United Kingdom: Spillover Report for the 2011 Article IV Consultation and Supplementary Information

International Monetary Fund

doi:10.5089/9781462336517.002.A001

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United Kingdom

Spillover Report for the 2011 Article IV Consultation and Supplementary Information

Author: International Monetary Fund

Publication Date:: 01 Aug 2011

eISBN:: 9781462336517

Language:: English

Keywords:: ISCR; CR; bank; financial institution; U.K. interbank market; U.K. bank; U.K. bond market; authorities' effort; pursuit of self-sufficiency; U.K. authorities; headquartered institution; Financial sector stability; Systemic risk; Financial sector; U.K. authority

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In recent years, the IMF has released a growing number of reports and other documents covering economic and financial developments and trends in member countries. Each report, prepared by a staff team after discussions with government officials, is published at the option of the member country.

Abstract

I. Context

1. This report examines the systemic impact of the U.K.’s economic and financial sector policies on the global economy. The U.K.’s potential for spillovers is concentrated in the financial sector. Though the U.K. is the fifth largest economy in the world at about 4 percent of global GDP the potential for systemic spillovers from the real economy is limited despite the economy’s comparative openness to trade. This is not to deny that real spillovers to a number of close partner economies could be significant.

2. Growth spillovers to the other S5 economies are moderate and concentrated on the euro-area in normal times. Spillovers to other G20 economies also appear moderate (see Supplement, notes VI and VII). A structural model suggests that the peak impulse responses of output to a range of shocks in the U.K. tend to increase with geographical proximity to the U.K., and is larger for financial shocks than for real shocks. The highest dependence is exhibited by Germany and France, reflecting their strong trade linkages, and there is also some impact on South Africa (see Figure 1). A sharp but contained increase in U.K. sovereign bond yields −a scenario simulated across the spillover reports for advanced economies—would likely have only a limited impact on bond yields and growth elsewhere (see Supplement, Note VIII). The Article IV staff report suggests that the government’s fiscal consolidation plan has significantly reduced the risk of such an event.

3. Spillovers could be much greater for a range of non-systemic economies that are heavily dependent on trade with the U.K. Model results are unavailable for these countries, but their high share of exports destined for the U.K. suggests they could face sizable spillovers. Examples include Ireland, Iceland, Norway, and much of the Commonwealth. Spillovers through transfers are also likely to be significant to low income countries (LICs), particularly in sub-Saharan Africa (SSA), which derive around 10 percent of their aid and remittances from the U.K. (See annex 1).

4. The more substantial systemic spillovers are expected to arise from U.K. financial sector developments and policies.¹ The remainder of the report lays out the channels through which U.K. markets, institutions, and policies influence the rest of the world, seen both from staff’s analysis, U.K. partners’ concerns, and the authorities’ reactions.

II. The U.K. Financial Sector’s Systemic Role

Size and role

5. The U.K. lies at the center of global finance, with U.K.-based banks playing a leading role in global financial intermediation. It ranks third world-wide in terms of external assets, which are mostly loans, debt securities and derivatives. This reflects U.K.-based banks’ domination of cross-border lending, particularly to other financial institutions (See Supplement, Note I). The U.K. also hosts critical markets and financial infrastructure. It is the center of global foreign exchange (37 percent of global turnover) and money markets (Libor market) and the dominant location for trading international bonds² and derivatives. (see Figure 3 and Supplement, Note II) This agglomeration of financial services has encouraged the development of trading platforms and supporting infrastructure including FX clearing and settlement systems, and the world’s largest central counterparties (CCPs).

High capacity to transmit shocks

6. The size and role of the U.K. financial system in global intermediation make it a potent originator and transmitter of shocks to the global system. The U.K. is a significant generator of “funding” globally (See Supplement, notes III to V) and contributor to the buoyancy of global markets. Figure 2, which shows net liquidity creation/import by banks based in a country as opposed to groupwide (such that a positive balance implies that global banks based in a country export funding to the rest of the world), indicates that U.K.-based institutions accounted for more than half of global funding generation during the boom, implying that a shock to their activity would have large global repercussions.³ This owes in part to the broad capacity to rehypothecate collateral in the U.K., which helps generate leverage and transmit liquidity through the financial system (see U.K. FSSA update).

7. In supporting this generation of liquidity, foreign-owned banks in the U.K. leverage their balance sheets, but in their deleveraging transmit shocks. The tendency for foreign-owned banks to be more leveraged than domestic institutions is true in most countries. The difference in the U.K. is the size of their balance sheets and degree of leverage: during 2005–07 foreign subsidiaries in the U.K. operated at leverage levels roughly double that of the consolidated group, on account of their tilt toward investment banking and derivatives activity (Figure 4). Conversely, in 2008–09, foreign-owned banks reduced their leverage ratios more quickly, showing higher procyclicality in the downturn than domestic institutions (Supplement, Note V).

