UK: Regulation and the Financial Sector - Right Direction But How Far and How Fast?

Last Updated: 10 June 2010
Article by Deloitte Financial Services Group

Most Read Contributor in UK, August 2017


The regulatory response to the financial crisis is of great interest not only to policymakers and those in the financial sector, but also to the wider public.

This paper, which is based on interviews with senior industry figures prior to the general election campaign, sets out some market reactions to the proposals made on capital and liquidity regulation, and on how best to deal with firms that are currently deemed 'too-big-to-fail'. As such, this paper provides input from the financial services industry into the debate underway in the UK and internationally on the new regulatory proposals. It focuses mainly on selected views of the larger banks operating in the UK.

Some of these issues were addressed in the Turner Review Conference Discussion Paper in October 2009, which focused on how far the policy response should take the form of capital surcharges, the separation of narrow banks from investment banking (or other structural changes), or recovery and resolution plans (sometimes dubbed 'living wills').

But this is only one in a torrent of proposals: one interviewee identified at least 60 papers of which his firm needed to take note, while another concluded that the 'greatest strategic issue facing bank boards around the world is regulatory change'. This report therefore considers a range of proposals on prudential regulation, and in that sense follows the Discussion Paper, which considered how the cumulative impact of these proposals should be assessed. This is of increasing relevance given the study of some of these issues recently commissioned by the new UK government.

In each section we begin by setting out the current proposals, followed by the views of those interviewed for the report.


The overwhelming consensus from those we spoke to in the financial services industry was that it was essential to view the regulatory changes as a whole, and be clear about the impact of a tightening in standards not just on regulated firms but on the availability of credit in the economy.

The emphasis on capital and liquidity was understandable, but there were issues over the amount, timing and purpose of the additional buffers. Without clarity on these points, planning became much more difficult and the availability of credit could be inappropriately constrained.

The other key messages from practitioners were as follows:

  • In the 'too-big-to-fail' debate some feared there was still too much focus on size per se. Some narrow banks failed; diversification of risk remained vital. To them the discussion about proprietary trading largely missed the point: the real problem with the trading book was specifically what was traded and how.
  • Timing was also important in the debate on the quality of capital and liquidity: new forms of core Tier 1 capital will take time to develop and issue, and there was a limited pool of high-quality liquid assets.
  • It was too soon to judge the impact of a leverage ratio in addition to everything else, until more of the details had been published.
  • There were important uncertainties and reservations about the recovery and resolution ('living wills') proposals, which (some feared) might be used by regulators to restructure the industry by stealth. As was the case for other proposals, UK institutions fear that other countries will not necessarily implement the living wills requirements as fully or quickly as the UK.

'Too-Big-to-Fail', 'Too-Big-to-Rescue' or 'Too-Interconnected-to-Fail'

These phrases encapsulate the issues which the FSA and the Financial Stability Board (FSB) are considering. Lord Turner instead used the term 'systemically important banks' in the Conference Paper, and to a lesser extent when giving evidence to the Treasury Committee.1

The range of possible solutions under consideration by the Standing Committee for Supervisory and Regulatory Co-operation (a sub-committee of the FSB which Lord Turner chairs) is wide, and includes restrictions on the breadth of activities which banks can carry out, even though his public pronouncements do not appear fully in line with the views of some of the narrow banking proponents.

Interviewees were still not clear which firms were considered 'too-important-to-fail', a matter on which regulators and central banks may, or may not, wish to remain ambiguous. The initial report of the FSB2 defined a systemic event (not an institution) as caused by an impairment of all or parts of the financial system with the potential to have serious negative consequences for the real economy. It set out three possible systemic criteria: size, substitutability (the extent to which others can provide similar services) and interconnectedness (linkages with other components of the system), but stressed the need for in-depth knowledge and analysis of financial structures and the exercise of judgement, given the lack of data and definition around 'systemic importance'.

Most participants noted it was not just the large banks, nor generally the universal banks, which had failed, but those with inadequate risk controls that had geared up their balance-sheets, often via the wholesale markets and securitisation. In the UK, HBOS, Northern Rock, Bradford & Bingley and the Icelandic banks were retail and commercial banks: the mutual sector also came under pressure. In Germany IKB, a real estate bank, had problems. In the US, Lehman Brothers and Bear Stearns, both investment banks, got into difficulty as well as Washington Mutual, a large mutual organisation; AIG (an insurance group) received extensive government support to meet non-insurance losses.

One interviewee described recent events as a 'unique collapse, in which no one was left out in the cold', and certainly many large firms, some of which would be considered systemic on any definition, received government support. Most banks, however, 'managed their way out of the crisis', albeit helped by central bank funding arrangements.

