This Selected Issues paper on the United Kingdom reviews the IMF's Global Economy Model, which incorporates energy to examine the impact of rising energy prices on the United Kingdom. The model incorporates energy as a final consumption good as well as a primary input in the production process. With energy entering the production process, increases in energy costs affect overall aggregate supply capacity as firms reduce output and factor-utilization rates given the real increase in their cost structures.


This Selected Issues paper on the United Kingdom reviews the IMF's Global Economy Model, which incorporates energy to examine the impact of rising energy prices on the United Kingdom. The model incorporates energy as a final consumption good as well as a primary input in the production process. With energy entering the production process, increases in energy costs affect overall aggregate supply capacity as firms reduce output and factor-utilization rates given the real increase in their cost structures.

VI. FSAP Follow-Up Report73

A. Introduction

1. The outlook for the U.K. banking system is favorable, while the health of the insurance industry has improved substantially over the past 3 years. Banks are well-capitalized, highly profitable and highly cost efficient. In the insurance sector, progress has been made in risk-reduction within investment portfolios, underpinned by regulatory reforms and supported by higher equity prices. Payment and settlements systems have been further strengthened, and measures to reduce the level of intraday interbank exposures, as well as the settlement risk in money market instruments and retail payments, have been implemented.

2. That said, medium-term risks exist, shaped by apparent expectations that benign credit conditions will continue indefinitely, and the intensifying inter-linkages across different segments of the financial sector. There is some concern that risk may currently be underpriced, as investors leverage-up in their search for returns in a low-yield environment, while banks come under increasing competitive pressures in the lending market. Meanwhile, rapid financial innovation has allowed banks to transfer credit risk outside the banking sector to other financial institutions. While the development of the credit risk transfer market is clearly positive in enabling the diversification of existing risk concentrations, any major shock to the financial system could potentially be magnified by the increased linkages among these institutions.

3. These risks are particularly pertinent for the United Kingdom, given its position as one of the biggest—and most open—financial centers in the world. Its banking sector is the third-largest by total assets, after the United States and Japan, and U.K. banks have increasingly expanded their operations internationally. Its insurance industry is the largest in Europe and the third largest in the world, and accounts for 17 percent of investment in the U.K. stock market, the world’s third largest by capitalization. London is also the main center of the global credit derivatives market—with a 44 percent share—ahead of even New York. As such, the stability of the financial sector in the United Kingdom has potentially far-reaching implications beyond its borders.

4. The 2002 Financial Sector Assessment Program (FSAP) mission made several recommendations to augment the United Kingdom’s already-strong financial stability framework.74 Key recommendations of the FSAP include: (i) rectifying the shortcomings in the insurance supervision framework via the implementation of the Tiner Report;75

(ii) pursuing the remaining steps needed to strengthen the payment and securities settlement infrastructure; (iii) strengthening surveillance and monitoring of inter-institutional linkages—notably in the interbank market and credit risk transfer market—including greater use of quantitative techniques to assess its vulnerabilities; (iv) continuing to promote improved disclosure and governance by financial institutions, ahead of international initiatives, if necessary; and (v) pursuing improvements to further strengthen the assessment and verification of financial institutions’ systems and controls.

5. This paper provides an update on developments in key areas identified in the 2002 FSAP, and assesses current risks to the U.K. financial sector outlook. The key risks to the banking sector, and its capacity to absorb and manage these risks are covered in Section II. The non-banking sector is discussed in Section III, while section IV analyses the credit risk transfer market in the United Kingdom. The progress made in improving the payment and settlements system is presented in Section V, followed by an assessment of the supervision and regulation issues faced by U.K. regulators in Section VI. Section VII concludes with recommendations to further strengthen the financial stability framework.

B. The Banking Sector

Structure of the Banking Sector

6. The banking sector in the United Kingdom had previously undergone significant domestic consolidation via the “big five”, namely, the Hongkong and Shanghai Banking Corporation Bank Group (“HSBC”), The Royal Bank of Scotland Group (“RBS”), Barclays Group (“Barclays”), Halifax Bank of Scotland Group (“HBOS”) and Lloyds TSB Group (“Lloyds”). Other major British banking groups (MBBGs) include Abbey Group, Alliance & Leicester Group, Bradford & Bingley plc and Northern Rock plc. Altogether, domestically-owned banks account for 81 percent of total national banking sector assets.

7. Many of the largest mortgage lenders in the United Kingdom are part of the MBBGs.76 According to the British Bankers’ Association, they account for about two-thirds of all outstanding mortgage loans and around 70 percent of gross lending. They also account for more than half of all outstanding consumer credit, including 70 percent of all credit card loans.

8. Some of the “big five” banks have expanded their operations overseas to diversify their sources of earnings, and invest in markets with higher growth prospects. In September 2005, RBS acquired a 5 percent share in the Bank of China, as part of a consortium, as well as continuing its expansion in Europe and the United States; Barclays acquired 56.1 percent in Absa Group, one of the largest South African banks, in July 2005, following an acquisition in Spain in 2003; HSBC expanded its Asian operations in 2004 with the purchase of a 20 percent stake in China’s Bank of Communications, following the acquisition of Republic National Bank (2000) and Grupo Financiero Bital (2003), in Mexico. In contrast, Lloyds has divested its international activities in New Zealand and Latin America to concentrate on its U.K. business.

9. The banking sector is also well-populated with other participants outside of the major institutions. Many of these are affiliated to the major banks and insurance groups, ranging from retailers’ financial services offerings to internet and telephone banking operations. There are relatively few foreign players in the purely domestic market to date. The purchase of Abbey National Bank—the sixth largest in the United Kingdom—by Banco Santander (Spain’s largest bank) in 2004, was a major development in this area.

Risk Assessment

Credit Risk

10. The personal lending (housing and consumer) market is considered an important source of risk for the banking sector. Total lending to households accounts for 43 percent of banking sector loans to the non-banking sector. The growth rate for total lending to individuals decelerated to a seasonally-adjusted 10.2 percent in November 2005, compared to 13.4 percent as at November 2004, as both consumer credit and secured lending slowed over this period. The deceleration in the latter started earlier and has been much sharper (Figure 1). Nonetheless, total household debt rose further, to 146 percent of aggregate disposable household income as at end-2005, from 140 percent a year ago.

Figure 1.
Figure 1.

Growth in Total Lending to Individuals, November 2003–November 2005

(12-monthly, in percent)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A006

Source: Bank of England.

11. Risks have become most evident in the unsecured household lending segment. Banks are reporting higher impairment charges with respect to their unsecured retail books—albeit from historically low levels—and are expected to increase loan loss provisioning.77 In December 2005, an estimated 99 percent of write-offs of household lending by U.K. banks was in unsecured loans, with 48 percent of this amount comprising credit card borrowings and the remainder to other unsecured loans.78 To put this in perspective, however, unsecured lending to households only makes up 5 percent of total banking assets, compared to mortgage lending, which makes up around 20 percent of banks’ total assets. Further, the recent deterioration, which is partly a manifestation of the effects of previous interest rate rises, is also partly attributable to changes in the bankruptcy legislation.

12. The secured lending market appears to be recovering, following the slowdown between mid-2004 and the first quarter of 2005 (Figure 2). Gross mortgage lending by banks in November 2005 amounted to a seasonally-adjusted £18.5 billion ($32.9 billion)—one of the highest on record, and up 23 percent from a year ago. Seasonally-adjusted net mortgage lending by banks in November 2005, amounting to £6.6 billion ($11.7 billion), was the strongest monthly increase since June 2004, and was well above the £2.5 billion ($4.4 billion) average over the first 10 months of 2005.79

Figure 2.
Figure 2.

