the new uk new financial regulatory framework

The new UK new financial regulatory framework

Somnath Chatterjee CCBS, Bank of England

CEMLA, November 2013

Disclaimer

The views expressed here are those of the presenter and not necessarily those of the Bank of England or any Committees of the Bank.


Regulatory landscape – pre-crisis


Bank of England

Monetary policy (MPC)Financial stabilityMarket operations

Microprudential regulation and supervisionConduct supervisionMarkets oversight

• MoU (2006) between HM Treasury, Bank of England and FSA establishes a framework for co-operation between the authorities in the field of financial stability.

• Tripartite Standing Committee on FS is the principal forum− Does not over-ride each authority’s powers/duties− Meets monthly at Deputies (official) level (in crisis time, at Principals level)− No minutes published

Then came… the run on the Rock


Northern Rock Bank, UK, mid-September 2007

Northern Rock (1)

• Retail depositors started queuing outside the branch offices only after the Bank of England announced its emergency liquidity assistance (ELA) for Northern Rock on Friday, September 14.

• But the demise of Northern Rock dates from August 9th, when the short-term funding market and interbank lending all but froze.

• The triggering event on the day was the news that BNP Paribus was closing three off-balance sheet investment vehicles with exposures to US subprime mortgage assets.

• In the days leading up to the August 9th watershed, other investment vehicles that tapped short-term financing had begun experiencing difficulties in rolling over their short-term borrowing.


Northern Rock (2)

• From a small regional building society to a sizeable player in the UK mortgage market– Total assets by 23% p.a. over 1999-2007– Market share in the UK mortgage market x3

• 19% of new lending in 2007H1• Competing aggressively on price: in NIM

• Seen as having a ‘sound’ banking book– Little unsecured consumer lending– Running down its commercial property book

• Operating cost efficiency – A relatively small branch network (internet banking)


Northern Rock (3)

• Seen as well capitalised...

• ...but heavily dependent on wholesale funding, in particular securitisation– WF = 68% of total liabilities – NR liquidity identified as a possible weakness by rating agencies but debt

rating upgraded in April 2007

• ...then came the summer 2007’s system-wide disruptions in credit markets and RMBS issuance– Planned sale of securitised notes in Sept 2007 could not proceed & difficulty

in rolling over S&MT funding


Northern Rock – balance sheet growth & liability structure (June 98-June 07)


Source: Northern Rock interim and annual reports, published in October 2007 BoE FSR

Northern Rock (4)

• Over-reliance on one funding source – securitisation– No proper liquidity contingency plan to deal with failure of that

source of funding Lack of liquidity rather than solvency problem (originally…)

• ELA announcement prompted retail run – Stopped by government guarantee on retail and wholesale deposits

• The depositor run was an event in the aftermath of the liquidity crisis at Northern Rock, rather than an event that triggered its liquidity crisis.


Faultlines in the tripartite system

• In times of crisis (Northern Rock) – Who is in charge during a crisis?– What can be done to alleviate stress at a FI/in the whole market?

• Inadequate framework for provision of liquidity, deposit insurance and no resolution powers adapted to the failure of FIs

• What could be done pre-emptively, ie, when systemic risk is building up in the system?– ‘Underlap’ for macroprudential risk analysis and mitigation

“The two institutions were so keen to concentrate on their own specific responsibility [...] that, as Paul Tucker has expressed it – we left an underlap between us.” A. Turner (2009), FSA Chairman

– Lack of (statutory) powers on FS for the Bank


Regulatory landscape – since 2009


Monetary policy (MPC)Financial stability Statutory since 2009Market operations ‘Red Book’ updateSpecial Resolution Regime for failing deposit-takers since 2009

Microprudential regulation and supervisionConduct supervisionMarkets oversight

The pre-crisis regime lacked the necessary tools to support the orderlyfailure of a bank. There was no bank resolution regime and the deposit protection regime was not sufficient to ensure depositor confidence. Both these two failings were addressed in this legislation.

Banking Act of 2009

Reform of the regulatory framework

FPC Financial Policy Committee

PRAPrudential Regulation

Authority

FCAFinancial Conduct

Authority

subsidiary of the Bankpowers of direction & recommendation to PRA & FCA in relation to FS

cooperation &

coordination

Dual-regulated firms(deposit takers, insurers & significant investment firms) All other regulated firms

microprudential regulation & supervision

microprudential & conduct regulation

conduct regulation

MPC

From 2013

The FPC and systemic risk

• There is now an international consensus on the need to re-orient regulatory frameworks to place stronger emphasis on mitigating risks in the financial system as a whole.

