United Kingdom
Financial System Stability Assessment including Reports on the Observance of Standards and Codes on the following topics: Banking Supervision, Insurance Supervision, Securities Regulation, Payment Systems, Monetary and Financial Transparency, Securities Settlement Systems, and Anti-Money Laundering and Countering Terrorist Financing

This paper presents key findings of the Financial System Stability Assessment for the United Kingdom, including Reports on the Observance of Standards and Codes on Banking Supervision, Insurance Supervision, Securities Regulation, Payments Systems, Monetary and Financial Policy Transparency, and Securities Settlement Systems. The financial sector of the United Kingdom is supported by a financial policy framework that has been significantly strengthened in a number of ways in recent years, and that in many respects is at the forefront internationally. The supervision framework complies or largely complies with most international standards and codes.


This paper presents key findings of the Financial System Stability Assessment for the United Kingdom, including Reports on the Observance of Standards and Codes on Banking Supervision, Insurance Supervision, Securities Regulation, Payments Systems, Monetary and Financial Policy Transparency, and Securities Settlement Systems. The financial sector of the United Kingdom is supported by a financial policy framework that has been significantly strengthened in a number of ways in recent years, and that in many respects is at the forefront internationally. The supervision framework complies or largely complies with most international standards and codes.

Section I. Staff Report on Financial System Stability

I. Overall Stability Assessment

1. The U.K.’s large and sophisticated financial sector features fundamentally sound and highly developed financial institutions, markets and infrastructure. It is supported by a financial stability policy framework that has been significantly strengthened in a number of ways in recent years, and that in many respects is at the forefront internationally. That is not to deny, firstly, that there have been specific and often high-profile problems in the U.K. financial system (and currently in the insurance sector); nor, secondly, that there are potential risks and vulnerabilities that policymakers need to pay particular attention to; nor, finally, that there are aspects of the policy framework that could desirably be strengthened somewhat further (see Box 1 below). But these issues do not constitute systemic concerns, in part because they are typically already well recognized by the authorities themselves, who are constantly striving for further improvement in the policy framework to address weaknesses. Indeed, it is notable that the U.K. financial system has shown itself to be resilient to significant shocks of various sorts in recent years. Just as important, the system itself and the underlying financial policy framework have generally been flexible enough to take on board the important lessons from past episodes.

2. A key feature distinguishing the U.K. system is of course its major international orientation. There are important but not dominating links between the international financial market activity in London and the U.K. financial system per se, and the recent reforms to bring key parts of the U.K. financial infrastructure up to the best international standard are an important mechanism for keeping the direct and indirect linkages manageable. Further, among the larger institutions at least, risk management practices have been strengthened significantly over the last decade or so—the larger U.K. banks as a group are among the highest-rated in the world.

Institutions, Markets, and Infrastructure

3. For the U.K. banking system, potential risks arise from both domestic and foreign sources. On the foreign side, the banks have so far been able to weather the credit deterioration stemming from the sharp slowdown in global growth in 2001 and 2002, weak equity markets, and large corporate and sovereign defaults. Nevertheless, a slower-than-envisaged recovery in global demand, or further declines in global equity prices, are potential sources of risk. On the domestic side, high household and corporate debt levels have so far been offset by the effects on servicing capacity of low interest rates and a relatively mild slowdown in activity in late 2001 and early 2002. However, risks to the financial system could arise from deteriorating domestic economic conditions, rising unemployment, or higher interest rates than currently expected, especially if these are accompanied by significant declines in property prices from their current high levels. These factors also need to be seen against the trend towards some narrowing in profit margins, at least among the bigger banks, due in part to continuing competitive pressures, regulatory pressures to limit some service fees, and rising loan loss provisions.

4. Based on a variety of quantitative approaches alongside more qualitative analysis, U.K. banks (and building societies as a group) appear sufficiently profitable and well-capitalized overall to be able to absorb the effects of the more likely macroeconomic shocks without systemic distress. This partly reflects healthy profits and capital accumulation during the past decade of strong economic performance. It also reflects the relatively broad range of the banks’ domestic and foreign activities, and continuing improvements in their risk management practices. The quantitative analyses tend to confirm other evidence that credit risk, rather than market risk, would be the main channel through which banks would be affected by shocks.

5. In contrast, the insurance sector in the U.K. as in many other countries is under considerable stress—especially the life and private pensions sector although the general insurance sector, including the Lloyds market, has its own challenges. The stress reflects depressed investment returns, declining profitability in basic life insurance products, increasing regulatory compliance costs as the FSA introduces (appropriately) more stringent prudential supervision of the sector and tightens supervision of long-term savings products, and rising uncertainty about the financial consequences of general insurance companies providing insurance against very low probability and catastrophic events. The life industry appears headed for large-scale consolidation in coming years in response to these issues. Although Lloyds members and London general insurance market participants were hard hit after 9/11, U.K. underwriters appear on the whole to have coped remarkably well, and are currently benefiting from higher premiums following the terrorist attacks.

6. The difficulties in the insurance sector, while significant, do not currently appear to constitute a systemic vulnerability for several reasons. In the life sector, most difficulties are concentrated in small-to-medium sized insurers rather than the larger companies—though some of the latter may also be adversely affected if equity market weakness continues—and the FSA is actively involved in addressing the problems. While there are some important ownership linkages with banks, generally these are less of an issue than in some other countries. Bank lending to insurers is also a small Fraction of U.K.-owned banks’ claims. Nevertheless, close monitoring of the situation is clearly required, due to the importance of the insurance industry in capital markets and the potential, at least, for current conditions to create incentives for some firms to move into higher risk-higher return strategies, such as greater involvement in credit-risk transfer markets than has occurred to date.

7. Turning to the major U.K. financial markets, the U.K. financial exchanges function well. Concerns associated with market fragmentation have not yet arisen to a significant degree in the U.K. compared to some other industrialized countries. The London Stock Exchange (LSE) and the London International Financial Futures and Options Exchange (now Euronext LIFFE) have taken steps to enhance their trading systems and adapt their rules to ensure their markets remain attractive to investors. In the derivative markets, and as noted above in the context of insurance companies, activity in credit-risk transfer markets will need to be monitored closely in case their systemic importance, or their relevance for supervision of risk taking at the individual institution level, grows further.

8. The money market does a good job in distributing the liquidity supplied by the BoE. While the unsecured interbank segment of the money market functions well, it could potentially act as a contagion channel in the unlikely event that a major participant experienced financial distress. The traditional structure of the U.K. banking system (a few large, direct clearing banks, and a large number of smaller, indirect clearers) may exacerbate this risk, since the smaller institutions tend to hold most of their liquidity in the form of unsecured deposits with the largest institutions. It may also contribute to the “too big to fail” perceptions that exist at the margin for the largest banks, to the extent it further adds to the systemic importance of these banks. The authorities were encouraged to continue intensifying their surveillance of these exposures, so that they can obtain a better sense of the distribution of claims in the banking system, and the risk of contagion in the event of a significant failure. Obtaining a complete picture of these exposures ultimately requires close collaboration between the U.K. authorities and their foreign counterparts, since many of these exposures involve foreign FIs that are not supervised by the U.K. authorities.

9. The global financial market activity that takes place in London does not, in itself, appear to pose significant risks to the stability of U.K. financial markets, or to the domestic and international financial system more generally. Although some U.K.-owned institutions are significant players in some of these markets, and some foreign-owned firms have a material presence in U.K. banking and insurance markets, trading activity is to an important extent insulated from the domestic financial system, in part because it primarily involves wholesale market transactions between branches of foreign institutions that have little connection to the domestic financial system. U.K.-owned institutions, meanwhile, obtain most of their profits from the provision of financial services to the domestic economy. In addition, the nature of this activity is such that the location of trading in London is largely divorced from the final processing and settlement of transactions, except in respect of LCH and CHAPS-Euro.

10. With respect to infrastructure, major reforms of the U.K. payments and securities settlement systems have been made in recent years, and the CHAPS and CREST systems are of a very high standard internationally. These reforms protect direct settlers from intraday exposures, although the two-tier structure of the banking system may still result in important intraday exposures between direct and indirect settling banks. That aspect aside, the authorities are rightly focusing on bringing the settlement of money market instruments into the CREST real-time DVP arrangement; and on addressing the payment arrangement for the central counterparty clearing house, LCH, which results in large albeit short-lived intraday exposures. The authorities were encouraged to continue their work on resolving these issues, including making supporting legislative amendments as necessary, and also to continue seeking risk management improvements in BACS, the largest retail payment system.

Institutional and Policy Framework for Financial Stability

11. The U.K. financial stability policy framework is at the forefront internationally in many respects. Clearly a great deal of thought has gone into making the institutional structure work—how to sharpen focus, accountabilities, and transparency; how at the same time to encourage and facilitate coordination between the main players, under the umbrella of the financial stability Memorandum of Understanding and the associated financial stability Standing Committee (FSSC); how, at the level of the FSA, to manage the potential trade-offs between the various objectives and principles of good regulation in the FSMA, within the context of integrated supervision; and how, in the BoE, to strengthen surveillance of broad conjunctural and structural factors affecting systemic stability and payment system oversight, and making the results of much of this work public in its semi-annual Financial Stability Review. The FSA is accountable for how it is balancing its various statutory objectives and principles; shifts in priorities and trade-offs can be expected to be made quite explicit in FSA publications, with operational implications laid out through its “risk-to-objectives” (RTO) framework.

12. Though the differences should not be overstated, it seems fair to characterize the U.K. supervision regime as somewhat less prescriptive overall than in some other countries, but with relatively more emphasis on policies to promote good corporate governance and market discipline. Regulatory principles on the responsibilities of owners/managers and proportionality of regulation are noteworthy in this context. Also of note is the requirement for explicit cost-benefit analyses of supervisory initiatives. The logic of the FSA’s risk-based framework, and specifically the flexibility to shift supervisory resources between objectives and risk areas, requires a strong underlying disclosure and governance regime to facilitate smooth shifts in focus when unexpected developments occur. This consideration also has implications for the nature of supervision, which needs to rely on independent assessments of the effectiveness of systems and controls, a strong baseline monitoring of key risks, including through regular coverage of core themes (such as validation of returns, AML, and credit risk management), and early intervention arrangements.

13. Continued further efforts to promote market discipline—if necessary ahead of the completion of international efforts—may be necessary to complement and underpin the U.K. supervisory philosophy. At the same time the move to International Accounting Standards poses important challenges for supervision and disclosure practices. The FSA is developing new proposals on “harnessing market forces,” but at this stage it seems that more could be done in several areas. While the emphasis on consumer education in general is laudable, the authorities were encouraged to closely consider further aspects such as more depositor-friendly prudential disclosures to enable retail customers to differentiate better between FIs; required FI ratings by rating agencies, and publication thereof; and the development of standardized market and credit risk disclosure requirements applicable cross-sectorally, and a consistent methodology for measuring insurance risk. Of course in a number of these areas the technical issues are not straightforward, but London’s status argues for continuing to probe the boundaries in this area.