Lord Turner on separating 'socially useful' banking from 'casino' banking

'Too-big-to-fail' is therefore too simplistic a description both for the regulators and the industry. It requires a deeper analysis of the risks posed (and the impact on society) from the failure of large, complex and interconnected organisations.

In parallel, the wider issue of externalities in the financial system is now more often discussed by policymakers: how far do the activities of firms spill over onto others, and is this fully taken into account by the present regulatory arrangements? For instance, Lord Turner has raised broader questions about the structure of the financial markets, such as – in the context of exotic credit default swaps – 'Can it be proved that this is a market that has an end purpose?'3 and 'Are all categories of credit equally useful ... we certainly do not want regulators or central banks to say that this credit is good and that credit is bad' but problems with commercial real estate might require 'new tools of macro-prudential control ... which might constrain credit in certain parts of the economy even more than in others'.

Breadth of activities as well as size is important, in his view. 'There are arguments for limiting the extent to which deposit-taking banks undertake proprietary trading, which is unrelated to customer service' (a reference to the 'Volcker rule' that would separate commercial banking in the US from in–house hedge funds, private equity and proprietary trading 'unrelated to customer service').4

However, this might be achieved not through a ban but through capital requirements. In his evidence to the Treasury Committee Lord Turner explained how he had described the FSA's method to Mr Volcker of 'tracking very carefully the day-to-day trading activities of our major banks and investment banks and observe whether they are volatile or small amounts of profit with only a small tail of higher profit and loss'. Higher capital requirements would then be imposed for proprietary trading. Similarly, Paul Volcker said to the Senate: 'Banking supervisors should be able to appraise the nature of those trading activities and contain excesses. An analysis of volume relative to customer relationships and of the relative volatility of gains and losses over a period of time in the 'trading book' should raise an examiner's eyebrows. Persisting over time, the result should be not just raised eyebrows but substantially raised capital requirements'.5

"Proprietary trading is much less important than people think"

In response, some participants said it was difficult, if not impossible, to 'unpick customer driven trading from trading on one's own account', adding that the latter probably accounted for only 5-10% of the trading book. One participant argued that in some of the banks that had failed the trading operations were quite small but overly focused on the retail and real estate markets with insufficient prudence in lending or diversification of risks. In fact, he argued, the 'trading book is better situated in more diversified banks with large balance sheets', better placed to meet any losses. Another, whose bank engaged in little proprietary trading, argued that 'the principal risk' lay in 'taking a view in order to facilitate clients', which meant that the bank had to take positions. Regulators needed to make appropriate distinctions between 'proprietary risk and principal risk' (resulting from client business) though this would not be simple to achieve.

One interviewee felt that the Volcker proposals would not be carried out, but that if they were the US bank holding companies would simply move offshore to avoid them, unless the rules were adopted internationally. The lesson of the loss of the Eurodollar market had not been forgotten. He too agreed that the way to deal with risks in the trading book was through increased capital.

"A bystander at a bar fight: I never liked him anyway, so I took the chance to hit him"

To one participant, this described the attitudes of some policymakers, particularly outside the UK. The chaotic environment of the financial crisis provided some with an opportunity to settle old scores, for instance by imposing restrictions on all kinds of activities, such as proprietary trading, hedge funds, private equity and investment banking. Their relevance to the crisis was often not proven and indeed, in some cases, regulators had said as much or had backtracked, although steps to regulate hedge funds more tightly and bans on short selling continued in some jurisdictions. So far as the debate on proprietary trading was concerned, it was argued that in the UK losses by banks mainly reflected positions in structured credit, rather than stemming from trading more widely.

Back to plain vanilla

To one banking executive, this approach 'tars all the trading book with one brush'. While 'structured products were not as well understood as they might be' the markets for foreign exchange derivatives, government and corporate bonds, and other plain vanilla derivatives generally functioned well in the crisis, and in general the models did what they were supposed to. Where there was greater complexity and less liquidity, the models were less adequate. Higher capital charges might delay the return of complex structured products, but it was unlikely that the buy side would come back quickly anyway given recent loss experience.

Others were quite clear about the future of some exotic products: simply stop the 'squaring' or 'cubing' of a derivative of a derivative.

"They were playing in an adult market and they were adolescents"

According to this executive, the structured products were not inherently wrong but much was wrong with the process of manufacturing and selling them. Buyers did not understand the difference between the credit and equity markets: the former, in his view, were extraordinarily unregulated and he questioned the way in which regulators decided which products counted as credit rather than equity. The manufacturer should have a responsibility to ensure that the product is described in a way that its risks could be understood by the buyer. As such the critical regulatory input should be full transparency over the constituent parts and risks of the product. 'The lack of transparency,' another commented, 'meant that people did not know where the rubbish was'. It was not necessary that all of these products should be sold through a central exchange, but they should be fully and centrally reported. Banks themselves, another commented, 'became lazy, relied on credit ratings and thus outsourced their core competence'.