• One of the regulatory failures leading up to the current crisis was the lack of a clear mandate and powers for any UK authority to tackle systemic risk

• Systemic risk may be defined as the risk across the system as a whole beyond those that arise when considering individual institutions in isolation.


The role of the Financial Policy Committee (FPC)

• The FPC’s statutory responsibility will be the:– ‘identification of, monitoring of and taking of action to remove or

reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system’

• The FPC’s task will not be to achieve resilience at any cost, however. Its actions must not, have – ‘a significant adverse affect on the capacity of the financial sector to

contribute to the growth of the economy in the medium or long-term.’

• Subject to achieving its primary objective, the FPC must also support– ‘the economic policy of the Government, including its objectives for

growth and employment.’


• Committee of 11 members – Some commonality of membership with MPC

• Accountability− Meet quarterly− Communication

• FSR (assessment of risks and actions taken)• Publication of a record of meetings

− Governor to brief the Chancellor every 6m on emerging risks to FS− Oversight by Treasury Select Committee (Parliament)

• Presumption of consensual decision-making

FPC accountability


Financial stability policy is not like monetary policy

• Monetary policy follows an instrument-target framework.

• There is an instrument –interest rates – that is manipulated by the policymaker to hit a single numerical target – specified as an inflation target or a social welfare function which penalises both inflation and inflation variability.

• In financial stability policy there are many instruments, even within the class of macroprudential policy tools.

• Many of the variables that have been promoted as decision variables – for example particular asset price levels or particular relationships between credit and GDP – do not have a clear relationship to social welfare.


Recommendations of the Financial Policy Committee (FPC)


Interim FPC meeting held in June 2011

• The FPC advises the FSA to ensure that improved disclosure of sovereign and banking sector exposures by major UK banks becomes a permanent part of their reporting framework.

• The FPC advises the FSA to extend its review of forbearance and associated provisioning practices across UK banks’ household and corporate sector exposures on a global basis.


Sources: EBA, published accounts and Bank Calculations

(a) All data as at end-September 2011 except HSBC which is at end-December 2010. Gross of provisions

0

20

40

60

80

100

120

HSBC Barc LBG RBS HSBC Barc LBG RBS

Spain Greece Ireland Italy Portugal

Retail Corporate

Per cent of core Tier 1 capital

Major UK banks’ exposures to corporate and retail sectors of vulnerable euro-area economies


Sources: Bank of England, published accounts and Bank calculations.(a) Barclays, HSBC, LBG and RBS.(b) Includes on balance sheet exposures as disclosed by banks according to counterparties’ country of domicile or incorporation. Where possible exposures are gross of impairment provisions but net of collateral and netting arrangements. The classification by counterparty sector is on a best-efforts basis.

Evolution of UK banks' gross exposures to vulnerable euro-area countries


0

20

40

60

80

100

120

140

160

2010 11 12 2010 11 12 2010 11 12

Sovereign Bank Private sector

Retail

Corporate

Net of provisions against non-bank private sector exposures

-16%

-34%

-49%

£ billions

Evidence of borrower distress

Forbearance

Classified as performing

No specific provisions made

RISKS: -Inadequate provisions made- particularly vulnerable to a rise in rates or slow recovery - lack of disclosure hides true extent of distress and creates uncertainty-new lending curtailed.

Classified as impaired

Specific provisions made

RISKS: - Vulnerable to a rise in rates or slow recovery- new lending curtailed

Foreclosure/ Insolvency

RISKS: - If widespread, potential firesalesand destabilisation of asset values- potentially large losses

Specific provisions and write-offs made

Risks from forbearance


Interim FPC meeting held in Sep 2011

• The FPC recommended that banks should take any opportunity they had to strengthen their capital and liquidity so as to increase their capacity to absorb flexibly any future shocks, without constraining lending to the wider economy.

• The FPC advised the FSA to encourage banks, via its supervisory dialogue, to manage their balance sheets in such a way that would not exacerbate market or economic fragility.


Sterling lending to UK non-financial corporations and households


Source: Bank of England

100

105

110

115

120

125

130

135

140

Loan-to-deposit ratioPer cent

2012 H12006 07 08 09 10 11

Sources: Bank of England, Published accounts and Bank calculations.(a) Major UK banks' customer lending as a percentage of customer deposits, where customer refers to non-banks.(b) As Co-operative Banking Services and Nationwide have not reported their 2012 H1 results, their end-2011 results have been used.