Bank Lending Secured on Dwellings, November 2003–November 2005

(In millions of British pounds)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A006

Source: Bank of England.

13. Sub-prime mortgage lending in the United Kingdom is reportedly increasing.80 This category of lending comprises products which are more flexible relative to the mainstream products. While this activity has largely been the preserve of specialist lenders in the past, more mainstream lenders are reportedly entering the market, albeit at the less-risky end of the sub-prime range initially.

14. There are indications of some easing in corporate lending standards. Banks are willing to lend more freely to corporates, as they compete with each other and with capital markets to provide funding in a low-yield environment. According to the Bank of England (BoE) loan covenants have also weakened. Banks have increased their exposure to higher-risk corporates through the underwriting of lower-rated debt issues and the provision of financing for increased private equity activity, such as leveraged buyouts. Some of the increased lending is attributable to mergers and acquisitions activity.81 Overall, non-financial corporates represent almost a quarter of total bank lending to the non-bank segment.

15. Banks’ commercial real estate exposures have risen sharply, and concerns about overvaluations in this sector are growing. The commercial property sector currently accounts for more than a third of the major banks’ outstanding loans to non-financial companies in the United Kingdom, or about 8 percent of total outstanding loans. Indeed, bank lending to U.K. resident commercial property has recorded growth rates that are twice as high as other forms of corporate lending.82 Banks are also susceptible to indirect risks from this market, with loans to small- and medium-sized enterprises—which represent 20 percent of corporate lending—usually collateralized by commercial property. The government’s approval of real estate investment trusts (REITS) as an investment vehicle could further inflate the prices of commercial property, which is expected to be a key segment of investment under this initiative.83

16. Concern over the buy-to-let market has also been rising. This market is very speculative and, according to analysts, is very difficult to model as it is a new market and little data are available. Lending to this segment has been growing faster than the rest of the mortgage market, with unregulated property investment clubs encouraging members to purchase off-the-plan flats. The growth in this particular market had been facilitated by the sharp increase in the number of flats from 21 percent to 46 percent of the new-build market, since 2000, following encouragement by the government to build on brownfield land (Figure 3).84

Figure 3.
Figure 3.

Buy-to-Let Lending and New Flats, H2 1999–H1 2005

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A006

Source: Financial Times.
Liquidity Risk

17. The banking system is largely funded by stable, highly diversified retail deposits from the domestic customer base. However, banks have been increasingly experiencing a funding gap since 2002 as credit growth outstripped deposit growth. As a result, greater use of wholesale funding by banks has been observed. This strategy has somewhat increased the liquidity risk for some banks, as wholesale funding may be difficult and costly to roll over during times of company-specific or market-wide stress. That said, with the rate of growth in bank lending and deposits from customers converging over the past year, the rate of growth in the funding gap has slowed.

18. From a longer-term perspective, banks in the United Kingdom are continually challenged to attract relatively inexpensive, stable deposit base. The competition for funds against other sources of savings, such as mutual funds, life insurance and pension funds, among other alternative investment vehicles, is likely to remain an important challenge for the banking sector.

19. The large interbank segment of the money market could potentially become the conduit for contagion during periods of extreme stress. On a day-to-day basis, the money market functions well in distributing liquidity within the financial system. However, the increasing links between financial institutions means that a shock to one financial institution could be quickly transmitted across the financial system, giving rise to systemic liquidity problems. Interbank lending is the single largest form of counterparty exposure among the major U.K. banks, in addition to exposures the major global large complex financial institutions (LCFIs). U.K. banks had large exposures to more than 50 different counterparties, as at end-September 2005.85

20. The balance between secured and unsecured lending in the interbank market has largely remained stable since 2003. Unsecured lending accounts for around 65 percent of the total, with the balance consisting of repo lending, which has grown by around 40 percent since early-2003 (Figures 4 and 5). The CD market has become increasingly concentrated in recent years, to fewer than 10 financial institutions, and is now dominated by large U.K. banks, which issue and purchase CDs from each other.

Figure 4.
Figure 4.

Components of U.K. Interbank Lending

(In billions of British pounds)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A006

Source: Bank of England.
Figure 5.
Figure 5.

Composition of U.K. Interbank Lending

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A006

Market Risk

21. Traditionally, U.K. banks have not taken aggressive positions with respect to trading and taking on market risks. Banks tend to use derivative products—such as exchange rate forwards, interest rate swaps and forward-rate agreements (FRAs)—for asset-liability management and in their trading activities.

22. Some of the major banks are important long-term investors in capital markets through their holdings in the insurance sector. Given that insurers are exposed to market risk through their investments in equity markets, these banks are similarly exposed.

23. The larger banks also participate in the credit derivatives market, which has experienced exponential growth in recent years.86 According to supervisors, they continually monitor the extent of banks’ involvement with these products to ensure adequacy of risk management systems and infrastructure development.

24. The underpricing of risk could pose problems for banks’ exposures, if a sudden, and sustained, reversal in the current benign credit environment occurs (Figure 6). Thus, general expectations that the low-yield environment—underpinned by ongoing macroeconomic stability—will continue in the foreseeable future, could result in the underestimation of risks being accumulated in banking books.

Figure 6.
Figure 6.

U.K. 10-Year Treasury Yields, April 2004–January 2006

(In percent)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A006

Source: Bloomberg LLP.

Capacity to Absorb and Manage Risks

25. The profitability of U.K. banks is among the highest in advanced economies (Figure 7), with relatively large margins. Strong profitability has allowed these institutions to generate—and where necessary raise—additional capital and grow their balance sheets. The interim results of the “big five” banks for the first-half of 2005 indicate that their solid performance has continued, with returns on equity ranging from 15–25 percent.87 Further, increased diversification of earnings sources will help banks maintain greater stability in their profits. Banks, such as HSBC, Barclays and RBS, have diversified geographically (see discussion in Section II above), as well as into other business lines, such as investment banking.

Figure 7.
Figure 7.

Cross-Country Comparison of Banks’ Returns on Equity, 2004

(In percent)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A006

Sources: Bank of Japan, European Central Bank, Federal Deposit Insurance Corporation, Office of the Superintendent of Financial Institutions Canada.

26. U.K. banks’ efficiency in controlling costs have enhanced their profitability. Indeed, U.K. banks are among the most cost-efficient in advanced economies (Figure 8). This suggests that banks should be able to absorb higher provisioning charges comfortably, as and when they occur. The cost-to-income ratios of all the “big five” banks remained below 55 percent in the first-half of 2005. For some banks, such as Barclays and HSBC, costs had been rising as a result of the expansion in their investment banking operations. That said, Barclays has been able to meet its rising expansion costs with increased income and profitability, while HSBC’s major investment phase is reportedly almost completed, at least for the time-being.

Figure 8.
Figure 8.

Cross-Country Comparison of Banks’ Cost-to-Income Ratios, 2004

(In percent)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A006

Sources: European Central Bank, Federal Deposit Insurance Corporation.

27. Other indicators of asset quality and solvency for the banking sector remain healthy (Table 1). Non-performing loans (NPLs) were stable at around 1.9 percent of total loans, as at end-2004, while loan-loss reserves coverage remains strong, especially among the MBBGs. The capital adequacy ratio was a healthy 12.7 percent as at the end of 2004. Among the “big five” banks, retail asset quality deteriorated, particularly in the unsecured segment, but this was offset by the reduced levels of delinquency in the corporate segment. Impaired loans fell as a percentage of gross loans, with the exception of HBOS and Lloyds, which have relatively greater weight in U.K. retail loans. The Tier 1 capital ratios for these “big five” banks remained strong in the first-half of 2005, ranging from 6.6–8.7 percent, despite some “distortions” as a result of International Financial Reporting Standards (IFRS) implementation.