14. Broader financial sector surveillance is a key component of an overall stability policy regime; thus, the work and publications of the BoE and FSA reflect a considerable emphasis on financial stability analysis and research. Such surveillance is essential for a focused assessment of the risks and vulnerabilities that may develop in the future, and for shaping supervisory policy and allocating supervisory resources. In addition to work on potential contagion channels already noted, the authorities were encouraged to also continue to standardize and extend the availability of aggregate financial soundness indicators; and to consider the scope for using macro-financial stress testing analysis of the sort undertaken for the FSAP exercise as an ongoing instrument of stability analysis.

15. The safety net arrangements and underlying legal framework for failure management enable the U.K. authorities to effectively manage instances of serious financial difficulties in FIs. There is no special insolvency/administration statute for FIs in the U.K., but the FSA has various important rights in insolvency proceedings as well as wide-ranging enforcement powers under the FSMA that can be used before the formal statutory proceedings are invoked. If circumstances arise where systemic issues appear possible, and where emergency liquidity support might be considered, the authorities’ response would be coordinated through the FSSC. Protection to depositors, investors, and insurance policy holders is provided through an ex-post industry-funded scheme that features a form of co-insurance arrangement up to maximum limits for investment and deposit compensation. Insurance compensation has no maximum limit, and there is no co-insurance for compulsory insurance. An upcoming review should consider, inter alia, the desirability of an explicit government credit line.

Supervisory, Transparency and Market Integrity Standards

16. The quality and effectiveness of financial sector supervision in the U.K. is strong in the banking and securities areas. As indicated in Section II, the FSA either fully or largely observes the Basel Core Principles for Effective Bank Supervision and the IOSCO Objectives and Principles of Securities Regulation. In both areas, some further technical improvements were suggested, largely reflecting the highly sophisticated nature of the U.K. financial system and London’s role as a key international financial center, and the desirability in that context of further strengthening and rebalancing various supervisory tools. For banking supervision, in particular, the issues mainly revolved around strengthening “baseline” supervision (i.e., the elements applying to all supervised FIs, irrespective of their risk/impact rating), and ensuring strong assessments of systems and controls.

17. In the case of insurance industry, U.K. authorities are developing proposals to significantly strengthen supervision, and are adding resources to the FSA for this purpose. Although the U.K. observes the regular prudential IAIS Insurance Core Principles, the proposed reforms are likely to deal with most of the weaknesses observed in the current supervisory framework relative to the enhanced standards that are more pertinent for an advanced and international insurance center like the U.K. Some additional technical recommendations were offered for consideration, again mainly reflecting that status.

18. With respect to the oversight of payments and securities settlement systems, the major progress in infrastructure reform in recent years illustrates how these functions have been significantly improved. Assessments against the relevant standards in Section II show a high degree of observance, with the main recommendations being for the authorities to push ahead with their efforts noted above to bring money market settlement fully into a real time delivery versus payment framework, and to address LCH’s cash payment arrangement.

19. The authorities’ strong commitment to policy transparency is reflected in the assessments of a very high degree of observance of the IMF Code of Good Practices on Transparency in Monetary and Financial Policies. There are a few areas in which both the BoE and the FSA could usefully go a little further to clarify still more their roles or policies, and progress is already being made in most of these areas.

20. The U.K. has a comprehensive legal, institutional and supervisory regime for AML/CFT. It is broadly in line with the criteria set forth in the FATF 40 Recommendations for Anti-Money Laundering and 8 Special Recommendations for Combating the Financing of Terrorism, and with the criteria set forth in the AML/CFT Methodology that is used to assess observance of those recommendations. The system has been made more robust over the last few years, and further important improvements are expected once key provisions of the Proceeds of Crime Act 2002 become effective and requirements are adopted for the inclusion of originator information on wire transfers originating in the United Kingdom. There is also scope for additional refinements in several areas.

Summary of Key FSAP Recommendations

While the U.K. benefits from a strong financial stability policy framework, the FSAP team put forth some technical recommendations in a number of areas to make the framework even stronger. This box summarizes the most important ones. The U.K. authorities recognize the significance of these issues overall, and are actively addressing them. Cost-benefit analyses would rightly need to be undertaken for supervisory initiatives and may imply that some of the recommendations might (e.g.) be best resolved in the context of broader international agreements. However, the U.K. authorities were encouraged to consider acting alone if it becomes apparent that international agreements will not be forthcoming within a reasonable period of time.

  • Especially given the current stress and trends confronting the insurance industry, continue work on rectifying the shortcomings that exist in the current insurance supervision framework, and implementing the recommendations of the Tiner Report so that insurance supervision is fully consistent with the importance of the U.K. insurance sector. Progress on this high-priority, albeit more medium-term, structural issue needs to be achieved at the same time as the supervisors deal forcefully with the current problems in the industry.

  • Actively pursue the remaining steps needed to strengthen the payments and securities settlement infrastructure. Here, the major issues are to bring money market instruments into the CREST real-time DVP system, and to improve LCH’s payment arrangements, including promoting the requisite legislative changes. Improved risk management in the BACS retail payment system is also desirable.

  • Continue to strengthen the surveillance and monitoring of the inter-institutional linkages that could be important channels for contagion, especially the unsecured intraday and overnight interbank exposures between banks; activity in the risk transfer markets is also important to monitor more closely. Consider making greater use of quantitative techniques to assess the resiliency of the financial system to potential shocks.

  • Continue efforts to promote market discipline through improved disclosure and governance in FIs, if necessary ahead of the completion of international efforts, while factoring in the implications for disclosure and supervision of the challenges arising from the move to IAS.

  • Within the supervisory framework in general, pursue technical improvements to strengthen further the assessment and verification of FIs’ systems and controls, and ensure a strong “baseline” monitoring of key risks, including regular coverage of core themes, and ensure that all institutions are subject to a credible threat of on-site inspection even if on a sampling basis.

  • In the area of AML/CFT, pursue a range of refinements to enhance the regime’s strength and effectiveness, in the wake of the new Proceeds of Crime Act.

II. Financial System Overview

A. Institutions

21. The U.K. financial sector is a large contributor to domestic economic activity, and has a major international orientation. In 2001, the financial sector contributed 5.2 percent of GDP, and net exports of insurance and financial services represented 1.3 percent of GDP. As of March 2002, banks and insurance companies’ financial assets were over 4.5 times GDP. Table 1 in the Statistical Appendix summarizes the structure of the sector. With respect to the banking sector, the U.K. resident banking system comprised 395 banks that held total assets of around £3,500 billion (3.5 times of GDP). There were also 65 building societies and 700 credit unions that together held assets of around £400 billion. The four major U.K.-owned commercial banks accounted for about 24 percent of the resident banking activities in the U.K.1 Assets of U.K.-incorporated banks, consolidated across branches and subsidiaries in the U.K. and worldwide, were around £2,500 billion.2

22. The U.K.-owned banks have a diversified set of claims against domestic and foreign counterparties (Table 2 of Statistical Appendix). Around 40 percent of total bank claims were against foreign counterparties, of which around half were cross-border claims,3 while the rest were foreign exposures in local currencies in banks’ branches and subsidiaries worldwide. In addition, off-balance sheet items of U.K.-owned banks represented around £925 billion, of which 17 percent are over-the-counter (OTC) derivative instruments—measured by their credit equivalent—mainly with domestic and foreign bank counterparties.

23. A few of the major U.K. institutions are Large Complex Financial Institutions (LCFIs), but most LCFIs operating in the U.K. are headquartered elsewhere. Generally, LCFIs are active in a range of commercial banking, investment banking, and insurance activities, have a significant presence in other major financial centers, and are active, often as market makers, in key OTC markets such as derivatives and foreign exchange. They have significant links to U.K. markets and counterparty credit relationships with domestic financial institutions that represent potential channels for contagion in the U.K.

24. Insurance and pension funds account for roughly another third of the financial sector’s contribution to GDP and employment. The U.K. general insurance industry is the third largest in the world (accounting for about 10 percent of worldwide net premium income) and consists of insurance companies, the Lloyd’s insurance market, underwriters, brokers, and intermediaries. The U.K. is the world’s leading market for internationally traded insurance and reinsurance. It includes the most important cross-border non-life insurance markets in Lloyds and the London Market, which together account for 65 percent of annual global cross-border non-life premium flows. It is also a significant supplier of life insurance products to residents of other EU countries.

25. U.K.-based insurers and self-administered pension funds are the most important repositories of U.K. household financial wealth. Of the £3 trillion in total financial assets held by households and related non-profits, more than half consisted of insurance policyholder related liabilities. Total investment assets under management exceed £1 trillion, and the life and pensions sectors are major providers of finance to government and private borrowers and major holders of equities.

26. The U.K. is one of the largest centers in the world for the management of institutional equity holdings. More than US$2.5 trillion of institutional equity holdings are managed by London managers—more than Amsterdam, Paris, Frankfurt, and Zurich combined. Two-thirds of this is managed for U.K. institutional clients and about 20 percent for foreign clients (the rest is for private U.K. clients). Edinburgh and Glasgow are also important centers in this regard—they rank fifteenth in the world. U.K.-owned and foreign investment banks operating out of London control over 40 percent of funds under management in the U.K.

27. The securities industry mainly consists of affiliates of domestic and foreign banking groups plus a large number of small independent firms. Also important in the U.K. is the substantial number of Highly Leveraged Financial Institutions (HLFIs), typically in the form of the funds management operations of hedge funds. While the funds themselves are offshore, they could become a source of market and credit risk in the U.K. financial system in the future should their leverage and risk taking increase. The amount of leverage that HLFIs can raise is limited by the financing that financial institutions are willing to extend to them, which in turn depends on the stringency of their risk management systems and the quality of information HLFIs provide to them. From a consumer protection angle, there would also be a concern if they started managing funds on behalf of retail investors: so far, however, this has only happened in a very limited way.

B. Markets

28. U.K. financial markets are highly-developed and international in nature. There are now six financial exchanges in London, of which the most active are the LSE and the Euronext LIFFE. More foreign companies are listed on the LSE than on any other exchange, and daily trading volumes for foreign equities are almost double those for domestic companies. Overall, the U.K. is the fifth most active center for exchange-traded derivatives contracts, with a seven percent share of global trading activity. Its success in attracting overseas business can be attributed to several factors, including: the network economies associated with a concentration of expertise in one place; a well-developed legal system; and the perception that the U.K. has a “proportionate” approach to regulation.4

29. The international character of U.K. markets is also reflected in the fixed income, foreign exchange and derivatives markets that operate on an OTC basis. The U.K. is unique among major industrialized countries in that a very large share of this trading represents cross-border transactions between financial institutions denominated in currencies other than the British pound.5 For example, the interbank market mainly consists of interbank deposits denominated in U.S. dollars and euros. In the foreign exchange market, the U.K. accounts for more than 30 percent of global market turnover, and is typically the most active trading center for currencies outside their home market. The U.K. also accounts for more than 70 percent of the global market for international bonds, which is dominated by U.S. investment banks operating out of London. Gilts account for almost half of domestic bonds outstanding and almost all secondary market trading. In derivatives, the U.K. is the most active center for OTC derivatives in the world (36 percent market share even though sterling transactions only account for 8 percent globally). Again, most transactions are in either U.S. dollars or euros.