One participant insisted that where securitisation was used as a way of ensuring the efficient utilisation of scarce financial resources, it was socially or economically useful: not merely regulatory arbitrage. But this was not the case where transactions were structured solely to reduce capital requirements, for example via the transfer of assets from the banking book to the trading book or to structured investment vehicles (SIVs). While the latter were theoretically separate from banks, when the market collapsed most banks chose either to provide liquidity or to take the assets back to avoid reputational risk.

There was a general consensus that more capital should and would be required for the trading book. Some just accepted this as inevitable. One bank argued that the new capital for the trading book should be restricted to new trades and brought in over a period of time.

All supported the need for greater transparency and other steps to reduce systemic risk, such as central clearing counterparties, which must themselves be circumscribed by appropriate legal and regulatory constraints so that they did not add to the threat of systemic risk. OTC trading let banks adapt contracts to a particular need and should still be allowed, so long as buyers understood fully the risks they were taking on. The structured products industry was itself seeking to develop best practice principles with particular reference to the information which should be made available to investors. The originator would also be required to retain some 'skin in the game', that is, to retain a slice of the risk.

"The focus is on the impact of failure and no one is thinking about the diversification of risk"

Participants understood the need to prevent such a crisis in future, and avoid burdening taxpayers with so many costs. However, many questions remained concerning the focus on 'systemically important' firms.

One executive commented that 'too-big-to-fail' 'appears to be about size when it should be about complexity and the degree of interconnectedness within the group', and the capacity of the firm to manage the resulting risks. Within his own bank the relevant functions were centralised, including reporting systems, credit and risk management. Although not a complex business, it is large, geographically diverse and well-managed. It did not suffer during the financial crisis. The FSA's requirements on governance, risk management and senior management responsibility should mean that it already had a full description of the organisation and responsibilities of all senior management throughout the bank, no matter how global its spread, to allow the regulator to appreciate the effectiveness of the firm's management structure. It should also be clear about the business responsibilities within a bank, its constantly up-dated organogram and the relationship between legal entities.

Regulators acknowledge that there is more to the issue than size, exemplified by their use of phrases other than 'too-big-to-fail'.

But complexity is not a one-way street. Most felt that diversification reduced the possibility of failure, whether or not it involved so-called 'casino' banking, and was often a corollary of globalisation. Just because some 'narrow' banks might face fewer or different risks from large complex banks, not all would; reference was made to experience in the UK, USA and some Continental European countries, where the regulators had encouraged mergers of co-operative retail banks to prevent failures even outside the current crisis. In addition, for many such banks, 'all the profit is in the deposits' for which there was now intense competition in the UK market.

However, the issue of splitting up banks remained on the table and 'set too many hares running', making the end-game unclear. How might a split be done – by type of customer or type of business? Where would the buyers be found, especially in markets where capital and other regulatory requirements constituted barriers to entry? 'Too-big-to-fail' 'continues to dominate the regulatory agenda with a view to creating a system where banks may be allowed to fail without a cost to the taxpayer' but with protection for retail depositors, according to one participant. But systemic issues can also be raised by smaller banks, individually or together, stressing the importance of 'not running with simplistic answers'.

Given industry opposition and the arguments in favour of size and diversification, a fundamental restructuring of this type seemed to our interviewees to be the least likely option to be pursued to prevent a financial crisis in the future, especially since it might trigger banks to relocate to countries that did not follow suit.

Regulators were also considering the possibility of capital surcharges for systemically important banks (however these might be defined) in an attempt to lessen the likelihood of such a firm failing. Despite the difficulties in quantifying the complexity and interconnectedness of a firm, it was possible that agreement on this might be reached internationally, in which case it would be particularly important to emphasise that it was not only size that mattered in this context.

In the next section of the report, we look at other elements of the debate on capital requirements.


The Trading Book

Quite apart from the debate on the separation of proprietary trading from banking, the Basel Committee is considering the level of capital for trading book risks. In July 2009 it announced measures for implementation at the end of 2010 that will supplement the current value-at-risk arrangements with an incremental risk charge to capture default risk and migration risk. For securitised products the capital charges of the banking book will apply, with some exceptions for correlation trading activities, where banks may under certain conditions calculate a comprehensive risk capital charge. Banks will also have to meet a stressed VaR requirement taking into account a one-year observation period that covers significant losses. The EU and FSA have consulted on the implementation of these proposals.6

The proposals are designed to reduce the opportunities for arbitrage with the banking book and improve the assessment of underlying credit risk in the trading book, where weaknesses had been identified. Regulators now believe that the low levels of capital in the trading book did not properly reflect the risks of adverse market movements, with some doubting if positions were placed within it because they could easily be traded rather than because of lower capital requirements.