8. The global transmission consequent on this deleveraging derives from the high degree of interconnectedness of the U.K. with the rest of the world—particularly Europe. A standard approach to network analysis based on BIS data on international claims shows the U.K.’s links are strongest with the Eurozone, but still significant with the U.S., Cayman Islands (a key offshore center for U.S. banks) and Japan, and smaller financial centers (Figure 5).⁴ The results are driven by business models of the large international banks many of which rely on U.K.-based entities to intermediate global flows, in particular those between the U.S. and the EU (Supplement, Note V).

9. U.K.-based banks deleveraged early, and accounted for 27 percent of the decline in cross-border lending through the first half of 2009 (Figure 6).⁵ Simulation analysis (see Supplement, Note IX) suggests that such shocks are likely to have a severe effect on countries that depend on the U.K. for short-term funding, particularly financial centers (Hong Kong, Luxemburg and Cyprus). There is also likely to be a large impact on other EU states. Ireland is the most extreme case, with “upstream exposure” (a measure of countries’ vulnerabilities to rollover risks from direct cross-border bank lending, and lending by foreign affiliates) to the U.K. exceeding 50 percent of its GDP. But exposure is also significant (5-10 percent of GDP) for large Euro-Area countries such as France and Spain.

10. The bond market represents an additional important channel of transmission of financial shocks. Structural Vector Autoregression (SVAR) results for 10-year government bond yields point to a significant role of the U.K. bond market: more than 50 percent of the initial yield shock in the U.K. spills over to euro area yields, and to a smaller extent to the U.S. and Japan (Figure 7). Given the finding reported above regarding spillovers from a U.K. sovereign shock (paragraph 2), this result is driven by the large volumes of non-UK sovereign bonds traded in London. Equity market spillovers, while significant, are found to be smaller and less persistent. (Supplement, Note VI)

Impact of shocks from the U.K.

11. A shock originating in the U.K. would similarly have sizeable cross-border effects, particularly on global financial centers.⁶ Changes to the perceived creditworthiness of U.K.-owned banks, proxied by CDS spreads, might lead to spillovers on financial institutions that either trade with them or are seen as having similar business models. The relationship can be quantified through a conditional probability of distress (CoPoD) approach, which examines how shocks to the CDS spreads of one bank in the U.K. impact those of financial institutions elsewhere (Figure 8 and Supplement, Note X). The CoPoD analysis confirms that the larger global U.K.-owned banks have a substantial impact on the rest of the world, exceeding that of more domestically focused institutions. They have greatest spillovers on financial institutions in the Euro-Area and emerging Europe, with less of an effect on Latin America or Asia.

12. Shocks from the U.K. have also had a large impact on measures of global financial market risk, explaining around a quarter of its movements (Figure 9). The weight of the U.K. is as large as that of the Euro-Area, and only slightly smaller than the U.S. The U.K. interbank and stock market seem to exhibit significant volatility spillovers vis-à-vis corresponding asset markets in the U.S. and to a lesser extent the Euro Area (despite, as noted above, smaller level effects in equity markets). It may be noted that this analysis reflects the U.K.’s role both as a transmitter of shocks and an originator (see Supplement, Note XI).

III. Partner Concerns

13. The U.K.’s potential to transmit shocks and to contribute to global financial stability is recognized in other financial centers. Many of them suffered liquidity drains from U.K.-based banks during the recent global crisis. Some financial institutions that had ready access to the U.K. interbank market when liquidity was buoyant were forced to deleverage when their credit lines were cut. Strengthened supervision and tighter regulation in the U.K. were thought likely to contribute to efforts to strengthen global financial stability. Over and above the U.K.’s own policies, interlocutors also recognized the role played by the U.K. in forging the intellectual case for ambitious global financial reforms. Outside financial centers, however, some did not see any exceptionality in the U.K. financial sector and downplayed its impact on Europe and the rest of the world.

14. Foreign regulators did not feel that the U.K. should draw back from reform for fear of losing business to other jurisdictions. Most thought that the pull factor of strong emerging market growth was the major explanation for the rising share of financial activity in Asia, with push factors such as regulatory changes of secondary importance. The agglomeration effects binding financial institutions to the U.K. were seen as powerful, and so the U.K. could contribute to global stability without unduly undermining its competitive position. However, market participants warned that should the U.K. exceed materially Basel III and other international regulatory agreements, some might consider the possibility of moving activities outside of the U.K. A number of interlocutors were concerned that measures to address too important to fail (TITF) institutions—such as ring-fencing of capital, liquidity or retail operations—could strengthen stability in the U.K. at the expense of other jurisdictions as improving resolvability of the U.K. entity does not necessarily improve resolvability of the whole entity, could limit resources available to solve problems elsewhere in the group, and create trapped pools of liquidity.

