrates risk in CCPs, increasing their systemic importance and possible consequences of failure. Product level requirements may generate higher total exposures for some market

Potential for differences between clearing requirements, e.g. EU-US.

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coordination difficulties which can impede their development.

participants if other related products are not centrally cleared and hence they would be unable to continue netting exposures across these products. Not clear how this is a macroprudential tool given that it will not be ‘switched on and off’.

Design & use of trading venues

Reduce possibility of extreme volatility and liquidity shocks by requiring trading venues to improve transparency or implement circuit-breakers.

G20 agreement to centrally clear all standardised OTC transactions. Draft MIFIR establishes that requirements to trade eligible OTC derivatives on organised venues will be set by ESMA.

ESMA FSA (FCA)

May discourage participation in some markets, resulting in a reduction in liquidity. Could lead to the development of opaque instruments to arbitrage requirements.

Potential for differences between clearing requirements, e.g. EU-US, resulting in arbitrage.

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ANNEX 2: Analysis of possible tools against Bank of England criteria Criteria / Assessment Criterion #1:

Effectiveness Criterion #2:Efficiency

Criterion #3:Transparency

Criterion #4:Coverage/Independence

Counter-Cyclical Buffer

Direct effect on loss absorbing capacity

Does not focus on specific sectors and there may be a reluctance to let banks draw the buffer down

Buffer rate & level will be disclosed but transmission mechanism opaque

Only applies to regulated sector but reciprocity provisions reduce leakage but are untested

Sectoral capital requirements

Could increase capital & disincentivise activity but needs effective implementation

Could be applied to individual asset classes but may displace risk. Implementation challenging

Low (to customer), limiting ‘signalling’ benefit and may lead to the FPC being drawn into discussion of broader economic policy

Could apply to all authorised firms but leakage could lead to arbitrage

Maximum leverage ratio

Can act as a backstop Incentivises risk taking to maintain ROE

Could be set transparently and would be disclosed

Design difficult. Can result in leakage and arbitrage

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Time-varying provisioning

Would enhance loss absorbency in specific sectors

Complex to implement Would distort financial statements

UK banks financial statements would not be IFRS compatible

Restrictions on distributions

Limits risk of disruption to credit supply

May cause deleveraging & would penalise stronger banks

Could be used transparently, if linked to specific capital ratios but may hinder ability to raise capital in long

Only applies to UK authorised banks

Counter-cyclical liquidity buffers

Reduction in mismatch may increase resilience & if used dynamically smooth credit cycle

Inefficient use of liquid assets & could cause risk-seeking as banks try to maintain ROE

Does nothing to signal that a buffer could be used in times of stress

Leakage could be an issue although arbitrage could be less than for capital buffer

LTV/LTI restrictions Targeted intervention which may limit the risk of bubbles, although evidence is limited on their application in western markets

Difficult to calibrate trade-off between stability & other public policy goals

Strong signalling advantages and more transparent to consumers than prudential tools exercised to achieve same effect

Not all lending is regulated & can be circumvented

Margining requirements

May enhance resilience of funding markets, reduce procyclicality and act on shadow banking sector

Not targeted. Effect might be offset by greater use of secured funding

Could be difficult to communicate given large number of potential instruments subject to requirements

Cross border & sector leakage could be an issue due to lack of international framework for margining

Disclosure requirements

Enhances market discipline & can promote investor confidence

Prescriptive templates can limit usefulness of data

Disclosure requests need to be cognisant of wider accounting framework/foreign listing requirements and practical limitations

Only applies to UK authorised firms

Use of central counterparties

Reduces interconnectedness,

Increase systemic importance of CCPs and

Simple for the market to understand

Would need to be internationally

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reduces spill over effects and provides greater transparency

may lead to new instruments emerging. Only standardised products can be centrally cleared

coordinated. May lead to the emergence of more opaque alternative instruments

Design & use of trading venues

Could enhance market liquidity

Could discourage participation in certain markets, reducing liquidity. Only practicable for standardised and liquid products

Objective criteria would need to be developed to identify transactions in scope

Could drive activity overseas

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ANNEX 3: Analysis of possible tools against BBA criteria Criteria / Assessment

Criterion #1:Simplicity

Criterion #2:Transparency

Criterion #3:Predictability

Criterion #4:Proportionality

Criterion #5Internationality

Counter-Cyclical Buffer

Moderate – but complexity will be greater for cross-border banks whose buffers will be the sum of their exposures in different markets

Buffer levels will be disclosed but authorities will need to be candid when conditions necessitate buffers should be drawn down to manage market expectations

High if linked to simple metric, lower if based on judgement alone. Questionable whether firms will drawdown buffer

Effects all banks, not just those exposed to risky sectors but not non regulated sector

Reciprocity reduces risk of leakage

Sectoral capital requirements

Potentially difficult to identify risky sectors but can be applied via adjustment to scaling factors

Higher risk weightings can be communicated, although limited ability to influence consumers behaviour

Would need transparent means of identifying when to act in specific sectors

Only applies to perceived risky sectors but may have broad economic and societal effects

No reciprocity and does not address lending by non-banks

Maximum leverage ratio

Simple to understand but difficult to calculate. As the ratio will vary across business lines may be better for supervisors to focus on the delta

Transparent if disclosed but could hide avoidance activities

Would be linked to objectiveness of trigger for increasing/decreasing

Effects all banks, no matter the riskiness of their assets

Design difficult due to different national standards

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Time-varying provisioning

Complex to implement

Opaque as distorts income statement

Moderate if implemented via a rules-based scheme

Moderate as only applies to banks operating in certain sectors

Inconsistent with IFRS. Leakage would be high as would not apply to braches

Restrictions on distributions

Simple to implement via supervisory dialogue

Moderate if discussed via ICAAP. Effect should be visible via financial statements

Dependent on implementation – higher if linked to stress testing or specific capital ratio requirement but transmission uncertain

Runs the risk of unintended consequences such as deleveraging

Vulnerable to international leakage

Counter-cyclical liquidity buffers

Dependent on model chosen but most value as a micro tool

Could be disclosed Calibration could be difficult

Would penalise all banks & could incentivise increase in risk taking to maintain ROE

Leakage could be high but potentially lower than capital based tools

LTV/LTI restrictions

Easy for consumers to understand and to implement/amend

Strong signalling effect and more transparent than prudential measures

Difficult to balance competing public policy objectives

Potential for policy errors

Possible to circumvent by consumers and international/non-banks

Margining requirements

Difficult to implement

Would need to apply to large number of instruments

Effect may be offset by secured lending

Can target provision of liquidity from the shadow banking sector and decrease leverage

Hindered due to lack of international agreement

Disclosure requirements

Simple to set Work to enhance market discipline

Requirements need to be built into

Only apply to regulated sector.

Only apply to UK authorised firms but

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and confidence regular supervisory process and be cognisant of related regulatory requirements and practical constraints

Can typically be implemented at minimal cost. Regulator must avoid temptation of trying to directly manage risks.

may drive international market best practice and can be syndicated via bodies such as FSB

Use of central counterparties

Complex to develop and only standardised products can be cleared

Provides greater transparency but may lead to unwanted innovation

May give rise to the development of opaque new instruments

Would apply to all transactions but would increase concentration of risk in CCPs

Would need to implemented internationally

Design & use of trading venues

Relatively simple to implement but can only apply to standardised/liquid instruments

May enhance transparency of certain transactions

Objective criteria would be needed to determine transactions within scope

Could discourage participation and reduce liquidity

Vulnerable to international leakage unless coordinated internationally

ANNEX 4: Possible additional ways of applying macroprudential supervision

Tool Summary Action EffectDownturn LGD for Retail Mortgages in IRB models

FSA prescribes benchmarks that firms must use. (e.g. minimum house price discount)

FPC prescribes downturn assumptions such as price discounts or cure rates

Would have a direct impact on Mortgage LGD and thereby RWA for IRB

Sovereign LGD BBA has proposed a simplified framework in

FPC could prescribe values available in framework or

Raises RWA levels for Sovereign exposures

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which LGD may take various discrete values

individual Sovereign values

Through the Cycle PD Calibration

FSA imposes uplifts to firm assumptions to mitigate weaknesses in methodologies

Use same approach to mitigate systemic risks

Allows FPC to direct increases in capital for specific firms or segments

LGD Discount factor for Cost of Capital

In calculating LGD Banks are required to discount recovery cash flows by their cost of capital

FPC could prescribe a minimum cost of capital

Would drive increased LGD with the effect varying by size and tenor of recovery cash flows

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ANNEX 5: Macro-prudential measures under the Capital Requirements Regulation

The current Danish Presidency compromise on the text of the CRR foresees some flexibility for Member States to vary the provisions of the Single Rulebook for macroprudential purposes. In particular, flexibility is provided in the areas of:

• Minimum capital requirements; • The level of the Capital Conservation Buffer; • Limits for large and intra financial sector exposures; • Disclosure requirements; • Liquidity requirements; and • Risk weightings for mortgage lending.

Article 443a

Macro-prudential or systemic risk identified at the level of a Member State

0. Member State shall designate the authority in charge of the application of this Article. This authority shall be the competent authority or the designated authority.

1. If the authority determined according to paragraph 0 identifies changes in the intensity of macro-prudential or systemic risk in the meaning of a risk of disruption in the financial system with the potential to have serious negative consequences to the financial system and the real economy in a specific Member State and which the authority determined according to paragraph 0 considers would better be addressed by means of national measures, it shall notify the Commission, the Council, the ESRB and EBA of that fact and submit relevant quantitative or qualitative evidence of all of the following:

a) the changes in the intensity of macro-prudential or systemic risk;

b) the reasons why such changes could pose a threat to financial stability at national level;

be) a justification of why Articles 119 and 160 of this Regulation and Articles 98, 99a, 100, 100a, 124a, and 126 of Directive [inserted by OP] cannot adequately address the identified macro-prudential or systemic risk, account taken of the relative effectiveness of these measures.

c) draft national measures for domestically authorised institutions, or a subset of those institutions, intended to mitigate the changes in the intensity of risk and concerning:

(i) the level of own funds laid down in Article 87;

(ii) the requirements for large exposures laid down in Article 381 and Article 384 to 392;

(iii) the public disclosure requirements laid down in articles 418 to 440; or

(iv) the level of the conservation buffer as set out in Article 123 of Directive [inserted by OP].

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(v) Liquidity requirements as set out in Part Six

(vi) Risk weights for targeting asset bubbles in the residential and commercial property

(vii) Intra financial sector exposures

d) an explanation as to why such draft measures are deemed by the authority determined according to paragraph 0 to be suitable, effective and proportionate to address the situation; and

e) an assessment of the likely positive or negative impact of the measures on the single market based on information which is available to the Member State.

1a. When authorised to apply national measures in accordance with this Article , the authorities determined in accordance with paragraph 0 shall provide relevant competent authorities in other countries with all relevant information.

2. Within one month of receiving the notification referred to in paragraph 1, the ESRB, EBA and the Commission shall provide their opinions on the points mentioned in paragraph 1 to the Council and the Member State in question. Within one month of receiving the opinion, the Member State may adopt the national measures referred to in paragraph 1(c) for a period of up to two years, unless the Council decides otherwise by means of an implementing measure adopted by qualified majority. The Council shall take a decision if it receives a negative opinion from at least one of the authorities mentioned above. The Council shall only decide otherwise if it is not satisfied that:

a) the changes in the intensity of macro-prudential or systemic risk are of such nature as to pose risk to financial stability at national level;

b) Articles 119 and 160 of this Regulation and Articles 98, 99a, 100, 100a, 124a, and 126 of Directive [inserted by OP] cannot adequately address the identified macro-prudential or systemic risk, account taken of the relative effectiveness of these measures;

c) the proposed national measures are more suitable to address the identified macro-prudential or systemic risk and do not entail disproportionate adverse effects on the whole or parts of the financial system in other Member States or of the Union as a whole, thus forming or creating an obstacle to the functioning of the internal market;

d) the issue concerns only one Member State; and

e) the risks have not already been addressed by other measures in this Regulation or in Directive [inserted by OP]

The assessment of the Council shall take account of the opinion of the ESRB, EBA and the Commission and shall be based on the evidence presented in accordance with paragraph 1 by the authority determined according to paragraph 0.

2a. Other Member States may recognise the measure set in accordance with this Article and apply the measures to domestically authorised branches located in the Member State authorised to apply the measures.

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2b. If Member States recognise the measures set in accordance with this article the Member State, they shall notify the Commission, the Council, EBA, the ESRB and the Member State authorised to apply the measures.

2c. When deciding whether to recognise the measures set in accordance with this Article the Member State shall take into consideration the criteria set in paragraph 2.

2d. The Member State authorised to apply the measures may ask the ESRB to issue a recommendation as referred to in Article 16 of Regulation (EU) No. 1092/2010 to one or more Member States which may recognise the measures.

3. Before the expiry of the authorisation issued in accordance with paragraph 2, the Member State shall, in consultation with the ESRB and EBA, review the situation and may accordingly adopt, in accordance with the procedure referred to in paragraph 2, a new decision for the extension of the period of application of national measures for one additional year each time. After the first extension, the Commission shall in consultation with the ESRB and EBA review at least every year the situation.

3x Notwithstanding the procedure as set out in paragraph 0 to 3, Member States shall be allowed to increase the risk weights beyond those provided in the Regulation of up to 25 % and tighten the large exposure limit provided in Article 384 of up to 15 %.

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Written evidence submitted by Barclays Introduction • Barclays welcomes the Treasury Committee’s decision to undertake an

inquiry into the macroprudential tools that will be given to the Financial Policy Committee (FPC) of the Bank of England (the Bank).

• We agree that macroprudential supervision is an important part of the new

approach to financial regulation. We also note that macroprudential policy is largely uncharted and untested in modern Western economies and that the application of tools could have a significant impact on the economy. For these reasons, we are supportive of the role of Parliament, through the Treasury Committee, to scrutinise this area of policy.

• Given the importance and implications of the use of macroprudential policy

and the application of macroprudential tools, we believe that some fundamental principles and considerations should be factored into their development:

o The wider economic implications of using macro-prudential tools must

be considered carefully by the FPC. As MPC member Alastair Clarke recognised, there is a need “to avoid a situation where, faced with a potential threat to financial stability, the FPC consistently erred on the side of excessive caution.” The Chancellor’s recent announcement of the change to the Financial Services Bill to ensure the FPC has an objective to consider the wider economic context will clearly be helpful here.

o Due to the largely untested nature of macro-prudential policy and

tools, there is need for considerable caution and careful testing to avoid unintended consequences or a disproportionately damaging impact. We would agree with the Bank’s approach to retain, in the first instance, a narrow suite of tools so that the authorities can learn how best to use such tools in the context of actual market behaviour.

o The UK’s freedom of action in macroprudential policy remains

uncertain given EU and international measures. The UK should seek to contribute to, influence, and then adhere to internationally harmonised approaches to macroprudential supervision. This will enhance the legitimacy and effectiveness of the tools used.

o Resolvability should be a key macroprudential area of focus. The FPC

will improve stability more by ensuring failure can occur without contagion, than by focusing on preventing (all) failures.

• Many of the points above are echoed by the BBA in its submission which

recommends the following additional principles we would agree with: o preference for simplicity; o an element of predictability;

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o proportionality; and o international coordination and reciprocity.

• We also note that, in its recent report on the Financial Services Bill, the

Treasury Committee called for enhanced parliamentary scrutiny of the secondary legislation to bring in the macroprudential tools. We support this recommendation.

Barclays specific responses to the areas in the Call for Evidence 1. Whether the interim FPC has requested the most appropriate tools

over which the FPC should be given the power of direction. 1.1 We understand and support the Bank’s decision to focus on a relatively

narrow set of powers of direction in the first instance. 1.2 In the largely uncharted territory of macroprudential policy, it seems

sensible to adopt a narrow suite of tools with care in the first instance and then build experience and understanding in how best to use such tools in the context of actual market behaviour.

1.3 Whilst we recognise the value of the counter-cyclical capital buffer, we

believe that in the suite of tools proposed there is too great a focus on capital measures. In fact, all three proposed powers of direction are different ways to do the same thing: increase capital.

1.4 It is important to recognise that much has already changed since the crisis.

The industry is now far better capitalised (with UK banks now generally holding over 10% core tier 1 equity capital), less leveraged and has far more liquidity on balance sheets. Barclays equity capital ratio has increased from 4.7% before the crisis to 10.9% in 2012; our liquidity buffer has increased from £19bn to £173bn; and leverage has declined from 33x to 20x. These changes are aside from the structural, market infrastructural, governance, and regulatory improvements that have either been made or are in train.

1.5 Increasing capital significantly above the levels dictated by changes that

have already been implemented and further reforms being implemented (including Basel III) will have ever more marginal benefits in addressing tail-risk in the banking sector and systemic risk, whilst having a disproportionate and material impact on the economy. It may also encourage the transfer of risk to the unregulated sector.

1.6 We are also not persuaded of the desirability of sectoral capital

requirements, especially if a counter-cyclical capital buffer is in place to lift across the board capital requirements in order to deal with excessive levels of credit. Sectoral requirements have two fundamental problems: first, any attempt to channel credit through adjusting risk weightings is unlikely to be effective or appropriate – it could open the FPC to the criticism of

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attempting to apply an ‘industrial policy’; and, similarly, we do not believe that attempting to ‘fine tune’ capital allocation by artificially adjusting the risk weightings of certain categories would be an effective tool, particularly in an extreme economic period (e.g., credit excess or extreme risk aversion), especially if banks from other jurisdictions were not working to the same constraints. In this context, it is worth noting that the counter-cyclical capital buffer as part of Basel III benefits from a mechanism whereby the actions of a UK regulator would be supported by international recognition and reciprocal application to UK lending by overseas banks up to certain limits. Varying sectoral capital requirements benefits from no such international reciprocal action and would be much more susceptible to “leakage”.

1.7 All of the proposed tools would have only limited policy impact outside of

the banking sector. If macro-prudential policy is to be truly effective, it must be an effective signal and influence to the economy more broadly. (Barclays views for how best to achieve this are set out below, under question 2.)

1.8 Finally, none of the proposed powers of direction would serve to reduce

the impact of a systemic bank failure. Other tools, such as central counterparties and effective resolution regimes, would be required to isolate the after-effects of a failure.

2. Whether additional tools should be given to the FPC (these may

include tools rejected by the FPC, not considered by the FPC or that use the balance sheet of the Bank of England).

2.1 We believe there is merit in having a tool which can address sector-specific

excess and would have a ‘signalling’ role (or ‘announcement effect’) to the wider economy – e.g., loan to value caps. Such a targeted tool, which was transparent and widely understood in the economy, would likely be more effective in the economy and create less blunt damage.