Major UK banks’ loan to deposit ratio(a)(b)


Sources: Dealogic, Markit Group Limited, JP Morgan Chase & Co, Bank of England and Bank calculations.(a) The net interest margin is calculated as interest spread earnings (relative to a matched-maturity risk free rate) on the stock of household and corporate lending minus interest spread payments on the funding side. That method attempts to abstract from any margins earned from taking interest rate risk. (b) About 25% is of lending is assumed to be funded through wholesale borrowing where a spread is calculated by comparing an issuance-weighted average spread of historical secured and unguaranteed unsecured wholesale funding costs. Those costs are proxied using RMBS spreads and CDS premia for the major UK banks.(c) About 70% of lending is assumed to be funded through household and corporate deposits, where a spread is calculated by comparing the effective interest rate on the deposit stock relative to Bank Rate.

Breakdown of estimated net interest margins earned on UK household and corporate lending(a)


0

20

40

60

80

100

2005 2008 2011 H1

Loans to households Loans to PNFCs Government debt securities(b)

Other debt and equity Derivatives Loans to banks and OFCs

Cash items Other assets

Real

Intra-financial

Other

Per cent

Sources: Published accounts, Bank of England and Bank calculations.(a) Chart takes September data as end year for National Australia Bank.(b) Includes loans to governments. Where government debt securities are not disclosed all debt securities are allocated to

'Other debt and equity'.

Major UK banks’ asset composition(a)


Sources: Bank of England, published accounts and Bank calculations.(a) See footnotes 7-10 in table Core indicator set for sectoral capital requirements.(b) The intra-financial lending and borrowing growth series are not adjusted for mergers/acquisitions.(c) Barclays, HSBC and RBS.(d) Gross notional value of derivative contracts.

Growth of major UK banks' balance sheet interconnectedness(a)


20

10

0

10

20

30

40

50

60

70

80

2002 03 04 05 06 07 08 09 10 11 12

Intra-financial lending (b)Intra-financial borrowing (b)Derivatives (c)(d)

Percentage changes on a year earlier

+

-

Interim FPC meeting held in Nov 2011

• The FPC recommends that, if earnings are insufficient to build capital further, banks should limit distributions and give serious consideration to raising external capital in the coming months.

• The FPC reiterates its advice to the FSA to encourage banks to improve the resilience of their balance sheets without exacerbating market fragility or reduced lending to the real economy.

• The FPC recommends that the FSA encourages banks to disclose their leverage ratios, as defined in the Basel III agreement, as part of their regular reporting not later than the beginning of 2013.


0

2

4

6

8

10

12

2

1

0

1

2

3

2001 02 03 04 05 06 07 08 09 2010 11 H112

Risk-weighted assets (right-hand scale)

Capital (right-hand scale)

Total change (right-hand scale)

Level of core tier 1 capital ratio (left-hand scale)

Per cent Percentage points

-

+

Sources: Bank of England, published accounts and Bank calculations.(a) As Co-operative Banking Group, Nationwide and Virgin Money have not yet reported H1 2012 results, no change is assumed from their end-2011 results.

Contributions to the change in major UK banks’ core Tier 1 capital ratios(a)


Contributions to the change in banks’ Tier 1 capital ratios


Source: SNL Financial and Bank calculations.(a) Change between end-2011 and end-2012. (b) Chart shows a decomposition of changes in the weighted average Tier 1 capital ratio of selected banks and large complex financial institutions. Tier one capital and risk weighted assets data are reported on a Basel 1 basis for US banks. For European banks, these data are reported on a Basel 2 basis up to and including 2010 and on a Basel 2.5 basis thereafter. (c) UK banks and building societies included are Barclays, HSBC, LBG, Nationwide and RBS.

0.0

0.5

1.0

1.5

2.0

2.5

2007 08 09 10 11 12

Major UK banks(b) US G-SIBs(c) Other European G-SIBs(d)

Ratio

Sources: Thomson Reuters Datastream and Bank calculations.(a) Chart shows the ratio of share price to book value per share. Simple averages of the ratios in each peer group are used. The chart plots the three-month rolling average.(b) Excludes Co-operative Banking Group, Northern Rock (from end-2007), Nationwide and Britannia.(c) Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JP Morgan, Morgan Stanley, State Street and Wells Fargo.(d) BBVA, BNP Paribas, Credit Suisse Group, Deutsche Bank, Nordea Bank, Societe Generale, UBS and Unicredit. For Group Credit Agricole and GroupeBPCE the traded entities Credit Agricole SA and Natixis are used respectively.

Major UK banks' and G-SIBs' price to book ratios(a)


0

2

4

6

8

10

12

14

16

0 0.5 1 1.5 2 2.5 3

France

Germany

Italy

Spain

Switzerland

United Kingdom

Price to book ratio

€ billions

Sources: Dealogic, Thomson Reuters Datastream and Bank calculations.(a) Data show the deal value of selected equity issuances by European banks, and the price to book value at the time of announcement.(b) Data exclude equity issuance with a deal value below £500 million, and those involving government intervention on a best-efforts basis.