30. The sterling money market is primarily a market for unsecured short-term interbank deposits and certificates of deposits, with a market for gilt repos growing in importance in recent years. In June 2002, unsecured obligations represented more than half of money market claims outstanding. The interbank market is also rather concentrated, 57 percent of interbank claims in the U.K. were held by ten institutions in 2001—a share that has been slowly rising in recent years as the banking industry consolidates. However, the unsecured segment of the sterling money market has declined markedly from the 80 percent level that prevailed prior to the introduction of repos in the mid-1990s. Since then, repos backed by gilts have become more prevalent as banks entered the repo market to shift from holding gilts on an outright basis to a repo basis, so that they could better manage their sterling liquidity.

31. A recent addition to OTC markets is the development of a market for risk transfers. This market comprises a range of transactions designed to enable financial institutions to trade different forms of risk between themselves or with other investors. Typical forms of risk transfers involve the transfer of credit risk from banks to insurance companies and institutional investors (e.g., through credit derivatives or asset-backed securities), and to a lesser extent, the transfer of insurance risk from insurance companies to other FIs (e.g., through a catastrophe bond). So far, U.K.-owned insurance companies have not been very active in these markets.

C. Payment and Settlement Systems

32. The value and volume of payments passing through the various U.K. payment systems has increased considerably in recent years, the value now being equivalent to around half of GDP on a daily basis. The main high-value payment system is CHAPS, the second most active RTGS system in the world. In addition to handling sterling transactions, there is also a CHAPS euro system, which provides for euro payments between member banks as well as the U.K. connection to TARGET (the system linking national RTGS euro systems within the EU). The two main retail payments clearing arrangements are BACS for non-paper items and the Cheque and Credit Clearing Company for paper items. On the foreign exchange side, potential vulnerabilities in settlement arrangements are being addressed through the creation of CLS Bank, which introduced real-time payment-versus-payment for foreign exchange transactions in September 2002.

33. CREST is the main securities settlement system. In late 2001, it moved to real-time delivery-versus-payment in central bank money in order to eliminate intraday risk that previously existed. However, this risk still exists for money market instruments, where payments are settled through the CMO at the end of the day on a net settlement basis. The necessary legal, operational and market processes are now in hand for integration of the settlement of money market instruments into CREST. In July 2002, an agreed merger between CREST and Euroclear was announced as a step towards building a European-wide securities settlement system. LCH acts as the central counterparty for transactions on financial exchanges and increasingly for some OTC markets such as interest rate swaps, offering economies of scale advantages in risk management.

D. Institutional and Policy Framework for Financial Stability

34. The U.K. financial stability policy framework is well-designed with clear focus, accountability and transparency arrangements, and effective modalities for formal and informal coordination across agencies. This institutional architecture is strongly supported by a strengthened macro-policy framework, well-functioning systemic liquidity and public debt management policies, a high quality accounting, auditing and disclosure regime, and effective safety net and insolvency arrangements.

35. A lynchpin of the financial stability policy framework in the U.K. is the FSSC, governed by the Memorandum of Understanding (MoU) between the BoE, the FSA and HMT. U.K. authorities have gone further than most of their counterparts by formulating an MoU that clearly articulates the roles and responsibilities for each of these agencies in the financial stability domain. The MoU and the associated FSSC composed of senior officials from each institution have helped to sharpen the focus and accountabilities of each of the players, as well as facilitate appropriate coordination and information sharing across the three institutions. In addition, these arrangements help ensure that the government is fully cognizant of the FSA’s approach to the regulation and supervision of financial institutions and markets.

Regulation and supervision

36. Under the FSMA 2000, which came into full-effect in December 2001, the U.K. has moved to a single regulatory agency (the FSA) and one governing statute. Generally, the FSMA provides a framework of four statutory objectives within which the FSA prepares more detailed rules. After lengthy consultations with stakeholders, a handbook of such rules has now been published. This reflects the FSA’s evolving approach to supervision. Some new rules are introduced for application commonly across all institutions, while others replace those set by the FSA’s predecessors in individual areas of regulated activity.

37. The FSA is implementing a general principle that similar risks across regulated entities should, to the extent feasible, be regulated in the same way, regardless of the type of institution. Full implementation of this strategy, with supporting rulebooks, will be a major item on the FSA’s agenda for several years to come. The FSA has also adopted a risk-based operating framework that focuses on the risks to its statutory objectives, taking into account the seven principles of good regulation that are also listed in the FSMA. The framework is applied both with respect to the FSA’s own strategic priorities, and to its supervision of regulated individuals and institutions, so that a close and continuous supervisory relationship is maintained for high risk/high impact institutions, while lower risk/lower impact entities are subject to more routine oversight. Another feature is the continued (albeit somewhat reduced) use of institutions’ own internal and external auditors and other “skilled persons” in the supervision process. Supervisory initiatives require preparation of explicit cost-benefit analyses.

Accounting, corporate governance, and information disclosure

38. U.K. accounting standards emphasize a “substance over form” approach, and are internationally recognized as being of a high quality. However, in listed company consolidated financial statements at least, they will be replaced by International Accounting Standards in 2005, in line with the EU’s “Convergence Regulation.” While U.K. standards are reasonably close to IAS, significant changes will be required. Few U.K. financial institutions currently report reconciliations of their accounts, prepared on the basis of U.K. standards, to international or U.S. GAAP standards. Thus, while convergence to international standards will help to harmonize accounting standards in concept, it will have significant implications for disclosure practices, and may accordingly affect financial market prices. The FSA is considering the implications of these accounting changes for regulatory reporting and supervision.

39. The U.K. disclosure regime is primarily based on the requirements of the U.K. Listing Rules and the annual publication of insurance company prudential returns. Among other things, the Listing Rules require publicly-traded financial institutions and non-financial corporations to annually publish financial statements that are fully audited and six-monthly interim statements, with continuous public reporting of significant events. They also incorporate disclosures on compliance with the governance arrangements contained in the Combined Code of Corporate Governance. The FSA is currently engaged in a number of initiatives to strengthen prudential and governance disclosures as well as consumer disclosures.

Insolvency framework

40. The U.K. insolvency regime contains a number of tools to address the problems of financially troubled companies. These include contractual receiverships and various procedures for the winding-up (liquidation) of companies, together with “administration” and “company voluntary arrangement” (CVA) procedures to, inter alia, facilitate the rehabilitation and rescue of troubled companies. Informal consensual workouts are also undertaken outside of these formal statutory processes, generally using principles embodied in the “London Approach” and the more recent INSOL Statement of Best Practices for Multi-Creditor Workouts.

41. The importance of rehabilitation and giving companies a fresh start has been a major theme of the Government over the last few years as it strives to promote enterprise and improve economic productivity. This has led to passage of the Insolvency Act 2000 (whose important CVA moratorium provisions for small businesses became effective on January 1, 2003), and to passage in late 2002 of the Enterprise Act. The latter legislation severely restricts the ability of “floating charge” holders to appoint administrative receivers (thereby shifting the balance away from individual administrative receiverships in favor of collective creditor proceedings); modifies and streamlines the existing administration procedure in significant respects (inter alia, by providing for non-court routes into administration); and abolishes the Crown’s status as a preferential creditor, preserving for unsecured creditors a portion of the amounts that are no longer payable to the Crown.6

42. The U.K. has no special statutory regime to address the insolvency of financial institutions. As such, banks and other financial institutions are subject to the same formal insolvency procedures as unregulated companies, with certain exceptions. For example, the FSA (the Financial Services Compensation Scheme—FSCS—in some circumstances) has various rights in insolvency proceedings involving financial institutions, and banks and insurers will not be able to benefit from the CVA moratorium that is to be made available to small companies. More generally, the insolvency practitioners appointed as, say, administrator or receiver of a financial institution would normally consult closely with the FSA in carrying out their responsibilities. In administrative proceedings, bank depositors might be subject to a stay that prevents the repayment of deposits. However, administrative proceedings trigger compensation arrangements through the FSCS for bank depositors. Administration does not in itself prevent repayment of deposits if administrators decide to do so.

43. The authorities, however, can take a number of enforcement actions before an institution reaches the stage of statutory insolvency proceedings. The FSMA gives the FSA a broad range of enforcement powers that can be used to deal with a troubled institution, including the ability to seek remedial plans from a firm to restore its financial position; it can also facilitate or coordinate market solutions for dealing with a troubled institution. Events with a systemic aspect would be dealt with at the level of the tripartite Financial Stability Standing Committee. Decisions on emergency liquidity support to an individual institution or to the market more generally would likewise be coordinated by this committee. In some cases, however, informal pre-statutory efforts may end in a statutory process (for example, Barings was ultimately resolved using statutory administration procedures after the BoE’s attempts to arrange an informal “lifeboat” operation proved unsuccessful).

Financial sector safety nets

44. The U.K. authorities prefer to facilitate private sector solutions to liquidity or solvency crises when practical, rather than provide public funds to support ailing institutions. There is no formal guidance, or examples in the last few years, as to how emergency financial assistance would work in practice beyond the principles laid out in the MoU between HMT, FSA, and the BoE. When public sector assistance was required, the authorities focused more on the possible systemic implications than on the size of the institution per se. Any official assistance might take a variety of forms—ranging from liquidity assistance from the BoE to the market or to an afflicted firm, to solvency support where it might typically still be channeled through the BoE’s balance sheet, but where a Treasury guarantee might be required. In addition to direct last resort lending, the BoE has occasionally inserted itself between the counterparties of a transaction when this is required to ensure that markets continue to function smoothly, or to facilitate the orderly liquidation of a troubled institution. The U.K. also provides protection to depositors/investors who may obtain compensation from an ex-post industry funded scheme (FSCS) covering not only deposits, but also investments and insurance, a form of coinsurance arrangement applies (except for compulsory insurance) and compensation is limited to certain maximum limits for depositors and investments.

Systemic liquidity and public debt management arrangements

45. The BoE’s monetary operating procedures have been significantly revised in recent years, helping to promote well-functioning financial markets which also benefit from the conservative management of public debt. The range of counterparties and collateral accepted by the BoE was significantly broadened in the late 1990s to facilitate more efficient liquidity management in the money market. U.K. markets have also benefited from the anchoring of inflation expectations that accompanied the adoption of inflation targeting as the monetary framework in October 1992, a move that was reinforced by the granting of operational independence to the BoE in 1997 and measures to improve the transparency and accountability of monetary policy. On the public debt front, public sector net debt totaled less than 30 percent of GDP in March 2002, the lowest ratio since 1992. There is minimal rollover risk and exchange rate risk in the U.K.’s public debt. Most of it consists of long-term bonds (gilts); there is only a limited amount of Treasury bills and foreign-currency debt outstanding. Most of the debt is held by U.K. insurance companies and pension funds. Non-residents hold less than 20 percent of gilts outstanding.

