Abstract
This paper estimates the extent of spare capacity in the U.K. economy using a range of methodologies pointing to an output gap and the behavior of inflation during large output gaps. The usefulness of fiscal rules in supporting fiscal consolidation is generally positive, and a more permanent rules-based fiscal framework is required. The banking system has recovered fast; however, the sustainability of the sector’s recovery is still uncertain, and risks remain. An update on reforms to the financial sector’s regulatory and supervisory framework is also provided.
VI. Recent and Pending Reforms to the UK Financial Sector’s Regulatory and Supervisory Framework1
This chapter provides an update on recent and pending reforms to the UK financial sector’s regulatory and supervisory framework. Key initiatives underway include: (i) reform of the institutional architecture for prudential oversight, including the dismantling of the Financial Services Authority (FSA) and transfer of prudential regulatory responsibilities to the Bank of England (BoE); (ii) regulatory changes alongside international initiatives spearheaded by the Basel Committee on Banking Supervision (BCBS), the Financial Stability Board (FSB), the G-20, and the European Union (EU); and (iii) independent commission review of the need for further structural reform of the UK banking sector.
A. Introduction
1. Financial sector regulation and supervision is a key issue in the UK given the UK’s status as a global financial center. The UK’s financial sector comprises both (i) British-owned financial firms, which feature relatively high concentration of financial activity in a few large groups, and (ii) hundreds of small-to-very-large UK-authorized entities (including branches and subsidiaries) controlled by foreign financial and nonfinancial firms. The sector’s significant effect on domestic employment and tax revenue, as well as the potential for high fiscal costs from resolution or support arrangements, gives the UK a significant stake in the global evolution of financial sector regulation and supervision.
2. This chapter provides a summary of recent and pending reforms to the UK’s regulatory and crisis resolution arrangements. Table 1 also describes the status of, and the UK authorities’ general views on, key regulatory initiatives at the international level. Given the importance of the financial sector to the UK’s economy, the authorities have played an important leadership role in advancing global regulatory reform, with innovative proposals in many areas.
B. Regulatory Developments
3. The new government announced in June that the existing tripartite regulatory regime will be restructured. In this context, the FSA will be unwound, and its tasks reassigned to new authorities:
A new Prudential Regulatory Authority (PRA) will be created; it will operate as a subsidiary of the BoE and will carry out the prudential regulation of deposit-taking institutions, investment banks, and insurance companies.
A new Consumer Protection and Markets Authority (CPMA) will be set up to regulate the conduct of authorized financial firms providing services to consumers and to protect market integrity.
In addition, a Financial Policy Committee (FPC) will be established at the BoE, with an explicit new mandate for macroprudential oversight. This will entail the careful monitoring of systemic risks as well as concrete policy action to curb such risks.
A formal consultative process is underway with the intention to introduce legislation and complete the formal transition to the future structure in 2012. As an interim step, the FSA in the first quarter of 2011 will divide its activities according to the shadow functions of the future PRA and CPMA.
4. The government also established in June 2010 the Independent Commission on Banking (ICB), chaired by Sir John Vickers, to consider further reforms to the banking system. The ICB will make recommendations to: (i) reduce systemic risk in the banking sector by exploring the risk posed by banks of different size, scale, and function; (ii) mitigate moral hazard in the banking system; (iii) reduce both the likelihood and impact of firm failure; and (iv) promote competition in banking for the benefit of consumers and businesses. The ICB’s recommendations will cover both structural measures, including the complex issue of potentially separating retail and investment banking functions, and related non-structural measures, to reform the banking system and promote stability and competition.
5. The government will introduce a bank levy beginning in January 2011. The levy is intended to promote less risky funding and will apply to the global balance sheets of UK banks and the UK operations of banks from other countries. The levy is expected to generate around £ 2.5 billion of general revenue annually. The proposal is in line with the design of the financial stability contribution (FSC) set out in the IMF’s paper prepared for the G-20—A Fair and Substantial Contribution by the Financial Sector.
6. The FSA unveiled tighter liquidity regulations in October 2009. The regulations precede the issuance of a final standard from the Basel Committee on Banking Supervision (BCBS) and from the European Commission (EC). The FSA’s rules will apply to all banks operating in the UK (including branches) until agreed international guidance is developed and/or common EU-wide rules enter into force.
7. The UK authorities are strong proponents of the ongoing Basel III initiatives to increase the minimum requirements and tighten the definition of capital to improve the loss absorption capacity of capital. Key aspects of the Basel III proposals include the following: 2
After a phase-in period, minimum capital ratios will increase: (i) there will be a new requirement that common equity after deductions (see next bullet) exceeds 4.5 percent of risk-weighted assets; (ii) that Tier 1 capital (which includes common equity and other non-common equity components) exceeds 6 percent of risk-weighted assets; and (iii) that total capital (Tier 1 plus Tier 2) exceeds 8 percent of risk-weighted assets. In addition, banks will have to hold 2.5 percent of common equity as a capital conservation buffer—capital that can be drawn down in times of stress. A further 2.5 percent of capital could be required as a countercyclical buffer.