European banks’ equity issuance since 2008(a)(b)


0

10

20

30

40

50

60

70

8020

07 08 09 10 11

H1

12

2007 08 09 10 11

H1

12

Maximum-minimum range Weighted average

Major UK banks (c) European G-SIBs(d)

Ratio

Sources: Bank of England, Capital IQ, published accounts, SNL Financial and Bank calculations.(a) Leverage ratio is defined as total assets divided by total equity.(b) 2007 to 2011 show year end positions. Due to different reporting years, March data are used for Nationwide and October data for National Australia Bank. Where 2012 H1 data not available yet, end-2011 data have been used.(c) Banco Santander, Bank of Ireland, Barclays, Co-operative Banking Group, HSBC, LBG, National Australia Bank, Nationwide and RBS.(d) Deutsche Bank, BNP Paribas, UBS, BBVA, Groupe BPCE, Group Crédit Agricole, ING Bank, Nordea, Société Générale and Unicredit Group. Credit Suisse is not included as it does not report on the same accounting basis.

Banks’ leverage ratios(a)(b)


Sources: Bank of England, SNL Financial, Thomson Reuters Datastream, and Bank calculations.(a) Calculated as market capitalisation divided by total book assets. Total assets data are as at end-2012.(b) Sample comprises the top 40 listed European banks in SNL by total assets, excluding Allied Irish, ING Group and Credit Suisse Group.(c) BBVA, BNP Paribas, Deutsche Bank, Nordea Bank, Société Générale, UBS and UniCredit. For Groupe Crédit Agricole and Groupe BPCE the traded entities Crédit Agricole SA and Natixis are used respectively.(d) Banco Santander, Barclays, HSBC, LBG, RBS and Standard Chartered.

European banks' market-based capital ratios(a)(b)


0

2

4

6

8

10

12

14Other globally-systemic European banks (c)

UK banks (d)

Other European banks

Per cent

Issuance of term bank senior secured and unsecured debt in public markets(a)(b)


0

50

100

150

200

250

300

350

400

H1 H2 H1 H2 H1 H2 H1 H1 H2 H1 H2 H1 H2 H1 H1 H2 H1 H2 H1 H2 H1

Unsecured(b) Secured(c) US$ billions

United KingdomUnited States Euro area

2010 11 12 13 2010 11 12 13 2010 11 12 13

Sources: Dealogic and Bank calculations.(a) Securities with an original contractual maturity or earliest call date of at least 18 months. Includes primary market issuance only and excludes issuance under government-guarantee schemes. Issuance is allocated to each region according to the bank’s nationality of operations listed on Dealogic. 2013 H1 data are up to and including 17 June 2013.(b) Unsecured issuance includes investment-grade and high-yield bonds and medium-term notes.(c) Secured issuance includes asset-backed securities, mortgage-backed securities and covered bonds.

Indicative measures of wholesale funding spreads for UK banks


Sources: Bloomberg, Markit Group Limited and Bank calculations.(a) Constant-maturity unweighted average of secondary market spreads to mid-swaps for the six largest UK banks' five-year euro senior unsecured bonds, where available. Where a five-year bond is unavailable, a proxy has been constructed based on the nearest maturity of bond available for a given institution and the historical relationship of that bond with the corresponding five-year bond.(b) The data show an unweighted average of the spread between euro-denominated covered bonds and equivalent-maturity swap rates for a selected bond issued by each of the six largest UK banks. The selected bonds have residual maturities of between three and seven years.(c) Unweighted average of the five-year senior CDS premia for the six largest UK banks which provides an indicator of the spread on euro-denominated long-term wholesale bonds.

0

50

100

150

200

250

300

350

400

Jan. Apr. Jul. Oct. Jan. Apr. Jul. Oct. Jan. Apr.

Senior unsecured (a) Covered bonds (b)

Credit default swaps (c)

2011 12 13

Basis points

Secured funding

Unsecured funding

Capital

Over-collateralisation

Remaining assets

Total assets

Encumbered assets

Encumbrance =Encumbered assets

Total assets

Source: Bank of England.

Secured creditors have prior claim on encumbered assets in the event of insolvency


Interim FPC meeting held in June 2012

• The FPC recommends that,...banks should continue to restrain cash dividends and compensation in order to maximise the ability to build equity through retained earnings.

• The FPC reiterates its recommendation to the FSA to encourage banks to improve the resilience of their balance sheets, including through prudent valuations, without exacerbating market fragility or reducing lending to the real economy.