E. Financial Crime

46. The legal framework has a number of components that deal with the prudential and criminal aspects of AML/CFT. There are also important statutory instruments, including in particular the Money Laundering Regulations 1993 and Money Laundering Regulations 2001. Moreover, the FSA has issued a Money Laundering Sourcebook for prudentially regulated firms that is intended to add a regulatory (as opposed to criminal law) focus on anti-money laundering systems and controls, and as such is parallel to, but separate from, the Money Laundering Regulations. The institutional arrangements are complex and include the following organizations:

  • the FSA, which not only has responsibility for regulatory and supervisory oversight, but also has the power to initiate criminal proceedings against regulated persons for breach of money laundering regulations;

  • HMCE, which was recently given responsibility for the oversight of money service businesses, and also exercises a wide range of law enforcement and even prosecution responsibilities;

  • HM Treasury and the U.K. Home Office, each of which has responsibilities for aspects of the policy and legal framework;

  • the NCIS, which has an Economic Crime Unit that serves as the U.K.’s FIU and also has broad responsibility for collating and coordinating the U.K.’s intelligence for AML,/CFT and other serious crimes;

  • over 50 national and local law enforcement agencies with jurisdiction over AML/CFT;

  • agencies with responsibility for prosecution of AML/CFT and for confiscation and other judicial proceedings, including the Crown Prosecution Service, the Serious Fraud Office and HMCE. In addition, a new Asset Recovery Agency was provided for in the Proceeds of Crime Act 2002.

  • A variety of HMG agencies and interagency groups with responsibility for various aspects of AML/CFT and other serious crimes, including the Serious Fraud Office and National Crimes Squad.

III. Macroeconomic Environment

A. Recent Macroeconomic Developments

47. The U.K. financial system has benefited from a stable macroeconomic environment, with sustained growth and low inflation for nearly a decade. These achievements owe much to sound macroeconomic policies, a strong policy framework, and sustained structural reform. In recent times, the monetary policy framework, based on inflation targeting and operational independence of the Bank of England, has emphasized transparency and predictability of monetary policies, and has succeeded in anchoring inflation expectations and fostering a stable monetary environment. As a result, nominal and real long-term interest rates have been low and stable. Also, the introduction in 1998 of a fiscal policy framework with a medium-term orientation and the marked strengthening of the public finances have been instrumental in minimizing demand shocks and fostering a climate conducive to high levels of investment. Sustained labor market and welfare reforms have allowed unemployment to fall to historical lows without triggering inflation. Output has increased by an average of 2.9 percent per year during 1992-2001, while inflation was the lowest in the EU in 2001.

48. Accompanying this strong economic performance, however, has been the emergence of some imbalances. Since 1996, as sterling appreciated sharply, growth has primarily been sustained by domestic demand—more recently by private and public consumption—while the current account has remained in deficit and has typically been a drag on growth. Buoyant domestic demand has been fueled by low unemployment and gains in disposable income and, particularly in the last two years, by burgeoning house prices and strong credit growth. As a result, private sector indebtedness has risen to high levels, and while corporate borrowing growth has declined recently, household credit growth remains unabated. On the supply side, the service sector has sustained strong growth, but manufacturing has slumped—hit by the strength of sterling and the recent decline in world demand.

49. Turning to the current conjuncture, the U.K. economy has experienced a slowdown in activity reflecting global developments and the recession in the information and communications technology and other “new economy” sectors. Output deceleration has been milder than in most other G-7 countries on account of fairly resilient consumer demand and expansionary policies. House prices have accelerated to a 12-month rate of 25 percent in 2002. The signals from financial and money markets remain somewhat mixed. Equity prices remain weak and prospects uncertain, partly reflecting the risks of conflict in the Middle East. Fixed income markets expect a stable monetary policy stance through the first half of 2003; the BoE’s official repo rate has been left unchanged at 4 percent since November 2001. Partly as a result of the recent appreciation of the euro against the U.S. dollar, sterling has depreciated somewhat against the euro and on a trade-weighted basis, but remains strong by historical standards.

B. Macroeconomic Sources of Risk to Financial Stability

50. The importance of domestic business to the balance sheets and profitability of U.K.-owned banks has helped to cushion them so far from the global slowdown. However, potential risks could emerge from the rapid growth in household and corporate borrowing that has taken place in recent years and some weakness in parts of the corporate sector. Also, external developments could pose risks given U.K. banks’ sizable foreign exposures.

51. Household debt-to-income is at a record high, due primarily to the rapid growth in mortgage lending that has fueled the strong growth in house prices. So far, however, households have not had difficulty in repaying debt and the default rate of households is at a historical low level (0.09 percent). This is partly due to the low unemployment rate and the low level of nominal interest rates. Measures of household gearing are significantly lower than their peaks in the late 1980s and early 1990s, and the default rate is also significantly lower than in the early 1990s.7 Nevertheless, as recent official publications have noted, the longer the growth in indebtedness continues, the more important the risk to sustainability becomes.8 Likewise, the longer that house prices grow rapidly, the more the risk of a sharp correction. A slowdown in household income growth or a rise in unemployment, particularly if accompanied by such a sharp correction in house prices, could adversely affect the sustainability of household debt levels, as could increases in interest rates given the floating rate nature of much of the debt.

52. Corporate debt-to-profit ratios are also high and are still growing in some sectors, while some corporate sectoral weakness remains, particularly in telecommunications and manufacturing. However, loans to manufacturing companies have continued to shrink, reflecting the pattern of domestic economic growth, while lending to the service and commercial property sectors has grown. The corporate bankruptcy rate has remained low (0.27 percent).

53. The domestic picture could thus change under different scenarios. For example, if economic conditions were to deteriorate due to a slowdown in domestic demand, banks’ profits would be affected in several ways. The high competition that prevails in the U.K. banking market, which in recent years has translated into smaller interest margins, has been offset by higher lending volumes and fee income. In the event of a slowdown in domestic credit demand, this strategy could be jeopardized. Scenarios with higher interest rates or rising unemployment are also a threat to banks’ profitability, especially if they are accompanied by falling house and commercial property prices from current peaks. Under those circumstances, the high indebtedness of the corporate and household sectors compounded with a concentration of corporate loans to the commercial real estate sector could prove problematic, leading to higher provisions, reduced profits, and a potential negative impact on banks’ capital.

54. Potential risks for U.K. banks also arise from the slow-down of the global economy and any additional deterioration of credit quality worldwide, due to their large exposures to foreign counterparties. U.K. banks have recently proved resilient to credit deterioration stemming from the sharp slowdown in global growth in 2001 and 2002, weak equity markets, and to large corporate and sovereign defaults (Enron and Argentina). However, potential sources of risk could emerge from a more protracted downturn in global demand than currently envisaged (for instance, as a result of tensions in the Middle East), and from a further fall in equity prices that could result from a downward revision in expected corporate earnings, particularly in the U.S.

55. Insurance companies’ and pension schemes’ income has been eroded by lower interest rates and weak equity markets; the latter factor in particular is a continuing risk element. The life insurance and pension sector has been especially affected by these trends, owing to its large holdings of bonds and equities. Difficulties in this sector have been magnified by some long-term liabilities based on guaranteed annuities or defined benefit schemes—often extended during periods of high interest rates and strong return on equities.

56. Apart from being affected by market risk, the insurance sector also constitutes a potential source of market risk, since insurance companies hold around a fifth of total U.K.-quoted equities. Insurance companies are currently subject to a “resilience test” that requires them to be able to withstand a given percentage fall in equity markets, and can have the unintended consequence of causing large sales of equities if all companies seek to rebalance their portfolios simultaneously. Indeed, in September 2001, the FSA temporarily suspended this test, forestalling destabilizing sales of equities by these companies at the time; and in June 2002 amended the test (to apply until at least May 2003) to reduce the impact of short-term market volatility by allowing companies to take account of equity price changes over the preceding 90 days, subject still to testing against a fall in equity prices of a further 10 percent.9

57. General insurance companies in the U.K. and other countries have also been hit by declining investment income. This is particularly significant because, in common with insurers elsewhere, they have been relying on investment income to offset underwriting losses. Moreover, this sector suffered substantial losses as a consequence of the September 11 terrorist attacks—estimated at about £2.5 billion, with a high concentration in the Lloyd’s market.10 However, it has benefited from subsequent increases in insurance premiums, and possibly from increased demand prompted by a heightened perception of risk.

IV. Vulnerabilities and Soundness of the Financial System

A. U.K.-Incorporated Banks

58. U.K. banks appear to be sufficiently profitable and well capitalized overall to be able to absorb, without systemic distress, the losses that might arise if the potential risks above were to crystallize. U.K. financial soundness indicators need to be interpreted with some caution (e.g., the need to rely on data from different sources with different levels of aggregation make compilation highly complex), but that said, the return on assets and equity have been coming down from their peaks of 1999, mostly due to narrowing interest spreads and reduced fee income, as well as higher non performing loans (NPLs) and provisions. However, bank profitability has remained reasonably high—although with some dispersion—when compared with historical and international performance.11 Tier 1 capital adequacy ratios are around 8 and 7 percent for the large commercial and mortgage banks respectively, and there has also been a fall in their unprovisioned NPLs relative to capital.12

59. A range of stress tests were developed by staff in conjunction with the U.K. authorities, in order to assess the ability of banks to absorb potential losses that may arise under alternative stress scenarios. A range of methodologies were used as a way of cross checking the reasonableness of results. A sample of large banks were asked to estimate the impact on their profits of shocks selected by the authorities and IMF staff that were translated into a set of consistent macroeconomic variables using the BoE’s main medium-term macroeconomic model. These scenarios embody an assumed monetary policy response by the authorities. The banks were also asked to calculate the first-round effects on their trading book of changes in some key individual variables. In addition, the authorities used aggregate supervisory data to compute the effect of the macroeconomic scenarios on the building societies sector. Finally, the FSAP team independently estimated the effects of several domestic and external shocks on the banks’ profits and capital with the help of some vector-autoregression models. Details on the stress test methodologies and results can be found in Appendix I.

60. The stress test results indicate that the stability of U.K. banks should not be compromised by the shocks postulated in the stress scenarios. The results obtained from the different approaches are consistent in that U.K. banks should still be profitable even in the event of relatively large shocks. Potential losses calculated under different methodologies never exceeded their annual profits or represented a large fraction of banks’ capital. Moreover, the standard deviations of the results from the bank-run scenarios are also tight, implying that the results are broadly consistent across institutions.

61. Supplementary information and indicators point to the fact that while new forms of risk continue to arise owing to innovations in the financial system, the credit risk component remains the most relevant one for U.K. banks, including in the event of equity price declines and other market risk sources.13 Indicators of other forms of risk were discussed with U.K. authorities, such as market risk in traded portfolios, interest rate risk in the banking portfolio, and liquidity risk. Institutions are aware of these risks and have specific structures in place to manage them. Potential losses due to these sources of risk appear to be generally well covered by capital.

B. Insurance Industry and Pension Funds

62. The insurance industry is under considerable stress. Although such stress is not limited to the U.K., locally it reflects depressed investment returns coupled with the effect of (appropriately) more stringent prudential supervision; tighter regulations surrounding the design and marketing of long-term insurance and savings products; rising uncertainty about general insurance companies’ exposure to very low probability and catastrophic (“long tail”) risks; and depressed capital resources for a significant number of players. One measure of financial strength, the “free asset” ratios of larger U.K.-resident insurers declined to a median value of around 6 percent for 2001, compared to levels some 1½ to 2 times higher in the preceding three years.14 An analysis of the life industry by capital strength shows a distinct bimodal distribution, with a large number of (generally smaller) life companies having capital relatively close to minimum required capital levels, and a smaller group maintaining much stronger capital positions. Furthermore, despite a reduction over recent years, U.K. life insurance companies remain heavily exposed to equities,15 and further losses will have been suffered in recent months.