"Higher capital charges may arguably delay the return and the popularity of the more speculative structured products"

"If the approach to the trading book is not risk-based, then it does not take into account the quality of the underlying assets (of structured products)"

"A rule-based approach divorces capital from risk"

The above quotations indicate some of the concerns with the trading book proposals. In particular, some consider that a models-based approach, despite its weaknesses, remains more risk-sensitive and leads to a better allocation of capital than a standardised rules-based approach. Moreover, if the effect of these changes is to make hedging more expensive, customers and banks may not do so, making the system as a whole riskier, and banks may keep fewer assets on their balance sheets, potentially leading to fewer originations and making credit more expensive.

Concern was also expressed about the nature and speed of implementation, with participants stressing that the FSA should amend its proposals if the remaining elements in the EU package ('CRD3') changed, and should ensure that the timetables for implementation remained aligned: this is currently set for the start of 2011 but could slip.

These changes are separate from and in advance of the fundamental review of the trading book regime announced in The Turner Review, which will take place under the auspices of the Basel Committee.

So while everyone accepted that higher capital requirements for the trading book were inevitable, many were concerned as to what exactly might emerge in this area in future.

The Banking Book

The major issue here is the level and quality of capital that will be required in future. Under the present Basel regime, the minimum capital requirement for a large diversified bank is 2% common equity to risk-based assets. The FSA's stated aim is both to increase the amount of capital a bank must hold and also the quality of capital, and there is concern that this may be done prior to final agreement on CRD3 and on Basel's more wide-ranging proposals, in part because the FSA has led the way in emphasising the importance of core Tier 1 capital, principally common equity and retained profits.

On hybrid capital, CEBS, the Committee of European Banking Supervisors, and the FSA set out certain minimum requirements for Tier 1 eligibility, in particular that it must be able to absorb any losses while the bank is a going concern. There is one area of super-equivalence from the FSA: Tier 1 instruments issued through special purpose vehicles will continue to be limited to 15% of the total. CEBS proposes to allow some grandfathering, i.e. existing Tier 1 instruments which do not meet the new requirements will be phased out only gradually. The Commission have also consulted on the latest changes under discussion at Basel (to be known as CRD4).

Basel set out these changes in a Consultation Paper, 'Strengthening the Resilience of the Banking Sector' in December 2009. The proposals aim to increase the quality, consistency and transparency of the capital base. More capital for the trading book will be required based on a stressed VaR requirement together with increased capital for counterparty credit risk exposures in derivatives, repos and securities financing activities. A leverage ratio will be implemented and measures will be proposed to encourage the build-up of 'countercyclical' capital buffers in good times. There are also restrictions proposed on the banks' ability to pay out dividends or bonuses unless their capital is well in excess of regulatory minima.

Much of the paper is devoted to improvements in the quality of capital, with a greater focus on core Tier 1, a simplification of the limits regime and a tightening of the adjustments made to capital. These include a tougher treatment of items such as deferred tax assets and minority interests, and go beyond CRD2 in other ways, e.g. proposing that innovative Tier 1 hybrids (which include a step-up coupon if the bond is not called at the first opportunity) would not count towards Tier 1 capital.

Basel proposes carrying out an impact assessment by June with a fully calibrated set of standards being developed by the end of 2010 to be phased in 'as financial conditions improve and the economic recovery is assured' with the aim of implementation by December 2012. There are, however, no specific figures on the extent of the proposed changes, which will emerge once the results of the impact study have been fully digested. That will also be the point at which regulators will decide on whether to raise the '8% minimum' capital requirement for internationally active banks. In addition there may be capital surcharges for 'systemically important' firms, designed to enable them to continue as going concerns even in highly stressed conditions.

The FSA and Bank of England both take the view that once recovery is under way, minimum capital requirements for banks will have to increase, and, given that some banks are making good profits, these should be retained in anticipation of the build-up of capital charges. But a cutback in dividends could conceivably lead pension funds and other institutional investors to respond by switching to other sectors in a search for income.

"Where is all this capital going to come from?"

"When someone has just had a heart attack, don't expect him to run a marathon"

"We have already doubled the average capital holding from 4% to 8%"

The concerns banking executives have at present are two-fold: what will count as high-quality capital in future and how much will be required? The greater focus on core Tier 1 limits the instruments available, with many hybrids at best eligible for total Tier 1, and it is unclear how much more capital would be required by banks in the EU and whether UK banks would have to find the lion's share.