The definition of capital has been cleaned up to limit inclusion of intangible assets and those elements that have debt characteristics. Many low-quality elements have been removed from the definition of capital, and those that remain will be subject to caps.3 The FSA was an early adopter of the concept of a “Core Tier 1 ratio,” which excluded hybrid capital components.
A leverage ratio (initially 3 percent Tier 1 capital to total assets) will be implemented in stages—beginning with a supervisory monitoring period that starts in 2011 and becoming a mandatory requirement from 2018. As early as March 2009, the FSA in its Turner Review identified the need for a leverage ratio as a backstop to discipline banks against excessive balance sheet growth.
C. Crisis Management Framework
8. The UK modernized its legislation for bank resolution with the passage of the Banking Act of 2009 following the difficulties associated with the resolution of Northern Rock. The Act established a new special resolution regime for failing banks and building societies, including by giving the BoE new resolution powers and the FSA new intervention powers. However, challenges remain with regard to the resolution of investment banking activities, large complex cross-border financial institutions, and the unwinding of large derivative portfolios. In this regard, a public consultation process is ongoing concerning the introduction of a special administration regime for investment firms.
9. The authorities support requiring large financial groups to have in place well-defined recovery and resolution plans (or “living wills”). In the case of recovery, such living wills require firms to show how the firm would, in the event of financial stress, be able to restore capital or liquidity positions by exiting particular lines of business, selling subsidiaries, or raising fresh capital. The plans, which are developed in conjunction with the authorities, would also aid in the identification of issues surrounding a potential failure without giving rise to systemic disruptions. A pilot exercise by the FSA is underway with several major UK banking groups. Effectively handling the failure of large entities with complex cross-border operations will also require greater international cooperation to establish stronger mechanisms for cross-border supervision and resolution.
10. Meanwhile, the European Commission is working toward an EU directive on resolution regimes. As this process moves ahead, some work will be necessary to ensure compatibility between the UK and what will ultimately be a system of national resolution regimes among EU countries. The directive would likely require as a minimum that resolution regimes facilitate the transfer of deposits and viable assets to another bank, with bad assets and other creditor claims going into an insolvency process—which is already a part of the UK system.
Key Financial Sector Reform Initiatives
Key Financial Sector Reform Initiatives
| Issue | UK Position | EU, BCBS, FSB, and other positions |
|---|---|---|
| Crisis Management Framework | ||
| Bank resolution legislation to replace the commercial insolvency framework. | The Banking Act of 2009 sets out a credible arrangement whereby the BoE administers the bank resolution process. The process is effective for domestic banks, but is untried for large, cross-border banks and does not apply to nonbank financial institutions. Related to this, public consultation is ongoing for the introduction of a special regime for investment banks, with the intention to enact legislation in 2011. | The European Commission seeks an EU regime for managing crises in cross-border banking groups, with the objective that banks can fail without damaging financial stability. |
| Recovery and Resolution Plans (living wills): Requires that systemically important financial groups have in place well-defined recovery and resolution plans. Requirement would be imposed by the home country/consolidated supervisor. | The UK authorities endorse living wills. Section 7 of the Financial Services Act of 2010 requires the FSA to issue rules requiring authorized firms to draw up and maintain recovery and resolution plans. A pilot exercise by the FSA is underway involving several major UK banking groups. | BCBS/FSB/IMF are studying the idea (along with subsidiarization and contingent capital).4 BoE Deputy Governor Paul Tucker chairs an FSB working group that is reviewing the utility of recovery and resolution plans. The United States has endorsed living wills in recent legislation (Frank-Dodd Act). |
| Regulatory initiatives | ||
| Improved microprudential standards to increase the amount and quality of capital and liquidity in the system. | The UK actively contributes to and supports ongoing work by the BCBS and the EU on the reform of microprudential regulations. The FSA published a new liquidity regulation in October 2009. |
Basel III will issue new minimum quantitative liquidity requirements in stages. The Liquidity Coverage Ratio (LCR) will require banks to maintain high-quality liquid assets to meet short-term stresses lasting up to 30 days. The LCR will be subject to observation beginning in 2011, with the standard to be introduced in 2015. The Net Stable Funding Ratio (NSFR) is designed to ensure a better matching of asset and liability maturities and discourage overuse of volatile funding. The NSFR will be under observation beginning in 2012, with implementation planned for 2018. |
| Introduction of macroprudential policy to improve the overall resilience of the financial system by addressing aggregate risks and vulnerabilities across the system and to enhance macroeconomic stability by addressing cyclical imbalances through the financial system, e.g. damping the credit cycle. | The UK actively contributes to and supports ongoing work by the BCBS, EU, and FSB on macroprudential policy measures. The authorities are currently consulting on tools that the FPC may need to meet its macroprudential objectives, including countercyclical buffers and possibly other tools. |
The BCBS has led much of the work on countercyclical buffers and has proposed an initial calibration of up to 2.5 percent of risk-weighted assets. (BIS press release) The FSB has proposed additional loss absorbency for systemically important financial institutions (FSB press release). |