Table 1.

United Kingdom: Financial Stability Indicators

(As at end of period, unless indicated)

article image
Sources: Bank of England (BoE) and Financial Services Authority (FSA).Note: Whereas data sourced from the BoE relate to the U.K. resident banks, data from the FSA (as denoted by “*”) relate to U.K.-owned banks. Compilation methods for some indicators included here differ from the proposed treatment for the FSI CCE. Throughout, “deposits” includes currency, deposits and money market instruments, and “loans” excludes investments. All BoE data sourced from BankStats publication, Tables A5.3, B2.1, B2.1.1 and C1.2.

FX loans less FX deposits.

FX loans/total loans and security.

Non-resident deposits/total deposits.

FX liabilities/total liabilities.

Excludes investments.

The figures for non-performing loans represent the gross value of loans against which specific provisions have been made.

Includes mortgage banks and building societies. This ratio is different from that presented in Figure 7 for the United Kingdom due to differences in definitions applied to the computations.

28. Banks’ mortgage books do not appear to be a significant direct source of vulnerability. Although the proportion of new mortgages with higher loan-to-value (LTV) ratios have increased, the average LTV ratio remains extremely favorable, at 40–50 percent. Analysts estimate that that property prices would have to fall by 30–40 percent before stresses are manifest in the banking sector. This scenario is considered highly unlikely—the housing market has been more resilient than expected (Figure 9), while the economy, particularly the low rate of unemployment, remains supportive overall.88 Further, the concentration is largely in fixed-rate mortgages, which should mitigate the interest burden for households, in the event of a sustained rise in interest rates.89

Figure 9.
Figure 9.

Nominal House Price Indices

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A006

29. The biggest vulnerability for banks lies in the “second round” effects of any sharp downturn in the property sector, given that the sector appears well-cushioned against any initial, direct impact. In the event of a spillover into the broader economy, consumer confidence would fall and jeopardize business confidence, and credit quality would deteriorate. That said, previous interest rate rises have had the effect of dampening demand for property, thus decreasing the probability of a significant drop in prices from this point.

30. In the buy-to-let market, private sector initiatives are being taken against speculative pressures.90 The property industry has lobbied the Financial Services Authority (FSA) to call for investor protection against property investment clubs, citing the inexperience of investors in this market and the potential fallout for property funds in general.91 Meanwhile, the reversal of a tax break proposal, which would have allowed investors to put residential property in their self-invested personal pensions, is also expected to remove some of the upward pressure on property values.

31. Banks’ corporate sector loans do not appear vulnerable at this point. The corporate insolvency rate has fallen to 25-year lows. Corporate sector credit quality remains very strong, with three major banks, Barclays, HSBC and RBS having reported a decline in impaired to gross loan ratios as at end-June 2005, compared with the start of the year.

32. U.K. banks’ exposure to commercial property merits close scrutiny moving forward. In the short-term, banks appear less vulnerable to speculative lending in the current environment. The commercial property sector is considered relatively solid, with low tenant-default rates. Additionally, the risks from commercial property lending activities are now reflected in banks’ improved risk management practices. That said, strong investor demand for commercial property has placed upward pressure on valuations. According to an assessment by the BoE, this demand appears to be based on expectations that rental growth would pick up from current levels; a key risk is that these expectations will not be met, especially given the increase in supply.92

33. The growth in investor interest in the commercial mortgage-backed securities (CMBS) in the United Kingdom could provide further support for lending to this market segment. The transfer of credit risk across a broad investor base helps to disperse its concentration from banks’ balance sheets, and removes the dependence of the commercial property market solely on banks, which may withdraw their credit at short-notice.

34. Banks appear to be managing their funding well. Despite the wider retail funding gap experienced by U.K. banks, the funding position (loan-to-deposit ratio) of the largest banks remains sound by global standards (Figure 10). Other funding sources have become increasingly diversified in terms of sources and maturities, and appear to be well-balanced. Large lenders are issuing more covered bonds and securitizing their books to enhance and vary their funding sources, while the smaller and more specialized lenders are increasing their use of residential mortgage-backed securities (RMBS) to transfer credit risk from their books 93

Figure 10.
Figure 10.

Cross-Country Comparison of Banks’ Loans-to-Deposits Ratios, 2002-04 Average

(Based on the largest banks in each country, in percent)

Citation: IMF Staff Country Reports 2006, 087; 10.5089/9781451814309.002.A006

Source: Standard & Poor’s.

35. Interbank money market exposures, including those of major foreign institutions, have come under intensified surveillance by the authorities. Steps taken by the authorities to mitigate this risk include more frequent analyses and monitoring of regulatory large exposures data (which discloses counterparty details), and comparing these data to aggregate interbank lending. The analysis results have also been published to highlight the extent of large exposures to U.K. counterparts and major foreign institutions.94

36. The money market has moved to a repo structure for the majority of short-dated funds, thus offering greater security for interbank transactions. There has also been a reduction in aggregate bank exposure to the CD market, as well as in the size of the CD market. The authorities attribute these developments to: (i) bank mergers (banks have kept the same counterparty limit post-merger as that of one of the merging banks pre-merger); (ii) the withdrawal by German banks from the CD market in 2000, when their capital charges for CDs were altered; (iii) the contraction in bid-offer margins and cheaper settlement costs in the derivatives market, which has reduced the attractiveness of using CDs to express interest rate trading views; and (iv) the reform of open-market-operations by the BoE, which includes the introduction of a long-term repo facility in January 2005.

37. Risk management by banks has continued to become more professionalized, ahead of the proposed introduction of a capital charge for operational risk under Basel II. Banks are focusing their resources on further developing their risk management expertise, with the majority of banks said to be collecting and analyzing loss data and implementing risk profiling of their main activities, in line with other developed banking systems. The bigger banks have the necessary expertise and sophistication to perform more complicated risk management tasks, but this may not necessarily be the case for the smaller banks.

38. There is currently wider use of stress-testing by banks. The BoE and the FSA have worked towards convincing the private sector to undertake the exercise regularly, and to continually enhance existing models.95 Nowadays, banks regularly stress-test their assets and liabilities to determine the potential outcomes under extreme economic and market scenarios. Banks are also recognizing that their risk functions have increased, and are increasingly aware of the need to integrate their credit, operation and market risks into their stress tests. Another area where banks’ modeling of risks could be improved is in taking the systemic implications of risks into account.

39. The impact of the shift to IFRS has been modest to date. Banks’ capital adequacy levels have remained stable, following the adoption of IFRS from 1 January 2005 (Table 1). Tier 1 capital ratios have decreased, while Tier 2 capital ratios have increased. The fall in Tier 1 capital ratios is mainly attributable to the difference in the treatment of capital instruments between IFRS and U.K. GAAP. This outcome poses little concern for supervisors as the drop is not substantial, and supervisors have been able to identify the key areas where changes have occurred.

C. The Non-Banking Sector

Insurance Sector

40. The outlook for the life insurance industry has improved significantly over the past three years. Private sector participants have credited the FSA with regulating the insurance industry back to health.96 The timing had also been fortuitous, as reform was effected during a buoyant period for capital markets, notably, rising equity prices. In that instance, the cost of regulation, while expensive, was deemed necessary. Overall, the cost of regulation in this sector is anticipated to decline, with the weeding out of weaker companies. There are few short-term risks at present.97

41. That said, the solvency coverage in some life insurance companies remains weak. Specifically, the quality of capital is suspect where implicit items, financial reinsurance and subordinated debt are used to boost capital coverage of the required minimum margin (RMM).98 As it is, the RMM for the industry is currently at historically low levels, at around 270 percent.99 Further, the use of implicit items in capital means that while the Tier I capital ratio is quite healthy, it does not necessarily reflect the strength of core capital, which comprises tangible equity.