Other participants had reservations about an approach that 'if we can only shore up banks with enough capital of the purest kind, everything will be fine'. First, this would make it less attractive to invest in banks, yet to attract the necessary capital to meet the new requirements the return on capital needed to be at least 10-12% even from a firm with relatively low risk. Second, improving the quality of risk management and the application of appropriate risk models (or risk assessments in the case of operational risk) was at least as important. Central banks and regulators needed an array of instruments and to be able to intervene flexibly when a bank was in difficulties. At present, what was being developed was described as 'an array of targets' rather than instruments.

The major issue for interviewees was the 'cumulative impact' of these proposals, many of which were regarded as 'highly laudable' individually. They are waiting for the studies by Basel into the quantitative impact of the proposals, and hoped that the European Commission and FSA would do likewise, despite, as one described it, the 'huge pressure from politicians'.

Some were pessimistic: the proposals at the moment were 'being considered on a measure by measure basis, rather than on their cumulative impact, nor the broader impact on the economy as a whole, nor on the stability of the system'. As well as the overall impact, policymakers needed to prioritise the proposals and decide which problem they wished to tackle first and by what means.

A further difficulty bankers feel they face is that at the same time as facing exhortations to retain profits for future capital requirements, they were being encouraged to lend to small and medium-sized companies. The FSA recognises that higher capital and liquidity charges will lead to banks charging higher prices for credit mediation and maturity transformation, which is why interviewees felt the impact of all these changes on future economic development needed to be assessed. Timing was also important: policymakers needed to decide how far we were out of recession before deciding how much more capital to require at this stage.

The Building Societies

One respondent said that building societies were especially hard hit by tougher capital (and liquidity) requirements. Some were potentially in a vicious circle, diverting funds to meet the new requirements with less profit, less lending and less capital from retained profits just when more was required. Funds which would otherwise be available for mortgages were being diverted into government bonds as a result of the need to hold liquid assets. Building societies needed to fund at least 50% of their lending from retail deposits, but figures from the Bank of England and the Building Societies Association show that the sector received its lowest inflows since the 1950s, with National Savings & Investments and the banks faring better due to the more attractive interest rates they offered. The impact of both the financial crisis and the squeeze on profits has led to a further reduction in the number of societies, from 60 in March 2007 to 51 three years later with more mergers announced, potentially lessening competition in the retail market. The squeeze on profitability makes building up capital more difficult, as the mutuals, with no recourse to shareholders, have to meet the same Tier 1 requirements as banks. It is for this reason that profit-participating deferred shares ('PPDS') were introduced as a new form of Tier 1 core capital.

These do not carry a coupon and are instead remunerated by a variable and fully discretionary dividend capped at a stated percentage of the issuing societies' current profits. The Treasury's discussion paper – 'Building Society Capital and related issues'7 – focuses on making PPDS more marketable and on proposing contingent capital as another source of capital for mutuals: the hope is that this will not undermine the mutual status of building societies and will act to preserve competition in the retail and mortgage markets.

New Forms of Capital

There is considerable interest in the contingent convertible bonds ('CoCos') launched by Lloyds Banking Group in November 2009 and the Yorkshire Building Society in December 2009 on its merger with the Chelsea Building Society. These would convert into core Tier 1 capital if the bank's total Tier 1 capital falls below a predetermined trigger, such as 5%. Rabobank's issuance of contingent capital in March this year also attracted interest – these securities do not convert into equity if the trigger is reached, but instead are written down to 25% of face value and then repaid. The advantage for the bank is that this enables it to reduce its liabilities, allowing it to book a profit, thus increasing its Tier 1 capital ratio.

To the regulators, contingent capital represents an insurance policy against failure, since it automatically converts to common equity at a particular point, and thus kicks in before a bank becomes insolvent. This form of capital could replace hybrids as a better-quality form of Tier 1 capital: in the regulators' view hybrids did not sufficiently absorb losses while the banks were still in business. For example, if a bank ran into difficulties, it could stop paying the coupon on a perpetual bond, but only temporarily: once new capital had been raised, coupon payments would need to be restored.

"But is there a market?"

Some were sceptical about the market for such instruments. One such executive thought the potential purchasers were those who believed that the CoCos were cheap relative to the bank's underlying equity, who might then model the notional exposure and sell the bank's shares short, making it more difficult for the bank in question if it needed more capital in addition to the converted CoCos.

Others emphasised the risks of CoCos for a bank which the regulators were trying to save. In their view the conversion of the instrument to equity might simply accelerate market pressures; conversion could be seen as a public acknowledgement that the bank was in serious trouble. In addition, such instruments might make valuing the existing instruments more difficult, given the risk of dilution of the value of the existing shares.