IV. Policy Spillovers

15. The U.K. has embarked on a major financial sector reform program—that could have important spillovers, at least transitionally. The effort is domestically focused, but aligned with the imperatives of global stability. Reforms range across supervision, regulation (including liquidity and capital buffers), and TITF policies. As these reforms impact all “U.K.-based intermediaries”, they affect the business models that use the U.K. for global asset and liability management. The scale and nature of policy spillovers from the U.K. however will be influenced by the policies of other jurisdictions. Uncertainty about the latter—in particular how the EU will go about implementing Basel III (under a new directive “CRD4”)—creates uncertainties about the extent of spillovers from U.K. policies.

16. Event studies suggest that markets have been keenly aware of the potential cross-border impact of regulatory changes in the U.K. A systemic risk survey compiled by the Bank of England in the immediate wake of the crisis indicated that financial institutions saw regulatory and accounting changes as among the top five risks to the U.K. financial system, and one of the two hardest risks for them to manage.⁷ While LIBOR-OIS, a common indicator of liquidity risk, did not immediately react to announcements on changes in U.K. regulation on liquidity standards, other risk measures moved sharply.⁸ The average price to book value of systemically important financial institutions (SIFIs) with a universal banking and investment banking business model relative to their home country index fell sharply on key dates coinciding with announcements or changes in the U.K.’s liquidity regulations (See Supplement, Note XII). A similar effect is seen in the price of hedging against tail risk in key currencies used by global SIFIs in intermediation of most markets via the U.K.

Prudential Oversight

17. Reforms to strengthen supervision will critically help contain the risks to global stability arising from the size and complexity of the U.K. financial sector. The build-up of systemic risks in the mid-2000s, including the rise of the shadow banking sector, was possible in part due to the U.K.’s “light touch” supervisory approach. In response, the authorities have begun to increase the resources devoted to supervision and strengthen stress testing, with further efforts required. Maintaining and building upon these improvements should help contain the risk of distress in U.K.-based banks and potential collateral damage abroad.

18. Strong supervision of CCPs is particularly important if tail risks are to be contained.⁹ If soundly run and regulated, CCPs could both lower and make more transparent the level of risk in derivatives (See Supplement, Note II). But CCPs also represent large risk nodes, that could face severe liquidity needs and potential losses if a large market participant were to default. Such a situation, if mishandled, could have systemic implications. Establishing an appropriate resolution framework, while ensuring that CCPs have adequate risk management and access to sufficient liquidity during crises will support these efforts.

Liquidity and leverage

19. The tightening of U.K. liquidity rules will constrain SIFIs, dampen the credit cycle, and should help lower systemic risks. The new, tougher approach in the U.K. approximates the liquidity coverage ratio (LCR) in Basel III, but the range of assets classified as liquid is narrower, and the required “stress survival period” at three months is longer.¹⁰ Maintaining liquid buffers in several jurisdictions, including the U.K, may raise the aggregate costs of liquidity for SIFIs. The rules regarding intra-group relationships have also been tightened, with supervisors factoring them into assessments of liquidity only if the entity can demonstrate reliable access to group resources. In principle, the new rules should help lower the probability and severity of possible future global crises, although the magnitude of this effect is hard to quantify, and seems subject to diminishing returns.¹¹

20. Such rules, while key to domestic and global stability, may also accelerate deleveraging, increase intermediation spreads, and lead to tighter credit standards. An assessment of upstream exposure, highlights very significant levels of funding dependence for a number of key jurisdictions (Figure 10). As it excludes (due to data constraints) dependence that arises from branches and subsidiaries, it provides a lower bound on the impact of a funding shock.

21. An unintended consequence of the U.K.’s pursuit of self-sufficiency in liquidity could be the emergence of trapped pools of liquidity, potentially detrimental to global financial stability. If the U.K. tightens liquidity standards and other regulators follow suit, it could become more complicated for global SIFIs to protect subsidiaries in the event of shocks. This risk may be mitigated, however, if in co-ordination with home supervisors, U.K. supervisors exercise discretion and modify liquidity requirements in recognition of reliable access to group resources.