42. Meanwhile, debt issuance by insurers has also increased, driven by the low cost of capital. However, the relative quality of debt has not been as good as in the past. Under current U.K. regulations, insurers are allowed to issue hybrid instruments up to 75 percent of total capital; however, rating agencies place a 15–25 percent limit on these instruments in assessing the quality of capital. Regulators attribute this marked difference in weightings to the cross-border nature of ratings exercises—ratings agencies tend to take a more stringent measure in order to promote credible cross-country comparisons of financial institutions that may be regulated under either principles-based or rules-based regimes or both.

43. The non-life insurance sector may have to absorb significantly higher exposures in the coming year. Following the catastrophic hurricane season of 2005, reinsurance rates are expected to rise sharply, notably in the property, marine and offshore energy segments, and may thus become too expensive for some primary insurers. As a result, some insurers may withdraw from covering catastrophe risks, while others may reinsure a smaller proportion of their exposures in 2006. However, given the relatively low barriers to entry, new participants in the reinsurance industry are expected to provide greater competition, thus reducing the higher costs eventually.

44. Progress has been made in risk-reduction within investment portfolios. The asset mix for insurers has shifted, from large equity holdings into bonds, and there is generally a much better matching of assets to liabilities currently. The quantification and management of risks within the insurance sector has also strengthened, albeit still variable across firms in terms of expertise.

45. The insurance sector is currently transitioning to the FSA’s risk-based approach to determining capital adequacy.100 The underlying principle of the new risk assessment framework is that insurers should consider all relevant risks, such as market risk and operation risk, but also insurance and other risks. The Individual Capital Adequacy Standard (ICAS)—which became effective from January 2005—encourages each insurance company to improve its understanding of existing risks.101 Further, it is anticipated that the Individual Capital Assessment exercise will enable the FSA to quickly build a database on the different ways in which insurers model their risk exposures.

46. It is unclear at this stage if the advances promulgated in the ICAS will eventually be incorporated into the EU’s Solvency II regulations. While the vast majority of EU countries reportedly favor the risk-based approach, U.K. regulators acknowledge that some aspects of Solvency II may differ from the ICAS. In this case, U.K. rules that are incompatible with Solvency II would need to be reworked, and U.K. regulators may reconsider the justification for any element of the local regime that is super-equivalent to EU requirements.

47. The Treating Customers Fairly (life) and Contract Certainty (non-life) initiatives, which are being pushed aggressively by the FSA, are considered crucial for the credibility of the industry. The FSA’s objective is to increase transparency, so that customers fully informed. On the life side, the TCF initiative emphasizes policyholder communications over the life of the contract, while the focus of contract certainty is on the documentation available at the inception of the contract.102

48. The new method for product distribution is aimed at providing consumers with improved choices, and, it is anticipated, eventually reducing costs for consumers. The concept of depolarization—which came into force on 1 December 2004—no longer requires life-insurance salespeople to be either fully independent or tied to a single provider. Rather, they may also choose to be “multi-tied” to several product providers. The new regime is expected to eventually increase competition for insurance products, likely leading to further consolidation among insurance providers.

49. The financial statements of insurance companies globally are largely considered opaque and difficult to understand, even by insurance sector analysts. Currently, EU insurance companies that are listed are required to comply with IFRS 4, which is considered a “stopgap”. This will be replaced in due course by a comprehensive standard that is often referred to as “Phase II” of the IFRS. The insurance industry in the United Kingdom has expressed disappointment at the lack of progress made by the EU on Phase II, and is looking for quicker implementation. It has the full support of the FSA towards this objective.

Building Societies

50. Building societies had previously come under some pressure with the slowdown in the mortgage market. These institutions have had to weather margin compression through increased competition in this market segment. Additionally, building societies tend to have higher cost bases due to smaller economies of scale; they also have little scope to diversify their operations to enhance profitability.

51. However, there is generally little concern about the health of the building societies at this point, given the resilience of the housing market. Credit risk is not considered significant for building societies, especially with the stabilization of the housing market. Further, unlike banks, building societies are established to serve the membership rather than to focus on achieving high profitability, which means that the squeeze on margins are of lesser significance from a perception perspective. The implementation of Basel II is expected to benefit building societies, in terms of reduced capital requirements.

D. The Credit Risk Transfer Market

52. Financial innovation has changed the landscape of risk—credit risk transfer (CRT) instruments are providing important diversification benefits, but their rapid growth is also creating some risks. A key concern is that the pace of innovation may have exceeded the development of market infrastructure and the risk management systems of financial institutions participating in this market. Consequently, any shock to the financial system may be exacerbated by the financial sector’s increased exposures to these instruments.

53. At the global level, the Delphi situation has focused regulators on the issue of credit exposures. Presently, there is little information on where the credit exposures lie, because data do not exist outside of the institutions that are involved these transactions. Fortunately, the market is not very fragmented, since these transactions are generally effected by large institutions. That said, the concentration of select corporate names in the majority of CDO deals could cause significant stress for the credit derivative market in the event of a default.103

54. The stresses induced by the Ford-GM and Delphi incidents are generally seen as a timely “reality check” for participants in the CRT market. The rapidity with which the market overcame the respective stresses is seen as a very positive indicator of its increasing maturity and liquidity. That said, policymakers and analysts acknowledge that these events have occurred during a period when credit conditions have remained benign. The resilience of the CRT market has not, as yet, been tested in a less accommodative credit environment.

55. The extent of U.K. banks’ and insurers’ exposures to the CRT market appears to be limited. 104 CRT activity by U.K. institutions is seen to be largely focused on residential mortgage-backed securities (RMBS) and credit card securitization between local banks and a more general investor base, with commercial mortgage-backed securities (CMBS) having grown rapidly over the past year. Meanwhile, synthetic CDO transactions undertaken by U.K. banks such as Barclays, HSBC and RBS are said to be largely for trading arbitrage purposes. Within the U.K. insurance sector, there is less urgency to seek yield pickup through alternative investments, such as structured products and credit derivatives, given that there are few insurance products left with guaranteed returns following the phasing out of with-profits policies.

56. This view is supported by key players in the origination segment of the market, who observe that U.K. financial institutions are not major participants in the structured credit products market. Rather, the biggest investors tend to be international institutions based in the United Kingdom, such as continental European insurance companies, as well as hedge funds. These observations are also supported by the lack of any significant impact from recent credit events in the corporate sector (for example, Ford, GM, Delphi) on U.K. banks and insurers.

57. Supervisors and private sector analysts acknowledge that it is very difficult to track transactions in the CRT market. The publicly available financial statements of financial institutions reveal little information on positions taken in these instruments. As a result, financial sector analysts are omitting the pricing of risk from CRT transactions in their analysis of individual financial institutions.

58. From a surveillance perspective, the FSA posits that understanding the extent to which real risk is transferred is a key element in monitoring the CRT market. To this end, the FSA has engaged in surveys—in particular, through the Joint Forum—to understand who the end investors are, and how well the risks are managed.105 The supervisor is also prioritizing the issue of model risk by initiating the hypothetical portfolio exercise to better understand how firms are modeling CRT instruments and to discover the challenges across firms.