The hope that these might provide a way out of problems therefore met with a lukewarm response from many participants.

The Leverage Ratio

Basel also plans to supplement the risk-based capital requirement with a leverage ratio, designed to put a floor under the build-up of leverage with – in its view – additional safeguards against model risk and measurement error via 'a simple, transparent, independent measure of risk that is based on gross exposure'. It is planned to complement the risk-based requirements with a view to migrating from a Pillar II to a Pillar I measurement, based on an appropriate review and calibration.

The US and Canadian authorities have already imposed such a ratio, as have the Swiss more recently, who stated when this was introduced that as 'domestic lending activities are important for the Swiss economy, this segment is exempted from the leverage ratio'.8 This raises the possibility that other national regulators may suggest similar exceptions or alternatively that the Basel Committee will prevent this from happening.

"A leverage ratio? Yes, but not yet"

"The devil is in the detail"

In an echo of St Augustine's prayer, bankers were reluctant to accept a leverage ratio on top of everything else, at least not yet, saying that the devil would be in the detail. The effectiveness of the proposal or the difficulty in handling it will depend, for example, on how much netting is allowed and what is on and off the balance sheet, and ultimately on the outcome of the calibration, and on what level the ratio is to be applied, whether at group or at subsidiary level.

The proposal to apply a leverage ratio without allowance for netting may cause balance sheet measures to 'balloon', especially for firms active in derivatives business who saw much of their activity as a service to clients, for example hedging exchange rate or interest rate risk for companies and local authorities.

Another large bank regarded the leverage ratio as a 'sideshow' and a 'blunt instrument'. The ratio was already in existence in the USA, but did not seem to have helped there very much. But 'it depends on where you set it and what's in and what's out, together with the application of accountancy rules'.

The leverage ratio has therefore been put in the pending tray, awaiting all the details before judgement is passed by the industry.


The various proposals for liquidity risk measurement and liquidity requirements are set out in three documents, Basel's 'International Framework for liquidity risk measurement, standards and monitoring', issued in December 2009, CEBS' 'Guidelines on Liquidity Buffers and Survival Periods', also issued in December, and the FSA's 'Strengthening Liquidity Standards', PS09/16, published in October 2009. This was the paper which attracted the attention of participants.

The first steps for compliance in the UK are the systems and controls switch-on, followed by applications for waivers, reporting requirements and then gradual compliance with the new quantitative standards, initially by the end of 2010.

Meeting the liquidity requirements involves holding sufficient high quality government bonds, central bank reserves and supranational debt, which – in the FSA's words – is 'predicated on the fact that a diversified set of holdings in government bonds is likely to provide the most effective buffer in a liquidity crisis'. In the absence of a waiver, every branch and legal entity must meet the quantitative requirements on a self-sufficient basis. The banks must also 'test' the liquidity of their assets by accessing regularly and randomly the relevant markets and the central bank facilities to which they have access.

In the view of some market participants, there are two significant differences between the other proposals and the FSA's policy.

One is that as well as central bank reserves, high quality government bonds, and securities issued by multilateral agencies, both the EU and the Basel Committee are considering including corporate debt and covered bonds, depending on a variety of factors including credit assessments and eligibility for central bank liquidity provision, and subject to a 20% or a 40% haircut.

The second is the FSA's timetable, with implementation beginning ahead of other centres. For instance, the Basel Committee expects its requirements to be introduced in 2012, in accordance with the G20 timescale. Meanwhile the focus of the CEBS guidelines is on liquidity risk management, stress tests, contingency funding and liquidity buffers rather than on specifying particular classes of liquid assets.

Banks are expected to apply stress tests which are specific to their business or markets or a combination of the two. These guidelines are expected to take effect in June this year.

In the UK banks may eventually need to more than double their holdings of gilts, in competition with insurance companies and pension funds. The FSA's calculation of an additional cost of up to £9 billion to meet the final liquidity requirements is regarded by bankers as an under-estimate, but will be revised in the light of Basel's proposals.

The FSA's full quantitative requirements will 'not be phased in until the economy improves,' and it recently announced that such an increase would be premature: it would revisit the issue later in the year with a further announcement in Q4. If the economy is deemed to have shown sufficient improvement by then, some bankers fear that liquidity buffers may need to be boosted rapidly, and are anxious both about the amount and speed of the build up that the FSA will require at that point.

