UK: Macro-Prudential Regulation

Last Updated: 20 September 2010
Article by Martin Day

Introduction

In this briefing, the nature of macro-prudential regulation in the financial service industry following the UK Coalition Government's proposal to establish a new prudential regulatory authority in the UK in future based at the Bank of England is examined. Macro-prudential supervision has also become a topic of importance in the rest of the European Union, and internationally, at the G20.

Dr Andrew Hilton, the Director of UK's Centre for the Study of Financial Innovation recently attempted to define macro-prudential supervision in Financial World magazine:

"At its simplest, [macro-prudential supervision] is a recognition that financial institutions are not entirely independent actors. They can get it wrong themselves, but they are at least equally likely to mess it up because they are part of a wider system—an economic or financial one that can lull them with low interest rates and liquidity, and then whack them with what...economists love to call an exogenous shock. Thus, financial institutions have to be supervised and regulated both as individuals ('bend over, Bunter; it was you who ate the pies') and as a group ('4C will stay behind after school')".

Whilst the concept of macro-prudentialism seems an obvious one, a panoply of institutions and new acronyms are now being created in the European Union with a proposed new mega-supervisor, the European Systemic Risk Board (the "ESRB"), as well as a plethora of committees created in Basel, Brussels and London, where academics, central bankers and regulators alike are trying to work out what a "systemic" approach to regulation means in practice for both the regulators and the regulated community in the financial industry. Macro-prudential supervision is based on such a systemic approach to regulation. It is also now being used as a justification for increasing the demands made on banks for more information on their risk positions, their counterparties and their individual business lines. These demands will also inevitably increase the cost of banking.

The Origin of the Macro-Prudential Regulatory Model

The conventional wisdom is that without proper macro-prudential analysis, the problems that have affected the banking system recently will not be adequately understood and nor will new ones be identified in the future. However, the origins of the macro-prudential approach can be traced back to the late 1970s when, an unpublished paper submitted to the Bank for International Settlements by the Bank of England for a G10 central bank governors' meeting, chaired by Baron Alexandré Lamfalussy (at a time when the Basel group was examining different approaches to limiting the then worrying herd-like growth in banks' international lending) strongly advocated that the existing micro-prudential aspects of bank supervision should be placed in a much wider context. The Bank of England's paper put forward a number of proposals, including changes in capital ratios, control of banks' country risks and other exposures and maturity transformations, as well as a more appropriate use of domestic monetary policy. The main point in the Bank of England's paper was that whilst the rate of growth of an individual bank's business might seem wholly acceptable from a micro-prudential standpoint, its overall rate of international lending might be of concern because borrowers might not be able to adjust sufficiently rapidly to service their debts. There was also concern about undue complacency by the central banks in relation to the funding risks to which this would expose the banks.

The Lamfalussy group consulted with the then predecessor of the Basel Committee on Banking Supervision, which surprisingly rejected these proposals, not just for reasons of technical difficulty in terms of their implementation, but also because of the lack of adequate justification for increasing capital requirements. They also considered that there would be a conflict between the macro-economic and prudential aims. If bank capital requirements were increased, for example, this could have an adverse effect on some member countries' economies.

This debate, unresolved at that time, has of course resurfaced in the 21st century in a rather more serious scenario. However, the issues remain essentially the same as they were in the late 1970s and they have still not been fully resolved despite the increased attention given to them over the intervening 30 years. Indeed, in 1986 there was a major report by the G10 central banks chaired by the New York Federal Reserve. In its summary of conclusions, in a section headed "Macro-prudential Policy", a number of trends were identified:

  • the highest-quality borrowers were increasingly turning to direct credit markets and the average quality of banks' loan assets may have declined in consequence;
  • in view of its narrower base, the international banking system could become less responsive to sudden liquidity needs;
  • a greater share of credit was likely to flow through capital market channels, which may be characterized by less supervision and more distant business relationships between debtor and creditor, thereby complicating the task of arranging any rescheduling;
  • both bank and non-bank financial institutions were relying more on income from off-balance-sheet business; and
  • the distinctions between banks and other financial institutions were becoming progressively blurred.