22. If imposed, a cap on leverage interacting with the policy intention of increased “self-sufficiency” of U.K. based institutions, could also lower risks. The Basel III agreement assumes that limits on the leverage ratio would enter into force in 2019, although it is unclear if the EU will include this measure in CRD4. If introduced in the U.K., it could limit procyclical expansions in leverage and impose efficiency costs on SIFIs funding themselves through intra-group transactions. However, the impact would depend upon how it is defined and calibrated, in particular whether it is applied at the solo level, as well as to consolidated balance sheets. The former approach could have a more powerful effect by capturing intra-group transactions. A cap on on-balance sheet leverage might also provide an incentive to financial institutions to increase their reliance on off-balance sheet funding sources (Supplement, Note V).

Capital

23. Given the size of balance sheets in the U.K., increased capital requirements could also contribute to global financial stability. As is the case for liquidity, increasing capital buffers should lower the risk of and size of crises, although the impact will depend upon whether they are applied at the solo or consolidated level.¹² Increased capital requirements could also carry benefits in normal times by dampening shocks transmitted by the U.K. financial sector and lowering the volatility of output.¹³ New capital requirements for globally important SIFIs will apply to the nodes in the financial network that can most rapidly propagate—or potentially ameliorate—the impact of shocks.

24. The output costs arising from higher capital requirements in the U.K. are likely to be modest and possibly transitory as banks adjust to the new standards. They arise from deleveraging, increased intermediation spreads and a tightening in credit standards, mitigated by changes in bank behavior (Figure 11, see Supplement, Note XIII). Simulations using a macroeconometric model indicate that a 1 percent increase in required capital (if implemented over two years) leads to output losses in the rest of the world that peak at 0.06 percent (this impact does not include the effects of possible offsetting monetary policy reactions). This impact is modest, though large relative to the U.K.’s share of global output. Non-investment grade borrowers, such as some emerging market or mid-sized corporates, could see their funding costs rise due to higher capital requirements on trading books, which are heavily concentrated in the U.K.

Macroprudential policies

25. The U.K. also seems well placed to contribute to the implementation of global macroprudential policies. The Financial Policy Committee (FPC), the body set up to implement macroprudential policies in the U.K., while having a mandate focused on domestic financial stability, is expected to consider the outward spillovers of its decisions, in particular possible feedback effects on the U.K. financial system.¹⁴ The FPC will be responsible for the U.K. implementation of the Basel III agreement on a countercyclical capital buffer (the only instrument on which there is international agreement so far), which will provide banks with more capital to withstand potential losses after a credit bubble.

26. The FPC can deliver this role through “jurisdictional reciprocity”, a process for ensuring that macroprudential policies are not arbitraged. As credit cycles vary sharply across economies, so will appropriate macroprudential standards in each jurisdiction. Any authority opting to apply measures to credit exposures will inform foreign counterparts so they ensure that their banks apply them to relevant exposures. The U.K.’s involvement in this process, whether for credit cycle risks or other systemic issues, would help ensure that internationally active banks do not, for instance, circumvent rules in one country by booking transactions through the U.K.

Managing Tail Risks: TITF institutions and Cross-border resolution

27. A number of U.K. initiatives to address tail risks could have spillover effects. A requirement that banks develop recovery and resolution plans (RRPs, also known as living wills) could help reduce the risks in the event that a complex institution fails and needs to be broken up. If adopted, the recommendations of the interim report of the Independent Commission on Banking could also have a significant impact on the capital requirements and organization of some internationally active U.K. banks.

28. However, the absence of an effective cross-border resolution framework raises particular concerns that U.K.-based institutions could propagate shocks in situations of stress. At present, EU regulations governing the “single market” and “passporting” arrangements limit the options for the U.K. (and other member states) to regulate and supervise U.K. banks that are branches of banks headquartered elsewhere in the EU. Thus, if a parent experiences distress, there is a risk of its U.K.-based branches causing disruption, and vice versa. The present system of “home country” control and resolution does not provide effective incentives for cross-border supervision and resolution, because the absence of ex ante burden sharing arrangements could induce home authorities to neglect prudential developments in other member states. This is a particular issue for the U.K. because it is host to so many branches¹⁵, over which the authorities have limited powers. Nevertheless, it would be hard for the authorities to exercise restraint in the case of an inadequate response by home states. The absence of harmonized resolution frameworks, within or beyond the EU, may induce the U.K. to ring-fence in times of crisis resulting in a suboptimal resolution for groups, exacerbating spillovers.¹⁶

29. New spillover effects could emerge if the U.K. becomes a base for financial innovation to arbitrage new global regulations. Its track record at creating new financial products, facilitated by the clustering of services and the depth of markets, makes it a natural location for such activity. New risks might arise if, for example, provisions in the U.S. Dodd-Frank act encouraging the spin-off of proprietary trading and derivatives activity; cross-border differences in margin requirements for derivative trades not cleared through CCPs; or, differences in the cross-border application of leverage limits, leads to the riskiest activity re-emerging in London¹⁷ (see U.S. spillover report for evidence of such risk).