63. However, it is also important to note that life insurance companies have been able to pass some of their investment losses on to policyholders by adjusting terminal benefits due to them and the cancellation penalties applicable to policies that are terminated ahead of schedule. U.K. authorities indicated that these measures helped companies manage their solvency positions when equity prices were falling, although judicial interpretations of the reasonable expectations of policyholders may in some cases limit this (as seen in the recent Equitable case). In addition, a number of life insurers have been raising further capital, either from markets or from their parents. Nevertheless, against this background, the life insurance industry, in particular, could be headed for large-scale consolidation in the coming years.

64. The general insurance industry does not face issues that are as difficult as those facing the life sector; however it does have its own challenges. These mainly relate to operating in a world of low investment returns, much fatter and less tractable claims tails than were previously thought to exist, and looming in the near future, a more demanding recognition of liabilities and capital allocation under a risk based prudential regime.16 These secular trends are all superimposed on an insurance premium pricing cycle that historically has been difficult to manage due to fluctuations in capitalization levels (which determine industry capacity). After a long period characterized by excess capital and strong price competition,17 the U.K.-based general insurers have been able to accelerate and widen a rise in premium rates especially post-September 11, 2001 (though the trend began in early 2001). London market players and Lloyds members in particular were hit hard by the terrorist attack on New York, but the U.K. underwriters appear on the whole to have coped remarkably well, even though certain segments of the market remain vulnerable.

65. Overall, the difficulties in the insurance sector, although significant, do not currently appear to be of a systemic nature; but they clearly require very close monitoring. The authorities are already closely involved in dealing with the situation and, up to now, most of the difficulties have been concentrated in small- to medium-sized long-term insurers. However, some larger companies, including non-life insurers with “long tail” liability exposures, could also be at risk if equity prices were to remain depressed or continue to decline for a prolonged period. The ability for life companies to pass at least some of their losses to policyholders provides an additional buffer, but further new capital may be needed in some cases. At a broader level, the links between insurers and banks have been growing but appear manageable to date: they are less tight that in countries where financial conglomerates offering both banking and insurance products have long been established. In addition, bank loans to insurers, a traditional channel of

66. contagion, represent only a small fraction of U.K.-owned banks’ claims.18 Linkages through the risk transfer markets also appear moderate given the current relatively low activity by U.K. insurers, but like other potential channels for spillovers will need to be watched. General insurers as a group, meanwhile, have been able to increase profits, at least in the short run, since the higher post 9/11 premiums have more than offset any increases in claims. In addition to the quite immediate problems in the insurance sector, there is the strong imperative to overhaul insurance supervision to introduce more risk-sensitive governance and prudential measures, and in particular, risk-based capital combined with appropriately determined long-term and long tail liabilities. The authorities have the task of achieving this supervisory reform expeditiously at the same time as they deal forcefully with the current problems in the industry.

C. Major Financial Markets

Resiliency of exchange-traded markets

67. The financial exchanges in London play an active role in intermediating funds and securities for both domestic and international investors. Like other major markets around the world, those in the U.K. have had to cope with a number of global shocks in recent years, including the boom and subsequent bust in share prices for high-technology and telecommunications firms, and the recent slowdown in global economic activity. In addition, U.K. debt and equity markets have had to cope with changes to U.K. pension and accounting rules, which are causing insurance companies and pension funds (the principal investors in U.K. equities) to reduce their holdings of equities in favor of fixed-income securities. Also in the background has been the consolidation of the securities regulators that supervised U.K. financial markets into the FSA, and the move to a risk-based supervision approach. These developments are expected to have significant implications for the future regulation of these markets.

68. The quality of trading on U.K. financial exchanges is high, and the exchanges function well. Concerns associated with market fragmentation have not yet arisen to a significant degree in the U.K. compared to some other industrialized countries. In some sectors, OTC markets and alternative trading systems could pose a competitive threat to the exchanges. However, in recent years the LSE and Euronext LIFFE have taken steps to enhance their trading systems and adapt their rules to ensure their markets remain attractive to investors.

Demands placed by global markets on the U.K. financial system

69. The global financial market activity that takes place in London does not appear to pose significant risks to the stability of U.K. financial markets or to the domestic financial system more generally beyond those that would normally arise from the cross-border activities of U.K. financial institutions. Although some of the U.K.-owned institutions are significant players in some of these markets, the trading activity is to an important extent insulated from the domestic financial system, in part because it primarily involves wholesale market transactions between branches of foreign institutions that have little connection to the domestic financial system. U.K.-owned institutions obtain most of their profits from the provision of financial services to the domestic economy rather than from their activities in global markets.

70. In addition, the nature of this activity is such that the location of trading in London is largely divorced from the final processing and settlement of transactions, except with respect to transactions that go through CHAPS-Euro and LCH. Although a large amount of back-office trade processing takes place in the U.K., it does not place significant additional demands on the U.K. payment and settlement systems.19 Two main exceptions are the LCH, which is playing a growing role in serving as the central counterparty to global OTC market transactions, and the RTGS payment system for the euro, which has an important node in London. It is critical that these parts of the U.K. financial infrastructure maintain their efficiency and risk-containment systems to ensure that they can handle the demands placed on them.

71. The global markets trading activity in the U.K. requires continued surveillance and supervision by the BoE and the FSA, who, together with central banks and supervisors in other major international financial centers, play an especially important role in promoting and fostering the smooth functioning of global financial markets. Both institutions play an active role in a number of international forums, promoting the development of more resilient institutions and market structures. The concentration of international financial activity in London also provides U.K. authorities with a useful perspective on developments and trends in the global financial markets, which can be invaluable when assessing the potential sources of strain that could affect the U.K. and international financial systems.

The risk of contagion associated with interbank exposures

72. The money market does a good job in distributing the liquidity supplied by the BoE. Market participants are generally able to distribute liquidity among one another without recourse to the BoE’s facilities. Similarly, the pound sterling foreign exchange market functions well, and has not required official intervention in recent years to promote orderly trading conditions. Both markets are also very liquid, although the increasing “lumpiness” of the order flows could potentially make it difficult for traders to manage their positions in stressful situations. This is not a trend specific to the U.K.; it is also evident in money and foreign exchange markets in other major global trading centers.

73. Although the large interbank segment of the money market functions well, it warrants close surveillance by the authorities because it could potentially act as a contagion channel in extreme circumstances. As noted previously, unsecured interbank deposits and CDs represent the largest segment of the money market, and most of them are held by less than ten institutions. The risk of contagion is also not helped by the fact that smaller U.K. banks tend to hold the most of their liquidity in the form of unsecured deposits issued by the largest institutions, nor by the two-tier structure of the U.K. payment system. Thus, while highly improbable, the failure of a major bank to honor its unsecured obligations could threaten the health of some other institutions. In light of the risks inherent in these exposures, the authorities are intensifying their surveillance of bilateral unsecured exposures between banks so that they can obtain a better sense of the distribution of these claims in the banking system, and the risk of contagion in the event that an institution is not able to honor its obligations. Consideration could also be given to publishing their findings on a regular basis, albeit in a highly aggregated form, so that banks can take the distribution of exposures in the system into account when they decide on how much unsecured credit they are willing to extend to one another.

74. While an active interbank market can be a useful market discipline device in that it forces banks to regularly “test their names” in the market, this could likely still take place if the unsecured segment of the market represented a smaller share of the money market. Consequently, the authorities were encouraged to continue championing measures that encourage netting, where feasible, and more trading between banks on a secured basis. However, there is also a need to ensure that such steps do not go so far as to unduly undermine the positions of unsecured creditors.

D. Payment and Settlement Infrastructure

75. Major reforms of the U.K. financial infrastructure have been initiated in recent years and the CHAPS and CREST systems are of a very high standard internationally. So far, the main priority has understandably been to improve the real-time gross settlement (RTGS) system for large-value payments and settlement mechanisms for the principal financial markets.

76. Nevertheless, some vulnerabilities remain, which need to be addressed. The tiering between direct settlement members and indirect members and end-users means that close attention needs to be paid to the risk exposures among inner-tier institutions and potential contagion risk. While CHAPS and CREST protect settlement members from intraday exposures, the two-tier structure of the payment system may still result in significant intraday exposures between direct and indirect settling banks, in addition to the overnight or longer exposures noted above. The U.K. authorities were encouraged to continue to give a very high priority to the identification and overall monitoring of these risks. This is all the more warranted in view of the rather common, and perhaps surprisingly explicit view of a number of market participants that the major settlement banks are “too big to fail.” The authorities are also rightly encouraging improvements to BACS, the largest retail payments system.

77. Foreign exchange settlement continues to take place through correspondent banking relationships, and as in all major industrialized countries, represents a key area in which the management of settlement risk needs to be enhanced. The introduction of the CLS system in September 2002 is expected to bring a clear improvement in this area. As the CLS system becomes more actively used, there might be a need for increased attention to availability and liquidity issues in CHAPS, since CLS settlement takes place under a tight time schedule starting in the early morning—a time when a high volume of CREST DVP transactions is also currently settled. However, no bottlenecks have emerged so far.

78. In the securities settlement area, the clearing and settlement of money market instruments needs to be brought onto a real-time delivery-versus-payment basis in CREST, as is done for other securities. This will require a legislative change to fully dematerialize these instruments. The government has set in train a consultation process that, subject to Parliament, should deliver the necessary change by mid-2003. CREST is planning to start integrating these instruments into its system through the second half of the year. Thus, it is important that the authorities give a high priority to the required legislative changes currently being discussed.

79. LCH is conservatively managed and close to best practice in many respects, but has an important weakness with its payment scheme, where it settles its cash payments across accounts held at various commercial banks, rather than using a default-risk free settlement asset. The resulting intraday risk exposures, whilst short lived and involving a group of well-regulated banks, are of a magnitude that could threaten the integrity of LCH. Given the importance of LCH for the U.K. and global financial markets, the authorities are working to resolve this issue with LCH. In addition, the placement of most of LCH’s funds in the money market has been collateralized using a tripartite repo structure, in order to limit unnecessary credit risk exposures. On the legal side, there are uncertainties about certain minor proportions of funds paid in by members to LCH’s default fund and some residual uncertainties attaching to the cross-margining link with CME (although this currently handles only small exposures). Work is underway to identify the best method of rectifying these legal uncertainties.