59. From a risk management perspective, market participants argue that understanding counterparty risk is crucial for managing credit risk from CRT instruments. Professional investors perform significant amounts of due diligence on counterparties, in terms of their counterparts’ risk management capacity, trading strategies and viability. Meanwhile, stress testing by market participants has also become very important following the Ford-GM incident.

60. The FSA maintains a conservative approach with respect to data collection on a regular basis under its existing cost-benefit framework for regulation. The regulator holds the view that such exercises incur high costs and may be of limited benefit. As a method of surveillance of the CRT market, the BoE and the FSA regularly publicize the risks associated with these instruments, along with more general evidence about the existing financial environment. Both the BoE and FSA also rely on “market intelligence” as one of their key surveillance tools.

61. The FSA and the New York Federal Reserve are currently working with major participants in the CRT market to resolve the issue of backlogs in trade confirmations and assignments. Both regulators and market participants anticipate that significant inroads will be made towards resolving the problem over the next 12 months; improved automation and increased use of standard contracts are expected to help reduce the problem in the future.106 This particular focus by the authorities has been generally well-received by market participants—those who had under-invested in the necessary technology and operational infrastructure are increasing their investment in this area.107

E. Payment and Settlements Systems

62. The authorities have, in recent years, collaborated closely with payment and settlements systems operators to mitigate key risks identified in the 2002 FSAP. Some of the key areas of improvement include:

  • Major advances in the disclosure of goals and the process of conducting oversight of payment and settlements systems. In January 2005, the BoE published its first annual Payment System Oversight Report (PSOR), which sets out clearly the role of the BoE in payment systems, the process for oversight, and the BoE’s assessment of the payment systems it oversees against the Core Principles.108 Moreover, publication of the PSOR has also acted as a disciplining device to the payment systems themselves—such a device is particularly important given that the BoE currently lacks power in carrying out its oversight responsibilities (see below).

  • Increased awareness by both the BoE and the FSA towards the intraday interbank exposures stemming from, for instance, tiering in major systems and U.S. dollar settlements in CREST and LCH. Clearnet. 109

  • The reduction in the level of intraday exposures, for example, broadening the first tier of banks in CHAPS, and the BoE taking over the role as concentration bank for LCH. Clearnet, in both sterling and euro. 110

  • The mitigation of settlement risk from settling money market instruments by introducing these instruments in CREST, which was made possible through legislative changes making dematerialization of money market instruments possible.

  • The significant reduction in the settlement risk of BACS, although there is still room for shortening the settlement cycle in BACS further.

63. Three additional issues are assessed in this update:111

  • The first deals with the mergers between CREST and Euroclear, and between LCH and Clearnet. The effects so far have been very small, and have not changed the risk assessments of these systems. There are some concrete plans for future changes, especially in the CREST-Euroclear case, in which the U.K. authorities are already involved, working with their counterparties in the other affected countries.

  • The second is that the BoE has made the decision not to join the TARGET 2 system for euro payments.112 This decision will have an insignificant effect on the current settlement banks in CHAPS Euro. The important issue is to find solid settlement facilities for other systems cash settlement, notably CREST and LCH. Clearnet. From a settlement risk perspective, the preferred solution is to find a way to settle these transactions through a central bank.

  • The third is that the distinction between the services provided by payment and settlements systems and banks is less clear than might be supposed. As highlighted in the discussions about tiering, there is substantial clearing activity being undertaken within financial institutions. There is, however, some concern over banks’ handling of credit derivatives and other complex instruments. There is a risk that the authorities may focus overly on the systems aspect, and overlook some of the important issues relating to the banks themselves.

64. The 2002 FSAP mission recommended that the authorities consider laying out the BoE’s oversight responsibility more formally and fully in the statute. Little has happened in this area, although few problems have arisen to this point. In light of recent merger activities within the infrastructure sector and the planned integration of these systems in coming years, it seems appropriate for the authorities to revisit this issue. In a national environment, tradition and moral suasion is often quite strong. However, this is not necessarily the case in a more international context, when formal powers for information gathering and sharing may be necessary.

F. Regulation and Supervision

The Cost-Benefit Framework

65. Overall, the financial sector is well-regulated. The FSA is generally perceived to be even-handed and professional in its approach to regulation and supervision. The FSA operates under a strict cost-benefit analysis (CBA) framework.113 The regulator is obliged to be cost-effective, in order to ensure the “proportionality” of any regulation it imposes. The cost of regulation is quantified, while benefits are assessed on a qualitative basis. In order to improve the efficiency and cost-effectiveness of regulation, the FSA has begun to employ CBA much earlier in its internal policy-making processes, and often seeks information from firms, consumers and other stakeholders on the impact of regulation in areas where market failure may exist.

66. Opinions are mixed on the focus of financial sector regulation. Some market participants observe that regulation in recent years has largely been driven by a consumerist agenda, and has incurred high business costs. In contrast, others posit that consumer regulation is only just “catching up” in the United Kingdom. The FSA argues that the use of the CBA mitigates any push by more politically-sensitive policymakers towards consumer-oriented regulation.

67. Supervisors and market participants have expressed their concerns about the costs of over-regulation. Notably, the weight of regulatory pressure on U.K. firms from the implementation of domestic initiatives and the EU Financial Services Action Plan, IFRS, IOSCO, Basel II and IFRS, and eventually, Solvency II, have become increasingly burdensome. As an example, anecdotal evidence suggests that corporate boards meetings are largely spent discussing regulatory issues, rather than business matters. It is unclear at this stage if financial institutions have the ability to absorb all the requisite regulatory changes, what the risks of unintended consequences are, or what the market’s reaction to these changes will be. The full impact of these developments is likely to unfold over the next 2–3 years.

68. To mitigate the problem, the FSA plans to move to a hybrid of principles- and rules-based supervision, with greater weight put on principles than rules. However, it is not certain that such a move will reduce the cost of regulation, at least in the short-term, since corporate management may need to spend more time understanding the principles, rather than applying mechanistic rules. The supervisor would still be legally obliged to perform CBA on EU proposals, to provide a more balanced view on their impact on financial institutions. Any issue arising from CBA findings would then be taken up at more senior levels of representation in the European Commission. Market participants expect the “deluge” of new regulations to slow following the implementation of the Markets in Financial Instruments Directive (MiFID, expected to be adopted during 2006), Basel II (in late-2006) and eventually, Solvency II.

The Home/Host Supervision Debate

69. Financial institutions are very concerned about the costs arising out of duplicative supervision at the international level, and have emphasized the need to streamline regulation. The FSA agrees with this view, but also recognizes the need for effective supervision, in addition to being efficient from the viewpoint of market participants.

70. The FSA is keen to see more efficient, risk-based collaboration among supervisors, which both improves the quality of supervision and reduces the burden on firms. This approach is supported by the FSA’s European regulatory counterparts and the European Commission.114 The FSA also supports the judicious delegation of tasks among supervisors, where appropriate, without changing the respective responsibilities (for example, reliance on work done by other supervisors, conduct of joint-visits to financial institutions). The nature of the relationship between international financial institutions and regulators in each country would also need to be clarified upfront.115

71. The FSA recognises the need for performing crisis simulation exercises at the EU level for crisis management purposes. Indeed, the United Kingdom has signed the EU Memorandum of Understanding for crisis management. However, while the FSA acknowledges that it would be helpful to establish memoranda of understanding and more formalized arrangements between regulators, it holds the view that it would be more important to know whom the individual counterparts are, in order to communicate efficiently in the event of a crisis.116

G. Conclusion

72. The U.K. banking system is one of the strongest among advanced economies, and the health of the insurance sector has improved substantially in recent years. That said, retail asset quality has deteriorated somewhat, with the uptick in personal insolvency rates, and banks’ rapidly increasing exposure to commercial property. There has also been some easing in corporate lending standards within an intensely competitive, low-yield environment. Further, the rapid growth of the CRT market—while providing important diversification benefits—is also creating risks. For instance, the speed of innovation may have outstripped the development of market infrastructure and risk management systems of financial institutions. The authorities are well aware of the medium-term risks to outlook for the financial system, and continue to publicize these concerns, as well as the more general evidence that risk may be underpriced.