V. Factors dampening or Modifying Financial-sector Spillovers

30. Spillovers could be dampened if financial activity progressively moved to other jurisdictions. Strong economic growth in emerging markets is spurring a shift in global financial activity, particularly to Asia. This trend could be amplified by a prolonged period of uncertainty about U.K. financial sector policies, or if eventual taxation and regulatory decisions drive a large wedge between operating costs in the U.K. and those of other jurisdictions. A fragmentation of SIFIs’ activities would diminish the share of global intermediation falling in the U.K. regulatory net, lead to risks falling between the regulatory cracks if other regulators do not widen the regulatory perimeter or developing a comprehensive view of complex institutions becomes more difficult, and complicate the U.K. authorities’ efforts to assess global systemic risks.

31. However, powerful agglomeration effects underpin the U.K.’s competitive position, reducing the incentives to relocate. The academic literature finds that financial centers are created by clustering effects because of the positive externalities from information sharing and proximity to customers¹⁸; in the U.K.’s case, further externalities arise from market infrastructure and the availability of skilled labor. The few examples of precipitous declines in financial centers have resulted either from severe political instability or a shift in activities from regions to national capitals, rather than regulatory change. So far, no SIFIs have moved out of the U.K., with relocation to date limited largely to hedge funds going to Switzerland. While the U.K. will probably lose market share to fast-growing emerging markets, the pace could be slow, and will depend upon the extent to which any tightening in regulation is matched by other jurisdictions.

32. Insufficiently strong or insufficiently flexible EU rules would also hinder U.K. efforts to strengthen financial sector regulations, leading to potentially larger spillovers.¹⁹ If CRD4 requires common regulatory standards across the EU that are not sufficiently strong (above Basel III minima) or does not allow sufficient flexibility for national authorities to use a range of macroprudential tools to mitigate systemic risks (which, to be effective, requires the European Systemic Risk Board to play a prominent role in ensuring home-host coordination and reciprocity), the U.K.’s ability to implement strong regulations to avoid financial instability will be reduced, increasing the spillovers from such instability.

VI. The U.K. in Global Surveillance—A Unique Lens

33. The U.K. has unique informational advantages that in principle could strengthen the work of fora charged with the surveillance of emerging systemic risks. The intersection of U.K. oversight of global intermediaries—though lack of information on the activities of branches is a blind spot—with the hosting of markets and infrastructure provides the U.K. with unique perspectives on global intermediation. There is considerable scope to draw further information from existing data sources. As a treasury hub, trends in cross-border source and use of funds; U.S. dollar and dollar-linked trading; the quality of collateral being pooled and posted in transactions; the cross-border direction of risk mitigation strategies; and, developments in the Libor/OIS markets can be gleaned from operations and markets in the U.K. In addition, the U.K. authorities could potentially observe some risks in less-regulated areas, such as hedge fund activity, which the FSA periodically surveys. While in principle, the U.K. could try to dampen global cycles, its impact would be enhanced though international coordination. As a host supervisor of a subsidiary in a consolidated group, it has the right to demand even higher buffers if it considers that those proposed by the national supervisor are inadequate or have not been applied quickly enough. However, coordination with partner macro-prudential authorities in managing global risk will likely yield more effective results and help reconcile situations where global financial stability and domestic stability considerations do not coincide. In addition, the U.K. could be a major contributor to international work streams monitoring the evolution of use of Intra-Group Guarantees and the Booking Practices of SIFIs to trace how cross-border risks relocate. Finally, the U.K. authorities’ capacity to address such risks might be hampered if CRD4 overly constrains the use of a range of macroprudential instruments in response to emerging risks.

VII. Authorities’ Reactions

34. The U.K. authorities welcomed the pilot spillover exercise for the major systemic economies, which bridges an important gap between the Fund’s bilateral and multilateral surveillance. The authorities noted the timeliness of the U.K. spillovers analysis given the changing domestic and global financial landscape. They also recognized that the report has been a particular challenge because of data limitations, the inherent complexity of the subject, and the lack of existing empirical work on the spillovers from the U.K. financial sector to other countries.