All this also sounds familiar in the modern context. But what is different today however, is that, in the 1980s, monetary policy was seen as operating in large part through the supply of credit. The concern then, as expressed by the G10 central bank governors, was that, because of the effects of innovation, deregulation and structural change, the scope for monetary policy to operate via changes in the availability of credit was being reduced relative to the role of interest rates and exchange rates. Indeed, the thinking of some central banks had reached the point where the role of credit expansion in leading to unsustainable booms and even bubbles was not felt to be something that it was their role as guardians of monetary policy to address. It was thought that monetary policy should instead focus purely on consumer prices, and this was enshrined in the progressive spread of inflation-targeting regimes.

Thus, despite earlier conclusions on the desirability of "macro-prudential policy", no concrete remedies to the challenges identified were ever proposed. Indeed, as the recent global financial crisis has demonstrated, such supervisory efforts to address them as were undertaken proved ineffective in averting the devastating market disruptions which then occurred in practice.

The 2009 Bank of England Paper

In late 2009, a discussion paper by the Bank of England, The Role of Macro-prudential Policy, was issued. This built on the FSA's Turner Review published a few months earlier and recast the challenge to succeed where previous attempts had failed. This was to be achieved by re-orientating prudential regulation towards risk across the financial system as a whole. It also sought to establish how instruments could be designed and used to mitigate such risks. The Bank of England examined in some detail a number of ideas focusing on a regime of systemic capital charges, applied either to headline capital requirements or by applying risk-weightings to particular types of exposures.

Recent Developments in the UK

The phrase "macro-prudential regulation" also appeared in the new UK Government's Coalition Agreement as the new political alliance embarks on reform of the UK's financial regulatory system. The May 2010 text of the Coalition Agreement stated:

"We agree to bring forward proposals to give the Bank of England control of macro-prudential regulation and oversight of micro-prudential regulation".

This also addressed the complaint of the Governor of the Bank of England that the Bank had become like "a church whose congregation attends weddings and burials but ignores the sermons in between".

Coupled with its statutory responsibility for financial stability since 2009, the Bank of England could now look forward through the creation of the new Financial Policy Committee, not only to monitoring the growth of credit, but also to being able to address the problems which that poses. This represented a return to the central bank role of being able to, in Bank of England Governor Mervyn King's words, to "take away the punchbowl" when required.

These now expected macro-reforms in the UK demonstrate a number of common themes in macro-prudential regulation:

  • the Bank of England in its enhanced role will in future consider factors other than consumer price inflation;
  • the Bank will adopt a counter-cyclical approach; and
  • the Bank will combine together "micro" supervision of large individual institutions with their impact in aggregate on the financial system as a whole.

Those themes are now also being pursued in the United States, where a Financial Stability Oversight Council is being created to monitor systemic risks and to ensure that the Federal Reserve System in future tightens its rules on capital, leverage and liquidity to limit the wider risks posed by large financial institutions.

In the EU, following the report of the De Larosiere group, the ESRB is now proposed as the macro-supervisory part of a wider package of EU-wide regulatory bodies. The ESRB is to monitor the soundness of the system. This, in turn, will include very different things, from the financial situation of the banks themselves and the potential existence of asset bubbles, to the efficient functioning of market infrastructures.

At the broader international level, the work of the Basel Committee in formulating Base III now has a macro-prudential element to it, for example, in the preparation of measures to reduce pro-cyclicality.

The New UK Prudential Regulator

Whatever lessons are learnt from the past, and in particular how the Bank of England should handle the creation of the new Prudential Regulatory Authority in the United Kingdom (the "PRA"), the outcome will need to be a robust, fair and transparent system of prudential supervision. As the PRA will in effect be part of the Bank of England (albeit a subsidiary undertaking of the Bank) it will need to have a close link with the new Financial Policy Committee being established by the Bank. The PRA's role will also need to be distinctive. Its approach and culture will also need to be built around judging and dealing with the build-up of excessive risk in the financial system, and thus it will need to concern itself with the robustness of the business models of the individual institutions it regulates. This approach will require the exercise of skilled judgment and the ability to use that judgment to influence, and not be browbeaten by the management of large firms. It is also likely to be politically unacceptable in the UK in future for any part of the financial industry to operate on the basis of a dependency on public money. Part of the solution for avoiding this will inevitably be the quantum and quality of capital held by the banks. Banks will need to build larger buffers to meet more demanding future regulatory requirements, notably in the new Basel III regime. Indeed, provided there is adequate transition to the new quanta of capital and liquidity this should enable the banks to build resilience through a greater retention of earnings, whilst maintaining lending.