| Structural Reform/Activity Restrictions | ||
| Curbs on activities, notably proprietary trading, intended to reduce conflicts of interest and prevent particularly high-risk activity in universal banks benefiting from deposit insurance and/or implicit guarantees. | In the UK, the Independent Commission on Banking is studying the proposal; a final report with recommendations will be published in September 2011. | Curbs on proprietary trading (Volcker rule) are included in the recent Frank-Dodd Act in the US. Limited support elsewhere. |
| Forced separation of commercial and investment banking (a la Glass/Steagall) to reduce conflicts of interest within universal banks and shield critical commercial bank functions from high-risk activities in investment banking. | In the UK, the Independent Commission on Banking is studying the proposal; a final report with recommendations will be published in September 2011. | No current initiatives in this direction. |
Key Financial Sector Reform Initiatives
| Issue | UK Position | EU, BCBS, FSB, and other positions |
|---|---|---|
| Crisis Management Framework | ||
| Bank resolution legislation to replace the commercial insolvency framework. | The Banking Act of 2009 sets out a credible arrangement whereby the BoE administers the bank resolution process. The process is effective for domestic banks, but is untried for large, cross-border banks and does not apply to nonbank financial institutions. Related to this, public consultation is ongoing for the introduction of a special regime for investment banks, with the intention to enact legislation in 2011. | The European Commission seeks an EU regime for managing crises in cross-border banking groups, with the objective that banks can fail without damaging financial stability. |
| Recovery and Resolution Plans (living wills): Requires that systemically important financial groups have in place well-defined recovery and resolution plans. Requirement would be imposed by the home country/consolidated supervisor. | The UK authorities endorse living wills. Section 7 of the Financial Services Act of 2010 requires the FSA to issue rules requiring authorized firms to draw up and maintain recovery and resolution plans. A pilot exercise by the FSA is underway involving several major UK banking groups. | BCBS/FSB/IMF are studying the idea (along with subsidiarization and contingent capital).4 BoE Deputy Governor Paul Tucker chairs an FSB working group that is reviewing the utility of recovery and resolution plans. The United States has endorsed living wills in recent legislation (Frank-Dodd Act). |
| Regulatory initiatives | ||
| Improved microprudential standards to increase the amount and quality of capital and liquidity in the system. | The UK actively contributes to and supports ongoing work by the BCBS and the EU on the reform of microprudential regulations. The FSA published a new liquidity regulation in October 2009. |
Basel III will issue new minimum quantitative liquidity requirements in stages. The Liquidity Coverage Ratio (LCR) will require banks to maintain high-quality liquid assets to meet short-term stresses lasting up to 30 days. The LCR will be subject to observation beginning in 2011, with the standard to be introduced in 2015. The Net Stable Funding Ratio (NSFR) is designed to ensure a better matching of asset and liability maturities and discourage overuse of volatile funding. The NSFR will be under observation beginning in 2012, with implementation planned for 2018. |
| Introduction of macroprudential policy to improve the overall resilience of the financial system by addressing aggregate risks and vulnerabilities across the system and to enhance macroeconomic stability by addressing cyclical imbalances through the financial system, e.g. damping the credit cycle. | The UK actively contributes to and supports ongoing work by the BCBS, EU, and FSB on macroprudential policy measures. The authorities are currently consulting on tools that the FPC may need to meet its macroprudential objectives, including countercyclical buffers and possibly other tools. |
The BCBS has led much of the work on countercyclical buffers and has proposed an initial calibration of up to 2.5 percent of risk-weighted assets. (BIS press release) The FSB has proposed additional loss absorbency for systemically important financial institutions (FSB press release). |
| Structural Reform/Activity Restrictions | ||
| Curbs on activities, notably proprietary trading, intended to reduce conflicts of interest and prevent particularly high-risk activity in universal banks benefiting from deposit insurance and/or implicit guarantees. | In the UK, the Independent Commission on Banking is studying the proposal; a final report with recommendations will be published in September 2011. | Curbs on proprietary trading (Volcker rule) are included in the recent Frank-Dodd Act in the US. Limited support elsewhere. |
| Forced separation of commercial and investment banking (a la Glass/Steagall) to reduce conflicts of interest within universal banks and shield critical commercial bank functions from high-risk activities in investment banking. | In the UK, the Independent Commission on Banking is studying the proposal; a final report with recommendations will be published in September 2011. | No current initiatives in this direction. |
Prepared by Michael Moore (MCM).
See BIS press release http://www.bis.org/press/p100912.htm.
The following items may be exempted from deduction each up to 10 percent and in aggregate up to 15 percent of common equity net of all other deductions, and subject to full disclosure: (i) significant investments in the common shares of unconsolidated financial institutions; (ii) mortgage servicing rights; and (iii) deferred tax assets arising from timing differences.
Subsidiarization for cross-border banks calls for greater reliance on subsidiaries (rather than branches) to segregate capital and impose liquidity requirements. Contingent capital is debt that converts into equity when certain criteria are met that triggers the conversion.