V. Managing the Vulnerabilities

A. Financial Stability Policy Framework

80. Although U.K. financial institutions and markets are generally sound and function well, the financial stability policy framework needs to adapt constantly to ongoing innovations in the global markets, and the growing complexity of institutions. Large institutions are increasingly playing an important role in financial intermediation in the U.K. As noted in the previous chapter, this contributes to financial stability in that the institutions in question have been able to achieve a broader global diversification of portfolio risks, with a reduced risk of these institutions being undermined by individual shocks. Similarly, they are better able to justify the expense associated with adopting leading-edge techniques to manage the risks associated with their activities. In addition, the U.K. authorities are to be commended for the many steps they have taken in recent years to improve the underlying macroeconomic policy framework, and to build a more resilient financial system infrastructure. As a result, the financial system is now almost certainly better positioned to tolerate the failure of significant institutions, as evidenced by its ability to successfully weather the failure of Barings a few years ago. The authorities are now able to focus more on systemic situations when dealing with shocks, rather than on the size of the institutions affected. Nevertheless, there may still be an issue of “too big to fail” perceptions, that may be exacerbated in the U.K. by the two-tier structure of the banking system. The associated risk of moral hazard is another reason for continuous review and development of the policy framework across all its aspects.

81. The U.K.’s financial stability policy framework is well designed. The roles and responsibilities of the key players in the framework (BoE, FSA, and HM Treasury) are clear and well-articulated. This has enabled each institution to focus on its own respective role and to be more accountable for its actions. While the framework has yet be tested in a genuine crisis, the MoU provides a strong framework for coordination and information sharing amongst the three organizations, both in crisis periods and more normal times.20 In addition, the safety net underpinning the system reinforces market discipline through appropriate co-insurance arrangements. One aspect to be noted at this broad level concerns the specification of the four statutory objectives for the FSA, under the FSMA. Although the FSA has been able to give greater attention to consumer protection and financial crime issues without significantly undermining the attention paid to financial risks in firms and markets, there is the potential for the objectives to conflict at times, at least at the margin; or more precisely, with scarce supervisory resources, they may compete for management attention and supervisory resources. Prioritization of those objectives might change over time, and it could be expected that through the FSA’s risk-based operating framework (see Appendix II for a description), such changes would be discussed fairly explicitly in the FSA’s publications—although this has yet to be fully tested. In any event, this operating framework is a major stride forward in making decisions about supervisory attention and resource allocation more transparent and consistent.

82. The framework is also highly transparent. The FSA and the BoE both compare very favorably with international transparency practices, as evidenced by their strong observance of the financial policies section of the Code of Good Practices on Transparency in Monetary and Financial Policies (Section II). Nevertheless, some further refinements in specific areas could make the transparency even more effective. For the FSA, this reflects the fact that the implementation of its new regulatory framework is still taking shape, and there is some continuing uncertainty in the financial sector as to the precise implications. Thus, it may need to take additional measures to help regulated entities and the general public improve their understanding of the new regulatory framework, and some streamlining of its consultation process would be desirable. For the BoE, it would be desirable to: (i) make available more information on the framework for its financial stability role, including in a crisis situation; and (ii) continue to provide more detailed public reporting on its financial stability and payments system oversight responsibilities, building on the very recent advances in its FSR assessment article, and (iii), at an appropriate time formalize more directly its financial stability and payment and settlement systems oversight functions in legislation.

83. While the surveillance of systemic developments and structural issues and the authorities’ efforts to build a more robust financial infrastructure have been of high quality, several challenges remain. The BoE, in particular, is well-regarded for the quality of its surveillance of systemic developments and structural changes taking place in the domestic and global financial system, and both it and the FSA have taken a number of steps in recent years to improve the system architecture, such as reducing intraday exposures in the payments system and promoting the use of repos in the money market, to name but two examples. Effective surveillance requires continuing cooperation and sharing of data and qualitative information between the BoE and the FSA (as envisaged in paragraph six of the MoU). Going forward, both the BoE and the FSA were encouraged to continue with their efforts to analyze and monitor interbank exposures (as noted above), to further develop and publish a broader range of aggregate statistics on the financial sector, and to consider making more regular use of stress tests in their monitoring of the health of the financial system. These initiatives could help strengthen their base-line surveillance of the financial system as a whole, as well as provide an extra dose of market discipline if ways can be found to publish the results.

84. The Bank’s systemic perspective, together with the FSA’s efforts to monitor risks in the U.K. financial system and its risk-based approach to supervision, provide a proactive focus towards emerging vulnerabilities in the financial system and provides a useful anchor for the allocation of the FSA’s supervisory resources. Both agencies are also very active on the international front, working on various committees to champion measures that help to foster a more resilient international financial system. One example in this regard is their contribution to work on how to unwind the activities of LCFIs in an orderly fashion in the event that one or more of them were to experience financial distress.

B. Integrated Supervision

85. The role and performance of the FSA as the first fully integrated regulator in a major economy has attracted world-wide attention. The organizational restructuring involved in combining and regrouping up to 11 predecessor agencies has itself been a major, if still incomplete, accomplishment. The changes in the supervisory regime, however, go well beyond the consolidation of multiple separate agencies into a single organization. The FSMA represents a comprehensive update of U.K. financial supervision legislation. It consolidates authority for financial supervision under the FSA, and it gives the FSA broad new statutory authority to carry out its responsibilities. Statutory regulation has displaced most of the self-regulatory arrangements that had been a traditional feature of U.K. financial markets. With its four statutory objectives and seven principles of good regulation (see Appendix II for a listing), the FSMA has also reoriented the U.K. approach to financial regulation. Reducing financial crime and ensuring appropriate consumer protection have been made explicit statutory objectives. Traditional regulatory objectives such as depositor protection or investor protection are now implicit in the broader, more general objectives of maintaining confidence in the financial system or promoting awareness of and understanding of the financial system. The traditional U.K. emphasis on strong governance by regulated parties and a preference for minimally prescriptive regulation has been retained.

86. To give operational content to its abstract statutory objectives the FSA has developed a distinctive risk based approach to supervision. The FSA approach sets supervisory priorities based on the risks posed by regulated individuals and firms, and by industry-wide developments, to the achievement of FSA’s statutory objectives. Processes are now focused more sharply on meeting the specified (albeit broad) statutory objectives. As a result, the supervisory process in the FSA is giving greater attention to consumer protection and financial crime issues without diluting attention to financial risks in firms and markets. The principles of good regulation in the FSMA underpin the risk-based framework that the FSA has developed to guide its own supervisory efforts, and, inter alia, reinforce the traditional U.K. emphasis on strong governance by regulated parties and a preference for minimally prescriptive regulation. While the risk-to-objectives framework (see Appendix II to this Section) provides an orderly framework for setting broad supervisory priorities, it is implemented at a high level of generality that still allows for considerable judgment and flexibility in, for example, the firms and risks that attract close supervision, and in determining “how much” supervision is enough. The framework makes more explicit the areas where judgment is required, however, and explicit, cost-benefit analyses are required for significant supervisory proposals.

87. The principle that similar risks should be regulated in the same way, regardless of type of institution, is giving a strong impetus to integrating not only FSA rules but also its organization and processes, although this is still at a preliminary stage. Implementation of the FSMA has allowed the FSA to introduce a single enforcement regime applicable to all firms and individuals it regulates. The new regime sets out which regulated activities require authorization, and the FSA authorizes firms by giving permissions defining which activities they can carry out. The FSA has developed an authorization process that applies across all sectors, and it includes giving approval to individuals responsible for key designated duties in authorized firms. Development of the authorized-persons regime is also giving the FSA an important tool for implementing its supervisory strategy which looks to firms’ directors and management to take responsibility for compliance with rules and regulations. Conduct-of-business rules have been developed that apply across all regulated firms. Prudential requirements across banks, insurance companies, and independent securities firms remain quite distinct, although projects are underway to achieve greater harmonization. Regulation of insurance is undergoing a fundamental review, which may lead to adoption of elements of the risk-based strategies used in the regulation of banks. Reporting requirements are also undergoing a systematic re-evaluation that is likely to lead to more commonality across financial sectors.

88. The new FSA approach has involved some tensions at the operating level, but no gaps in regulation were detected as a result of these tensions. The risk-based approach to bank supervision is supporting the development of a more intensive oversight of the financial operations of large integrated financial firms, both domestic and foreign, that are so prominent in the U.K., but at the same time there is more competition for regulatory resources to carry out FSA responsibilities in the areas of financial crime and consumer protection. Specialized firms, particularly in the securities area, expressed concerns that their unique requirements might receive less attention as the integrated approach develops. Insurance firms expressed concern that the staffing and structure of the FSA will lead to bank-like supervision that may be inappropriate for insurance firms. Among financial firms there is some concern that the FSA’s

89. statutory framework, its strong statutory powers, and a greater priority to financial crime and consumer protections will push the FSA in the direction of a more rule-based regulatory regime. Staff turnover in the FSA has seen some skills loss in some specialized areas, particularly securities. To help mitigate such unavoidable tensions, the FSA engages in extensive consultation with industry before undertaking new initiatives. Industry contacts expressed strong appreciation for the openness of the FSA in its consultative processes.

C. Adequacy of Supervision

90. The quality and effectiveness of financial sector supervision in the U.K. is strong in the banking area. The FSA showed a high degree of observance of the Basel Core Principles for Effective Banking Supervision (Section II). Judged by results, the U.K. banking sector is well-capitalized, highly profitable and has shown considerable resilience to both market stress and in stress test simulations. The prudential regime for banks is fully developed, and well explained and documented in the Handbook. An extensive mix of on-site and off-site techniques is used to carry out ongoing supervision, with the intensity of FSA oversight calibrated to risks. Close attention is given to both the qualitative and quantitative aspects of supervision. Capital and large exposure requirements are firmly enforced on both a solo and on a fully consolidated basis. A clear framework is used to oversee risks arising from various lines of business wherever that business is conducted. Consistent with London’s role as an international financial center, the FSA has a very well-developed and active program for exchanging information and cooperating with overseas supervisors.21

91. A few additional measures were recommended to reinforce base line monitoring and to more fully exploit the on-site work done in the higher impact firms, and the FSA has already launched a project to examine issues here.22 The additional measures included: (i) the need for a more complete supervisory validation of systems and controls for “medium-high impact” banks; (ii) a possible need to undertake more on-site work for “low-impact” banks if measures to sharpen disclosure and market disciplines (noted below) are not implemented quickly; (iii) additional efforts to review and validate supervisory returns; and (iv) improved reporting requirements for classified and nonperforming loans.

92. The supervision of bank liquidity risk management could be improved. The Sterling Stock Liquidity Ratio used to supervise the liquidity of the major U.K.-owned banks has served an important function in ensuring a level playing field and minimum holdings of sterling stock liquidity in the context of prudential standards and the BoE’s official money market operations. However, it seems to have adversely affected the liquidity management behavior of some banks. In particular, some of them appear to be focusing too much on meeting the supervisory requirement, and are not using the more sophisticated liquidity management practices found elsewhere in the market. The FSA recognizes that the current approach used to supervise bank liquidity risk management practices needs to change, and is consulting with stakeholders on how best to proceed. It was encouraged to consider introducing a common liquidity reporting system for all banks that would collect liquidity data on a global basis, and to take more fully into account the maturity distribution of assets and liabilities in a behavioral sense.