The question will also need to be addressed as to whether banks need to be restructured to facilitate the bringing to an end of the 'Too Big/Important to Fail' issue. If that is to be done, then the UK will need to take one or both of two approaches. The first approach would be to separate out the deposit base of a bank that should be protected and restrict that to narrow banks that have appropriately low probabilities of failing. The permitted asset classes of such a bank should be high quality, and the return to depositors would then reflect that. This used to exist in the UK in the case of the trustee savings banks. A second and perhaps more challenging approach to dealing with the 'Too big/Important to Fail' issue would be to require banks to restructure and downsize themselves so that they can be allowed to fail in future. Adopting this so-called 'Volcker Rule' or some similar restriction, however will not of itself turn a bank into something that can be dealt with if it fails over a weekend using the tools of the new resolution regime. The Bank of England will need to be confident that it could and would use such resolution tools on such a bank without either damaging the financial system or resorting to the use of public funds. This is the principal issue that has still to be resolved in relation to the new regulatory structure which the UK Government now envisages.

Market Regulation – the Missing Third "Peak"?

Arguably, when the UK Government's proposed new regulatory system is introduced by the end of 2012 based on the "Twin Peaks" model with separate prudential and conduct of business regulators, a third "peak" in the form of a separate market surveillance and regulatory authority will be missing from it. Markets can also be the origin of systemic risk, and therefore their surveillance should not be limited to conduct of business issues.

The recent move towards a "twin-peaks" supervisory architecture in the United Kingdom and some other jurisdictions has focused attention on the relationship between prudential and conduct of business regulation. A result has been that the role of market regulators, particularly in the regulation of systemic risk has tended to take a back seat in the discussions. It could therefore be a mistake to leave prudential regulation and the regulation of systemic risk entirely to a central bank based regulator. To support this view, one can cite IOSCO's recently revised "Objectives and Principles of Securities Regulation" which includes eight new principles focusing on systemic risk within securities markets.

It is also clearly wrong that higher capital requirements alone will be determinative of conduct, and to view markets purely structurally and through the eyes of individual institutions. Rather, armed with an understanding of markets as networks, regulators will need to look at ways to intervene to prevent phenomena such as asset bubbles and commission-driven selling practices that have led to significant market problems in the past. That requires instead a paradigm shift of attitudes from a highly structural approach, focused on financial institutions alone. It requires looking beyond capital and liquidity ratios to fundamentally new forms of regulatory intervention if understanding systemic risk in markets is to be taken into account in future.

Conclusion

Within the next two years some major issues will clearly need to be addressed in the UK with the proposed new "Twin Peaks" regulatory structure of a Prudential Regulatory Authority and a Consumer Protection and Markets Authority. Splitting the existing financial regulator, the Financial Services Authority ("the FSA"), into two will be a major operational challenge and will be difficult to achieve without considerable disruption. As noted above, there are also complex issues still to be resolved, on the markets side, where some market functions will relate to prudential and financial stability issues and others to conduct of business issues only. The links between conduct and prudential regulation also need current consideration as clearly there are already areas where they overlap, as in the FSA's recent review of the mortgage market. In addition, it must not be overlooked, as Lord Adair Turner, Chairman of the FSA, pointed out in his address to the British Bankers' Association on 13 July 2010 that the retail financial services industry does not operate in a market like that for restaurant meals, cars, hotels, electrical appliances or clothes, where the philosophy of free competition and free customer choice can easily produce good results. This will involve a major shift in philosophy from that of the present FSA, but a necessary one.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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