35. The authorities concurred with the staff analysis that the size and role of the U.K. financial system in global intermediation, underpinned by powerful agglomeration effects, has important implications for the origination, transmission and dampening of shocks to the global financial system. They noted, however, that care was needed in the interpretation of spillovers emanating from U.K. headquartered institutions or domestic policy as distinct from the U.K. “host” functions as a recipient or a global conduit of shocks that originate from elsewhere. The authorities stressed that this work should serve as a good foundation for more in-depth analysis, for example on the impact of country-specific policies on the functioning of global liquidity.

36. The authorities agreed with the staff analysis that the overhaul of U.K. regulation and oversight, while domestically focused, is appropriately aligned with the imperatives of global stability, a view that is also consistent with the U.K. FSAP report. They recognized that the action taken domestically on capital and liquidity policy has an impact on global asset and liability management, and welcomed the staff judgment that the resulting benefits to global as well as U.K. financial stability exceed any potential liquidity efficiency costs.

37. However, the authorities underlined that the U.K. can only do so much on its own and that strong cooperation with and reform by global partners are needed to secure stability. Indeed, they echoed the direct EU-level financial stability risks set out in the report, which have the potential to cause and magnify spillovers from the U.K. In particular those risks arising from EU passporting arrangements in the event of less ambitious EU/EEA standards and from CRD4 limiting the scope for appropriate national discretion in policy making.

38. The U.K. authorities agreed that the concentration of activities in the U.K. presents some coordination and informational benefits compared to a more globally fragmented financial landscape. However, they emphasized that effective global surveillance and regulation ultimately requires sustained international cooperation and action, including by all key global financial centers and through ongoing workstreams and processes in international bodies like the IMF, FSB and ESRB. The U.K. authorities could also feed into this through the market intelligence it collects from its regular contact with the private sector in London. More broadly, the authorities confirmed their intention to continue taking a strong leadership role in policy discussions in these fora.

VIII. Conclusions

39. The size and role of the U.K. financial system allows it to originate, transmit, and potentially dampen risks and shocks to the global financial system. The agglomeration of core functions found in the U.K. makes it a central node in “funding” liquidity and balance sheet hedging, providing buoyancy to global markets (and as such contributing to the buildup of global risk)—but equally able to withdraw it abruptly, as became evident in the crisis. By the same token, any shock originating from the U.K. financial sector would have material implications throughout the global financial system.

40. The stability and efficiency of the U.K. financial sector is therefore a global public good, requiring the highest quality supervision and regulation. Significant efforts are underway to strengthen U.K. supervision, particularly of on-site inspections. Stronger liquidity and capital buffers as envisaged will dampen risks and shocks originated or transmitted through the U.K. financial sector, as will improved resolution regimes. That said, given the U.K.’s role, policies that limit leverage and require financial institutions to be more “self-sufficient” in liquidity will affect business models that use the U.K. for global asset and liability management, although the stability benefits will likely exceed potential global efficiency costs.

41. For optimal results, implementation of this agenda requires cooperation and coordination with global partners. Cooperation is key with all major financial centers, particularly so with the EU. U.K. financial stability will be weakened (with adverse spillovers) if EU rules constrain U.K. financial regulations at insufficiently ambitious levels or if they limit the ability to use a range of macroprudential instruments to address emerging risks. Similarly, very close home-host supervisor cooperation is essential to ensure that EU passporting arrangements do not undermine financial stability in the U.K. Additionally, the pursuit of “self-sufficiency” in liquidity, if pursued on a strictly national (rather than group-wide) basis, is useful primarily from the standpoint of domestic stability. However, globally coordinated approaches would be preferable in order to avoid the risk of fragmented, trapped, pools of liquidity that could hamper parent banks’ ability to support branches/subsidiaries in periods of stress. These would be inefficient and could even increase systemic risk. Thus, it will be important for the U.K. to continue the dialogue with global partners to develop protocols on access to liquidity in periods of stress. Co-operation is also required to develop cross-border resolution frameworks that would reduce the risk of U.K.-based institutions propagating shocks in tail-risk situations.

42. The U.K. authorities, while in principle uniquely placed to contribute to efforts at enhanced surveillance of global systemic risks, face important challenges in doing so in terms of data, resources and authority. The FPC can observe emerging stress and risks that might arise from the nexus of SIFIs, hedge funds and financial market infrastructure, but remaining gaps in data on systemic risks, including through the activity of branches, would need to be addressed. In this regard, vigilance will be needed on risks being pushed out—in response to regulatory reforms in other jurisdictions—or passported into deep and innovative U.K. markets. Although naturally focusing on domestic stability issues, the newly established FPC should take international spillovers into account.