"These are the most stringent liquidity requirements in the world"

"The liquidity rules will act as a brake on our activities"

The FSA's liquidity requirements were a concern for many of the participants interviewed, although there is no dispute about the need to develop a robust liquidity regime. As one participant put it, 'We are genuinely scared of a run on the bank, so we need a vast amount of high quality liquid assets'. But the insistence on government bonds alone and the declaration that the buffer 'must not chase yield' means that banks have to hold large quantities of assets which produce low returns and therefore affect the profitability of banks and the availability of funds to lend. 'The problem is that the FSA is front running international standards', another participant commented, fearing this would affect UK bank competitiveness.

The daily reporting of the liquidity positions of the bank and the new systems requirements have proved to be a burden to smaller firms and overseas banks. Reporting on liquidity positions used to be carried out less frequently and a degree of tolerance was allowed: this is no longer the case. For large international banks, the new requirements are no less demanding. One such bank had 50 staff working on the development of new systems. The banker in question saw it as an example of the 'more intrusive' regulatory stance adopted by the FSA, and wondered how far this additional information could be effectively utilised by regulators.

Others argue that the current proposals would not of themselves have averted the crisis in the UK, since this resulted from the markets remaining closed, making it impossible to refinance securitisations which had reached maturity.

Nevertheless most participants agreed that there was a need to increase liquidity buffers but that this should be seen as part of a complex process of regulatory reform, which should be assessed as a whole and would undoubtedly increase the cost of borrowing.


Apart from structural reforms and the strengthening of prudential standards, the FSA regards living wills or 'recovery and resolution plans' as another means of dealing with banks which are 'too big' from whatever point of view. As described by Dr Huertas, FSA Banking Sector Director, 'The social risk posed by the failure of a large systemically important bank can be defined as the probability that such failure will occur times the impact such a failure would have'.9 Since recovery plans may reduce the impact of failure, this could 'logically translate into lower capital and liquidity requirements ... than would otherwise be required'.

The recovery plan requires the bank to work out what it would do if the bank were to face extreme stress. It is about financial continuity: what would the bank do to ensure that it continued to maintain adequate capital and liquidity. Banks would be required to produce plans and keep them up-to-date, with the ability if the need arose to establish a data room, virtual or otherwise, for the purpose of the authorities' resolution plan. As such it goes beyond the capital and liquidity planning which banks are already required to do, under conditions of severe stress.

The concept requires banks to inform their supervisor of the action they would take if capital and liquidity came under even greater stress. The plan should fulfil the following criteria:

  1. The plans should be capable of being carried out within three months ideally (and no longer than six months) with a high degree of certainty of success.
  2. They should be sizeable plans both individually and in total so that they can restore the bank's capital and liquidity positions.
  3. There should be a wide enough range of options so that the bank can select which one is the most appropriate.
  4. The alternatives should be credible to key stakeholders – such as shareholders, debt-holders, depositors, counterparties, central banks and supervisors. The bank should consider how its recovery plan would be communicated to all stakeholders and to the public at large so as to maintain confidence in the bank during the recovery process.
  5. The choices are likely to consist of issuing new equity capital; selling or running down certain businesses or even selling the bank itself. The other alternative would be to issue contingent capital.

The FSA has considered these elements in more detail. The sale or run-down of a business activity would be much easier where the activity was in a separate subsidiary (so that it can be sold through the sale of stock to a third party buyer), operationally separate and self-sufficient in terms of capital and liquidity.

Running down the book is likely to restrict income and result in capital losses, but may reduce the requirements for capital and liquidity. One way of achieving this is to increase the liquidity charges to the trading desk so that it reduces the positions to be financed and the capital to be posted.

The success or otherwise of these strategies depends on the state of the market: clearly if only one bank is in difficulties, then such a run-off may be handled more easily than if the sector as a whole is in trouble.

Finally the sale of the whole business to a third party is a last resort. A large, complex bank is only likely to be purchased by another such firm, which potentially leads to further problems, such as anti-trust issues. The buyers of a large bank close to resolution may well require a liquidity backstop and some kind of guarantee from the sellers as well as regulatory approval of the deal. The sale process would have to start early enough in the course of the bank's difficulties to allow time for these assessments to take place.

The FSA has set up a pilot project working with four banks to develop 'living wills' and work is expected to continue during the remainder of 2010.

"Are they more than a business plan?"

"Who should these be shared with?"

Some participants were concerned about the practicalities of the proposals and the risks involved in drawing up such plans. Not only the most senior executives would be involved but probably two levels of executives below that. The plans would have to be shared with the home country regulator and presumably with third country regulators as well, though at what stage was not clear.

Others suggested that such recovery plans would all too easily become part of the worst case scenarios considered by analysts. Assuming the plan was agreed with the home regulator then a global bank would have to share this with other regulators and seek to impose possibly unpopular plans on them.