2.2 The main mitigator of risk to the system as a whole is to ensure that

financial institutions can fail without threatening the wider system. There is considerable progress being made in this area – recovery and resolution plans are at an advanced stage of being developed and tested in the UK and tools like bail-in within the new Recovery and Resolution Directive proposed reforms in the EU. The FPC should be identifying instruments which either contribute to bank resolvability or enable international resolvability measures to function more effectively.

2.3 To summarise, an initial suite of powers of direction for the FPC could

include:

a) the counter-cyclical capital buffer; and

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b) a ‘real economy’ signalling tool or intervention into the transactions of a sector such as a loan to value (LTV) cap.

2.4 Beyond these powers of direction, the FPC should undertake research into

instruments to encourage effective resolvability.

2.5 Over time, there may be a case to consider cross-sectional tools which would deal with inter-connectedness in the system.

3. The extent to which the FPC’s powers of recommendation are appropriate, and how they will work with the powers of direction.

3.1 We have some remaining concerns with the Financial Services Bill

provisions for accountability and governance of the regulators, and the way the powers to recommend will work. In particular, it seems incongruous that the PRA should be expected to make an objective decision whether or not to accept the recommendations made by the FPC considering the PRA is chaired by the same person as the FPC.

3.2 Whilst not strictly related to the power to recommend, we believe it is

worth noting that one of the most effective tools for the FPC will be the informal contributions and comments made to the PRA’s and FCA’s work plans to ensure that supervision is conducted with an eye to the stability of the financial system as well as to the soundness of individual institutions.

3.3 We also believe that, under normal circumstance, the FPC will be better

able to achieve its objectives, particularly around market structure, through the PRA and FCA rather than through direct intervention.

4. What structures should be created to provide the necessary transparency and accountability structures for the use of the tools.

4.1 First, it is important that decisions taken by the FPC to use macroprudential

tools will be made with ex ante consideration of their impact on the wider economy.

4.2 Secondly, there should be a rigorous public consultation process built in to

the development and use of the FPC tools. Consultation should be used, for example:

a) on the design of the tools themselves in secondary legislation

(through HM Treasury consultation based on the Bank’s proposals);

b) on the FPC’s general policies in relation to the use of the tools (which should be public); and

c) on any proposed use of the tools where there is no urgency (for

example adjusting the costs of credit as a bubble gradually emerges). Whilst there is need for emergency action in certain

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4.3 Thirdly, whatever tools are eventually selected and used, the principles of

proportionality and transparency (through anticipatory signalling to the market) will be of great importance – almost as much as the use of the tools themselves. These could be achieved through the development of objective indicators and proper impact analysis.

4.4 Finally, we are concerned that there is no real mechanism for public

communication with the FPC other than the ‘one-way’ FPC pronouncements on what will be fundamentally political issues that could affect the whole economy. We would welcome a framework for relatively informal dialogue to help consideration of, and then reflection on, measures that could be and are taken.

5. Whether the FPC should provide guidance on the use of the tools,

and if so, what form that guidance should take. 5.1 Guidance is partly about creating a predictable environment for market

participants. The actions of the FPC generally, and the use of macroprudential tools in particular, should be predictable and transparent. The FPC should be expected to explain why a particular tool has been selected. This could include, for example, a range of published indicators that can be monitored by market participants to help guard against the use of a macro-prudential tool where firm-specific solutions would have been more appropriate.

5.2 The development of the tools should be coupled with accompanying

guidance which provides a clear road map for the way in which tools would be used: trigger points; management and oversight of the tool; and an exit strategy to explain how the macroprudential tool can be effectively and safely dis-applied.

5.3 We would also welcome guidance on how macro-prudential directions and

recommendations would be translated into (micro-) prudential measures likely to be put into practice by the PRA and FCA, as well as on how an exit strategy on such measures would operate.

6. Whether the tools requested, taken as a whole, should be

symmetrical, that is, the extent to which they should ameliorate downturns as well as upswings in credit cycles.

6.1 It would be somewhat perverse if the FPC only has tools to deal with one

direction of macroprudential policy.

6.2 It is not so much about the symmetry across the suite of tools as being able to use each specific tool at different points in the economic cycle and/or to be able to dis-apply it effectively.

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6.3 Experience suggests that the pro-cyclical effect of market forces may make

it hard to release capital buffers in times of uncertainty or when losses are anticipated. (Simply put, the market will punish any perceived sign of weakness from a bank during a downturn.)

6.4 Macroprudential tools that focus on transactions, such as an LTV cap, are

able to be deployed and removed under full control from the authorities (e.g., a homebuyer with only 10% of equity as a deposit will not be punished by the market if they are eventually brought back into potential scope by the authorities.)

7. What further analysis should be provided by the Bank of England

before the macroprudential tools are granted to the FPC, and what analysis should be periodically produced by the Bank of England once any tools have been introduced

7.1 Following proper policy consultation from Government ahead of secondary

legislation, the Bank should conduct thorough impact analysis before the tools are finally deployed.

7.2 As mentioned in paragraph 4.3, the Bank should also develop objective

indicators that can enable analysis of the effectiveness and unintended consequences of a measure once it has been deployed.

7.3 It would make sense for careful consideration to be given by the Bank to

whether and how tools should be deployed outside of the banking system.

June 2012

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Written evidence submitted by Lloyds

Executive Summary

1. Lloyd’s is a society of underwriters that operates as an insurance and reinsurance market, based in London. Its aggregate gross written premium income in 2011 was £23.5bn, from over 200 countries and territories worldwide.

2. Our evidence to this inquiry relates to the possible use by the statutory FPC of its

powers to Direct action in relation to insurers, particularly non-life insurers. Our concerns are:

2.1. All the tools that the FPC proposes to use come from the banking regulatory

toolkit. This is appropriate if their use is restricted to banks, where the main risks to financial stability clearly sit.

2.2. However, the FPC’s brief mention of applying these tools to insurers suggests

that the FPC has not considered either the difficulties or the appropriateness of doing this.

2.3. More widely, this suggests that the FPC, a banking-focused entity, has not

analysed the fundamental differences between banking and insurance and the evidence that “traditional” insurance underwriting does not pose systemic risk.

2.4. This, in turn, reinforces our concerns that the FPC does not have sufficient

access to insurance expertise. Without such expertise, there are clearly risks arising from a situation in which, from a banking perspective, they intend to direct the PRA to take action affecting individual insurers.

Background

3. In March 2012, the interim FPC published advice to HM Treasury about macroprudential tools over which the statutory FPC should have powers to Direct action by the Prudential Regulation Authority and the Financial Conduct Authority. This advice recommends that:

“In addition to banks, the range of institutions to which these tools would apply could include building societies, investment firms, insurers and a variety of funds and investment vehicles.”

4. We understand that the FPC needs consistent discretionary powers across the whole

financial services sector. Nevertheless, we wish raise our concern that the FPC’s statement envisages the application of what may be inappropriate measures to the insurance sector, without any apparent consideration of the fundamental differences between banking and insurance, particularly non-life insurance. This reinforces our longstanding concerns about the absence of insurance expertise within the FPC.

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Systemic risk and insurance

5. The financial crisis has prompted detailed assessments of the extent to which insurance causes or contributes to instability within the financial system. Two important studies are those produced by the Geneva Association “System Risk in Insurance – An analysis of insurance and financial stability”1 and the International Association of Insurance Supervisors “Insurance and financial stability”2. The second of these documents, which summarises the views of experienced insurance supervisors around the world, says that:

“…based on information analysed to date, for most lines of business there is little evidence of traditional insurance either generating or amplifying systemic risk within the financial system or in the real economy.”3

6. Traditional insurance and reinsurance do not create systemic risk because:

6.1. The insurance business model is different from the banking model. The services provided by the two sectors differ: the core activity of insurers is risk pooling and risk transformation, whereas the core activity of banks is collecting deposits and issuing loans, together with the provision of a variety of fee-based services. Consequently, their risk profiles differ fundamentally. The core of the insurance business model is diversification of risk in the portfolio and over time. This determines insurers’ long-term risk profile, in contrast to the more short-term risk profile of banks. Insurers are not subject to the liquidity risk that affects banks. Insurers are prefunded by relatively stable flows of premiums and, unlike banks, do not rely on short term market funding.

6.2. The impact of insurance failures on other financial institutions and the

real economy is different. The reasons for these differences reside in the particulars of the insurance business model; in the disciplined implementation of a predominantly liability-driven investment approach; in the nature of insurance claims that often allow the management of cash outflows (predominantly claims) over an extended period of time (from weeks to months to years, depending on the line of business – see paragraph 6.5); and in the high degree of substitutability, allowing comparatively easy market entry into most lines of business.

6.3. Insurance is a source of stability in the financial system. Insurance is funded

by up-front premiums, giving insurers strong operating cash-flow without requiring wholesale funding. Insurance policies are generally long-term, with controlled outflows, enabling insurers to act as stabilisers to the financial system. During the crisis, insurers maintained relatively steady capacity, business volumes and prices.

6.4. The insurance cycle operates independently of the economic cycle. The

insurance cycle is largely determined by factors such as supply and demand,

1 March 2010. Available here: http://www.genevaassociation.org/Publications/Books_and_monographs.aspx 2 November 2011. Available here: http://www.iaisweb.org/Other-papers-and-reports-46 3 IAIS “Insurance and Financial Stability”, paragraph 9.

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insurance capacity and the frequency and severity of claims experience. Claims costs are determined by the incidence of valid claims and are not as contingent on broader economic factors as the lending practices of banks.

6.5. There is lower contagion risk: Financial problems develop at a much slower pace in insurance than in banking. This gives management and supervisors time to apply corrective measures. The longer incubation time in the insurance sector allows the supervisory ladder of intervention to function effectively. The slower speed of impact allows insurers to absorb losses and to take measures such as raising capital over time or, at worst, engaging in an orderly wind-up. This is easier for insurers, since they aim to match expected future claims by policyholders with sufficient assets (technical provisions), which facilitates the transfer or run-off of their portfolios.

6.6. Interconnectivity is a smaller issue for insurers than for bankers. Interconnectivity between institutions is a core part of the banking business model (in particular due to interbank lending), whereas in insurance it is low. Features of insurers’ interconnectedness mean that contagion risk is limited

6.7. Insurance markets are competitive and the degree of substitutability is high. Competition in most lines of business tends to be strong. Substitutability - the continuation of the supply of insurance coverage after a single entity’s failure - is likely to be a less material issue in insurance than in banking.

7. This assessment draws a distinction between “traditional” and “non-traditional” insurance activities. It is notorious that the financial crisis commencing in 2007 saw some financial services groups experience difficulties and require (foreign) government bail-outs, notably the AIG. In every case, these problems were the consequence of engagement in business other than the underwriting of risk that forms the basis of traditional insurance: in the case of AIG it was the issuing of credit default swaps (CDS).

8. There may be occasions when financial stability considerations justify the application

of powers of Direction to insurance companies. It is important that such application is carried out on an informed basis, with full knowledge of the differences between banking and insurance. The FPC should recognise that, as traditional insurance does not represent a systemic risk, it is unlikely to apply its macroprudential tools to insurers restricting their activities to traditional insurance. We reiterate our reservations about whether the predominantly banking-focused FPC will have access to sufficient non-banking expertise to make these judgements.

Solvency II 9. Solvency II is a comprehensive EU legislative programme of insurance regulation.

Member States will probably transpose it into national law in 2013, so that it is applied to EU insurers in 2014. It has some similarities with, but also significant differences from, the Basel II and III regulatory regimes for banks, as shown by Solvency II’s objectives:

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“The main objective of insurance and reinsurance regulation and supervision is the adequate protection of policy holders and beneficiaries…Financial stability and fair and stable markets are other objectives of insurance and reinsurance regulation and supervision which should also be taken into account but should not undermine the main objective.”4

10. Solvency II has been developed over many years, with significant policy input from

UK supervisors and technical input from the UK insurance industry. It follows a risk-based economic approach, taking a comprehensive view of risks arising from assets and liabilities, recognising the concentration and diversification effects that are crucial for the insurance business model. It requires insurers to calculate their risk exposure using a total balance sheet approach, rewarding a proper matching of assets and liabilities.

11. As its main objective suggests, Solvency II is not a regime for the regulation of

systemic risk within the insurance sector. It focuses on the supervision of individual insurers and reinsurers; its risk-based approach means that capital requirements are adjusted to the risk profiles of individual companies.

12. The FSA insurance regulatory regime that Solvency II will replace includes Individual

Capital Adequacy Standards (ICAS). These have many similarities with Solvency II’s risk-based system of capital setting.

Application of macroprudential tools to insurers 13. For the reasons set out below, we believe that there would be practical difficulties in

applying the macroprudential tools listed by the FPC to insurers. The tools proposed are from the banking regulatory toolkit, rather than implements of universal application. Solvency II, which will shortly apply to UK insurers, does not make provision for the use of these tools on insurers.

14. The Countercyclical capital buffer: This is a feature of the Basel III regulatory

programme for banks. It requires authorities to monitor credit growth and to make assessments of whether growth is excessive and posing a systemic risk. If the authorities consider it necessary, they can impose countercyclical buffers of up to 2.5% on individual banks.

15. Solvency II does not contain a countercyclical capital buffer, nor have there been

suggestions that such a tool should form part of the EU’s insurance supervisory regime. The closest approximation in Solvency II is the capital add-on. Supervisors may impose a capital add-on “in exceptional circumstances”, following a supervisory review of a supervised insurer, if they conclude that the insurer’s risk profile deviates significantly from the assumptions underlying its regulatory capital requirement or that the insurer’s system of governance is inadequate5. This is not designed to be a macroprudential tool: rather, it is intended to protect the policyholders of an individual insurer, in line with Solvency II’s main objective.

4 Solvency II Directive 2009/138/EC, recital 16 5 Solvency II Directive, Article 37

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16. Sectoral capital requirements: The FPC has asked for powers to vary financial

institutions’ capital requirements against exposures to specific sectors over time.

17. Solvency II does not give powers to supervisors to vary capital requirements in response to particular exposures on a short-term basis. Solvency II’s capital requirements mean that insurers calculate their regulatory capital using risk modules, including underwriting risk (for life, non-life and health) and market risk modules. This approach means that particular exposures require particular levels of capital, although the calculations are complex and take account of other variables. Furthermore, the approach is set at EU level by the European Insurance and Occupational Pensions Authority (EIOPA). Solvency II does not envisage national supervisors taking unilateral decisions to vary capital requirements for the national insurance industry for financial stability reasons.

18. Leverage ratio: This is an important part of Basel III, as excessive leverage by banks

is widely believed to have contributed to the financial crisis. It is due to be phased in by 2018.

19. Leverage is not part of the traditional insurance business model and excessive

leverage usually only concerns insurance supervisors if the insurers they are supervising form parts of groups engaged in non-insurance activities (such as AIG and CDS). Consequently, Solvency II does not contain any measures regulating leverages. We do not consider that the need will ever arise for the application of leverage ratios to insurers engaged purely in traditional insurance activities.

Conclusions 20. We understand that the FPC needs discretionary powers across the whole financial

services sector. Nevertheless, it is approaching questions of systemic risk from a purely bank-centric point of view. So long as its focus remains on the banking sector that is fine. If, as its statement suggests, it intends to widen the field of its actions to include other financial institutions, it must do so from a position of informed expertise about those institutions. In relation to insurance, it should appreciate:

• The fundamental differences between banking and insurance. • That managing systemic risk in the insurance sector requires detailed

understanding of precisely how such risk can arise in the sector. Evidence suggests that traditional insurance and reinsurance do not give rise to systemic risk.

• That insurance will shortly be subject to the EU’s Solvency II’s regime. This is not

a macroprudential regulatory system: it focuses on the protection of policyholders.

• The macroprudential tools to which its statement refers are intended for use

with banks. It may be difficult and inappropriate to apply tools borrowed from the banking regulatory regime to insurers subject to Solvency II.

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June 2012

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Written evidence submitted by T R G Bingham1

SUMMARY

The draft legislation before Parliament needs to

• Ensure that the tools of the Financial Policy Committee are well suited to addressing the fundamental causes of systemic instability. The tools now being proposed for use by the FPC are too heavily focused on dealing with cyclical or time varying factors affecting financial stability. They are based on its powers of direction. Priority should be given to addressing structural flaws. This is more difficult, but more important. It would require the FPC to make use of its powers of recommendation.

• Ensure that the tools are effective. In the EU, there is a statutory obligation to consult the ECB about legislation on matters in its field of competence. The provisions in the draft legislation are weaker. The FPC will have the explicit power to make recommendations. However, there is nothing in the current legislation to ensure that the FPC’s recommendations will be seriously considered or lead to action. At the very least there should be requirement that the recommendations it makes to the Treasury or to other persons relating to legislation be made public.

• Ensure that there is accountability in the use of the tools. Parliament and its Committees need to evaluate whether there is an appropriate balance between the use of powers of direction to deal with time-varying vulnerabilities and the powers of recommendation to achieve changes in the structure and operation of the financial system are appropriate. Court should periodically evaluate the processes used by the Bank and its committees to ensure such a balance.

1. General comments

The draft legislation provides the Financial Policy Committee (FPC) with a mandate to identify, monitor and take action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system. It foresees the FPC giving directions to the regulator (PRA or FCA) or making recommendations to a wider set of actors, including the Treasury and “other persons”.

In making recommendations about the specific types of tools the statutory FPC will use, the FPC and the Bank have undertaken a thoughtful analysis of the sources of systemic risk. They have identified incentive distortions, informational frictions and coordination problems as underlying sources of instability. They have rightly made a distinction between intra-financial system activity and transactions with those who are outside the system in considering how to address systemic risk.

1 Partner, Systemic Policy Partnership, formerly Secretary General, Central Bank Governance Forum.

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However, the initial set of tools that the Bank has proposed for the FPC does not build upon these ideas and the instruments proposed, as useful as they are, do not address the more fundamental causes of systemic instability. This is partly because the FPC has, rightly, taken an evolutionary approach to developing an appropriate set of tools. But it is also because the FPC has tended to focus on time varying or cyclical factors rather than on the more important and more difficult structural factors.

The excessive focus on time varying measures may be a consequence of the way the FPC operates. There is a temptation for a body that meets every three months to look at cyclical factors. These are ones that will have changed in the intervening period. While cyclical factors should not be ignored, it would be useful to modify the agenda, so that the FPC regularly considers studies by Bank staff (and possibly others) of structural factors that it has identified as being significant and reaches conclusions on what actions are warranted to cope with the risks.