73. The authorities are also continuing to enhance an already-strong financial stability framework. In the insurance sector, the FSA’s risk-based approach to determining capital adequacy is aimed at improving risk assessment within the industry. The authorities have also taken concerted actions to reduce the level of intraday interbank exposures and reduce settlement risk in money market instruments and retail payments. On an international level, much progress is being made in developing home/host supervision arrangements, both within Europe and with non-EEA regulators, and the FSA is keen to build on this.

74. Moving forward, the authorities have identified several priority risks to the financial sector outlook, against which a business plan is set.117 On the wholesale side, issues such as extreme risk scenarios, terrorism, valuation of illiquid financial instruments, outstanding credit derivatives trade confirmations, financial fraud and volume of regulation are considered key. Concerns in the retail segment include the high levels of borrowing by households, an increasingly uncertain financial environment and complex retirement decisions. Three alternative economic scenarios and their implications for financial sector stability are also being considered, namely, an oil price shock, a slowdown in global consumption and a disorderly unwinding of U.S. imbalances.

75. The two main recommendations of this report are that:

  • The FSA should continually enhance its surveillance of the CRT market—in cooperation with their overseas counterparts—given the rapid evolution of the market. While the financial sector in the United Kingdom is well-regulated and well-supervised, the transaction counterparties to U.K. institutions may be domiciled in financial systems that are less well regulated and supervised, potentially giving rise to systemic risks. The authorities should also encourage private sector initiatives to increase disclosure of exposures to these instruments, to alleviate the burden on the FSA’s limited resources.

  • Risk mitigation in clearing arrangements within banks needs to be improved further, on the back of strengthened payment and settlements systems. To date, measures have been taken to reduce the level of intraday interbank exposures and the settlement risk in money market instruments and retail payments. However, as greater clearing activities are undertaken within banks, for example in the processing of transactions related to credit risk transfer instruments, these activities are becoming more important for financial sector stability.

APPENDIX An Update on the Payment and Settlements System

During the 2002 Financial Stability Assessment Program (FSAP) for the United Kingdom, a detailed assessment was made of the payment and settlement systems. The systems, CHAPS Sterling and CHAPS Euro, were assessed against the Core Principles for Systemically Important Payment Systems, and CREST, was assessed against the Recommendations for Securities Settlement Systems. In addition, less detailed assessments were made on CMO, BACS and LCH. This report follows up on the issues raised in the FSAP, and examines several other issues which have evolved since then.

A. The Main Issues Raised in the 2002 FSAP

The mission noted that the U.K. financial infrastructure had undergone considerable improvements in mitigating key risks since the late 1990s. Priority had been given to the large value payment system (CHAPS) and the main securities settlement system (CREST), in order to safeguard the most critical functions from a financial stability perspective. Consequently, most of the issues raised by the mission were outside these central systems, even though there were some areas where additional improvements could still be effected.

The main issues raised were connected to intraday risk exposures—which according to the IMF mission was not given appropriate attention—and various types of settlement risks still remaining in the systems:

(i) Intraday risk exposures of significant values had originated from several sources within the infrastructure.

  • First, a high degree of tiering existed in payment and settlement systems, between the direct settlement members on the one hand, and indirect members and end-users on the other. The intraday risks stemming from tiering was highly concentrated in a few large settlement members, who act as first tier banks in CHAPS, CREST and LCH. The concern raised was that the U.K. authorities did not pay enough attention to the risks associated to tiering, and the fact that those potentially large intraday exposures could have a systemic impact.

  • Second, risks existed within the payment mechanism of the LCH. Large potential intraday exposures were building up in settlement banks participating in the “Protected Payment System” (PPS), and exposures were concentrated on one bank—the “concentration bank”—during the settlement process. In contrast to what its name implied, the PPS was not a protected scheme. However, little information was provided to participating banks of their financial risk exposures from participating in PPS.

(ii) Of the identified settlement risks, the most important were the significant shortcomings in the CMO system for money market instruments, which, among other things, did not provide delivery versus payment (DvP) in settling these instruments. Other settlement risks identified were:

  • The risks in the U.S. dollar settlement of CREST and LCH, which took place via correspondent banks and therefore not settled on a DvP-basis. It was noted that although the value involved was rather small at the time, this could easily change in future years, partly due to of London’s role as an international financial center.

  • The shortcomings in the risk management procedures of the BACS system for electronic retail payments. The system could not ensure timely completion of settlement if the largest net debtor were to fail. In addition, there were rather long settlement cycles (3 days), with the effect of increasing participants’ settlement exposures.

B. Major Achievements

Intraday Risk Exposures

Since the 2002 FSAP, progress has been made in terms of raising the authorities’ awareness of the exposures and the actions taken to reduce the level of tiering.

(i) Several exercises have been undertaken to improve the authorities’ understanding of existing exposures:

  • In 2004, a study by the Bank of England (BoE) quantified the credit risk arising due to intraday settlement-related exposures between first and second tier banks in CHAPS Sterling. In 2005, the BoE also analyzed the impact of tiering in CREST Sterling. The credit lines extended by first- to second-tier banks were larger in CREST than in CHAPS, and to a greater extent, collateralized. The finding is that under stressful scenarios, the combination of credit in CHAPS and CREST could pose a considerable risk to settlement banks.118 However, the scenarios that could threaten the credit standing of settlement banks are very low probability events. Moreover, even under these extreme scenarios, the BoE’s analysis indicates that the solvency of settlement banks would not be threatened. Indeed, the analysis suggests that the risks from tiering are more likely to apply to second-tier banks rather than to settlement banks.119 Further, the analysis suggests that further work needs to be done to assess whether second-tier banks have contingency plans, in the event of a significant operational disruption to their settlement bank.

  • The effects of tiering on LCH. Clearnet and CLS have also been analyzed.120 While the numbers in LCH. Clearnet are fairly small, they are very substantial in the case of CLS. The total value of trades settled through CLS on behalf of third-party users was estimated at $220 billon per day in April 2005.

  • During 2005, the Market Infrastructure Division within the Financial Services Authority (FSA) conducted an educational exercise for bank supervisors on risk stemming from tiering, in order to increase the latter’s awareness of these risks. In addition, a survey of risk management practices of first- and second-tier banks was performed.

(ii) Actions have also been taken to reduce the identified exposures:

  • A new Settlement Account Policy was implemented by the BoE in 2003, which enabled more banks to participate in the first tier. In addition, a new Money Market Reform will be implemented in 2006, aimed at encouraging wider membership in CHAPS, among other things.

  • On the risk surrounding the payment mechanism of LCH. Clearnet, the Bank of England took over the role as concentration bank in 2005, and thereby effectively eliminated that risk. In addition, LCH. Clearnet introduced a new agreement for PPS banks in 2005, which sets out more clearly the risks incurred by participating in the scheme and specifies when payments to the concentration bank should be done and the penalties for breaking these rules.