93. In the case of insurance supervision, U.K. authorities are significantly strengthening supervision in this area, and are shifting resources within the FSA to insurance sector oversight. This is timely given the significant stress in the industry and the strong incentive for excessive risk taking in the current environment. Given the importance of U.K. insurance companies and markets in the global insurance industry, and the highly sophisticated nature of the U.K. market, the assessment of U.K. regulation in this area was made on the basis of the more stringent enhanced criteria underpinning the IAIS Insurance Core Principles (Section II). Even though it would be deemed to observe the prudential core principles using the more commonly used criteria, based on the enhanced criteria, (and at the time of the assessment at least) the FSA’s regulatory and prudential regime required an increased degree of hands-on prudential supervision and was not sufficiently proactive. Reflecting in part the absence of formal actuarial, general insurance, and reinsurance involvement in the risk review and assessment process, the current prudential regime may not ensure a sufficiently comprehensive review of the appropriateness of firms’ risk management systems, asset allocation limits, and internal controls, in light of the nature and amount of business underwritten.23 Also, the desk-based analysis of statutory returns may not adequately capture the nature and scale of risks of underlying asset and reinsurance exposures. The authorities were encouraged to consider a further strengthening of insurance supervisory resources and processes within the FSA. In addition, the need for improved transparency of early intervention actions was stressed, along with stronger reporting, disclosure, and governance-related requirements for insurance companies.

94. The FSA is already making important progress on insurance supervision reform. It is in the process of rolling out a strengthened approach under its risk-based framework, in line with its own comprehensive review of the prudential regime for insurance (see the “Tiner Report”) which was in train at the time of the FSAP assessment. These reforms are expected to remedy most of the shortcomings noted in the assessment of observance of the enhanced version of the IAIS Principles (see Section II).

95. Securities regulation is strong. The U.K. observes all of the elements of the IOSCO Objectives and Principles of Securities Regulation (Section II). Nevertheless, some technical suggestions were provided to enhance the quality of supervision given the importance of the U.K. as a major trading center in global markets. Inter alia, care needs to be taken to ensure that competitive pressures between markets and exchanges do not result in developments that undermine market participants’ ability to monitor the flow of buy and sell orders going forward.

D. Accounting, Corporate Governance, and Information Disclosure Issues

96. Though the differences should not be overstated, it seems fair to characterize the U.K. supervision regime as somewhat less prescriptive, and somewhat less intrusive overall, than in some other countries, but with relatively more emphasis on policies to promote market discipline. Regulatory principles of attention to the responsibilities of owners/managers, and proportionality of regulation (with the attendant requirement for explicit cost-benefit analysis of new regulatory proposals), are noteworthy in this context. Indeed, the logic of the FSA’s risk-based framework, and specifically the envisaged flexibility to shift supervisory resources between objectives and risk areas, requires a strong underlying disclosure and governance regime to cushion and minimize the potential costs of the shifts in supervisory focus in the face of unexpected developments. This consideration also has implications for the nature of supervision, which needs to rely on independent assessments of the effectiveness of systems and controls, a strong baseline monitoring of key risks, including through regular coverage of core themes (such as validation of returns, anti-money laundering, and credit risk management), and early intervention arrangements. In sum, continued further efforts to promote market discipline—if necessary, ahead of the completion of international efforts—are necessary to complement and underpin the U.K. supervisory philosophy, as well as being part of the policy response for minimizing perceptions of “too big to fail.”

97. There are a number of issues arising from U.K. convergence to IAS. Financial institutions, especially insurance companies, are facing considerable and complex changes to financial reporting which need to be implemented in a short period of time (before 2005). Some 34 standards are being reviewed. While the adoption of IAS offers considerable benefits in the form of comparable accounting across the EU and (in the case of insurance companies) more relevant financial reporting, the process to convergence will be extremely costly and resource intensive for financial institutions, particularly insurance companies. An especially difficult challenge will be the convergence to financial instrument accounting rules (IAS 39). These rules are quite restrictive, and many institutions that use derivatives to hedge economic risks could find themselves reporting more volatile earnings than if they did not hedge. They are looking to the FSA for guidance on how marked to market volatility arising from financial instrument accounting will be treated for regulatory capital purposes.

98. A new system of non-statutory independent regulation of the accountancy profession’s audit activities has recently been established under the auspices of the Accountancy Foundation (AF). That system of regulation of financial reporting is currently being reviewed by the Government. As part of that review, consideration should be given to bringing together the regulation of financial reporting, currently under the Financial Reporting Council (FRC), and the Accounting Standards Board (ASB), together with that of the profession, under the AF.

99. The FSA is conscious of the importance of having consumer self-help measures in place to reinforce market disciplines in the provision of financial services, and is taking measures in this direction. Given the significant reliance placed on disclosure practices in the supervision framework, the authorities should ensure that consumer investment advisor and investment product disclosures are not complex and use plain language, to develop depositor-friendly comparative prudential disclosures for deposit-takers, and to ensure that these requirements are adequately enforced.

100. There is also a need for market and credit risk disclosure requirements applicable across all sectors of the finance industry, or at least for the large or “high impact” financial institutions. Many large institutions are already disclosing market risk information using VAR methodologies and credit exposure concentrations. However, the usefulness of these disclosures is undermined because there is no industry-wide measurement standard (e.g., for VAR-holding period, confidence interval). Consideration could be given to mandating market and credit risk disclosure requirements broadly in line with the proposals of the Multidisciplinary Working Group on Enhanced Disclosures, starting with the large “high impact” financial institutions. In addition, all institutions should be required to publish financial reports on a six monthly basis that have at least “negative assurances” from auditors (certifying that they have no reason to believe that the reported information is not materially correct), coupled with a continuous disclosure requirement.

101. Proposals have been made to update governance arrangements in U.K.-regulated institutions. The DTI’s review of company law published in 2001 noted that U.K. law has fallen behind other jurisdictions that have rewritten their legislation, frequently based on U.K. models. The final report proposed a thorough revision to the U.K. law covering issues such as disclosure to shareholders, fair treatment, and accounting and auditing standards. Implementation of the report’s recommendations is expected to begin in the near future with the publication of a consultation paper.

E. Insolvency Framework

102. Receiverships and liquidations currently account for the majority of corporate insolvency proceedings in the U.K., and the U.K. system is still ranked as one of the most “creditor-friendly” among major industrialized countries. Nevertheless, the government’s recent reform initiatives, as embodied in the Insolvency Act 2000 and the last year’s Enterprise Act, make significant strides towards making the U.K. regime more supportive of business rescue while also ensuring protection of creditors’ rights. In this regard, it is commendable that the Insolvency Act’s CVA moratorium provisions became effective in January 2003, and it is recommended that the authorities continue with efforts to make the corporate insolvency provisions of the Enterprise Act effective as soon as possible.24

103. Despite the important and commendable reforms already undertaken, a few broad policy areas merit additional attention. Specific further measures would need to strike an appropriate balance between different considerations, such as whether they would make the system more effective in accomplishing the broader value maximization, risk allocation and financial soundness objectives that underlie orderly and effective insolvency systems. They would also need to be designed to avoid counterproductive results, such as encouraging commercially imprudent behavior by debtors, or creation of disincentives for lenders to provide reasonably priced financing to enterprises. Bearing in mind these issues, consideration should be given to adoption of the following additional reforms: (i) expanding the Insolvency Act 2000’s CVA moratorium procedures to cover a wider range of companies, including at least medium-sized businesses, given that the CVA remains the primary insolvency procedure which does not displace a firm’s existing management; (ii) examining the scope for inclusion of a moratorium in scheme of arrangement procedures, given the availability of these procedures for complex workout situations; (iii) broadening the criteria for commencement of administration proceedings to include additional circumstances where a debtor is not insolvent or in immediate danger of insolvency; (iv) reducing the creditor voting majorities required for approval of CVAs and schemes of arrangement, as a means of facilitating creditor approval of restructuring plans; (v) adopting reforms to expedite court approval of agreements that have been negotiated out-of-court between a debtor company and a qualified majority of its creditors; and (vi) adopting innovative solutions to facilitate the provision of financing to troubled but viable companies, while preserving the security interests of existing creditors.

104. The expeditious nature of the U.K. legal system offers some comfort that the FSA’s ability to take actions in the event of a financial institution’s insolvency should not be unduly constrained by the fact that they are subject to the normal corporate insolvency laws. Although the FSMA gives the FSA and FSCS a role in financial institution insolvency proceedings, the insolvency laws contain firm requirements governing the roles and duties of the court, and of the administrator or receiver appointed to manage the affairs of a troubled institution. These requirements would have to be observed by the FSA and other governmental agencies (subject of course to the FSA’s normal supervision and regulation of any regulated activities that may be carried on by an institution in insolvency proceedings). However, the FSA also has some strong rights that help balance this situation, especially the right to petition the court, a presumption that a receiver or administrator would consult the FSA, and the right to file objections with the court.

105. The option of pre-statutory insolvency actions by the authorities reduces the scope for any delays or difficulties from the various statutory routes, and the system appears to work well in practice. This does not completely eliminate the issue, however, as the statutory route may in some cases be unavoidable: for example, where pre-statutory efforts are insufficient to resolve an institution (e.g., Barings), or in cases where insolvency proceedings are initiated by any creditor of the institution (creditors are authorized to initiate proceedings where the statutory requirements are met without consulting the FSA). The authorities were encouraged to keep the issue under review to ensure that the balance of powers and duties continues to allow the authorities to do what is necessary from a stability perspective, and with a view to considering the scope and desirability of possible reforms to the system to broaden the ability of the FSA and/or other governmental agencies to restructure and liquidate financial institutions outside of the corporate insolvency system.

F. Safety Nets

106. If the U.K. regime is to be able to permit poorly-managed financial institutions to fail, its credibility will be highly dependent on appropriately designed safety nets that are well-understood by potential claimants. The FSCS is well-designed in that it supports the exercise of market discipline through the use of co-insurance risk-sharing when losses exceed prescribed modest thresholds (except in the case of compulsory insurance). Thresholds for co-insurance also help to ensure proportionately greater protection for those lower-income claimants least able to sustain financial losses. However, public awareness of the FSCS is limited and consumers will only directly benefit from the FSCS if they are aware of their rights and privileges under the scheme. This issue has been recognized by the authorities, who are taking steps to address it. In May 2002, the FSA issued a consultation paper, which proposed that regulated entities be required to disclose to their clients relevant information about the compensation scheme, its coverage, and limits. And, the FSCS is working with stakeholders and the media to make its presence better known. A review of the FSCS is upcoming, and one of the aspects that should be considered is whether a more explicit contingency credit line from the Government would be desirable.

G. Oversight and Supervision of Payment and Securities Settlement Systems

107. The oversight of the CHAPS payment system and CREST securities settlement system is strong. Although some technical strengthening of some aspects of the supervision of securities settlement systems is desirable, the overall effectiveness of the oversight arrangements is reflected in the fact that these systems are of a very high standard internationally, as evidenced by the U.K.’s high degree of observance of the CPSS Core Principles for Systemically Important Payment Systems and the IOSCO/CPSS Recommendations for Securities Settlement Systems (Section II). As noted previously, for the BoE, some further refinements over time on the transparency front would be helpful, but in any event oversight should include exploring the risk between the direct and indirect settlers, given the large interbank exposures that partially reflect the tiered payment system. Both the BoE and the FSA being designators under the Settlement Finality Regulations, and it is important that the flow of information and data between the two organizations continues to be smooth on both system- and settlement member-specific issues.