Focusing on structural factors has two advantages. First, by addressing the underlying causes of instability, it makes the financial system more resilient. Second, if structural measures are properly designed and implemented, they will make the system less susceptible to cyclical risks. Some cyclical variation in systemic risk — for example the build up of leverage in periods of euphoria — is at least partially the result of structural features such as the use of accounting conventions that permit the recognition of unrealized capital gains and the writing down of liabilities that have become impaired.

The FPC should therefore focus on directions or recommendations affecting the structure of the financial system. It should, for example, as a matter of priority determine what functions performed by private financial institutions are critical for the stability of the system (e.g. provision of custodial services), whether there is a concentration in the performance of these functions by particular institutions and, if so, what actions should be taken to address systemic risks. In addition it should pay close attention to, and take action to address, structural factors such as the size of financial firms, the scope of their business, the complexity and resolvability of financial groups, interconnectedness in the financial industry, the concentration of risk, the nature and extent of limitations on the liability of both managers and shareholders, the tax treatment of interest and dividends, accounting standards that are appropriate for financial institutions. To address some of these factors, the FPC could, if empowered through secondary legislation, direct the regulator to impose SIFI capital surcharges or to reduce intra financial system leverage.

2. Recommendation vs. direction

Many of the actions needed to address flaws in the structure and operation of the financial system require action that is beyond the purview of the FPC, the Bank or the regulators. Changes in the extent to which institutions can limit their liability, decisions on the tax treatment of interest and dividends, provisions that permit the authorities to pierce the corporate veil of large and complex firms go to the heart of the way a market economy works and would require primary legislation. Such legislation needs both technical expertise and political consensus. The FPC and the Bank can provide the former; they cannot provide the latter. For this reasons such decisions must be made in the political arena. At the same time the decisions should benefit from the technical expertise, which can be provided through the power of recommendation.

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The ECB has a legal mandate to provide technical expertise on matters within its areas of competence for EU legislation and the legislation of member states.2 The statutes specify that the ECB shall be consulted and they empower it to provide an opinion in the event that it is not consulted. Neither the Bank of England nor the FPC have equivalent obligations and rights, and it is unlikely that amendments to the legislation before Parliament would give these to them (though this could and should be considered in future reforms).

The FPC still has some scope to bring its expertise to bear by making use of its powers of recommendation. Sections 9N to 9Q give it explicit power to make recommendations to the Bank, the Treasury, the regulators and to “other persons”. The most effective route would be to use the powers under section 9O to make recommendations to the Treasury to introduce relevant legislation for consideration by Parliament.

Except for the provisions that require the PRA and the FSA to comply or explain with respect to specific types of recommendations from the FPC, there is nothing to ensure that recommendations provided by the FPC under Section 9 of the draft legislation will be considered, amended accepted or rejected. For example, there is nothing that ensures that the recommendations relating to legislation will be made public or that the recommendations will be subject to Parliamentary scrutiny. At the very least there should be such a provision.

3. Accountability

In order to ensure that the Bank and the FPC achieve an appropriate balance between structural and cyclical measures in the pursuit of their statutory objectives, use should be made of three accountability mechanisms. First there should be a requirement that recommendations for legislation be made public. Unlike some other recommendations such as those made to the PRA or the FCA about the use of specific regulatory instruments, it is difficult to think of justification for keeping recommendations for legislative change covert. Secondly, Parliament and its committees should make an assessment of the appropriateness of the balance between the use by the FPC of cyclical and structural tools and of its powers of direction and recommendation as regular part of its reviews. Thirdly, Court in its review of the Bank’s processes and procedures should evaluate whether these are conducive to giving adequate attention to structural factors affecting the stability and resilience of the financial system.

June 2012

2 The ECB’s competence to deliver an opinion on these matters is based on Articles 127(4) and 282(5) of the Treaty on the

Functioning of the European Union and the third indent of Article 2(1) of Council Decision 98/415/EC of 29 June 1998 on the consultation of the European Central Bank by national authorities regarding draft legislative provisions. There is, however, a carve out for the United Kingdom and no obligation to consult or right to issue an opinion.

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Written evidence submitted by Virgin Money

Executive Summary

Two of the tools proposed by the FPC for inclusion in its initial macroprudential toolkit, the countercyclical capital buffer and the leverage ratio, are part of the revised Basel regulations. The third, sectoral capital requirements, is a tool that is closely related to the other two, but is more focused and could well be more effective. It is appropriate that these tools should be in the FPC's initial toolkit, and that the FPC should be responsible for setting their levels as required over time.

However, the internal models-based approach used by large banks under the Basel regulations is losing credibility, because of its failure to anticipate market risk losses in 2008 during the banking crisis, or credit risk losses like those seen at Bankia. The Basel Committee has recently published a paper in which it has identified some structural and technical weaknesses in the models-based approach. [1] In addition, the December 2011 Financial Stability Report observed that some banks were meeting higher capital ratio requirements by 'RWA optimisation' rather than by raising new capital. [2]

There is a case for clarifying whether the criteria set by HM Treasury might allow the use of a wider set of macroprudential tools, including disclosure requirements and some other tools that are not related to the Basel framework, or whether additional powers might be given to allow a wider set of tools.

We recognise the need to ensure that the FPC's use of its powers in respect of the tools in its macroprudential toolkit does not conflict with other bodies' objectives in pursuit of overall economic policy. Our responses in this submission are intended not to make any comment on the interaction between macroprudential policy and overall economic policy. However, we note the statement made recently by the Chancellor of the Exchequer that, "the Government will amend the Financial Services Bill to give the FPC a secondary objective to support the economic policy of the Government." [3]

1. Fundamental review of the trading book, Basel Committee on Banking Supervision, Bank for International Settlements, May 2012.

2. Financial Stability Report, Bank of England, December 2011. 3. Speech at the Lord Mayor’s dinner for bankers and merchants of the City of

London by the Chancellor of the Exchequer, Mansion House, London, June 2012.

1. whether the interim FPC has requested the most appropriate tools over which the FPC should be given the power of direction

The proposed components of the initial toolkit are appropriate to the planned role of the FPC:

• The counter-cyclical capital buffer is an important component of the revised Basel regulations, and its level in any country is to be set by the local regulator. [1] In the UK, the FPC is the most appropriate body to set the level of this buffer.

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• The leverage ratio is another component of the revised Basel regulations. [2] It seems sensible to give the FPC the power to vary it along with the counter-cyclical capital buffer, to prevent arbitrage between the two ratios, and to prevent unintended constraints on lending, particularly by banks whose assets are mainly low-risk prime mortgages. [3]

• Sectoral capital limits (for example, on mortgage lending or commercial property lending) could exert more direct control over the causes of a 'bubble'. So, although not part of the Basel regulations, if they are to be used, it is logical that they should be applied by the FPC in a manner that is consistent with the other two measures.

As to whether the tools that have been proposed are sufficient:

• The three tools that have been proposed are all in the first of three categories of possible tools that were set out in the Bank of England's discussion paper ("Balance sheet tools"). They are closely related to the Basel regulations, although a number of weaknesses in the models-based approach used by large banks under the Basel regulations have been identified in a recent consultative document by the Basel Committee. [4] It might be useful to include more tools that would address the causes of 'bubbles' directly, rather than by controlling the balance sheets of banks, preferably by including some tools from either or both of the other two categories ("Tools that influence the terms and conditions of loans" and "Market structure").

• Large banks have been adept at 'gaming the system', [5] and each of the proposed tools could be susceptible to manipulation by banks using the internal models-based approach. Banks could meet higher counter-cyclical buffer requirements by 'RWA optimisation' (to reduce their risk-weighted assets) rather than by raising new capital, as some did to meet the higher minimum equity capital ratio of 9% set by the ECB last year. [6] Sectoral exposures are hard to define precisely. For example, much non-property commercial lending may turn out to be backed by property assets, and banks could choose how to categorise assets to meet sectoral constraints. Application of leverage ratios could encourage higher-risk lending, because banks would not suffer additional capital requirements for investing in more risky assets. The danger of unintended consequences was mentioned on a number of occasions in the BBA's response to the Bank of England's discussion paper. [7]

1. "Each Basel Committee member jurisdiction will identify an authority with the responsibility to make decisions on the size of the countercyclical capital buffer. If the relevant national authority judges a period of excess credit growth to be leading to the build up of system-wide risk, they will consider, together with any other macroprudential tools at their disposal, putting in place a countercyclical buffer

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requirement. This will vary between zero and 2.5% of risk weighted assets, depending on their judgement as to the extent of the build up of system-wide risk." Basel III: A global regulatory framework for more resilient banks and banking systems, Bank for International Settlements, December 2010 (rev June 2011), page 58.

2. "One of the underlying features of the crisis was the build up of excessive on- and off-balance sheet leverage in the banking system. [...] The Committee is therefore introducing a leverage ratio requirement", Basel III: A global regulatory framework for more resilient banks and banking systems, Bank for International Settlements, December 2010 (rev June 2011), page 4.

3. "The use of a maximum non-risk weighted leverage ratio (of total assets to bank equity) could have a detrimental effect on firms whose balance sheets are predominantly made up of low-risk assets", 'Instruments of macroprudential policy, A response by the Building Societies Association', Building Societies Association, February 2012, page 2.

4. For example: "A number of weaknesses have been identified with using value-at-risk (VaR) for determining regulatory capital requirements, including its inability to capture 'tail risk'." Fundamental Review of the trading book, Basel Committee on Banking Supervision, Bank for International Settlements, May 2012, page 3.

5. For example, see Don't Be Fooled Again: Lessons in the Good, Bad and Unpredictable Behaviour of Global Finance, Meyrick Chapman, 2010.

6. "The advent of internal models in the regulatory framework also strengthens banks' incentives to adjust their RWA calculations - not because their assessment of risk has changed, but as a way of minimising regulatory capital charges. These incentives have been illustrated recently in the context of the EBA recapitalization exercise. Some banks have announced their intention to meet the required 9% capital ratio through so-called 'RWA optimisation' - changes in risk measurement methodology that lead to reductions in reported RWAs. Such changes may not result in any improvement in underlying resilience", Financial Stability Report, Bank of England, December 2011, page 39.

7. For example: "Capital buffers of the type are a blunt tool with a questionable track record of effectiveness and the potential to create unintended consequences", 'BBA briefing on Instruments of Macroprudential Policy', BBA, February 2012.

2. whether additional tools should be given to the FPC (these may include tools rejected by the FPC, not considered by the FPC or that use the balance sheet of the Bank of England)

The FPC statement commented on four possible tools which it had considered but not recommended for inclusion in its initial toolkit. We agree that further consideration of the first two, time-varying liquidity tools and collateralised transactions by financial institutions, should be deferred to await the outcomes of international discussions. We understand the reasons for caution about including the other two, disclosure

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requirements and LTV and LTI restrictions, at least at this stage, but we suggest that further consideration be given to each of them, with a view to possibly including them at a later stage, if not initially.

Disclosure requirements

As the Bank of England's discussion paper observes: "Reliable, timely and granular information is a prerequisite for effective market discipline and the effective functioning of markets." [1] Pillar 3 disclosures, required from banks under the Basel regulations, are intended to encourage market discipline. [2] However, they have some important limitations:

• Pillar 3 disclosures are limited to key banking risks: credit risk (now including information about securitisations), market risk and operational risk. [3]

− They do not cover stress tests, although, as the Bank of England's discussion paper pointed out, market participants have placed more value on the results of US and European stress tests than on the detailed disclosures. [4]

− They do not disclose the Individual Capital Guidance given by regulators to banks, allowing for 'add-ons' to their Pillar 1 capital requirements, although, under Solvency II, the equivalent regulations for insurers, 'add-ons' will have to be disclosed. [5]

− In their Pillar 3 disclosures, banks have given information about credit risk (including securitisations), market risk and operational risk, but have given little or no information about liquidity risk, although liquidity shortages have been a principal issue leading to bank failures over recent years.

• Pillar 3 disclosures are made principally through an extensive set of schedules, which are not easy to understand. The internal risk models used by banks, under the Basel regulations, are opaque, as was noted by the Governor of the Bank of England when introducing the December 2011 Financial Stability Report. [6] By contrast, Solvency II disclosures, made by insurers, must include an executive summary, which must be written in language that can be understood by policyholders. [7]

We believe that there is a strong case for requiring greater disclosure by banks, to support market discipline, particularly on matters relevant to financial stability. [8] We agree with the Bank of England's discussion paper that, "This tool could be used to enhance firms' regular reporting frameworks and, on occasion, to require disclosures on exposures to specific risks." [9] For example:

• Regular reporting: Given that 'bubbles' have typically been property-related, the FPC could require banks to make periodic disclosures of mortgage lending by volume across LTV and LTI bands. Similar disclosures could be required for commercial property lending. For both mortgages and commercial property lending, banks might be required to disclose the extent of their forbearance, and their associated provisioning practices.

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• On occasion: Given the extent of information contagion caused in 2007-08 by uncertainty about where sub-prime exposures lay across the banking system, and more recently by uncertainty about exposures to eurozone risks, the FPC could require banks to disclose their exposures to such risks, preferably at a relatively early stage.

We note that the FPC's first two policy recommendations "focused on public release of information about sovereign and banking sector exposures". [10] However, we are not confident that recommendations will be sufficient, particularly in periods of stress, given the Financial Stability Board's view that "public sector initiatives must be used where market pressure and private sector initiatives cannot provide the desired transparency outcomes in a timely manner, such as during periods of market turmoil". [11] The Financial Stability Board's view is supported by incidents such as RBS's reluctance to disclose its capital ratios, after its acquisition of ABN AMRO, at the presentation of its results for 2007. [12] So, while we support the use of recommendations on disclosures, we believe that the FPC should also have powers to direct disclosures by banks.

However, we note the comment in the FPC statement that "the Committee agreed that powers of Direction over disclosure requirements would be desirable but that it could be difficult to meet the test set by HM Treasury in its February 2011 Consultation Document that powers of Direction should be specific." [13] Commenting on the direction-making powers of the FPC, HM Treasury said in this consultation document that: "The Government recognises that a power of direction is a significant intervention, and it is vital that the macro-prudential tools be carefully chosen and designed to make sure that they are effective, but also to minimise the risk of unintended consequences, such as the FPC encroaching on decisions that are rightly for the regulators", and that "a potential tool should be specific: in other words, the power should only extend to regulatory aspects that are clearly delineated. Ill-defined powers in relation to broad and open-ended areas clearly risk encroaching on the regulators’ remit." [14] We therefore suggest that the FPC and HM Treasury resolve:

• whether some disclosure requirements, within firm's regulatory reporting requirements, are consistent with the criteria set by HM Treasury.

• whether HM Treasury might, if necessary, slightly amend its set criteria to allow disclosure requirements on occasions when circumstances warrant them.

A reason sometimes given for caution about greater disclosures is that they might 'spook the market'. [15] We appreciate that markets are currently very sensitive to news on eurozone risks, and that any requirements for enhanced disclosures would have to be introduced carefully, and that the possible unintended consequences of disclosure requirements would have to be considered. But we do not believe that fear of 'spooking the market' is a valid reason for limiting disclosures:

• Regular reporting of matters such as LTV and LTI measures should help to avoid 'bubbles' arising. With regular reporting, there should not be surprises which

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could 'spook the market', such as those which recently caused problems in Bankia, and in Spanish banking and government debt markets.

• In the banking crisis, and in the eurozone crisis, lack of bank-specific information 'spooked the market'. In each case, markets had a good sense of likely losses across the banking system as a whole, but, because of the lack of information and the complexity of exposures (both gross and net after hedging), did not know where the losses might emerge. In the autumn of 2007, heavy selling and short-selling led to sharp falls in the share prices of many banks, and forced them to disclose their sub-prime exposures. During 2011, after the results were published in July of the EU-wide stress test, which assumed that there would be no defaults by EU Member States, [16] markets fell sharply, and forced the EBA to present a more cautious assessment of the results of its stress test, and to require European banks to increase their equity capital ratio to at least 9% by the end of June 2012. [17] With hindsight, in each case, it might have been better if 'on occasion' disclosures had been required at a relatively early stage.

• Markets have had some information which discriminated between banks, in ratings given by credit rating agencies, spreads on credit default swaps and margins charged by clearing houses such as LCH Clearnet. However, ratings awarded by credit rating agencies have not been reliable as forward-looking indicators of risks, while spreads on credit default swaps and margins charged by clearing houses may be more forward-looking, but are not readily available to, or understandable by, many market participants. It seems preferable that market participants should get relevant information directly from banks, rather than have to rely on third parties to assess the riskiness of banks for them.

• Greater disclosures would reduce the likelihood of information contagion, an important topic that was highlighted in the Bank of England's discussion paper. [18] We recognise that 'on occasion' disclosure requirements might highlight problems in some banks, but the authorities could then concentrate on these banks, rather than on the banking system as a whole, and could use the new EU-wide rules for bank recovery and resolution, which "ensure that in future the authorities will have the means to intervene decisively both before problems occur and early on in the process if they do". [19]

• We accept that the risk of 'spooking the market' is "likely to be particularly acute for liquidity risks, given the potential for funding to dry up rapidly." [20] However, we note and agree with the comments made recently by the Governor of the Bank of England that: "Difficulties in liquidity and funding are often a reflection of insufficient capital". [21] While liquidity disclosure requirements may be more likely to 'spook the market', particularly in periods of stress, it is possible that regular reporting liquidity disclosures might 'nip in the bud' problems which might erode capital before they had any significant impact on liquidity and funding.

Loan to value and loan to income restrictions

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Powers to impose, and to vary, LTV and LTI ratios seem attractive, because they are simple and transparent, and would send a "clear and strong public signal of emerging risks to lenders and borrowers". [22] Also, they would enable the FPC to address the tendency towards higher-risk lending in a property 'bubble' directly, rather through capital constraints, and to do so before higher-risk lending became too deeply embedded in banks' balance sheets.