Settlement Risks

The settlement risk from settling money market instruments was mitigated, when the CMO system was closed and the settlement of money market instruments transferred to CREST in October 2003. U.S. dollar settlement has risen significantly since the 2002 FSAP, although values are still small compared to sterling activities. The most important achievement in this area has been the closer attention paid to this settlement risk exposure. For example, CREST and the settlement banks are investigating the possibility of jointly developing a multilateral net settlement arrangement, via U.S. Federal Reserve facilities. As long as the value remains small, mitigating this risk is not a key concern; however, it is important for U.K. authorities to actively monitor this development, as well as how banks are managing this exposure.

The settlement risk in BACS was significantly reduced during 2005, with the implementation of the Liquidity Funding and Collateralization Agreement (LFCA). Under the LFCA, settlement for a failing member would be completed through committed liquidity from surviving members. This liquidity injection would then be reimbursed to the extent possible by selling the collateral pledged by the failing member. There is no guarantee, however, that the net debit position of a failing member is not larger than the liquidity committed by surviving members, since there is currently no debit cap in the system. Further development to eliminate settlement risk in the BACS system is encouraged.

There is an initiative to introduce retail payments with a shorter settlement cycle. This is positive from an efficiency perspective. There is also still room for shortening the settlement cycle in BACS so that settlement risks can be reduced, as is being encouraged by the BoE.

Improved Oversight

The publication by the BoE of an Annual Payment System Oversight Report (PSOR) represents a significant step towards best practice in terms of transparency and accountability:

  • The 2004 PSOR was published in January 2005, and sets out in Chapters 1 and 2 the role of the BoE in payment systems, with Chapter 2 describing the oversight process in the United Kingdom. Chapter 3 assesses the systems overseen by the BoE against the Core Principles, and Chapter 4 concludes with future policy priorities. The first PSOR also sets out in a box (pages 38–41) the BoE’s response to the 2002 FSAP recommendations.

  • The BoE is currently in the process of finalizing the 2005 PSOR, which will set out its assessment of the systems, as well as the BoE’s oversight priorities for 2006. Moreover, the report contains a section on the new risk framework for oversight, which the BoE developed in 2005, and which it plans to roll out during 2006.

C. Current Issues

New Ownership Structures

Thus far, the changes in CREST have been minor, and do not materially change the assessment made during the 2002 FSAP. The operations in CREST are run as a separate company, with only a few centralized functions.121 That said, the new company aims to migrate CREST’s transaction processing onto Euroclear’s “Single Settlement Engine” (SSE) in July 2006, while the money settlement will migrate to the single platform in 2009. These changes will have an impact on operational as well as settlement risks in CREST. The BoE and the FSA are currently working closely with CREST on these matters. Although it is too early to say what the impact will be for the settlement of U.K. securities, the fact that the U.K. authorities are closely involved in the process is a positive development. LCH. Clearnet is also run as separate companies, and in reality, the merger has not effected the assessment of the clearing scheme.

As a direct consequence of these mergers, the FSA and the BoE have been involved in colleges with authorities in the other countries where the companies operate. These colleges are set up based on Memoranda of Understanding, and facilitate collaboration on technical work, as well as more high-level decision-making.

Euro Settlement Post-Target

In November 2005, the Bank of England decided not to join the TARGET 2 system for euro payments. Since the decision is still relatively recent, there is currently no clear solution on how euro settlements, currently done through CHAPS Euro, will be handled in the future. CREST, LCH. Clearnet and BACS all currently settle euro payments through the books of the BoE. From a settlement risk perspective, the preliminary assessment by the BoE that a preferred solution is to find a way to settle these transactions through a central bank, is a sound one. The potentially large intraday balances on the BoE’s euro account, in acting as a concentration bank for LCH. Clearnet, provides support for this argument.

By and large, settlement banks in CHAPS Euro appear to be operating smoothly. Most of them already have a presence within the monetary union. However, the rest may decide to use other banks as settlement banks, thereby increasing the tiering problem discussed above. The share of these banks’ payments in CHAPS Euro is, however, less than 1.5 percent, so they should only have a marginal impact.

A Statutory Base for Payment Systems Oversight?

The 2002 FSAP mission recommended that the authorities consider laying out the BoE’s oversight responsibility more formally and fully in the statute. It was noted that the BoE plays a crucial role in payment and settlements systems oversight, arising from its inherent central banking functions related to monetary policy and financial system stability. However, the existing statute at the time did not fully reflect this responsibility; and this work has not yet proceeded.

The oversight role is even more important in the current environment, given that major infrastructure providers are part of international groups. In a national environment, tradition and moral suasion is often quite effective; this may not necessarily be true in an international context, when formal powers for, say, information gathering and sharing may be necessary. In light of the recent merger activities within the infrastructure providers, it is appropriate for the authorities to revisit this issue. Currently, the BoE likely does not have the right to disclose information for oversight purposes to third parties—such as the FSA and other central banks—without the consent of the relevant payment system, since information is provided voluntarily by these system operators.

Systems versus Institutions

The distinction between the services provided by payment and settlements systems and banks is less clear than might be supposed. As highlighted in the discussions about tiering, there are substantial clearing activities being performed within institutions. This is true for settlement banks in different systems, as well as correspondent banking activities and banks acting as custodians. These activities entail many of the risk characteristics that are normally attributed to payment and settlements systems. Given the increased attention to risks stemming from financial market activities, it is important that these issues are not overlooked. For example, except for the FSA’s valuable work on reducing confirmation backlogs in credit derivatives transactions, there has been relatively little attention paid to this area.

There is a risk that the authorities may overly focus on the systems and potentially overlook more important issues relating to the banks themselves. As an example, it may be more important for the BoE, given its financial stability focus, to use its market intelligence to increase the awareness of clearing arrangements for credit derivatives, rather than going in-depth into pure retail systems like the ATM network (LINK) and the debit card scheme (U.K. Maestro), as is currently the case.

Banks’ clearing arrangements are not always very well-known to banking supervisors. Although initiatives have been taken within the FSA, from the market infrastructure perspective, to educate their bank supervisors in clearing and settlement risks, anecdotal evidence suggests that there is still room for considerable improvement. Using the information gathered on market infrastructure to increase awareness of these risks would be an important first step in making sure these risks are carefully managed.


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Prepared by Li Lian Ong (MFD) and Martin Andersson (MFD technical expert, Sveriges Riksbank).


The mortgage lenders within the MBBGs comprise 12 of the 15 largest in the country.


See also Croft (2005).


The total write-off of unsecured household loans represented 75 percent of all write-offs by banks in December 2005.


Some analysts attribute the firming demand for mortgages in the months leading up to December 2005 to speculation about the new pension regime.


Sub-prime lending is a flexible approach for lending to borrowers with little or poor credit experience. This credit history serves as a barrier to traditional or conforming credit markets. Sub-prime loans are priced according to risk, although pricing is only one characteristic of such loans. Sub-prime lending also includes structuring payments, offering credit enhancements, and providing otherwise non-traditional loan terms to allow customers to best meet their financial needs (Bartlett, 2000).


According to a recent survey, 75 percent of total debt secured by commercial property was held by 12 organizations at the end of 2004 (see Maxted and Porter, 2005). The average loan-to-value (LTV) ratios increased for all commercial sectors in 2004, with those for prime office and prime retail property reaching their highest levels since 1999.


It should be noted that the introduction of REITS is widely expected to provide benefits such as improving the liquidity of the property market, and increasing diversification opportunities for investors.


“Brownfield” is the term generally used to describe previously developed land, which may or may not be contaminated from previous industrial uses. Recent government objectives have initiated a move towards redevelopment of brownfield land instead of greenfield sites, to relieve the pressure on the countryside and green belt areas. The Government has targeted the development of 60 percent of new housing on brownfield sites.