H. Systemic Liquidity Arrangements

108. The BoE’s monetary framework and operating procedures are fundamentally sound, and have contributed to well functioning financial markets. Monetary policy and the BoE’s market operations in money and foreign exchange markets are now conducted in a highly transparent fashion, as evidenced by the BoE’s strong degree of observance of the monetary policy portion of the Code of Good Practices on Transparency in Monetary and Financial Policies (Section II). This helps to minimize uncertainty in markets regarding the Bank’s intentions. In addition, the granting of operational independence in 1997 and associated institutional changes at the BoE helped to provide a clear focus to its monetary policy and financial stability activities, which has helped market participants by providing a stronger anchor for inflation expectations. Nevertheless, there is scope for some minor technical improvements at the margin, including: (i) possibly some streamlining of the BoE’s daily operations in the market if the daily liquidity forecasting process can be improved; (ii) the desirability of additional risk management mechanisms for the substantially expanded range of high-grade securities that are now eligible collateral for BoE operations; and (iii) down the road, possibly reintroducing some longer-term operations into the mix.

I. Public Debt Management

109. The management of public debt is not a source of vulnerability for the financial system given the low level of government indebtedness and the conservative approach to managing the risks associated with the debt U.K.’s practices are fully consistent with the IMF/World Bank Guidelines for Public Debt Management. The transfer of cash management responsibilities from the BoE to the DMO in 2000 went smoothly, and there have been a large number of initiatives to minimize the fragmentation of the debt stock and maintain issuance volumes in a period of modest borrowing requirements. Going forward, consideration could be given to some minor technical innovations, such as introducing some indicators to explicitly articulate the government’s preferred cost-risk tradeoff, and automating the bid-capture process used in debt auctions in order to reduce operational risk and improve auction-processing times.

110. Nevertheless, the gilt market has been distorted by changes to accounting and pension rules. It is important to note that these distortions are gradually being resolved by market participants themselves as insurance companies and pension funds become more adept at investing in non-gilt securities, and as other borrowers enter the market to take advantage of the high demand for sterling-denominated debt.

J. Financial Crime

111. The U.K. has a comprehensive legal, institutional and supervisory regime for AML/CFT that is broadly in line with the criteria set forth in the FATF 40+8 Recommendations and the AML/CFT Methodology (Section II). The only significant gap relates to FATF Special Recommendation VII, as current U.K. law (like the laws of most other countries) does not require the inclusion of originator information on funds transfers and related messages. In May 2002, the authorities issued for public comment a proposal to implement this

112. requirement, with exemptions for certain wire transfers. However, given the subsequent issuance for comments of a proposed FATF Interpretative Note on Special Recommendation VII, the authorities have decided to await the final outcome of the FATF consultation before finalizing any new requirements in this area. More generally, the AML/CFT framework has been made more robust over the last few years, with the adoption of key measures on terrorist financing and non-bank financial institutions (money services businesses—bureaux de change, money remitters, and check cashers), as well as by issuance of the FSA’s Money Laundering Sourcebook. Further substantive improvements should emerge once all the relevant AML provisions of the Proceeds of Crime Act 2002 are made effective, and a requirement is adopted to mandate the inclusion of originator information on funds transfers. The authorities were provided with some additional technical recommendations to enhance the strength and effectiveness of the legal framework and supervisory regime for AML/CFT in key areas.


Table 1.

U.K. Banks and Insurance Companies (March 2002)

article image
Table 2.

U.K.-Incorporated Banks—Composition of Balance Sheet Claims

article image
Source: Bank of England, BIS, FSA, and staff estimates
Table 3.

United Kingdom - Selected Economic Indicators, 1997–2001

Total population (end-2000) 59.5 million

GDP per capita (2001): $23,783.4

article image
Sources: Bank of England: and Fund staff calculations
Table 4.

United Kingdom - Financial Soundness Indicators for the UK Financial System, 1997-2002 1/

(In percent, unless otherwise indicated)

article image
Sources: Bank of England, FSA; Moodys and Fund staff calculations; S&P Thesys.

Aggregate data, unless otherwise indicated.

2001 data are as of September.

Consolidated figures arc for UK-owned banks only.

2002 figures are at of end October 2002.

Quarterly data reported as end of period basis in this is case, end June 2002.

Total UK non-life insurance less global branches.

All companies.

8/ As of June 2002.

As of March 2002.

Annualized on the basis for the first 6 months.

APPENDIX I U.K. FSAP: Stress Testing Methodology and Results


Stress tests performed by banks

113. Two types of tests were carried out by the U.K. banks. One set of tests;—scenario analysis—was based on shocks selected by the U.K. authorities and IMF staff that were translated into a set of consistent macroeconomic variables using the BoE’s main medium-term econometric model. The severity of the initial shocks was calibrated to represent a 0.5 percent probability event based on past history. Four adverse shocks were chosen to generate the stress scenarios: (i) 35 percent decline in world and U.K. equity prices (relative to the base case that incorporates a small rise); (ii) a 12 percent decline in U.K. house and commercial property prices (relative to a base case that has some deceleration in house prices from current levels); (iii) a 1½ percentage point unanticipated increase in U.K. average earnings growth; and (iv) a 15 percent initial unanticipated depreciation in the trade-weighted sterling exchange rate. All scenarios were estimated relative to a base case specially constructed for this purpose to give a plausible projection of macroeconomic variables. The base case assumed constant nominal short-term interest rates, starting from actual data available for 2001 Q4. It should be noted that since the scenarios are based on full macroeconomic simulations, they incorporate a monetary policy reaction function (simulated assuming a Taylor rule) that mitigates the effects of the exogenous shocks.

114. Each bank in the sample was asked to identify the potential impact according to five main risk classes: market risk, interest rate risk, credit risk, insurance risk, and a residual ‘other’ risk. The U.K.-owned institutions were asked to consider the effects on both their domestic and global operations. The foreign-owned institutions reported the impact solely in relation to business units operating in the U.K. The risk horizon was one year (March 2002-March 2003).

115. A second set of tests—single factor sensitivity tests—was based on the direct effect of separate single shocks on banks’ traded positions as of December 200125 under ceteris paribus assumptions. In addition to the scenario analysis, each of the banks were asked to investigate the impact on market risks in the trading book of the following univariate shocks: (i) a 1 percentage point rise in interest rates; (ii) 3 percentage point rise in interest rates; and (iii) a 10 percent depreciation of the sterling/dollar exchange rate.

U.K. authorities stress test for building societies on an aggregate basis

116. The FSA undertook the stress testing of the building society sector in aggregate as a representative peer group of small institutions. This complemented the stress test of the largest banks. The stress tests of building societies were based on an assessment of the impact of the four scenarios derived by the Bank of England for the stress tests of banks (described above) on (i) the retail deposit rate; (ii) the mortgage lending rate; (iii) other building societies’ income; (iv) management expenses; and (v) provisions. These factors were then used to estimate the building societies’ profits and capital as of end-2001.

U.K. authorities’ “top down approach” to stress testing

117. As a complement to the ‘bottom-up’ calculations based on the responses of the banks, the Bank of England also investigated the impact of the four shocks used in the banks’ scenarios tests on U.K. commercial banks’ provisions using a single-equation econometric model. The model was specified in reduced-form and so, it cannot describe the exact causal links involved. But the underlying economic intuition is based on the impact of the macroeconomic shocks on borrowers’ financial health feeding through to greater loan defaults, and ultimately probable credit losses for banks. The risk-horizon was two years.

Stress tests undertaken by the IMF mission

118. IMF staff used two different methodologies for assessing the resilience of U.K.-owned FIs in relation to domestic and external shocks: (i) a Vector Auto-Regression (VAR) approach to forecast the impact of changes in macroeconomic variables on household and domestic corporate loan losses; and (ii) a credit ratings approach to assess the risk of exposures to foreign counterparties. The chosen shocks were: a shock to interest rates of 530 bps; falls in real estate prices of 11 percent, 30 percent and 40 percent; a GDP fall of 2.3 percent; a fall in employment that corresponds to a rise of close to 3 percentage points in the unemployment rate; an ERI depreciation of 18 percent; and falls in equity prices of 30 percent and 40 percent. The risk-horizon was one year. The shocks were applied to the banks’ positions as of June 2002. The size of the shocks represent the worst historical realization of each variable, except in the case of the 30 percent and 40 percent drop in real estate prices that were based on the possible existence of a bubble in U.K. real estate prices.

119. Staff estimated two different VARs depending on the type of borrower (households or non financial corporations) and then used the estimated coefficients to simulate conditional future household and corporate defaults rates in the event of selected macroeconomic shocks. Specifically, the variables used in the model are the following: (i) credit quality (loan default rate); (ii) a measure of leverage (for households, total interest payments to disposable income; for corporations, the debt to market value of equity ratio). (iii) macroeconomic variables (for households, unemployment and the real estate price index; for corporations the real estate price index and the nominal exchange rate, (iv)policy variables: the nominal lending interest rate. Based on available information, default rate of loans to households was proxied by the default rate of mortgage loans. The default rate of loans to domestic corporations was proxied by the rate of bank corporate loan write-offs.

120. The VARs were intended to be parsimonious while at the same time capturing most of the impact of macroeconomic variables on bank clients. For that reason, the GDP growth was chosen for corporations and the employment rate for households. In the same vein, the equity price was chosen for households for its impact on household wealth while the nominal exchange rate (GBP/DM) was chosen for corporations for its impact on the level of domestic business. The sample period for households was from 1987:01 to 2001:4 and 1987:01 to 2001:02 for corporations. There were two monetary regimes in this period: exchange rate targeting (Deutsche Mark) up to 1992 and since 1992, an inflation targeting framework. A dummy variable was included to take account of this change in the policy regime. Two lags were included in the VAR for households and three in the VAR for corporates.

121. The credit ratings approach for foreign exposures weights total exposure to each country by each country’s probability of default, based on its ratings. For each country three sectors were considered: corporate, banks and sovereign. The probability of default for each country was estimated at the weighted average of the probabilities of default of each sector. The probability of default of each sector, in each country, was estimated as the weighted average of all rated institution within the sector. The first 10 locations, ranked by the losses forecasted by the rating approach were: US, Indonesia, China, Argentina, Netherlands, Hong Kong, Cayman Islands, Liberia, Germany, and Brazil.


122. Table 1.1 and 1.2 below summarize the results of the stress tests carried out by the banks, focusing on the distribution of outcomes. Table 1.3 shows the predicted annual rates of households and corporate defaults. Those rates were applied to the outstanding amounts of corporate and household loans in order to obtain the forecasted losses over a one-year horizon reported in Table 2. In all cases, the recovery rate was assumed to be zero. Potential losses due to exposures to households and domestic corporates turn out to be roughly similar.

123. Table 2 summarizes the sum of aggregate potential losses under each test in £mn and also as a ratio to a common denominator (all U.K.-incorporated banks’ own funds) in order to facilitate comparisons. Potential losses are small in all cases, and robust to how results are reported. The worst potential losses, excluded the scenarios that postulate defaults by foreign counterparties, were recorded for the scenario where there is a 35 percent decline in world equity prices.

Table 1.1.

Stress Tests Perforated by the Banks—Aggregate Effects (in £mn)

article image