Annex 1. Spillovers to Low Income Countries

1. Spillovers could be significant to a disparate group of mainly small economies that are heavily dependent on trade with the U.K, but for which model results are unavailable. Examples (with the share of their exports targeted at the U.K.) include

Former U.K. colonies (middle-income): Mauritius (32 percent), Seychelles (24 percent), and St Lucia (16 percent).
Former U.K. colonies (low-income): Gambia and Kenya (11 percent both).

2. Spillovers to low income countries (LICs) through remittance flows and aid from the U.K. are significant, particularly for Sub-Saharan Africa (SSA). This includes substantial remittances to Nigeria ($460 million, or 26 percent of the total), Uganda ($373 million, or 62 percent of the total), and Kenya ($254 million, or 59 percent). The U.K. also accounts for around 10 percent of aid flows to LICs, focused on the poorest countries. In contrast to many other donors, it has not cut aid flows in recessions, and plans to increase aid by 30 percent in real terms in next four years in spite of a major fiscal adjustment effort.

Like the companion FSSA, this report takes a broad definition of the U.K. financial sector, financial institutions based in the U.K.—whether U.K. owned or not—as well as the operations of subsidiaries and branches of U.K. banks abroad.

This includes non-dollar government bonds as well as Eurobonds of all currencies.

Owing to data limitations, this approach does not take into account the impact of the overseas activities of U.K. banks on global liquidity (see Supplement, Note IV for details).

See Understanding Financial Interconnectedness (2010) for further elaboration on the methodology. Espinosa-Vega and Sole (2010) illustrates how financial interconnections can amplify shocks through successive reductions in funding.

See Hoggarth, Mahadeva and Martin (2010).

Hoggarth et al (ibid).

Bank of England Quarterly Bulletin, 2009 Q3.

As suggested in the Bank of England Quarterly Bulletin (2009, Q4), this may be the result of Libor fixings being less indicative of actual transacted rates between banks and as such underestimating true cost of funding.

Adequate regulation and supervision of other critical pieces of market infrastructure is also essential to prevent adverse spillovers. This includes, for instance, CHAPS, the U.K.’s real-time gross settlement system, which provides settlement services for CLS (one of the key global clearers of forex payments).

Supervisors are also applying stress tests (using firm-specific and market-wide shocks) to review firms’ own assessments of liquidity needs.

See BCBS (2010).

BCBS (Ibid)

BCBS (Ibid) estimates that a 2 percentage point increase in capital ratios in the U.S. or Euro-Area would lead to 2 percent reduction in the standard deviation of output.

The FPC will also analyze financial sector vulnerabilities more generally, and make proposals on information gathering or microprudential measures complementing macroprudential policies.

The U.K. authorities have, by contrast, full powers to resolve foreign subsidiaries.

A recent proposal from the European Commission could alleviate some of these concerns. It would harmonize EU Member States’ legal and institutional arrangements for managing banking crises, bringing closer an integrated framework for crisis prevention, management and resolution.

The U.K. authorities are aware of such risks, and are monitoring the possible consequences of, for instance, new funding products that comply with revised liquidity regulations, but could create sizable rollover risks just beyond regulatory horizons (See Bank of England Financial Stability Report (2010)).

See the location of financial activity and the euro (an EMU Study) “HM Treasury” (2003).

This paragraph should be read in conjunction with paragraph 50 of the Staff Report on the 2011 Article IV consultation with the U.K.

Prepared by Vanessa Le Lesle (MCM) for the 2011 U.K. Financial Sector Assessment Program Update.

For example, Santander U.K. is a U.K.-owned and incorporated bank, established via the acquisitions of U.K. banks Abbey National, Bradford and Bingley, and Alliance and Leicester. See also Box 1 in the Bank of England Financial Stability Report (London, June 2010).

Prepared by Manmohan Singh, Vanessa Le Leslé (both MCM), and Alvaro Piris (SPR).

Today LIFFE’s transactions are technically cleared by LCH Clearnet Limited.

Australian dollar, Canadian dollar, Swiss franc, Czech koruna, Danish kroner, Euro, Sterling, Hong Kong dollar, Hungarian forint, Icelandic króna, Japanese yen, Norwegian krone, New Zealand dollar, Polish zloty, Swedish krona, South African rand, and the U.S. dollar.

Prepared by Karim Youssef (SPR).

An omnibus account groups together individual client accounts (including those of other brokers, banks, institutional investors, and Funds). It is a unified account, which does not allow for the retention of information about the individual accounts. Omnibus accounts are seen as an efficient way to augment inter and intra-firm operations in different markets and countries. They also allow firms to offer clients the ability to transact via a single firm across markets and countries.