However, at a hearing of the Treasury Committee, Lord Turner explained that the FPC had considered the pros and cons of LTV and LTI restrictions at great length, but had decided against proposing them for inclusion in its initial macroprudential toolkit. [23] Also, in its response to the Bank of England's discussion paper, the Building Societies Association said that: "limits on the terms and conditions of certain transactions, notably limits on loan-to-value (LTV) and loan-to-income (LTI) ratios, would be undesirable because they would not sufficiently take individual circumstances into account. [...] Furthermore, the use of these tools would have to be carefully calibrated with existing conduct-of-business regulations." [24]

The FPC's statement said that, "while powers of Direction over loan to value (LTV) and loan to income (LTI) ratios could be beneficial for financial stability, use of these tools would require a high level of public acceptability". The FPC statement "encouraged further debate" and suggested that "these tools may be appropriate after further analysis and reflection". [25] The argument, of public acceptability, against LTV and LTI restrictions, at least at this stage, could also be applied to the Mortgage Market Review proposals, but in the latter case the benefits of the proposals seem to have been given higher priority than public acceptability. [26] Under the Mortgage Market Review, as currently proposed, the non-advised sales process will be removed, lenders will not be allowed to offer execution-only sales face-to-face (except to mortgage professionals and high net worth individuals), and will find it hard to offer execution-only sales online because any type of interaction may be deemed as advice, and the availability of interest-only mortgages is likely to be greatly reduced. [27]

The Bank of England's discussion paper pointed out that LTV and LTI restrictions might lead to lower house prices, at least in the short term, [28] but the Mortgage Market Review proposals might also have this effect.

We suggest that there is a case for considering further whether some form of LTV and LTI restrictions be included in the FPC's toolkit, and whether, along with this, it might be possible to simplify the Mortgage Market Review proposals.

1. Instruments of macroprudential policy, Bank of England, December 2011, page 28. 2. 'Pillar 3', FSA, February 2012. 3. Thematic Review on Risk Disclosure Practices, Peer Review Report, Financial Stability

Board, March 2011, page 23.

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4. "Indeed, market participants have generally placed more value on the disclosure accompanying US and European stress tests than the quantitative results themselves", Instruments of macroprudential policy, Bank of England, December 2011, page 29.

5. "The disclosure of the Solvency Capital Requirement referred to in point (e) (ii) of paragraph 1 shall show separately the amount calculated in accordance with Chapter VI, Section 4, Subsections 2 and 3 and any capital add-on imposed in accordance with Article 37 or the impact of the specific parameters the insurance or reinsurance undertaking is required to use in accordance with Article 110, together with concise information on its justification by the supervisory authority concerned", Directive 2009/138/EC of the European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II) (recast).

6. "It is also important that investors are able to make a clear assessment of the strength of banks’ balance sheets. The Committee recognises that concerns about the opacity of the internal risk weights used by banks in calculating regulatory capital ratios can undermine confidence in those measures", Opening Remarks by the Governor, Financial Stability Report, December 2011.

7. "Executive Summary: 3.91. In order to assist readers of the SFCR, a short and easily understandable executive summary aimed specifically at policyholders should be provided. 3.92. The executive summary should also highlight clearly any material changes that have occurred in the undertaking’s or the group’s business written, risk profile, solvency position or system of governance since the last reporting period. This information should provide the reader with a brief summary of the contents of the SFCR." CEIOPS’ Advice for Level 2 Implementing Measures on Solvency II: Supervisory Reporting and Public Disclosure Requirements (former Consultation Paper 58).

8. "In principle, powers to require financial institutions to publish consistent information in a timely manner about their activities could be a powerful tool in fostering awareness of risks in the financial system and allowing market participants to take appropriate mitigating actions, thus enhancing market discipline", Financial Policy Committee statement, March 2012, page 4.

9. Instruments of macroprudential policy, Bank of England, December 2011, page 28. 10. 'Enhancing financial stability: the role of transparency', Donald Kohn, September

2011, page 3. 11. Thematic Review on Risk Disclosure Practices, Peer Review Report, Financial Stability

Board, March 2011, page 28. 12. "Transcripts of analysts’ calls around the same time evidenced imprecision from RBS

senior management on how its capital position had been affected by the ABN AMRO takeover. For example, the then RBS Group Finance Director responded to a question on the firm’s capital position. The analyst asked what was RBS’s core equity tier 1 position on a proportional basis: ‘it’s a number, you can work it out… It does begin with a four and it does begin with a seven, I think would be as much as we would like to say at this point’. Some institutional investors also commented that it was difficult, in meetings with the RBS CEO, to gather detailed information on the firm’s capital position and strategy", The failure of the Royal Bank of Scotland: Financial Services Authority Board Report, FSA, December 2011, page 90.

13. Financial Policy Committee statement, March 2012, page 1. 14. A new approach to financial regulation: building a stronger system, HM Treasury,

February 2011, page 24.

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15. "It is sometimes argued that enhanced disclosure may reveal information that triggers an adverse market reaction", Instruments of macroprudential policy, Bank of England, December 2011, page 29.

16. European Banking Authority 2011 EU-wide Stress Test Aggregate Report, EBA, July 2011.

17. 'The EBA details the EU measures to restore confidence in the banking sector', EBA, October 2011.

18. "And in the downswing, […] contagion fed on fears over the financial health of counterparties, contributing to the general squeeze on funding", Instruments of macroprudential policy, Bank of England, December 2011, page 28.

19. 'New crisis management measures to avoid future bank bail-outs', European Commission, June 2012.

20. Instruments of macroprudential policy, Bank of England, December 2011, page 29. 21. Speech given by Sir Mervyn King, Governor of the Bank of England, at the Lord

Mayor’s Banquet, June 2012, page 5.

22. Financial Policy Committee statement, March 2012, page 4. 23. "There are a lot of arguments for and against these, and we did go through this in

immense detail. We found that it was very difficult to set, for instance, a loan-to-income ratio or a debt-servicing ratio that had high discriminant power. […] I entirely accept that there would have been some advantages in having nice, clear, simple rules, but we did go through the arguments very carefully and decided against it", Uncorrected transcript of oral evidence, To be published as HC 1895-i, House of Commons, March 2012, page 12.

24. 'Instruments of macroprudential policy, A response by the Building Societies Association', Building Societies Association, February 2012, page 1.

25. Financial Policy Committee statement, March 2012, page 1. 26. "Paul Smee, Director General at the Council of Mortgage Lenders (CML), reflects

on the CML's analysis of the proposals, concluding that the new regime is likely to tighten access to mortgage finance overall, increasing consumer protection but potentially at the expense of access to finance for some creditworthy borrowers", Oxera, April 2012.

27. See Virgin Money's submission in response to Mortgage Market Review. 28. "More generally, while evidence from experience of LTV caps around the world has

been somewhat mixed, the balance seems to suggest that tighter LTV limits lead to lower house prices, at least in the short run", Instruments of macroprudential policy, Bank of England, December 2011, page 25.

3. the extent to which the FPC’s powers of recommendation are appropriate, and how they will work with the powers of direction

Although much of the Bank of England's discussion paper and the FPC's statement, and this response, focus on tools over which the FPC could be given powers of direction, the other work of the FPC is important, and should not be overlooked.

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Comments in the Financial Stability Report, and in the minutes of FPC meetings, can be very useful, and important, in alerting market participants to emerging risks, and in stimulating debate about them. In 'normal' circumstances, recommendations might be sufficient to ensure that developments which could lead to 'bubbles' are addressed at a relatively early stage. But we have not been in 'normal' circumstances for some years, and we agree with the Bank of England's discussion paper that "Directions could be particularly valuable in circumstances in which action is required urgently". [1] So we support the current focus on ensuring that the FPC has in place an effective set of tools over which it has powers of direction.

1. Instruments of macroprudential policy, Bank of England, December 2011, page 7.

5. whether the FPC should provide guidance on the use of the tools, and if so, what form that guidance should take

It seems desirable that FPC should give guidance as to how matters over which they give direction under their powers should be implemented:

• There should be consistency across banks, in matters such as calculating the leverage ratio, so that market participants can compare different banks.

• The methods used by banks to calculate measures such as the countercyclical capital buffer should be reliable, and that banks using internal models should be discouraged from engaging in practices such as 'RWA optimisation'. [1]

1. Financial Stability Report, Bank of England, December 2011.

6. whether the tools requested, taken as a whole, should be symmetrical, that is, the extent to which they should ameliorate downturns as well as upswings in credit cycles

We believe that the tools, taken as a whole, should be symmetrical, and note that this is consistent with the Chancellor's recent statement that "the Government will amend the Financial Services Bill to give the FPC a secondary objective to support the economic policy of the Government". [1] However, we recognise that this will be difficult for the FPC to achieve, even with an appropriate toolkit, because so many changes to banking regulations have been introduced since the banking crisis, with as yet only limited experience from which to judge their effectiveness.

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Before and during the banking crisis, internal models used in the advanced approach allowed under the Basel regulations had a pro-cyclical impact on the capital requirements and reported results of banks, as did two aspects of IFRS accounting regulations: mark-to-market loss accounting in the trading book, and incurred loss accounting in the banking book. [2]

Since the banking crisis, minimum capital requirements have been increased substantially, [3] and the Independent Commission on Banking has recommended that long-term unsecured debt should be capable of being bailed in. [4] In addition, a number of measures have been announced, or already introduced, to counteract procyclicality. These measures have included the introduction of capital conservation buffers (which can be eaten into, in times of stress), stressed value-at-risk for market risk and through-the-cycle probabilities of default for credit risk, [5] as well as the promotion of more forward-looking loan provisions by moving the accounting basis to expected loss accounting instead of incurred loss accounting. [6]

For the FPC applying the counter-cyclical buffer and other tools, there is clearly a requirement to ensure that banks hold sufficient capital to ensure that tax-payers are not required to provide further support, and that they increase their loss-absorbing capital ahead of possible problems to dampen cycles. However, recent developments in some eurozone countries have underlined that it is equally important to avoid constraints on the supply of credit which could cause recession and increase the fiscal deficit.

1. Speech at the Lord Mayor’s dinner for bankers and merchants of the City of London by the Chancellor of the Exchequer, Mansion House, London, June 2012.

2. "One of the most destabilising elements of the crisis has been procyclical amplification of financial shocks throughout the banking system, financial markets and the broader economy. The tendency of market participants to behave in a procyclical manner has been amplified through a variety of channels, including through accounting standards for both mark-to-market assets and held-to-maturity loans", Basel III: A global regulatory framework for more resilient banks and banking systems, Bank for International Settlements, November 2010 (rev June 2011), page 5.

3. Final Report, Independent Commission on Banking, September 2011, Chapter 4. 4. Final Report, Independent Commission on Banking, September 2011, Chapter 9. 5. Basel III: A global regulatory framework for more resilient banks and banking

systems, Bank for International Settlements, December 2010 (rev June 2011). 6. See 'Changes to accounting for loan losses: Practical considerations for banks',

PWC, February 2012

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7. what further analysis should be provided by the Bank of England before the macroprudential tools are granted to the FPC, and what analysis should be periodically produced by the Bank of England once any tools have been introduced Back-testing Even if only as a theoretical exercise, it would be interesting to consider how the proposed tools might have been used in the banking crisis and subsequently in the eurozone crisis (assuming that the macroprudential tools proposed for the FPC's initial toolkit, and the changes to the Basel regulations which have been implemented, were already in place), the extent to which they might have been effective in ameliorating the upswing and the subsequent downswing, and whether any other tools might have been useful, either in the upswing or the downswing. Unintended consequences Given the evidence that large banks have been adept at gaming the system, and the possibility of unintended consequences, as mentioned by the BBA in its response to the Bank of England's discussion paper, [1] it might be useful to commission a paper on the possible unintended consequences of the proposed toolkit, or of a broader set of possible tools, such as all those mentioned in the FPC's statement. Such a paper might follow the lines of the IMF's analysis of possible unintended consequences of Basel III and Solvency II. [2] Periodic reviews It is expected that the FPC will produce periodic reviews assessing the effectiveness of the tools in its toolkit, and considering whether any other tools should be added, particularly the four tools that were mentioned in the FPC's statement but were not recommended for inclusion in its initial toolkit (time-varying liquidity tools, collateralised transactions by financial institutions, disclosure requirements, and loan to value and loan to income restrictions). Such reviews might also consider the effectiveness of the many changes since the banking crisis in regulations on capital, liquidity and accounting standards in avoiding upswings and downswings. 1. 'BBA briefing on Instruments of Macroprudential Policy', BBA, February 2012. 2. Possible Unintended Consequences of Basel III and Solvency II, IMF Working Paper,

International Monetary Fund, August 2011.

June 2012

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Written evidence submitted by HSBC Holdings Ltd The Committee has asked for evidence on the following areas:

Questions HSBC Commentary Whether the interim FPC has requested the most appropriate tools over which the FPC should be given the power of direction?

We believe the tools specified are largely appropriate; most importantly while high capital ratios do not necessarily make banks safer, and at worst simply fund future crises ex ante, the relationship between capital ratios and lending capacity, given that capital is a finite resource, offers the opportunity to regulate credit supply in order to respond to identified fluctuations in systemic risk. Our specific comments are set out below. The countercyclical capital buffer As a macroprudential tool, we do not believe that the concept of the countercyclical capital buffer is particularly effective, for the following reasons: 1. A general increase in capital

requirements, at a time of increased risk because of exuberance in a defined asset class, will not necessarily have the effect of lowering risk. Banks might perversely choose to shift capital allocation to the asset class evidencing the highest return on capital, which is therefore more likely to be mispriced for risk, in order to preserve profitability on a less leveraged capital base.

2. There has to date been no guidance on how a countercyclical buffer could be removed in a way likely to be accepted by markets. There is therefore a likelihood that once applied, a countercyclical buffer would become a new regulatory minimum. This could have a very procyclical effect, driving downturns.

3. We further believe the principal

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indicator for applying the buffer, according to Basel Committee methodology – the credit to GDP ratio – is flawed because of its simplicity. It is conceivable that unsustainable increases in credit supply could drive unsustainable increases in GDP (as happened in the run-up to the crisis). However if credit expansion moves in lockstep with economic expansion, the fact that financial stability is endangered through the growing ‘bubble’ would not be identified by the ratio.

More generally, we would draw the Committee’s attention to BCBS Working Papers No. 20 & 21, of 15 May 2012, if the members have not already studied them. Section 4 (4) of Paper 20, entitled “Are better capitalised banking systems more prone to bubbles”, affirms the point made at (1) above, and suggests that more onerous capital requirements could lead to increased incentives for engaging in arbitrage through risk-shifting. This carries wider implications for the current ideology which is driving higher capital requirements for banks. Sectoral capital requirements For reasons consistent with the arguments above, we believe that the power to vary sectoral capital requirements would be the most appropriate macroprudential tool and therefore are pleased to see this in the proposed toolkit. We believe any increase in the capital ratio requirement must be targeted on the asset class(es) demonstrating higher levels of risk if it is to be effective. While we note the Basel capital adequacy regime was not originally designed as an instrument of financial stability, Pillar II of Basel II would need

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little modification to empower it as the principal channel of macroprudential policy decisions, focused on exuberant or constrained asset classes, without precluding other instruments. We do not support adjustment of risk weights as the best way to apply this tool. Higher trending probability of default (‘PD’) and loss given default (‘LGD’) expectations are already accommodated in the current capital framework; the situation that requires further input is where loss expectations have yet to reflect macroprudential concerns over the asset class(es) in question. Once exuberance in an asset class has been detected by the FPC, it should Direct the PRA to make use of Pillar II dialogues with banks to ensure that each bank is holding sufficient capital against that asset class to meet the increased level of risk. Adjustments could be made by altering the Basel II scaling factor, currently set at x1.06 for all asset classes, in respect of the exuberant asset class. Adjustment of risk weights would alter the Pillar I calibration of capital, which should only be shifted in response to the threat of exogenous shocks to the financial system. Asset bubbles, which are driven by excess credit supply, are by definition endogenous. Once PD/LGD experience catches up with macroprudential concerns the FPC can revise downwards the scaling factors. The leverage ratio Leverage ratios are not particularly effective as fixed backstops, nor when used dynamically as a macroprudential tool. More importantly the chosen leverage ratio should be the expression of the Government’s risk appetite for its financial sector, with the Financial Policy Committee charged with maintaining leverage to a set target – just as the Monetary Policy Committee is charged with maintaining interest

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rates to a set target. Separately, it is worth noting that adjustment of the leverage ratio is not in the permitted list under the EU Credit Requirements Directive/Credit Requirements Regulation (see below). It is also worth noting that in its White Paper on the recommendations of the Independent Commission on Banking, HM Treasury rejected application of a tighter leverage ratio. Mr Graham Beale, CEO of Nationwide, wrote a helpful explanatory letter on this subject to the Financial Times on 20 June 2012.

Whether additional tools should be given to the FPC (these may include tools rejected by the FPC, not considered by the FPC or that use the balance sheet of the Bank of England)?

Loan to Value and Loan to Income ratio caps The FPC, while acknowledging the utility of such caps, specifically rejected holding the power to cap LTV and LTI ratios, seeing imposition of such measures as the responsibility of Government, given their public policy and political implications.. In our view, asset-class-specific capital adjustment is in principle superior to administered caps as it leaves lending decisions in the hands of lenders, and does not, through use of administrative tools, distort incentives to calibrate risk accurately. That said, we do see a possible secondary role for administrative tools such as LTV and LTI ratio caps, should adjustment of capital requirements not have the intended effect or as a public policy constraint to require specified levels of equity in secured lending. LTV and LTI caps have proved very effective in some jurisdictions, such as Hong Kong, even in stress environments, where as a result of their long history, their more immediate social consequences are accepted more easily than would perhaps be likely in the UK. Australia and Canada also utilise LTV caps

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effectively. LTV caps are however not a panacea, as credit supply from the shadow banking sector can infill restrictions imposed upon regulated banks. Liquidity The interim FPC was minded to recommend a liquidity tool. However, views expressed recently by Deputy Governor of the Bank of England Paul Tucker, in his 12 June 2012 Alastair Ross Goobey lecture, suggested a distinction between the role of capital and the role of liquidity, and the importance that central banks stand ready to provide liquidity to see the banking system through stressed conditions. Liquidity might prove a more difficult tool to calibrate in a macroprudential context. However, if permitted under the CRR final text, this could be an area to explore, for example by permitting variation of the eventual Liquidity Coverage Ratio requirements as an alternative to central bank support in stressed conditions. Powers around terms of collateralised transactions Depending on international developments, in particular the ability for there to be a level playing field, this could be another possible area to explore.

The extent to which the FPC’s powers of recommendation are appropriate, and how they will work with the powers of direction?

In effect, the interim FPC has suggested that it should have the power of recommendation of other tools explored in the Bank of England’s paper on the subject. Given that such recommendations would be the subject of the FPC Chairman’s letter to the Chancellor and Chairman of the Treasury Select Committee, there would be adequate opportunity for

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evaluation of the recommendations, and for consensus to be reached on whether or not such recommendations should be followed. In practice it will be interesting to note whether there is much difference in reaction to a recommendation as opposed to a direction given the governance risk from being seen to reject a recommendation that turns out to be appropriate. It is also worth noting that all powers will need to be permitted under the CRD / CRR framework. At the time of writing, the Council text permits the following: (i) level of own funds (capital) (ii) large exposures requirements (iii) public disclosure requirements (iv) level of the conservation buffer (v) Liquidity requirements (vi) Risk weights for targeting asset bubbles in the residential and commercial property (vii) Intra financial sector exposures

What structures should be created to provide the necessary transparency and accountability structures for the use of the tools?