Interviewees identified two dangers in this process. Firstly given the large number of people involved, the chances of total secrecy were remote. Secondly, if the plan involved selling part of the business in a third country, then this could be difficult for the regulators there to handle, especially if the business made a significant contribution to the economy or the skills base of the third country.

In theory, a bank which is subsidiary-led, rather than branch-led, would be more easily divisible, and to that extent the recovery plan was built into the structure of the bank. However, it might be impossible to push forward the sale of a subsidiary if its IT system was enmeshed with that of the group as a whole, as was often the case.

In addition there might be centralised risk and treasury management, whereby cash is lent from one unit to another, with the treasury placing the net surplus or borrowing the net deficit in the market, or hedging positions centrally to reduce operational risk and market exposures. Participants felt this illustrated the difficulties of disentangling subsidiaries and preparing them for sale.

Some suspected that the FSA wanted all banks to be structured as subsidiaries, but, as one participant put it, that puts banks 'into a straitjacket' and ignored the value of diversification of risk, not to mention the tax and operational benefits. Another regarded the proposals, which on one level seemed to be entirely sensible, as potentially a means to press for changes in business models to those considered to be more resistant to stress, such as separating out the trading book or adopting a subsidiarisation model. The issues had not been prioritised. 'What would you do in a situation of stress, extreme stress, unmitigated disaster?' Which situation, in other words, is the living will designed to address? Does it involve the regulator asking 'what is in your bottom drawer? Or what is at the bottom of your bottom drawer?' In this person's view the proposals were incomplete in that they did not specify the triggers or what would activate such triggers.

The participants are seeking to accommodate the regulators in preparing such plans, but the pilot project is clearly demanding in terms of staff time and effort. One senior executive described it as a project which he could see eventually not coming to fruition.


Many of those interviewed had concerns about the emerging regulatory blueprint. Their greatest concern was the need to assess the economic impact of the demand for more capital against a background where access to credit is vital to the slow recovery in the global economy. They were also worried that in some areas the UK may press ahead with changes before these have been finalised internationally.

The requirements for more and better quality capital and liquidity are seen as particularly demanding. Those interviewed acknowledged that the banks needed more of both, but felt that regulators must take into account that supply was constrained, and that the outlook for profits are likely to limit the boost from retained earnings. Noting the commitments made to this effect, they hoped that regulatory requirements would be phased in over time with a careful eye on the impact on the economy of these measures, and consideration of the reforms as a package rather than in isolation from one another.

Senior executives believe that the real issue regarding the trading book was not so much proprietary trading as what was traded and how. To echo the words of one, banks must be entirely transparent about the structured products they are selling. The manufacturer has certain responsibilities to the buyer. The buyer must also exercise due diligence and should not rely on others to assess the value of the underlying assets. Many of these transactions should take place through centralised reporting or clearing services, but with the clear understanding that the risks are transferred to others.

The UK's changes in resolution procedures have been widely welcomed, but not all interviewees were yet persuaded that recovery plans, beyond those already required under Pillar II for strategic business continuity and crisis management, will do much to restore confidence in the banking system. At the same time senior executives wish to play their full part in the process of strengthening the resilience of the banking system so that the right decisions are taken over time to build a robust but competitive financial services industry.


1. Treasury Committee Hearing: Too important to fail – too important to ignore, 2 March 2010, Ninth report of the Treasury Select Committee, HC 261-II, Evidence

2. Guidance to Assess the Systematic Importance of Financial Institutions, Markets and Instruments: Initial Considerations, Report to the G2) Finance Ministers and Central Bank Governors, October 2009

3. Lord Turner, Evidence to the Treasury Committee Hearing: Too Important to fail – Too important to ignore', 2 March 2010, 9th Report session 2009- 10 Volume II Oral and Written Evidence

4. The White House Press Release of the President's 21 January statement is: – 'The President and his economic team will work with Congress to ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund or proprietary trading operations unrelated to serving customers for its own profit'. Members of the Select Committee understood Paul Volcker to favour the banning of proprietary trading unrelated to customer service from their meetings with him

5. Statement of Paul A Volcker before the Committee on Banking, Housing and Urban Affairs of the US Senate, 2 February 2010

6. CP 09/29 'Strengthening Capital Standards 3, which sets out the FSA's approach to CRD 2 and 3 which will amend the Capital Requirements Directive, and Revisions to the Basel II market risk framework and Guidelines for computing capital for incremental risk in the trading book

7. HM Treasury, 31 March 2010

8. SFBC and large banks agree to set higher capital adequacy targets and introduce a leverage ratio, Press Release, SFBC, October 2008

9. Living Wills: How can the concept be implemented? Speech by Thomas F Huertas, 12 February 2010

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