Prepared by Irena Asmundson, Chris Marsh, and Karim Youssef (all SPR).

This measure is a simple proxy, given data limitations. A more accurate measure would require a more complete dataset including both claims and liabilities of the consolidated and locational balance sheets of domestically chartered banks, as well as subsidiaries and branches of foreign banks for every jurisdiction. The proxy measure does not take into account the claims of the consolidated balance sheet of a given country’s banks on their own foreign subsidiaries, but captures any claims by the subsidiaries on the consolidated balance sheet.

Prepared by Manuela Goretti, Alvaro Piris, and Karim Youssef (all SPR), and Manmohan Singh (MCM).

Tobias Adrian & Hyun Song Shin: “Financial intermediary leverage and value at risk,” Federal Reserve Bank of New York, Staff Reports 338 (2008).

Throughout the analysis, leverage is defined as (Total assets) over (Total shareholders’ equity). Total capital rather than Tier I capital is used given lack of uniform and complete data on the latter. Banks’ coverage varies across charts due to different data availability for on- and off-balance sheet definitions, as specified in the relevant footnotes to the figures.

Recently released figures for 2010 for some of the banks in sample confirm these results.

See note III, “The Role of the U.K. in SIFI business models”.

Prepared by T. Bui and M. Goretti (SPR), based on Bayoumi, T. and Bui, T. (2010), Deconstructing the International Business Cycle: Why Does a U.S. Sneeze Give the Rest of the World a Cold? IMF WP/10/239, October.

The analysis builds on the identification method in Rigobon, R. (2003), Identification through Heteroskedasticity, The Review of Economics and Statistics, Vol. 85 (4), pp. 777-792.

Outward spillovers from the U.S. dominate the “great moderation” period, while they are comparable in size to spillovers from the U.K. once the global crisis time window is included, despite the different relative size of the two economies due to the amplified financial channel in the latter.

Prepared by Francis Vitek and Gavin Gray.

Vitek, F. (2010), Monetary policy analysis and forecasting in the Group of Twenty: A panel unobserved components approach, International Monetary Fund Working Paper, 152.

Prepared by Francis Vitek (SPR)

Vitek, F. (2010), Monetary policy analysis and forecasting in the Group of Twenty: A panel unobserved components approach, International Monetary Fund Working Paper, 152. The calibration of the impact of the sovereign debt shock on U.K. and other markets is based on empirical studies for the United States, scaled by the relative size of the relevant financial markets.

Prepared by Eugenio Cerutti (RES)

Prepared by Gavin Gray, Siret Dinc, Mohamed Norat, and Malika Pant.

The U.K. banks included in the model comprise Barclays, HSBC, Lloyds, RBS, and Standard Chartered.

The CoPoDs are estimated as in Segoviano (2006), “Consistent Information Multivariate Density Optimizing Methodology,” Financial Markets Group, London School of Economics, Discussion Paper 557, Segoviano (2006), “The Conditional Probability of Default Methodology,” Financial Markets Group, London School of Economics, Discussion Paper 557, and Segoviano and Goodhart (2009), “Banking Stability Measures,” IMF Working Paper, WP/09/04.

A credit event could be a default or a restructuring in which bondholders are forced to bear losses. The mapping from CDS spreads to probabilities of distress assumes a fixed recovery rate of 40 percent given distress.

Prepared by Silvia Sgherri (SPR).

The importance of risk commonalities varies over time, being greater at time of generalized stress in financial markets. On average, over the sample August 2007–February 2011, risk commonalities are found to explain about one-third of the total volatility for the portfolio considered.

Prepared by Karim Youssef (SPR).

Prepared by Alvaro Piris and Francis Vitek (SPR).

This follows the work reported by the Macroeconomic Assessment Group “Final report: Assessing the Macroeconomic Impact of the Transition to Stronger Capital and Liquidity Requirements”, BIS, December 2010. FSA estimates for the U.K. are marginally lower (by less than one basis point).

Admati, A.R., P.M. De Marzo, M.F. Hellwig and P. Pfleiderer, “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why bank Equity is Not Expensive”, available at: http://www.gsb.stanford.edu/news/research/admati.etal.html

Francis, W. and M. Osborne, “Bank Regulation, Capital and Credit Supply: Measuring the Impact of Prudential Standards”, FSA Occasional Paper no. 36, September 2009.

See for example Angelini, P., L. Clerc, V. Cúrdia, L. Gambacorta, A. Gerali, A. Locarno, R. Motto, W. Roeger, S. Van den Heuvel and J. Vlček, “BASEL III: Long-term impact on economic performance and fluctuations”, BIS Working Paper no. 338, February 2011.

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