Accountability structures The Monetary Policy Committee works to an inflation target set by government. Once inflation diverges from an accepted band either side of the target, the Chairman of the Committee is required to write a letter of explanation to the Chancellor. We believe that this sets a good precedent for the operation of the FPC . We have proposed that the FPC should be set a target for leverage in the financial system, that target being set by Government and aligned with its targeted growth in the economy. The Chairman of the Committee might therefore be required to write a letter of explanation to the Chancellor and the Chairman of the Treasury Select Committee if leverage diverges from

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an agreed band either side of the target. We strongly support the secondary FPC objective announced by the Chancellor in his recent Mansion House speech, and would suggest that the Chairman’s letter to the Chancellor should be the vehicle through which the FPC will meet its legal requirement to report, for every action it takes, how that action is compatible with economic growth as well as stability. The letter should be public. If macroprudential policy tools have been activated, the Chairman of the Committee should be required to write a follow-up letter after a period to be determined – perhaps every six months – to describe their effect. The Chairman of the FPC and the Deputy Governor of the Bank with responsibility for financial stability should also be available to report to the Treasury Select Committee when required. These provisions should be in addition to the EU ex ante/ex post requirements in Article 443a of the current Council text. In addition: 1. HSBC believes that the

macroprudential framework needs to be underpinned by a better articulation of the meaning and preferred outcomes of financial stability.

2. We believe that financial stability is closely bound up with, but not exactly the same as, stability and sustainability of the supply of credit to the economy, and stability also of its price, to the extent that stability of both can be achieved at the same time. A stable and sustainable supply of credit does not mean a fixed supply: it requires that the credit expansion needed to

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support economic growth should at all times be supported by an appropriate level of capital, adequately remunerated to ensure its sustainability.

3. We believe that financial stability is also concerned with the integrity, resilience and sustainability of the supply of payments services, maturity transformation, risk pooling and risk transfer. HSBC’s preferred definition of financial stability implicitly includes an outcome in terms of economic activity and recognises that there may be a trade-off between economic activity and resilience.

Whether the FPC should provide guidance on the use of the tools, and if so, what form that guidance should take Whether the tools requested, taken as a whole, should be symmetrical, that is, the extent to which they should ameliorate downturns as well as upswings in credit cycles?

Directions for the use of macroprudential tools will in general be implemented by the prudential regulator, in the future the Prudential Regulation Authority. In implementation of the tools directed, the PRA should be fully accountable in this regard to the FPC, within the FPC’s own statutory reporting requirement to the government. In addition, other actions taken by the PRA in the course of its role as prudential regulator, which could have economic impact – such as adjustments to Capital Planning Buffers or to risk weightings – should be covered by the same direct accountability to the FPC, with the FPC required by law to report on such actions to the government. The EU CRD/CRR will act as constraints, with requirements for ex ante scrutiny. Macroprudential tools should be symmetrical, and this would be achieved if the FPC objective required the Committee to ensure a stable and sustainable supply of credit to the economy, as defined above. Such an

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objective would complement the objective of the Monetary Policy Committee to maintain price stability. For example, the FPC might want to adjust scaling factors upwards to counteract rising risk in commercial property lending. But it might also adjust scaling factors downwards, either restoring them to former levels once risk recedes, or reducing them where risk is over-priced, for example in the case of trade finance.

What further analysis should be provided by the Bank of England before the macroprudential tools are granted to the FPC, and what analysis should be periodically produced by the Bank of England once any tools have been introduced?

The Global Financial Crisis has had its greatest impact in developed economies. However the experience exemplifies and mirrors crises seen in emerging markets over the last 25 to 30 years, in particular the Latin American crises and the Asian Crisis of 1998. Many of these regimes have since successfully used macroprudential levers to address incidents of stress which could threaten financial stability, both in terms of excessive and constrained credit growth. The Bank of England and the FPC should consider the lessons which can be learned and implemented from these emerging markets experiences. In addition, account will need to be taken of the requirements set out in CRR Article 443a (full current Council text in attached annex), i.e.: 1. changes in the intensity of macro-

prudential or systemic risk 2. reasons why such changes could

pose a threat to financial stability at national level

3. justification of why other measures (Pillar II, Counter-Cyclical buffer) cannot adequately address the identified macro-prudential or systemic risk, account taken of the relative effectiveness of these measures

4. draft national measures for domestically authorised institutions,

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or a subset of those institutions, intended to mitigate the changes in the intensity of risk – for scrutiny

5. an explanation as to why such draft measures are deemed to be suitable, effective and proportionate to address the situation

6. an assessment of the likely positive or negative impact of the measures on the single market based on information which is available to the Member State.

June 2012

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Annex

Capital Requirements Regulation (Council “general approach” text, agreed at 15 May ECOFIN)

Article 443a

Macro-prudential or systemic risk identified at the level of a Member State

0. Member State shall designate the authority in charge of the application of this Article. This authority shall be the competent authority or the designated authority. 1. If the authority determined according to paragraph 0 identifies changes in the intensity of macro-prudential or systemic risk in the meaning of a risk of disruption in the financial system with the potential to have serious negative consequences to the financial system and the real economy in a specific Member State and which the authority determined according to paragraph 0 considers would better be addressed by means of national measures, it shall notify the Commission, the Council, the ESRB and EBA of that fact and submit relevant quantitative or qualitative evidence of all of the following:

a) the changes in the intensity of macro-prudential or systemic risk; b) the reasons why such changes could pose a threat to financial

stability at national level; be) a justification of why Articles 119 and 160 of this Regulation and

Articles 98, 99a, 100, 100a, 124a, and 126 of Directive [inserted by OP] cannot adequately address the identified macro-prudential or systemic risk, account taken of the relative effectiveness of these measures.

c) draft national measures for domestically authorised institutions, or

a subset of those institutions, intended to mitigate the changes in the intensity of risk and concerning:

(i) the level of own funds laid down in Article 87; (ii) the requirements for large exposures laid down in Article

381 and Article 384 to 392; (iii) the public disclosure requirements laid down in articles 418

to 440; or (iv) the level of the conservation buffer as set out in Article 123

of Directive [inserted by OP].

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Written evidence submitted by Nationwide Building Society

1. Nationwide welcomes the opportunity to provide a written submission to the

Committee on the macroprudential tools of the Financial Policy Committee (FPC). This short response provides an overview of our position on the FPC’s recommended tools and suggests some specific issues that the Committee should consider as part of the inquiry.

Summary of Nationwide’s position on the FPC’s Macroprudential Tools 2. The financial crisis exposed weaknesses in the global financial and regulatory

system and came at a very high cost. We therefore broadly support regulatory proposals and the creation of the FPC to ensure resilience of the financial system. The FPC does require appropriate tools in contributing to the Bank of England’s financial stability objectives. However, the recommended macroprudential tools of the FPC do have the potential to cause some uncertainty where we would welcome some clarity.

3. It is vital that the FPC’s macroprudential tools are:

Used in a proportionate way. Transparent in how and why they are to be used or in what triggers their

use. Harmonised and sympathetic to international standards in a way that

does not damage the competitiveness of the UK’s financial service sector. Used in a way which avoids unintended consequences. For example,

while we are not seeking special exemption on the use of the tools, the leverage ratio has the potential to have a differential impact on low risk business models such as building societies.

4. Details on the practical interaction between the responsibilities and actions of

the Monetary Policy Committee and the FPC are required, especially when the Bank is seeking wider macro-economic goals.

Leverage ratio 5. We support the Government’s approach to use of a leverage ratio for the

reasons stated in the Banking Reform White Paper: “Increasing the leverage ratio would also risk making it the primary capital constraint on banks, rather than a backstop to risk-based capital ratios, and would particularly impact some institutions that performed well compared to others during the recent crisis.

“The Government does not therefore see a case for regulators permanently to increase the minimum leverage ratio beyond the Basel III international standard for large ring-fenced banks, as proposed by the ICB.”1

6. The FPC should be guided by the approach to the leverage ratio taken by the

Government which is internationally coordinated. 1 http://www.hm-treasury.gov.uk/d/whitepaper_banking_reform_140512.pdf - Banking reform: delivering stability and supporting a sustainable economy

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7. We feel that should the FPC not follow this approach, powers to vary an

unweighted leverage ratio in a blanket way will have the potential to disproportionately impact Nationwide and other low-risk institutions. Without careful consideration, a higher leverage ratio could cause significant unintended consequences for these institutions, impacting on consumers and the wider economy.

8. For an organisation such as Nationwide, changes to our leverage ratio could

not be adjusted in a short-term way. Indeed, Nationwide is restricted by statute and can only engage in low risk activity. There should be recognition that mutuals have different forms of raising capital compared with plc banks. Given mutuals’ continued reliance on retained profits as a source of new capital, generating capital in response to a varied leverage ratio requirement, would not be realistic given that it requires significant lead times to plan for and come into effect.

9. We believe it is more appropriate for leverage to be monitored as part of the

supervisory regime, both at individual firm and macroprudential levels in line with international standards and methods underpinning those standards. In particular the new Prudential Regulatory Authority should have the tools to effectively monitor trends in leverage at a macro and institutional level to ensure sustainable business practices.

Sectoral capital requirements 10. We would encourage sector capital requirements to be proportionate to the

issues they are seeking to resolve, while also being non-duplicative. 11. We feel that the FPC’s rejection of powers to limit loan-to-value (LTV) and

loan-to-income (LTI) ratios is the correct decision. The use of LTV/LTI caps to manage mortgage lending are inappropriate instruments which have unintended consequences. Any action to use such tools has the potential to do no more than precipitate an adverse response from consumers which their use is ultimately aimed at avoiding. This is because caps may lead consumers to seek other, riskier sources of borrowing, while satisfying LTV requirements. We feel that these tools fail to reflect key underlying dynamics of the market at an individual account level.

12. We also believe that there is insufficient evidence that such caps are effective

in producing the intended macroprudential outcomes. The FSA had noted that other factors (e.g. self-certification) played a more significant role in falling credit standards in the past than high LTVs and defaults. Indeed the FSA’s Mortgage Market Review (MMR) Consultation Paper warns against LTV limits, given their potential to restrict first time buyer access to mortgages. Supervisory regulation, as proposed through the MMR, offers more flexible approach to addressing systemic risks within the mortgage market.

Use of powers 13. The interim FPC has recommended it be granted some wide-ranging powers

over macroprudential tools. Clarity on use of these tools and powers – of direction and recommendation – is essential in minimising uncertainty.

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14. The FPC must use its tools in a proportionate way which is appropriate to

achieving its objectives. 15. The FPC should set out the intentions and purpose of the use of each

macroprudential tool and the circumstances for their use. Therefore, clarity on the criteria and triggers for use of each tool are required.

16. As outlined in the points above regarding the leverage ratio, clarity on how

the tools would be applied in line with international and EU law is paramount in ensuring the competitiveness of UK financial services sector. The FPC have noted that they may be constrained by other regulatory bodies, but clarity is required where, for instance, the FPC decides to go further than CRD IV requirements.

17. The timescales in which the FPC would implement its powers, or by when

firms would need to comply with the specific tools is required to provide a greater degree of certainty. Furthermore, the means of communicating the use of each tool needs to established.

18. Confirmation would also be valuable on how these tools would explicitly

apply to building societies in addition to banks – the records of the interim FPC discussions to date suggest, “in addition to banks the range [of institutions to which the tools could apply] could include building societies”2.

19. Further detail is particularly required regarding the FPC powers of

recommendation, which have the potential to be much more wide-ranging across the functions of the FCA and PRA.

20. It is essential to understand the practical interactions between the

Committees of the Bank, namely the Monetary Policy Committee and the FPC. There may be cases where the FPC is pursuing a wider financial stability objective, which has the potential to conflict with the approach taken by the MPC in setting interest rates, for example. Furthermore, depending upon how it works in practice, we will be interested to see how the additional objective for the FPC to support the economic policy of the government is taken into account.

June 2012

2 http://www.bankofengland.co.uk/publications/Documents/records/fpc/pdf/2012/record1203.pdf - Record of the Interim Financial Policy Committee Meeting, 16 March 2012

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Written evidence submitted by Professor Jagjit Chadha, Professor of Economics, Chair in Banking and Finance, School of Economics

University of Kent

1) The ongoing financial crisis continues to expose the binding links between financial and macroeconomic stability. And yet, prior to the financial crisis a form of Separation Principle was in place, whereby monetary policy concentrated on inflation, and financial or credit policy was treated as essentially a matter for microeconomic regulation. The new monetary policy consensus that emerged in the 1990s appeared to have solved many of the technical problems of monetary policy management. It turned out though that the use of Bank Rate alone to achieve an inflation target was not sufficient to guarantee economic stability. In fact, it would be wise to understand at the outset of this Inquiry that stability cannot be guaranteed by any set of policy instruments, even macro-prudential ones. But it has become increasingly difficult not to agree with the proposition that the scale and extent of financial regulation, fiscal policy and, even, the objectives of overseas policymakers combine in some manner with the actions of monetary policy makers to lead jointly to a given economic outcome. Indeed, in his June 2010 Mansion House speech, the Governor of the Bank of England welcomed whole heartedly the Chancellor's plan to re-combine monetary and financial policy: the Bank (will) take on (responsibilities) in respect of micro prudential regulation and macro prudential control of the balance sheets of the financial system as a whole. I welcome those new responsibilities. Monetary stability and financial stability are two sides of the same coin. During the crisis the former was threatened by the failure to secure the latter.

2) Following the publication of its Discussion paper on Instruments of Macroprudential Policy in December 2011 and a period for discussion and comment, at its 16 March 2012 meeting, the interim Financial Policy Committee agreed that the statutory FPC should have powers of direction over the countercyclical capital buffer, sectoral capital requirements and a leverage ratio. According to the minutes of this meeting, published on 28 March, the interim FPC was minded to advise HM Treasury that the statutory FPC should, in due course, have powers over a time-varying liquidity tool, margin requirements, to continue to consider the merits of loan-to-value and loan-to-income ratios, as well as various forms of balance sheet and leverage disclosure by banks. So although it might seem that the interim FPC has not asked for a full set of Macro-Prudential Instruments (MPIs), it has reserved the right to do so at a later stage when there is clearer international consensus on the appropriate levels and also more understanding of their likely impact. So it would seem that nothing has been ruled out at this stage. It would have been helpful if the interim FPC had followed the example of the Treasury Committee and published the responses to its Discussion paper and written a formal response.

3) In the absence of a clear analytical framework for thinking about the effectiveness of any one MPI with respect to some underlying objective for economic stability (however defined), which may have implications for other closely related objectives, it is quite hard to know which instruments should be employed and how. There also seems to have been little overall discussion, if any, on whether the lender of last resort function is to be included in or treated separately from MPIs. Or indeed how it should operate in

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tandem with MPIs. I am most concerned with the scope for any new set of instruments to impact on any stated objective when they may present a trade-off for either or both of monetary and financial stability. This means that we really do need to articulate with models and/or with further empirical research exactly how MPIs will impact on the appropriate stance of Bank Rate and fiscal policy.

4) I am somewhat concerned that the overall objective of these instruments is rather unclear to me - `to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system' sounds rather asymmetric and can be dealt with by thinking about appropriate buffers as well as cyclical deviations in targets. There are therefore two stages to think about here: first, what are the appropriate long run levels of the various MPIs and, secondly, to what extent should they be allowed to vary over the cycle. The Chancellor's June 2012 Mansion House Speech is helpful in that it tries to introduce some symmetry in the pursuit of financial stability: ...I can announce that the Government will amend the Financial Services Bill to give the FPC a secondary objective to support the economic policy of the Government. I will make it a legal requirement for the FPC to report, for every action it takes, how that action is compatible with economic growth as well as stability. But it is not clear with what aspect of economic growth MPIs have to be compatible, as it is itself highly cyclical and also prone to pro-cyclical revisions in expectations about its capacity. So I am not quite sure following this statement whether the potential asymmetry is offset or not because the additional objective is so hard to measure and target.

5) A taxonomy on what kind of risks are militated against by each tool is helpful, as I tend to think of liquidity as helping with refinancing risks, capital with insolvency risks and lending criteria as precautionary guidance but it will be hard in real time to judge the balance of these risks and so calibrate any of these tools particularly accurately and so I am concerned that the tools may be seen as a substitute for effective overall regulation, which they are not. And so my comments are rather thematic or generic, in the sense that in the absence of a specific model or set of models in which both monetary and financial stability are defined and instruments have been set to minimise inefficient fluctuations, it is hard to know exactly how instruments for the latter should be set as there will be many interactions that affect the correct choice. Again the need to understand the nexus between monetary-fiscal and financial policy has become paramount as a result of this crisis. Monetary and Financial Stability

6) It is possible to take the view that financial and monetary policy should simply run in tandem. So that managing the latter well also requires attention to be paid and information to be exchanged in the pursuit of the two objectives jointly. Actually the historical record suggests a slightly different juxtaposition - that the nature and scope of the regulation of financial intermediation was closely linked to the monetary policy regime. And so the immediate postwar period with the Bretton Woods system of fixed-but-adjustable exchange rates was associated with both extensive regulation of the financial system and also the virtual elimination of banking crises, apart from in Brazil in 1962.

7) But the cost of such extensive supervision, was such that it is probably the case that the financial system did not allocate investment particularly efficiently over this period and momentum for deregulation built up to a considerable degree. In principle therefore

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there is a trade-off between designing instruments to stabilise the financial system and prevent excessively volatile financial outcomes and ensuring that the financial sector retains the correct incentives to locate investment opportunities and allocate funds accordingly. It is not initially clear that employment of MPI in any particular currency area, such as the UK, can work independently of further controls on the movement of capital across currency regions, particularly when financial intermediaries have interests overseas. And so what we are looking for are instruments that will work given the kind of monetary policy regime that we currently have in place.

8) From the perspective of monetary policy makers, the initial debate was whether inflation targeting could be modified so that an additional instrument could be used to stabilise financial imbalances or directly control the extent of financial intermediation. The answer that emerged prior to the full force of the financial crisis was understood was that there was limited scope to do much. Some have argued that it is optimal under discretion to ignore any asset price boom and only mitigate any fallout on collapse and under commitment it turns out there is even less incentive to stabilise output when the economy is overheating. Others have considered that `flexible inflation targeting' that stabilises output and inflation may have an occasionally binding constraint to ensure financial stability and booms (busts) can justify an inflation undershoot (overshoot), as well as an extended period of adjustment back to target. Even if a limited number of modifications to monetary policy operating procedures are sufficient to stabilise macroeconomic outcomes, they may not be enough to realise financial stability for which appropriate supervision and regulation are unlikely to be replaced simply by new instruments.