See Selected Issues Paper, “United Kingdom—The Credit Risk Transfer Market and Implications for Financial Sector Stability.”


Discussions with supervisors reveal that the unemployment rate is a closely-watched statistic, as it is considered a key flag of potential problems in the housing market and banks’ credit quality.


The split of fixed/floating rate loans to households was 30 percent at floating rate and 70 percent at fixed rate, for 2005, compared to 32 percent floating and 68 percent fixed for 2004.


In December 2005, Portman Building Society, the third largest buy-to-let lender in the United Kingdom, became the first lender to refuse approval of buy-to-let mortgages on new flats (Pickard, 2005a).


See also Pickard (2005b, 2005c).


A covered bond is an instrument directly issued by a bank and guaranteed by the collateral that the bank puts aside, by selling it to a special purpose vehicle. Covered bonds offer favorable funding costs relative to RMBS, as well as the ability to lengthen liability profiles and access new investors. The FSA recently clarified the guideline relating to banks’ issuance of covered bonds. Essentially, banks are expected to inform the FSA if their total covered bond issuance exceeds 4 percent of total assets, to enable a case-by-case assessment of additional risk to depositors beyond this threshold. The issuance of covered bonds beyond 20 percent of total assets is likely to be considered sufficiently material to require an increase in a bank’s individual capital ratio (ICR), the minimum capital ratio that a bank should maintain.


Within Europe, the advent of Basel II, which would require banks to carry more capital to cover unsecured loans, is yet another factor influencing interbank market participants to prefer secured over unsecured lending.


See FSA (2005a). The BoE’s own stress-test model has also changed significantly since the 2002 FSAP (see Bunn, Cunningham and Drehmann, 2005; Goodhart and Zicchino, 2005). The new model is built from micro foundations, with core (theoretical) and non-core (set of equations which fit data better and pick up correlations) components, whereas the old model was more data driven.


Currently, Standard & Poor’s has assigned a stable outlook to 85 percent of ratings in the life sector (Button and Harrison, 2005).


Implicit items are intangible assets, which under certain conditions are admissible to cover an insurance company’s required minimum margin of solvency. Future profits are implicit items. Intangible items will be phased out over the next two years under the enhanced Solvency I requirements. (Solvency I comprises various EU directives, which make only modest changes to existing regulations. They were adopted in March 2002, and became effective in member countries on January 1, 2004.)


The RMM is effectively a weighted average of provisions (life insurance) or premiums/claims (non-life insurance). It is the minimum level that a regulated insurance company needs to cover with solvency capital to operate under normal conditions. The solvency capital requirement reflects a level of capital that enables an insurer to absorb significant unforeseen losses, thus providing reasonable assurance to policyholders.


The insurers initially provide the FSA with an assessment of its own risk exposures and potential losses. Upon the FSA’s receipt of the insurer’s assessment, an actuarial team would review the assessment and then issue an Individual Capital Guideline (ICG) to the insurance company. The eventual determination of an insurer’s capital adequacy would be the result of an interactive process between the insurer and the FSA, with stress-testing required in the modeling to justify the insurer’s capital assessment. The first cycle of assessments is expected to be completed by the first quarter of 2006. The second iteration, which is expected to include broader risk assessments, will likely take another two years.


The common practice with documentation has been for insurers to issue policies way after their cover had run out (“deal now, detail later”), resulting in uncertainty on the part of both parties as to the details of the coverage.


According to South (2005), the top 3 corporate names are each referenced in more than 80 percent of transactions in European synthetic CDOs, and each of the top 40 corporate names appear in more than half the of the transactions. In the case of the former, South estimates that any default by any one of the three corporates could lead to ratings downgrades for 47 percent of synthetic CDOs, by an average 2.5 notches.


Empirical evidence using publicly available market data suggests that any exposure of major U.K. financial institutions to the different tranches of credit derivatives instruments appear to be well diversified across institutions; there appears to be little cause for concern at this stage (see Selected Issues Paper, “The United Kingdom—The Credit Risk Transfer Market and Implications for Financial Sector Stability.”)


International initiatives on surveillance of the credit derivatives market include the Joint Forum and the Financial Stability Forum (see Joint Forum, 2004)


The implementation of the ISDA Master Agreement is expected to help mitigate risks (although hedge funds, which are major players in this market, have not signed up). The ISDA Master Agreement is a standardized contract that two parties sign before they trade derivatives with each other. This Master Agreement is a bilateral agreement. It contains general terms and conditions that apply to all the individual derivative contracts that the two parties may enter into later.


See also Simensen and Beales (2005).


See BoE (2005c). The BoE is in the process of finalizing the second PSOR, which will also include a section on the new risk framework for oversight that the BoE developed in 2005, and will be implementing in 2006. These developments represent a significant step by the BoE towards best practice in being transparent and accountable to the public about its oversight function.


In a tiered system, a few member banks (first-tier banks) settle directly with the central bank, while a larger number of customer banks (second-tier banks) processes their payments through the direct members.


The concentration bank holds the accounts where all net funds from LCH. Clearnet are accumulated.


See Appendix, “An Update on the Payment and Settlements System,” for further details.


The BoE concluded that it was not essential, from either a financial or a monetary stability perspective, for there to be a high-value euro payment system in London. The BoE was prepared to provide such a service, but only on a full cost-recovery basis. Since there was insufficient information on the costs it would incur, and the ability to recover those costs, the BoE concluded it should not participate in TARGET 2.


Within the EU, there is already a particular set of arrangements prescribed by directives.


The most fully-developed example of home/host collaboration at present is the tripartite of Switzerland, the United Kingdom and the United States.


The Cross-Market Business Continuity Group (CMBCG) is an explicit and formal arrangement between the authorities (BoE and FSA) and key financial institutions operating in the United Kingdom, irrespective of their U.K. or non-U.K. status. It has been set-up to establish contacts in advance of a crisis, and can be called upon whether the event is an operational disruption or a financial crisis.


See the FSA’s 2006 Financial Risk Outlook (FSA, 2006a) and 2006/07 Business Plan (FSA, 2006b).


For example, during periods of general market stress, a settlement bank may delay making payments on behalf of the customers of second-tier banks in favor of making its own payments and/or cut intraday credit lines extended to the customers of its second-tier banks thereby exacerbating any liquidity pressures faced by the second-tier banks.


In 2003 LCH merged with Clearnet and the name was changed to LCH. Clearnet.


In 2002, CRESTCo and Euroclear merged. The merger was announced during the FSAP mission, but since there were no significant changes in CREST operations at that stage, the assessment was performed on CREST as an individual system.

United Kingdom: Selected Issues
Author: International Monetary Fund
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    Growth in Total Lending to Individuals, November 2003–November 2005

    (12-monthly, in percent)

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    Bank Lending Secured on Dwellings, November 2003–November 2005

    (In millions of British pounds)

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    Buy-to-Let Lending and New Flats, H2 1999–H1 2005

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    Components of U.K. Interbank Lending

    (In billions of British pounds)

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    Composition of U.K. Interbank Lending

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    U.K. 10-Year Treasury Yields, April 2004–January 2006

    (In percent)

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    Cross-Country Comparison of Banks’ Returns on Equity, 2004

    (In percent)

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    Cross-Country Comparison of Banks’ Cost-to-Income Ratios, 2004

    (In percent)

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    Nominal House Price Indices

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    Cross-Country Comparison of Banks’ Loans-to-Deposits Ratios, 2002-04 Average

    (Based on the largest banks in each country, in percent)