• The FPC recommends that the FSA makes clearer to banks that they are free to use their liquid asset buffers in the event of a liquidity stress.


Liquidity regulation in the UK

• The FPC has agreed that the PRA should employ the Liquidity Coverage Ratio (LCR) as defined in the EU’s implementation of the Basel standard.

• It is designed to ensure that banks hold a buffer of liquid assets to survive a short-term liquidity stress.

• The minimum requirement should be set at an LCR of 80% until January 2015, rising thereafter to reach an LCR of 100% on January 2018.

• The Net Stable Funding Ratio, is designed to promote stable funding structures and is currently under review by BCBS.


Mitigating liquidity risk

• Banks can mitigate these liquidity risks in two ways.

• First, they can seek to attract stable sources of funding that are less likely to ‘run’ in the event of stressed market conditions.

• Second, banks can hold a buffer of highly liquid assets or cash that can be drawn down when their liabilities fall due.– this buffer is important if a bank is unable to roll over its existing

sources of funding or– if other assets are not easy to liquidate.


What is the LCR?

• LCR defined as:

LCR intended to ensure banks:1. Hold a sizeable buffer of liquid assets ;2. Have strong incentives to prudently structure their liabilities to

manage liquidity risk3. Can survive a significant liquidity stress without reliance on other

financial institutions or central banks.


Key Design Questions for LCR?

1. Defining liquid assets

2. Defining outflows and inflows in a 30 day liquidity stress

3. Quantifying economic impact of introducing LCR


Defining Liquid Assets

High Quality Liquid Assets (HQLA) should be immediately convertible into cash at little or no loss of value through sale or repo markets. LCR text sets out a range of desirable characteristics for HQLA:• Low credit risk and low correlation with risky assets• Ease and certainty of valuation:• Listed on a developed and recognised exchange• Active and sizable market• Low volatility• Flight to quality• Central bank eligibility


Defining Stressed Outflows and Inflows

How should the size of the liquidity shock be set?

LCR combines an idiosyncratic and market stress, drawing on features of 2008 crisis, but stopping short of a full blown run. It includes:a) the run-off of a proportion of retail deposits; b) a partial loss of unsecured wholesale funding capacity; c) a partial loss of secured, short-term financing; d) additional contractual outflows due to a 3 notch downgradee) increases in market volatilities that impact collateral haircuts and

derivative positions f) unscheduled draws on committed facilities


Quantifying economic impact of the LCR

How to balance enhancing resilience to liquidity risk with supporting credit creation? Important for setting appropriate level of outflow calibration, and HQLA buffer.

• Estimates of economic impact difficult to perform in the absence of historical examples.

• Basel Committee opted for a conservative approach – allowing LCR to be phased in – starting from minimum of 60% in 2015 to 100% in 2019.


References (1)• Memorandum of Understanding between HM Treasury, the Bank

of England and the Financial Services Authority (2006)http://externalboeweb/financialstability/mou.pdf

• Turner review (2009): a regulatory response to the global crisis, FSA, March 2009 http://www.fsa.gov.uk/pubs/other/turner_review.pdf

• FSA (2011), ‘The failure of the Royal Bank of Scotland’, FSA Board Report, Dec 2011http://www.fsa.gov.uk/static/pubs/other/rbs.pdf

• Banking Act of 2009 http://www.opsi.gov.uk/acts/acts2009/pdf/ukpga_20090001_en.pdf

• Governor’s speech at Mansion House dinner, 16 June 2010 http://www.bankofengland.co.uk/publications/speeches/2010/speech437.pdf

• HM’s Treasury (2011 and 2012), “A new approach to financial regulation”, Consultation Documents http://www.hm-treasury.gov.uk/d/consult_newfinancial_regulation170211.pdfhttp://www.hm-treasury.gov.uk/d/fin_fs_bill_policy_document_jan2012.pdf


References (2)• Bank of England (2011), ‘Our approach to banking supervision’,

May 2011http://www.bankofengland.co.uk/publications/other/financialstability/uk_reg_framework/pra_approach.pdf

• Bank of England (2009), ‘The role of macroprudential policy’, BoE DP http://www.bankofengland.co.uk/publications/Documents/other/financialstability/roleofmacroprudentialpolicy091121.pdf

• Bank of England (2011), ‘Instruments of macroprudential policy’, BoE DPhttp://www.bankofengland.co.uk/publications/other/financialstability/discussionpaper111220.pdf

• Hyun Song Shin (2008), ‘Reflections on Modern Bank Runs: A Case Study of Northern Rock’, Princeton University