9) Actually, it turned out in the event that another instrument was developed but this was quantitative easing and was designed to deal directly with the lower zero bound faced by Bank Rate. The purchase of gilts under QE1 seems to have driven medium term yields down by the extent to which they might have been expected to fall had short term interest rates been lowered by some 2-4%. The swap of reserves for bonds has not palpably augmented bank lending but the counterfactual - with a changing regulatory framework for liquidity in prospect and a large shortfall in output below its pre-2007 trend - is rather hard to evaluate. There seems to be no attempt to consider using this stock of bonds held to help regulate the financial system on an ongoing basis. Typically, financial intermediaries cannot create sufficient liquidity and so in principle the central bank can regulate the flow of liquidity over the business cycle in order to prevent excessive amplification of the business cycle by financial intermediaries by controlling the size of its balance sheet.

10) In fact a number of non-conventional monetary policy tools have been developed here and overseas that might have implications for both monetary and financial stability. Recent research work has found that each of a number of non-conventional tools augmented the stabilising properties of the interest rate rule from each of the asset (via reserves) and liability (via bank capital) side of a bank's balance sheet as well as preferences of household to hold short run bonds and also implied less financial volatility. Overall non-conventional tools would seem to have some financial stability considerations, there is (i) guidance or signalling, which includes the recent fashion for central bank forecasts of policy rates for extended periods, which fits in with both the New Keynesian orthodoxy, in which monetary operations do not impact on net wealth

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and therefore do not affect consumption but might impact on the expected path of interest rates, but also with an older tradition of the `governor's eyebrows'; (ii) there have been temporary liquidity injections of reserve money, or extended OMOs, which are essentially QE; (iii) the direct purchase of distressed assets. And on the fiscal side, there is bank recapitalisation and credit easing and although in the latter case, this has come to mean in the US context the composition of the CB balance sheet rather than direct lending directly to the private sector. So I think we have (i) signalling; (ii) liquidity; (iii) asset support; (iv) fiscal policy. Clearly, there are elements of one in each of the others and any operation is surely tantamount to a signal of some sort, as well as providing some fiscal support by reducing the cost of debt service - each of these can be viewed through some lens as a form of MPI. The Loss Function

11) The MPIs considered by the FPC are variable capital, margin, liquidity and equity-loan ratios. There is a danger that, given the recent experience of an overextended financial system, the mindset with which we are pursuing the development of MPI implies an asymmetric concern with the stability of the financial system, rather like that with the foundations of a building or the construction of a dam, so that we are in general concerned with reining in excessive intermediation rather than too little. Put rather bluntly: who on the FPC would lose their job if the financial system were considered to be excessively safe compared to the converse?

12) But an asymmetric loss function does not necessarily have to be pursued asymmetrically. The policy maker simply has to pursue a slightly different target. This is because minimising losses with an asymmetric loss function does not occur at the stated target, as it does with symmetric losses, but at some point in the opposite direction of the steeper asymmetric loss. So, for example, given some target level of capital, if we are then very worried about too little capital compared to too much capital, we simply slightly target higher levels of capital over the business cycle with the actual target increasing in the variance of shocks and our extent of risk aversion. It therefore makes sense to develop steady state targets that build in a precautionary target for more liquidity, capital and equity to loan ratios than a strict minimum might imply. The FPC may give some thought to the development of long run targets for MPIs that are consistent with growth in long run capacity as well as cyclical deviations, which deal with risks in an appropriate manner. Targets and Instruments

13) As is rather well known, we want to count the number of independent instruments and objectives. In the current set-up, the MPC will continue to set Bank Rate to pursue the inflation target and it will be the FPC that will have instruments at its disposal to pursue financial stability. To the extent that we cannot be sure about the impact of any instrument, parameter uncertainty introduces a trade-off between the achievement of the target and the minimisation of uncertainty induced by the use of an instrument. There are two further problems here in the case of MPIs, (i) there is likely to be considerably more uncertainty with a set of untried instruments that may also have a correlation structure with each other but (ii) also because they may alter the behaviour of the financial system, they will impact directly on the impact of any given stance of monetary policy.

14) On the first point, it might be that we can treat the new MPIs as a portfolio of

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instruments that jointly will reduce the idiosyncratic risk of using any one new instrument. But without specification, calibration or testing of the impact of any one instrument in combination with the others, we cannot probably be very sure at all whether such a portfolio of instruments will be available. The FPC might therefore give more thought not only to which instruments may be used but how they might be used together and in a manner that does not induce greater uncertainty into the operation of monetary policy.

15) To the extent that changing the constraints faced by financial intermediaries will alter the financial conditions, as the choice made on the quantity and price of intermediation will be affected, there may not only be an impact on the appropriate stance of monetary policy but also an impact on the appropriate MPIs conditioned on the monetary policy stance. Consider a world in which the monetary policy maker wishes to smooth the response of consumption to a large negative shock to aggregate demand and reduces interest rates faced by collateral-constrained consumers. Simultaneously, financial stability may be considered to be threatened and various MPIs may be tightened, which would act against the interest rate changes made by the monetary policy maker and may need further or extended lower rates of interest rates. If on the other hand, sufficient precautionary moves had been made by the FPC in advance there may be no immediate conflict.

16) There may be a need for explicit co-ordination of Bank Rate and MPIs. The standard example of monetary-fiscal interactions may be instructive. Suppose that both the MPC and FPC face a trade-off between interest rates and financial conditions. Now imagine that a conservative MPC bank wants lower inflation than society, it will then tend to choose higher interest rates for every level of financial conditions. The FPC on the other hand, may reflect more closely societal preferences and prefer a lower level of financial conditions for each interest rate, hence the monetary policy reaction (MPR) function may differ than the financial policy reaction (FPR) function. Without any co-ordination, the point at which the reaction functions cross may well imply high interest rates and loose financial conditions. But society may well prefer though lower interest rates and tighter financial conditions but that will require some form of co-operation as the correct mix may depend on the current state of the business cycle. Presently, although the two bodies (MPC and FPC) sit in the same institution, the exact extent of co-operation, if any, is not terribly transparent. Operating MPIs

17) MPIs may be used to help stabilise the financial system over the business cycle. Perhaps to prevent some of the risks associated with a boom from building up, as Andrew Crockett put it: `The received wisdom is that risk increases in recessions and falls in booms. In contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and materialising in recessions'. There are though quite separate issues to consider when designing MPIs to help stabilise a reasonably well functioning financial system, which might be thought of leaning against the wind, and in considering the correct responses for a highly vulnerable and undercapitalised financial system. The former implies the use of cyclical instruments to prevent a problematic build up of risk and the latter some attention to the superstructure of the financial system with individual firms and the sector as a whole not only able to withstand shocks but sufficiently robust as not to amplify them.

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18) And yet the financial system is already undergoing a considerable deleveraging that has involved a build up in core capital, increased holdings of liquid assets and greater margin requirements. In a sense the financial system is moving from a loose regime to another tighter one but too fast a transition may have unwanted macroeconomic consequences. The extent to which difficulties in obtaining finance may constrain the investment or consumption plans of some firms and households may imply that although what may be optimal are tougher long run regulatory targets there may be some sense in thinking about how to allow the divergence from these targets for extended periods. Rather like a credible fiscal regime that ensures sustainable public finances is one more likely to allow the full force of automatic stabilisers to operate. In this sense, if banks are forced to observe a target at all times, this may be counterproductive for the system as a whole. It is an example of Charles Goodhart's taxi example: where a taxi at a railway station at night could not accept a fare because of a regulation that at least one taxi had to be at the railway station all the time. So if countercyclical targets are to make sense they have to be set so as to allow some deviation away from the targets in extremis.

19) One of the results to emerge from the analysis of monetary policy is that the control of a forward-looking system is best achieved by setting predictable policy that allows forward-looking agents to plan conditional on the likely policy response. There has been considerable work to suggest that the impact of monetary policy is a function of both the level and the path of interest rates, which is likely to be closely related to predictability. As well as thus evaluating instruments, the FPC will have to pay careful attention to how expectations of changes in MPIs are formed and whether partial adjustment towards some intermediate or cyclical target for a given level of capital, liquidity or loan-to-value will be adopted. The alternative of jumping to new requirements may induce large adjustment costs for the financial sector and the use of considerable resources to predict future movements in requirements. The private sector may also be induced to bring forward or delay financial transactions depending on the expectations of collateral requirements. In a slightly different context, the pre-announced abolition of double rates of mortgage interest relief at source (MIRAS) may have played a role in stoking some aspects of the house price boom of the late 1980s. Under some circumstances, such a response reflecting strong intertemporal switching may be entirely what the FPC may wish to bring about but, more generally, when agents are well informed and forward-looking some thought has to be given to developing a framework for understanding agents' responses to any expected or pre-announced changes in the rules governing financial intermediation. Monetary Policy and MPIs

20) Some recent work on the nexus of MPIs and monetary policy do suggest that there may be a complementarity. The widespread adoption of non-conventional monetary policies has provided some evidence on the efficacy of liquidity and asset purchases for offsetting the lower zero bound. Central banks have thus been reminded as to the effectiveness of extended open market operations as a supplementary tool of monetary policy. These tools can essentially be thought of as fiscal instruments, as they issue interest rate bearing central bank liabilities. If these tools are placed in the government's present value budget constraint and the consequences of these operations in a micro-founded macroeconomic model of banking and money is

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examined. The responses of the Federal Reserve balance sheet to the financial crisis are mimicked. Specifically, the role of reserves for bond and capital swaps in stabilising the economy and also the impact of changing the composition of the central bank balance sheet is examined. It is found that such policies can significantly enhance the ability of the central bank to stabilise the economy. This is because balance sheet operations supply (remove) liquidity to a financial market that is otherwise short (long) of liquidity and hence allows other financial spreads to move less violently over the cycle to compensate.

21) The case for the systematic use of balance sheet or reserve policies can also be examined. Because compared to a model that does not explicitly model bank balance sheets, this model can deliver an endogenous dynamic response for various risk premia and for the supply of loans and deposits. Using standard macroeconomic analysis, the responses of the economy with and without reserve injections. Having approximated the welfare of the representative household, it is found that the economy in which commercial banks have an endogenous choice over reserve holdings performs better in welfare terms than when commercial banks do not have such an choice. The holding of reserves over the business cycle acts as a substitute for more costly provision of illiquid commercial bank assets and thus reduces the volatility of interest spreads to shocks, and varying the availability of reserves over expansions and contractions, acts to help stabilize the impulse from the monetary sector.

22) But such work, in my view, is rather at an early stage and has yet to be tested under more uncertainty under instrument choice. It would be useful to summarise some of the emergent literature as well, which I cannot do here under the time constraint. And there are a number of missing elements to the analysis: (i) the consideration of fiscal policy, which if excessively expansionary may induce increases in liquidity premia, or may be in a position to offset liquidity shortages by trading long run debt for short run liabilities and (ii) the consideration of non-linearities or discontinuities in responses e.g. from bankruptcy. That said, current work does suggest though that the gains from jointly determined MPIs and standard interest rate responses, conditioned on sustainable public finances, may lead to welfare gains. Again more work is required by central banks to try and understand how these tools interact. Concluding Remarks

Following the financial crisis, and need to undo the Separation Principle for monetary and financial stability, we can agree there are missing instruments and there is a hunt to locate ones that can be employed, or suggested for us, by the FPC. I remain concerned as to how long run targets for capital, liquidity and asset-mix and lending criteria will be set and whether a bias to over-regulation may be set in train. It is not at all clear how many new cyclical MPIs will interact with each other and impact on the setting of monetary policy. A reverse causation is also possible, whereby the stance of monetary policy may have implications for the correct setting of MPIs. The management of expectations over any announcements of changing MPIs will be a crucial area in a modern financial system - it was probably significantly easier in a world of extensive capital and exchange controls that characterised the immediate postwar period. All that said, early results from a new generation of micro-founded macro models do suggest that there may be significant gains from getting the calibration of these new instruments right but much work remains to be

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done. June 2012

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Written evidence submitted by Sir Andrew Large Dear Andrew Governance of the Bank I enjoyed our recent discussion on issues relating to the above: inevitable side effects I fear of concentrating so much power in one institution. Although I know that my points may have exaggerated what was in your report, I do feel that you will get better long term results by beefing up the capabilities of Parliament to ask the right questions than by trying to use the Board (Court) in terms of resolving policy conflict. I think it’s important to underline that policy objectives are set by ministers. It is surely they who provide the relevant but separate policy mandates [for monetary policy, macroprudential policy, and for that matter microprudential policy]. So it should be they who handle and resolve any otherwise irresolvable policy conflicts to the extent that these cannot be resolved by the Governor. To my mind this would be a preferable route compared to trying to get this done by the Board which would need to interpret what the view of Ministers themselves, or indeed Parliament, may be. It seemed to me that we were not too far apart on these issues. Of course there is plenty of grey rather than black and white! FPC and powers of direction You asked me to write on the other subject we touched on towards the end of our conversation, namely the powers of direction under debate for the FPC. I suggested that I think there is a flaw in the thinking which lies behind the proposition that the FPC should submit ex-ante a list of instruments over which they request such a power of direction, for approval by Parliament. I can well understand the logic of thinking about such an approach, particularly since I know that there is a general reluctance to grant ‘blanket’ powers. And we now of course have to hand the Statement of 16 March policy meeting of the FPC. However I think that this approach overlooks the following. In many instances powers of direction as such are likely to be unnecessary [as the FPC acknowledges in the discussion on instruments to strengthen the resilience of the system]. I think in fact that the alternative of the ‘comply or explain’ regime will take you a long way. It would enable and require the party who might otherwise be directed, to put forward reasons for non-implementation which in turn would have to stand public scrutiny. And if those reasons are ‘valid’ – which they may be - there should be time for the FPC to devise another approach to solving the problem for which they had intended that the instrument was the solution. [Equally if the reasons for non-implementation are valid it might not be sensible to seek an alternative, depending on what the reasons were].

Contd / …

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In addition the heads of the two main parties whose instruments might be so used – namely PRA and FCA - would be sitting on the FPC itself. This should mean that cases of this sort should be reasonably rare. And the PRA in particular would already within its remit need to take account of systemic prudential issues in their deliberations. On the other hand the time where direction may be necessary is when the FPC detects that specific vulnerabilities are rising even though crisis may not yet be imminent. That is when there should be no delay or doubt as to whether the instrument that is felt by the FPC to be necessary will in fact be deployed expeditiously. This may relate to issues which fall within the immediate remit of the PRA or FCA, but could extend outside that boundary. As we know there is a large number of potential instruments which the FPC may wish to deploy as they spot vulnerabilities which they need to address. However the basic problem is that it may well not be possible ex ante to predict which instruments might be most suitable to meet the challenges then posed. Nor, in the absence of heightened vulnerability might it be easy to justify why powers of direction for that specific instrument were requested. The present intention, as I understand it, is to cover such circumstances through an expeditious parliamentary process to enable rapid deployment in relation to the instruments so chosen. This of course may suffice, but all will depend on the workings of the process being satisfactory: without delay on the one hand, and without removing from the FPC the responsibility for decisions as to when and if to deploy the instrument on the other. Alternatively there might be merit for the FPC to have a general power of direction, if it felt that the danger in relation to the systemic conjuncture demanded it. The scope, thresholds, and trigger would clearly need careful consideration. The knowledge that such a power existed however [whether using the expeditious route or through a general power], should also help to overcome any residual danger of forbearance, or indeed resistance. Of course I realise that this would raise significant accountability issues particularly since it might affect property rights. This might be analogous to the deployment of contingent powers of resolution for use in crisis situations for example. Perhaps a suitable approach could be found here also, however contentious the provision of contingent powers might be. On a practical note, it is true that the very fact that the FPC might be using such powers might cause uncertain behaviours. These could be adverse [rapid withdrawal from assets to cash]. But equally they could induce helpful behaviours, given the strong signal of the authorities’ concerns that would be given by such actions. So careful judgments would in all cases be needed. FPC policy objectives and ‘Symmetry’ In closing I couldn't help noticing your reported remarks about symmetry and adding tonic at the end of the cycle. I can quite see the need for the FPC to have regard for growth issues and that the remit to which it works may be conditioned to achieve this. But I fear I beg to differ if you are arguing in favour of the FPC having in effect dual objectives of on the one hand preventing crises and on the other proactively promoting

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[credit] growth. If you would like to discuss that one day I'd be happy to do so: I attach a list of points which I think are relevant for considering it. Best wishes Andrew

Symmetry: should the FPC be required to stimulate credit as well as to prevent crises? Goals of the FPC o We should remember what the FPC was set up to do! That is to fill a gap in policy that was shown to be missing when crisis hit in 2007-8. The objective is for the FPC to work on systemic risks to prevent crisis from occurring: this needs a forensic approach of identifying early warnings and taking mitigating actions. Implications of this are: o There may be a necessary tension between this work and the job of getting credit to flow [sometimes used as shorthand for 'improving growth']. o To a significant extent those trying to achieve financial stability at the FPC need a different mind-set from policymakers involved with driving the macroeconomy [MPC included, but including eg areas of policy with respect to the supply side and fiscal issues]. If parliament were to insist on symmetry then I worry that the following would result: o Confusion. The public would be confused as to what the FPC was meant to be doing. This would undermine the legitimacy and credibility of an area which needs that ‘in spades’, given the difficult judgments and the unpopular decisions which they will have to make [such as 'taking away the punchbowl']. o People enjoy parties. The public [and maybe some politicians!] will want to go on partying at the time the punchbowl has to be removed. So the unpopularity of necessary decisions would test the perceived legitimacy of the FPC. o Dual objectives. Delegating authority to a body which then has dual objectives may prove a recipe for neither of the objectives being met: particularly where one of the objectives is unobservable. You can measure growth. You cannot measure ex ante the level of leverage at which a crisis will occur, even if you have some idea of the strength of the system’s structure to withstand shocks. o A new and difficult policy area. This is a new area of policy framework, and a very difficult one. [The present noisy debate about which instruments should be subject to powers of direction illustrates some of the difficulties.] There are many uncertainties as to what indicators matter, what data is relevant, what instruments will work, how they should be calibrated, and how they will be deployed. The area should be allowed to develop and mature before its policy objectives are widened so substantially. o Elusive growth. Getting growth to happen is also very difficult and inevitably so at a time like today when there is still a need for general deleverage. But don't let’s allow the frustration spill over into asking a new and untested FPC to take on another policy area of equivalent difficulty. Even if politically it may be expedient to find a party to whom to delegate such responsibility, it would be very unwise to do so if this eroded the ability for the FPC to undertake the vital task of preventing the next crisis. The frustration is understandable but the FPC is not the solution.

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o Governance. This would represent providing yet more power to the Bank of England: in practice I worry that this will add to the governance and accountability issues presently under review. o Technical objections. There are a number of more specific or technical objections to putting 'pro growth' on the agenda alongside 'stopping crises': o No reaction function. There would be little possibility of creating a reaction function, and in turn this would make the calibration judgments in relation to individual instruments even harder. o Different skill sets. The skill sets needed forensically to detect impending vulnerabilities on the radar screen are different from those associated with getting the economy to grow. How would you find and accommodate both within one decision making body? o Instruments. Using - and justifying - the sort of instruments available to the FPC to try to accelerate growth seems to me like pushing on the end of a string. Animal spirits no doubt need arousing: but there are so many determinants of growth that it will be hard to put accountability process in place for the FPC to achieve it! So what can be done? Various factors can be taken into account in setting the mandate, as set by the Chancellor, under which the FPC operates. The FPC's actions may indeed impinge on policy objectives in a number of policy areas. This might include not just creation of credit and growth of the economy, but also other social objectives, like home ownership, or welfare or competition. It is to be hoped therefore that the intentions of Government will follow the approach used for the MPC where its remit requires it to ‘have regard’ to other economic policy objectives of government, but only ‘subject to’ it fulfilling its primary remit of price stability. This would enable an effective mandate to be given to the FPC: • The mandate should cover to what policy areas should the FPC have regard, and to what extent should that regard be allowed to interfere with the primary remit of securing financial stability over the long run. This should start from an attempt to articulate how safe the system should be. The safer the system, the more the measures in place to provide that safety will be likely to have an impact on growth. This requires thought as to the appetite for risk. Like an insurance company, should the requirement be for the system to be safe enough to withstand the shocks that might emerge in a 5 year period? Or should it be safer with a 10 or even a 100 year return period? I believe that risk appetite is a determination that belongs to Ministers and Parliament rather than for the FPC itself. Just as the inflation target is a political choice. In reacting to this mandate if the guidance given is to take a longer return period, the FPC would be expected to take a slightly less austere approach than in the case where the return period would be shorter. • And if, for whatever level of risk appetite, the mandate requires them to take account of the impact on growth, this could influence the choice of instruments to achieve the systemic objectives in favour of those less likely to impact growth. Sadly we are faced with difficult realities. Unless we are going to accept regular recurrence of crises and destruction of GNP, the long-term sustainable rate of growth seems likely to be lower than was presumed before the crisis. So we have to grit our teeth somewhat rather than looking vainly for another party like the FPC to find a

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'magic solution'. Necessary deleveraging after such a long and ill-judged party is a long-term and unpleasant process for all of us who seek growth! Symmetry: Should Macroprudential Authorities be required to stimulate credit

and growth as well as to prevent crises? Some reflections for debate.

The present impasse in Europe as to how to get economies going again, and the populist and political hysteria about the austerity agenda, is encouraging debate as to the role that Macroprudential Authorities set up to undertake independent policy assessment [MPAs] might play in a pro-growth direction. In addition to their duties to prevent crises, should they also be given the task of trying to get economies to move again? I would anticipate that this debate will intensify.

The 'political' proposition is that if MPAs become competent at preventing asset bubbles and leverage build up, they might be thought to be competent in the opposite direction as well. I would argue - for debate - that whilst this sounds intellectually tempting, it would be dangerous for legislators to move in this direction.

What are MPAs trying to do?

MPAs are being constituted as a response to filling a gap in policy that was shown to be missing when crisis hit in 2007-8. They are tasked with working on systemic risks to prevent crisis from occurring: this needs a forensic approach of identifying early warnings and taking mitigating actions.

Market based macroeconomic policy areas, including that of monetary policy, had not managed to lean or take preventive measures against increasing and mainly leverage-related systemic risks. What was needed was a determined 'sleuth', to intervene as needed, and with the thought processes of a detective developing an effective radar screen. The tasks and mindsets of fire prevention differ from those of the users of the buildings which the fire prevention is designed to protect!

Policy Conflicts

There may of course be a necessary tension between policies to ensure safety of the financial system and those needed to get credit to flow [often used as shorthand in political minds for 'creating growth']. This policy conflict needs to be resolved: but my thesis is that it is better to encourage other authorities, backed by political will, to promote the growth agenda. What the MPAs can do in today’s overleveraged post crisis world is to make sure that leverage levels in the economy gradually get to the level at which the necessary level of confidence is restored , to lend, invest and consume, which is a vital precondition for growth to resume. They can also act, as suggested below, in ways that have regard for other policy areas, including those relevant for growth. But I would worry about asking MPAs to be proactively engaged to deliver both objectives.

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An exception might be in jurisdictions where the MPA and the Government are effectively one and the same [ie there is no 'independent' macroprudential policy assessment].

Some concerns

If legislators do indeed insist that MPAs work symmetrically then I would be concerned about the following:

• Confusion. The public would be confused as to what the MPA was meant to be doing. This would undermine the legitimacy and credibility of a policy area which needs plenty of both. Systemic or Macroprudential policies require difficult judgements and result in unpopular decisions. ['taking away the punchbowl']. And people enjoy parties: the public [and maybe some politicians] will want to go on partying at the time the punchbowl has to be removed.

• Dual objectives. Delegating authority to a body which has dual objectives raises real danger that neither of the objectives would be met: particularly where one of the objectives is unobservable. You can measure growth. You cannot measure ex ante the level of leverage at which a crisis will occur. And how do you make such a body accountable if you have such disparate objectives?

• A new and difficult policy area. Macroprudential or systemic policy is a new and evolving area of policy framework, and a very difficult one in two senses. Firstly there are difficult Governance issues which arise where you necessarily have several separate authorities engaged towards a common good [central bank, ministries of finance and supervisors]. But secondly there are many uncertainties as to how to ‘do’ macroprudential policy: issues such as what indicators matter, what data is relevant, what instruments will work, how they should be calibrated, and how they will be deployed. The area should be allowed the time to develop and mature before its policy objectives are widened so brutally.

• Elusive growth. Getting growth to happen is clearly a major challenge, and inevitably so at a time like today when levels of debt and leverage within economies are still too high to regain the confidence [and hence willingness to invest/consume] of private markets. Contemporaneous deleveraging and encouragement of growth are difficult bedfellows. We know that for confidence to be restored deleveraging in a broad sense is still needed to some level lower than it is today. Attempts to spend your way indiscriminately out of trouble are likely to be upset by the actions of bond vigilantes - a real constraint for many jurisdictions, as in Europe today. [Perhaps may be less the case if you have a reserve asset currency like the dollar, or you can easily turn on the tap of infrastructure projects whose rate of return on capital can be judged].

But I would urge avoiding allowing this frustration to spill over into asking new and untested MPAs to take on the growth agenda - another policy area of equivalent difficulty - for which they cannot readily be designed. And even if it might be politically helpful to find a party to whom to delegate this responsibility, it would be very unwise to do so if this eroded the ability for the

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MPA to undertake the vital task of preventing the next crisis. Future generations will certainly not thank us.

• Long term growth rate. Attitudes towards what is the long-term sustainable rate of growth may need to change. Given the huge cost of crises and destruction of GNP, this seems likely to be lower than was earlier presumed. So although I am certainly not on the side of ‘austerity or nothing’ we have to be patient and certainly not look vainly for another party such as an MPA to find a 'magic solution'. Necessary deleveraging after such a long and ill judged party is a long-term and unpleasant process for those who seek growth! Statesmanship in getting the message across before becoming engulfed by populist movements is of course a key issue for today.

Technical objections. There are a number of more specific or technical objections to putting 'pro growth' on the agenda alongside 'stopping crises'

• No reaction function. There would be little possibility for the MPA to create a reaction function. In turn this would make the calibration judgements in relation to individual instruments even harder. Maybe it is rather ambitious to be speaking in these terms: but the stakes are high and it would be a pity to cut off this possibility. Unless agents are clear on the policy objective of the policymaker, how can they know how they are supposed to react?

• Different skill and mind sets. The skill sets and experience needed forensically to detect impending vulnerabilities on the radar screen are different from those associated with getting the economy to grow. How would you find and accommodate both within one decision making body? Although there are clear overlaps, those trying to achieve financial stability need a particular mindset that differs from policymakers involved with the cycles of the macroeconomy. I would include in large measure mindsets of those involved with monetary policy [indeed this is an argument for keeping MPAs separate from monetary policy authorities] but also other areas of policy with respect to the supply side as well as fiscal issues.

• Instruments and accountability. Using – and justifying - the sort of instruments available to MPAs to try to accelerate growth seems to me like pushing on the end of a string. Animal spirits no doubt need arousing: but there are so many determinants of growth that it will surely be hard to put an accountability process in place for the MPA to achieve it.

So what can be done? All this is far from suggesting that nothing can be done. Just as policies in respect of fire prevention need to accept that people need to be able to work in the buildings that they protect, so MPAs need to take account of the implications of systemic policies on other areas of policy like growth.

In some jurisdictions the mandates of policy areas such as monetary policy, and now macroprudential policy, are set by the political process. In turn these can be adjusted with some regularity. This suggests the following possibilities to resolve policy conflicts as ingredients in relation to the setting of mandates:

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Firstly there needs to be guidance as regards how safe should the system be. The safer the system, the more the measures in place to provide that safety may impact growth. So how safe should the system be? This requires thought as to the appetite for risk. Each jurisdiction needs to form a view on this. It may be a tough area to get one’s mind round, but there is no such thing as an absolutely safe financial system [unless you ban credit and leverage which seems to call into question the very basics of our modern-day economies]. So, as a crude approach, do you require the system to be safe enough to withstand the shocks that might emerge in a 10 year period? Or do you want it to be safer with a 20 or even a 100 year return period? Depending on this determination guidelines can be given as part of the MPA's mandate. If the decision is to take a shorter return period, the MPA can take a slightly riskier approach than if longer.

I would suggest that risk appetite is a determination that should belong to the jurisdiction as a whole [and hence its political process] and not left to policymakers such as MPAs themselves. It may be difficult to articulate, but it's too important to be put in the too difficult box.

But secondly to what specified other policy objectives should the MPA have regard? The MPA's actions may indeed impinge on policy objectives in a number of policy areas whatever the level of risk appetite. So there is a legitimate question: for what areas of policy should the MPA have regard? This should be made clear in the MPA's mandate.

For example if the mandate requires the MPA to take account of the impact on growth, this could influence the choice of instruments in favour of those less likely to have an impact on it whilst still achieving the systemic objectives.

Equally the mandate could cover other social objectives, like home ownership, or welfare or competition. So for example in the area of home ownership instruments designed to increase the cost of intermediation in a sectoral sense might be used instead of LTV [which could have a greater impact on social priorities].

Overall the target of stability needs to have primacy. But I do not think it naïve to suggest that the route/choice of policy instruments chosen in many cases could take account of other objectives. Instruments of a conjunctural nature designed to raise the cost of intermediation so as to work against leverage build up may have a more direct impact on growth compared to instruments designed to strengthen the resilience of the system to withstand shocks.

In fire prevention you can either act to prevent the temperature from rising [ie no petrol allowed inside the building: akin to preventing the increase of leverage and credit bubbles] or you can make the building stronger and with thicker walls and doors or smaller windows to improve resilience [akin to better

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regulation and stronger banks]. A similar type of trade off may be achievable in the area of macroprudential policy.

To achieve success MPAs need time to develop. We shouldn't forget for what they were set up. And I hope we won't let them be hijacked as new enthusiasms and priorities emerge. Whatever these may be, systemic risks will surely be ever present. My thesis is that if future generations are going to feel that we have taken on board the implications of recent calamities we should certainly make sure we focus on this reality.

June 2012

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Written evidence submitted by the Association for Financial Markets in Europe

Introduction

1. The Association for Financial Markets in Europe (AFME) welcomes the opportunity to give evidence to the Treasury Committee (the Committee) in connection with their inquiry into the Bank of England (the Bank) macroprudential tools.

2. AFME represents a broad array of European and global participants in the wholesale financial markets. Our 197 members comprise all pan-EU and global banks as well as key regional banks, brokers, law firms, investors and other financial market participants. We advocate stable, competitive and sustainable European financial markets that support economic growth and benefit society. Given that the importance of the UK macroprudential framework - both to help to identify future risks to the EU and to help guide other Member States in the development of similar approaches – and the importance of the UK framework dovetailing with Europe, we believe it is important that AFME continue to engage in the ongoing debate. Executive Summary

3. Before focussing on the Financial Policy Committee’s (FPC’s) macroprudential tools, it is important to consider the wider domestic and international frameworks in which they will be developed and used; in particular:

• The effectiveness of the FPC’s powers of direction and recommendation and the

underlying macroprudential tools can be limited by inadequate coverage. The interim FPC appreciates that significant systemic risks can be posed by non-banks and that the perimeter of regulation therefore needs to be kept under constant review to ensure that tools can be applied to the relevant risk posing entities. However, AFME believes that it is also important to consider and take into account that, notwithstanding changes to the regulatory perimeter, some types of macoprudential tool may not be effective with or applicable to some types of firm. For example, regulatory capital or liquidity requirements do not apply to some sizeable types of consumer lending operation and so varying capital or liquidity buffer requirements would have no impact.

• Whilst there is a clear case for individual countries to have a macroprudential authority with the capacity and flexibility to vary capital, liquidity and perhaps margining requirements to underpin the resilience of the financial system, nevertheless, given the close integration of global capital markets, the high risks of spillovers and regulatory arbitrage, it is important to consider the international and global aspects of macroprudential policymaking. There are also clear risks to economic growth of the unilateral application of capital or other requirements to UK firms only. Effective coordination mechanisms and/or instrument design features will therefore be needed in those instances in which specific macroprudential tools are

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used in response to sources of vulnerabilities that impact across national jurisdictions and to mitigate the risk of level playing field issues arising.

• Although the interim FPC acknowledges the importance of international coordination it is not clear how the FPC might interact with the European Systemic Risk Board (ESRB) or the European Supervisory Authorities (ESA’s), or wider international fora including the Financial Stability Board (FSB). Particularly given the FPC’s limited scope in relation to branches of incoming EEA firms and cross-border business, we believe that the Financial Services Bill should set out the FPC’s responsibilities to and gateways with the ESRB.

• We also continue to believe that the FPC’s objectives should be aligned, in so far as is

appropriate, with the ESRB, and we welcome the Chancellor’s recent announcement of the change to the Financial Services Bill to ensure the FPC has an objective to consider the wider economic context.

• Resolvability and linkages to the evolving crisis management framework should also

be a key area of focus, as ensuring failure can occur without contagion should contribute significantly to ensuring financial stability.

4. AFME is conscious that practical experience with the formulation and use of macroprudential

policy and tools is relatively limited, and we are broadly supportive in principle of the macroprudential tools the interim FPC has requested the FPC be granted powers of direction over, although with important caveats and concerns in some areas. We have also noted additional tools which might over time be provided to the FPC, including LTV and LTI tools and the ability for regulators to define stress tests and test parameters in relation to firms’ Internal Capital Adequacy Assessment and Individual Liquidity Adequacy Assessment frameworks. It will be important, more widely, to ensure that the macroprudential tools selected provide sufficient flexibility either on an individual basis or in combination to enable supervisors to target and mitigate sources of systemic risk without causing significant unintended consequences to other businesses and the wider economy.

5. AFME considers also that supplementary buffers, capital requirements or other resources built-up or retained during an upswing should be released sufficiently in advance of a downturn to reduce impediments to the flow of credit to the economy and to ameliorate pressures on the real economy and economic growth. We do, however, note that to date all of the tools proposed relate to the ability to vary regulatory capital requirements and we would caution against an undue focus on capital only, and we set out concerns as to the extent to which the release of prudential resources might be possible in practice. In particular, it is possible that markets may view firms that did release their buffers in a less positive light.

Whether the interim FPC has requested the most appropriate tools over which the FPC should be given the power of direction?

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   6. AFME is supportive of the interim FPC’s overarching considerations in relation to the selection of

its tools and view the tools requested as having the potential to provide ways of seeking to address macroprudential risks, albeit with some important caveats surrounding their use. Given the relative inexperience with the use of macroprudential policy and tools, AFME agrees with the FPC’s approach in the near term to confine the range of tools to a fairly narrow range and we consider that over time a wider range of tools might be developed as experience and understanding in the use and effects of tools increases.

7. AFME agrees with HM Treasury also that the tools over which the FPC would have powers of Direction should be specific, rather than broad or open ended. However, innovation and change in the financial system together with lessons learned on the design and implementation of macroprudential tools point to the fact that it will be important to ensure that there is sufficient flexibility to allow this set of tools to be augmented or adapted quickly when the need arises.

8. AFME considers that the countercyclical capital buffer could indeed provide a simple, aggregate

tool and that the Basel III framework envisages reciprocity agreements to deal with concerns of cross-border leakage. However, we note that the additional costs the buffer imposes may encourage banks to seek higher profits to compensate for the higher costs of capital and therefore increase exposure to higher risk areas at the expense, potentially, of sectors of more direct relevance to the real economy and economic growth.

9. AFME notes the possible use of sectoral capital requirements in conjunction with or as an alternative to the use of countercyclical buffers. AFME agrees that the use of sectoral capital requirements could enable macroprudential supervisors to better target sources of systemic risk by allowing them to target a particular class or type of asset. It is, however, not clear how the concept of sectoral requirements or variable risk weights could be applied consistently to firms using different approaches and models for the calculation of their Pillar 1 capital requirements. In addition, there is a risk also that attempting to channel credit through adjusting risk weights could be perceived as applying a form of ‘industrial policy’ without adequate Parliamentary oversight. . Moreover, it is not clear how effective attempts to vary the flow of credit to different sectors of the economy are likely to be, especially in extreme economic periods and if banks from other jurisdictions were not working to the same constraints.

10. AFME agrees that leverage ratio can be used as a backstop to risk weighted requirements, particularly where excessively optimistic risk measures tend to reduce risk weighted assets and associated capital requirements. However, we are also of the view that the leverage ratio should remain a Pillar 2 measure and should not be transitioned to Pillar 1. This is because the leverage ratio presents a greater constraint to some types of firm, e.g. a universal bank is more heavily impacted than a broker dealer, it has a disproportionate impact on some types of business, e.g. trade finance, and it may give rise to counter-intuitive risk management incentives as in general the effects of hedging transactions are not recognised, and indeed count towards the leverage limit.

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   11. More widely, we note that all of the proposed powers of direction relate to the ability to vary

regulatory capital requirements and we would caution against an undue focus on capital only.

Whether additional tools should be given to the FPC (these may include tools rejected by the FPC, not considered by the FPC or that use the balance sheet of the Bank of England).

12. In terms of LTV and LTI restrictions, the interim FPC stated some of the attractive features of these tools, including the advantage that they send a clear and strong public signal of emerging risks to lenders and borrowers. AFME would add also that these measures have the advantages also of being targeted and straight-forward to implement and adjust in line with developments in the market and that they are likely to limit lending more directly or quickly than changes in capital or liquidity requirements which work through the price of lending. On a less positive note these instruments might unduly restrict lending to some credit-worthy borrowers and could be avoided by borrowers increasing borrowing for the purchase of property through personal loans and/or other types of borrowing.

13. We note that, given the socio-economic effects, the interim FPC considered that the use of these tools would require a high level of public acceptability; the interim FPC, therefore, agreed that it should not advise HM Treasury that it be given powers of direction over such tools at this time but that these tools might be appropriate after further analysis, reflection and public debate. AFME and its members disagree, however, and consider that the FPC must be able to send strong signals to the economy as a whole about bubble concerns directly rather than only through instigating changes to firms’ balance sheets. We agree also with the IMF which has stated that ‘additional powers should include the ability to limit LTV and LTI ratios, as higher capital requirements alone may be insufficient to restrain property bubbles. This will be especially true if most banks are comfortably above minimum capital requirements during the boom, such that higher risk weights on property loans may have little effect on banks’ lending behaviour. In addition, we would note that LTV and LTI restrictions can be removed or relaxed by regulatory authorities without influencing the markets’ perception of individual firms.

14. A further and important tool which does not appear to have been considered by the Committee is the use of stress testing to inform variable capital and liquidity requirements. In particular, regulators could instruct firms in relation to the stress tests and test parameters that need to be modeled in firms’ Internal Capital Adequacy Assessment Process (‘ICAAP’) and Individual Liquidity Adequacy Assessments (‘ILAAs’), and these tests would in turn impact the scale and composition of the liquid assets buffer and capital requirements (denominator and numerator) as part of the Pillar 2 framework rather than through trying to apply more ‘rigid’ or ‘one size fits all’ approaches under Pillar 1 calculations.

15. AFME agrees that it would be desirable for the FPC in due course to consider powers of direction over time varying liquidity tools. However, it will be important first for regulators to ensure that there are sufficiently clear and effective international arrangements in place for the microprduential supervision of liquidity before this can take place.

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16. AFME, in addition, considers that margining requirements can target the provision of liquidity

from the shadow banking sector but that these are difficult to implement and are sometimes easy to circumvent. Any tools in this area would need to take into account international developments to ensure consistency and that approaches to dealing with potential inconsistencies and difficulties are reflected. There may also be concerns that regulatory authorities may seek to directly alter the commercial terms of individual transactions.

17. Tools that use the balance sheet of the Bank of England, such as for example reserve requirements, have the advantages that they are straight forward to implement and can be varied to reduce overall levels of lending. They tend, however, to be unsophisticated and do not target particular categories of lending and so could be damaging to certain economic sectors. They may in addition cause banks to seek higher returns to compensate for increased costs of funding and therefore expand higher risk businesses. The FPC might also seek to consider tools that influence market structures which are primarily geared towards dealing with cross-sectoral risks.

18. It is, moreover, equally important to consider that in addition to the use of macroprudential

tools, the ability to allow firms to fail without leading to contagion to other financial institutions is a very significant mitigant to systemic risk, and there may be a role for the FPC in identifying instruments which contribute to bank resolvability or enable international resolvability measures to function more effectively.

The extent to which the FPC’s powers of recommendation are appropriate, and how they will work with the powers of direction.

19. The FPC’s powers of recommendations are widely drawn; in particular, the FPC may give recommendations to “persons other than” the Bank, the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA). Whilst we recognise the rationale for this widely drawn power, we are unsure of the power that an FPC recommendation would have if given to a body such as the Financial Reporting Council and believe that there should be some check to seek to ensure that recommendations focus on the FPC’s areas of competence. We also believe that any recommendations to classes of authorised persons should be made through the appropriate microprudential regulator and not directly.

20. In practice, we believe that the FPC is likely to use its powers of recommendation more frequently that its powers of direction - which we see as an in extremis measures. We believe that such an approach would recognise both the ‘sovereignty’ and the competence of the micro-prudential regulators, with powers of direction being used in emergency situations or where the PRA and the FCA have not resolved material concerns that were the subject of previous FPC recommendations.

What structures should be created to provide the necessary transparency and accountability structures for the use of the tools;

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   21. The ongoing debate with respect to the governance arrangements for the enlarged Bank –

which we will not enter into in this response - is critical to ensuring the new tools are subject to proper transparency and accountability. In particular, though, we concur with the Committee that, to avoid the risk of ‘groupthink’ within the FPC, and to ensure there is an appropriate range of expertise available, there should be a majority of external members.

22. In our view, transparency and the clear communication of policy decisions are central elements of accountability. We therefore welcome the requirement that the FPC publish ex ante statements of the general policy it proposes to follow in relation to the exercise of its power of direction in so far as it relates to a particular tool (although, as discussed later, there may also be a case for the FPC to publish guidelines on the use of its power of recommendation) and records of FPC meetings and meetings between the Governor and the Chancellor.

23. We believe, however, that, in addition:

• there should be a rigorous public consultation process built into the development and use of FPC tools. Consultations should be required on, for example, on the design of the tools in secondary legislation (e.g. an HM Treasury consultation based on Bank of England proposals) and the FPC’s general policies in relation to the use of tools, and where possible on exit strategies from the use of particular tools, both when they are deemed to have served the purpose intended or when they might be considered obsolete owing to changes in the market or the development of more appropriate regulatory tools and frameworks.

• HM Treasury should be required (except in extremis) to lay a copy of all directions before Parliament (rather than laying a direction “if they think fit”) to enable proper Parliamentary scrutiny (particularly by the Committee).

• FPC recommendations in relation to the use of specific macro-prudential tools should be subject to the same scrutiny process as directions.

• The FPC should be required give Treasury – and Treasury should be required to lay before Parliament - an ex post assessment of the impact/effects of each direction given by the FPC (or recommendation in relation to the use of a specific macro-prudential tool). That said, given the timings differences between the implementation of macroprudential policy and the accrual of difficult to measure and intangible benefits, it is important that the FPC should be sufficiently insulated from pressures linked to the political cycle.

24. More specifically, AFME agrees with the points raised in the Committee’s report to the House of

Lords on the Bill in relation to the need for the development of indicators of financial stability which should be published and against which the FPC should report.

Whether the FPC should provide guidance on the use of the tools, and if so, what from that guidance should take.

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   25. AFME supports the requirement that the FPC prepare and maintain a written statement of the

general policy that it proposes to follow in relation to the exercise of its power of direction so far as it relates to a particular tool. There may also be a case for the FPC to prepare and publish guidelines on the circumstances under which it is likely to use its power of recommendation in relation to specific macroprudential tools.

26. To the extent necessary, guidance on the use of particular tools in specific circumstances could prove useful in enabling the regulatory authorities to identify and target particular types of categories of risk. The form of guidance would depend on the nature and extent of the systemic risks that needed to be addressed and on the complexity and inter-relationships of the products, firms and markets on a case by case basis. Such guidance could form part of the FPC’s policy statement and/or, given that the PRA and FCA may be given discretion as to how to comply with an FPC direction, be published separately by the PRA and FCA.

Whether the tools requested, taken as a whole, should be symmetrical, that is, the extent to which they should ameliorate downturns as well as upswings in credit cycles.

27. Supplementary buffers, capital requirements or other resources built up or retained during an upswing should be released sufficiently in advance of a downturn, to reduce impediments to the flow of credit to the economy and to ameliorate the downward pressures on the real economy and economic growth. If regulatory requirements were responsive to changes in economic factors, it would ensure that the right balance is struck between ensuring a stable financial system and enabling banks to support economic growth. Nevertheless, practical concerns remain as to the extent to which firms would actually be able to reduce buffers or other requirements during a downturn. By way of illustration, markets are by their very nature pro-cyclical, and even if the FPC and regulatory authorities relaxed macroprudential requirements in a down-turn, it is possible that markets may view firms that did reduce their buffers in a less positive light.

What further analysis should be provided by the Bank of England before the macroprudential tools are granted to the FPC, and what analysis should be periodically produced by the Bank of England once any tools have been introduced.

28. There are significant and often complex inter-linkages between several areas of the prudential framework, for example regulations on capital, leverage, liquidity and large exposures, and it will be important for the FPC/Bank to understand and to be able to model the interplay and effects of changes in these areas to avoid unintended consequences and market distortions.

29. Once the tools have been introduced, we believe the Bank should provide detailed on-going and ex post analyses of the actual effects of tools, both to update their internal models and to improve the FPC’s and Parliament’s understanding of any socio-economic impacts. It is also important that the FPC maintains an ongoing dialogue with the ESRB and other international and domestic bodies with a macroprudential remit to share data and emerging best practices.

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30. In particular, given the importance of international coordination, including the potential

economic impact of the unilateral use of tools in the UK only, we believe that that the FPC should be required to report on the extent of international reciprocity and the extent to which any other mechanisms to ensure global consistency have been effective.

June 2012

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Supplementary written evidence submitted by the British Bankers Association 1) In response to Mark Garnier MP, in administrative costs within an organisation,

what's the difference between organising a £25k loan, a £250k loan and a £5m loan?

There is a baseline administrative cost associated with any type and size of loan. These costs typically increase in relation to the size of the facility; the complexity of the proposals; the degree of due diligence required; the experience and seniority of the staff engaged in the process. In view of the Committee's interest in the SME credit decisioning process, the BBA would be happy to facilitate the opportunity for members to undertake an in-bank visit to gain a further understanding of the credit process for SME lending. This would involve a half-day at the offices of one of our members working with their credit teams and discussing their processes around lending decisions. As part of this the bank would guide you through the process of making a decision on extending credit to a business customer, including case studies of recent applications. It would also cover the relationship between front-line Relationship Managers and locally-based credit teams, the process for appealing initial decisions and what happens when lending applications are declined. 2) In response to John Mann MP, to provide an evidence base that indicates that

small businesses (not micros) are 'inherently riskier' than larger businesses. Experience demonstrates that the default rate of smaller SMEs in a downturn, for example, is substantially greater than well-established larger corporates. This is evidenced by independent research such as ‘Small Firms in the Credit Crisis: Evidence from the UK Survey of SME Finances’ undertaken by Dr Stuart Fraser of Warwick Business School in October 20091 (we would particularly draw attention to ‘Chapter 4: Default Risk’, provided to the Committee as a separate attachment). Research undertaken in 2012 by Ares & co of a ‘typical European Bank’ corroborates this picture (see Annex A). Consequently the regulatory risk weighted assets held against SME exposure, which tend to have fewer tangible assets, are usually higher than those to be held against a typical corporate loan. We also see that when an early stage SME is growing quickly, the business conducted, will at times, grow faster than the cash generated by that business. Banks are required to lend responsibly and to ensure customers can afford to repay any lending undertaken. When assessing a business for these affordability parameters required of the banks, the business’ projected cash flows form an important part of the assessment when calculating the required Debt Coverage Ratio which if not met can mean the business cannot access finance because of affordability concerns. The banking industry is currently working with government in examining whether there is an intervention that may help this 'affordability' gap. In addition, the SME Finance Monitor run by BDRC Continental, which includes a Dun & Bradsheet and Experian review process, reflects that overall, 39% of all UK SMEs - excluding those with no employees - are rated a worse than average risk. This rises to 51% of all UK SMEs if businesses that have no employees are included.

1 http://www2.warwick.ac.uk/fac/soc/wbs/research/csme/research/latest/small_firms_in_the_credit_crisis_v3-oct09.pdf

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We have previously proposed to government and FSA a range of options that could mitigate the regulatory effect for SMEs and these include the following:

Option 1 - Looking through to the customers of SMEs: Banks often have long-standing corporate clients who depend on SME suppliers. These SMEs need finance to complete orders for these larger corporate clients. Some corporate clients provide banks with documentation relating to their orders, for example invoices from the SME suppliers. As a result banks may classify such finance to suppliers as lower risk if the corporate customer of the SME is known to the bank and has a good record of invoice settlement. If the capital rules were amended such that the banks can look through to the corporate customer of the SME supplier and thus able to apply a lower risk rating there could be a positive impact on pricing and availability of SME finance. For these reasons the banking industry is very engaged with and supportive to the current government’s Supply Chain Finance activity and is working with many corporates and SMEs in this area. Option 2 - A regulatory capital relief: Undrawn SME facilities could carry an even lesser risk weight than they do now and the resultant capital benefit be used to reduce loan pricing to SMEs. Option 3 - A regulatory capital credit: It is important that macroprudential regulation works to promote continued lending to the SME sector. This could be achieved by segmenting the capital conservation capital buffer to make it sub-sector specific. This could potentially allow for a ‘buffer-credit’ to SME lending at the appropriate point in the cycle which would reduce capital requirements. This idea could be explored as part of finalising the approach to capital buffers that is on the Basel Committee’s current agenda.

3) Suggesting methods of deepening government engagement with the EU

At the TSC hearing on 16 October 2012, Anthony Browne, Chief Executive, British Bankers’ Association stated the following:

• UK needs to pay greater attention to EU legislation and regulation.

• Parliament could play a leading role in highlighting and understanding EU regulation and its impact on the UK economy.

As part of the BBA’s supplementary evidence to the Committee, this document sets out some procedural suggestions with regard to the role that Parliament could play and identifies some policy areas where the UK could have taken a more constructive approach.

Parliamentary scrutiny of EU legislation

We believe Parliament should play a much greater role in the development and scrutiny of EU policy and the Government’s approach to engaging with European institutions. The European Scrutiny Committee is a critical committee and does an impressive job, given the amount of legislation that it is responsible for reviewing. However, given the sector-specific expertise of their members, we believe the Select Committees should play a much greater role in scrutinising the EU legislation in its specific area. This could include the following:

• Specific hearings twice a year on the EU regulatory agenda. Witnesses could include Ministers, European Commissioners/officials, UKREP, MEPs and relevant stakeholders and the hearings should consider, amongst other things, its impact on the economy.

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• Hearings could also be held with individual businesses so the impact of EU regulation onto non-financial services companies can be fully understood.

• Give select committees the power to force a debate about such matters on the floor of the House.

• Increased opportunities for MPs to visit Brussels.

• Greater dialogue between MEPs and MPs. This could include the Treasury Committee holding sessions with the UK members of the ECON Committee on a quarterly basis.

Case studies:

ICB/Vickers

The Independent Commission on Banking, which finished its work last year, proposed banks should hold additional core tier 1 capital against their lending exposures. This will be legislated for in the UK next year.

At the same time however, CRD IV, which implements the Basel III requirements, is being finalised at the EU-level and should be in place in 1 January 20132,before the introduction of the legislation implementing the ICB's proposals. It will be important that the UK legislation implementing ICB is coherent with CRDIV.

It should also be noted that Draft Banking Reform Bill – that will introduce a form of structural separation of retail and wholesale banking inside major financial institutions - is undergoing its pre-legislative scrutiny by the Parliamentary Commission on Banking. This is occurring before the European Commission has introduced its legislation to take forward the findings of the High-level Expert Group on reforming the structure of the EU banking sector (the ‘Liikanen Group’). This could, of course, have a major impact on the operations of banks based in the UK that are also active in other parts of the EU. The BBA noted the following in its evidence to the Parliamentary Commission in its submission on the Draft Banking Reform Bill:

We believe the delegated powers provide the means by which the Government can respond to changing conditions and achieve an appropriate level of consistency with developing EU legislation such as the draft Recovery and Resolution Directive, CRD IV and possibly outputs from the Liikanen review. It is unclear however whether accountability to Parliament and the public for these arrangements are as strong as they need be. It is also important that draft secondary legislation is tabled while the primary legislation is being debated in Parliament - as currently envisaged - to ensure sufficient input into the legislative process from all interested parties. For example, if the threshold for the application of the ring-fence were lowered significantly, it would result in the measures applying to a wider number of firms, some of which may not be engaging fully with the process and possible implications for their business models.

Remuneration:

The FSA already has additional requirements in place on remuneration for code staff and is pressing ahead with additional reform of remuneration rules (such as director disclosures), The BBA supports the extra transparency this will bring. The EU is yet to come forward with proposals expected under the Corporate Governance Directive which may seek to cap the ratio of fixed to variable pay.

2 although a later mid 2013 implementation date looks increasingly likely

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Special Resolution Regime

Through the Financial Services Bill, the UK Government is legislating to extend the Special Resolution Regime (SRR) to investment banks, parent holding companies and certain financial market infrastructures such as clearing houses. While the industry is supportive of measures ensuring there are appropriate arrangements to ensure orderly resolution for all potentially systemic firms or infrastructure, we question why the UK has decided to front-run measures currently under negotiation in Europe and internationally which will address these issues. Our presumption is that the UK should participate fully in the development of international standards and then implement in the UK in an internationally harmonised fashion.

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Annex A: SME lending risk and return

Extract from a report produced by Ares & Co To test the point about SMEs perceived riskiness we used our risk specialists to calculate probability of default (PD) for SMEs versus the other main lending sectors in a typical European bank. The chart below shows the PD of SME loans relative to lending to large corporates and retail customers in two periods.

Figure C1 – Changes in probability of default by sector

1.0%

1.5%

2.5%

2.0%

Average probability of default

0.5%

0.0%

2.15%

1.10%1.27%

Today

1.40%

1.68%

Pre-crisis (illustrative)

1.50%

SME segment Corp segmentRetail segment Source: Ares & Co analysis

It is clear from the data that SMEs are more risky than the other two sectors and that PDs for SMEs worsen more than those for retail customers and large corporates in recessionary times. This extra riskiness is translated into an extra allocation of capital to SMEs. This results in return on capital for SMEs that is lower than for large corporates and retail customers.

Figure C2 – Business line profitability differences

0%

5%

10%

Retailsegment

SMEsegment

Corporatesegment

6.8%

Return on Equity

2.7%

4.0%

Source: Ares & Co analysis

These charts demonstrate why, in a credit constrained environment, SMEs may have more difficulty than other sectors in obtaining finance.

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