Tripartite Review Preliminary Report

Descriptor I (Author: service area, industry or audience) Descriptor II (Topic: service or industry)
The Tripartite Review

A review of the UKs Tripartite system of financial regulation in relation to financial stability Preliminary Report
March 2009
Contents
Foreword .......................................................................................3 Terms of reference and review process ......................................13 Executive summary .....................................................................15 Preliminary recommendations .....................................................19 Introduction..................................................................................23 Why did the existing system fail? ................................................27 The macro-prudential regime ......................................................41 Micro-prudential regulation..........................................................54 Strengthening regulatory capabilities ..........................................62 Inter-authority and international relationships .............................74
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Foreword
9 March, 2009
Last autumn you asked me to carry out a review of the UK's Tripartite regulatory structure for handling matters of financial stability. I now have pleasure in enclosing my preliminary report. I have consulted widely and, based on that consultation, I set out a programme of significant reform of the operations of the Tripartite authorities HM Treasury, the Bank of England and the Financial Services Authority (FSA). However, I stress the preliminary nature of this report. The crisis is ongoing and there is still uncertainty about how much of the UKs banking industry will end up in public ownership. As we continue to learn lessons from the unfolding events, it is important that the question of how to improve the regulation of financial services should continue to be debated and that we do not jump to over-hasty conclusions. Any system of financial regulation must, of course, be focused on many issues beyond financial stability. For the future health of the UK economy, it is important that the authorities continue to ensure that consumers of financial services get a fairer deal; that the regime continues to operate in a non-discriminatory way, so encouraging non-UK financial services firms to operate in, and out of, the UK; that the regime continues to benefit from an approach focusing on substance rather than form; that there is a real focus on driving out financial crime; and that the relative openness of the UK authorities to appropriate innovation is not lost. However, the focus of this report is on the adequacy of the Tripartite system in relation to financial stability. The experience of the past 18 months has shown that, in relation to financial stability, the UK system has failed in critical respects. The financial authorities did not have clearly defined powers (or responsibilities) to take pre-emptive action in response to the threats to systemic stability, as opposed to the stability of individual firms, which emerged over a number of years leading up to the 2007 crisis; the authorities lacked appropriate instruments to mitigate these risks; there was inadequate enforcement of existing prudential regulation; and the authorities were poorly co-ordinated and inadequately equipped to handle the crisis when it hit. A major overhaul needs to take place if the UK is to have a financial stability framework that maximises our chances of spotting emerging threats, of dealing with them appropriately and of having authorities adequately prepared to handle the inevitable crises in a professional manner. It is important to note, though, that the financial stability regime also covers matters of operational disruption to the financial markets. Much work has been done in this area by the Tripartite authorities, particularly following 11 September, 2001, and it is important that the current focus on the financial crisis does not mean that the authorities lessen their work to guard against the financial market consequences of threats from terrorist attacks, extreme weather events, pandemics and other disruptive events. Indeed, efforts in these areas need, if anything, to be redoubled, as the effects of operational disruption are likely to be even more severe at a time of on-going fragility in markets. Important current initiatives, such as the proposed central
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clearing of derivatives, should increase the resilience of the system as well as helping deal with financial crises. It must also be remembered that threats to the financial system take many forms and are relatively frequent events. In the UK, for example, the falling equity markets of late 2002 and early 2003 threatened the solvency of some of the UKs largest life insurance companies. In that case, the FSA, by effectively bringing forward a more flexible capital regime, acted to diffuse the crisis. Looking forward, it is important that the Tripartite arrangements recognise the diversity of possible financial crises, and that we do not simply construct a system that is designed to fight the last war. There remains much work and consultation to flesh out key areas of my recommendations but it is my intention, at this stage, to sketch out the main areas where I believe change is required. I am very conscious that fundamental questions, including about the nature of new capital and liquidity regimes, accounting conventions, transparency, management incentivisation and so on are beyond the scope of this report to resolve but I will not hesitate to inject elements into those debates where appropriate. It would also be foolish not to recognise up front that critical new proposals on the future structure of European banking regulation are starting to emerge from Brussels. It is regrettable that at a time when Jacques de Larosire has been reviewing the structure of European financial regulation and when European Central Bank (ECB) board members have been calling for the ECB to become the pan-European bank regulator, the UK authorities voice has been publicly silent on the European dimension and that the authorities have done little to coordinate a clear UK public-private sector view on how the interests of the UK in terms of financial stability and competitiveness would be best served.
The better identification of emerging systemic risks and how to ensure appropriate regulatory responses From at least 2005, the Bank of England, in its Financial Stability Reviews, and other private and public sector analysts in the UK and globally, identified some of the key emerging risks. Where the system failed was in not translating the warnings into pre-emptive action, particularly in the years 2005-07 as banking leverage soared and asset price bubbles grew. As Mervyn King, Governor of the Bank of England, put it in a speech on 20 January, 2009: it is clear that policy did not succeed in preventing the development of an unsustainable position. The fact that, in this very period, the Bank of England significantly downsized the resource devoted to monitoring and analysing changes in the structure of the financial system and assessing their implications for its stability, efficiency and effectiveness; that it lost and did not replace critical financial market expertise among its senior executive team; and that it narrowed the focus of its Financial Stability Reviews, meant that the Bank was actually, and mistakenly, lessening its engagement with the markets in the immediate run-up to the financial crisis. As Sir Andrew Large, former Deputy Governor of the Bank of England, wrote in the Financial Times on 5 January, 2009: the systemic [scrutiny] role has been underemphasised in recent years. The Bank of Englands surveillance and analytical capability now needs to be enhanced in support of its statutory financial stability objective. This requires the Bank to be explicitly and continuously engaged with developments in the financial markets and not just in the banking markets. In 2004 the Bank dropped its third core purpose, relating to the efficiency and effectiveness of the financial system. The Bank had previously regarded this as an important underpinning for its two main objectives of maintaining monetary and financial stability, although it was sometimes characterised, erroneously or at least anachronistically, as conducting a lobbying role in Whitehall on behalf of the City. For the Bank to be effective in identifying emerging systemic risks, it should in future be formally bound, in support of its financial stability objective, to be monitoring and assessing
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developments in UK and global financial markets and considering their implications for financial stability. It will be a matter for the Governor and Court, on the recommendation of the Deputy Governor for Financial Stability, to decide what additional quantity and quality of resource will be needed to fulfil this remit. The Bank should specify to the micro-prudential regulator (i.e. the supervisor of individual firms, since 1997 the FSA) what data it requires for its system-wide analysis, whether at the sector or firm level, and this should be provided through the micro-prudential regulator. For the avoidance of doubt, the Bank should have a statutory right to receive such data as it deems necessary for its macro-prudential work. This role cannot merely be a desktop exercise but requires the Bank to be conducting a continuous high level dialogue with market participants and with the providers of market infrastructure such as trading, clearing and settlement facilities, if it is to be effective. The Bank's limited dialogue with, and understanding of, markets in recent years are often unfavourably contrasted with that of the Federal Reserve Bank of New York. While I have some sympathy with the financial institutions that complain that they did not have a sufficiently close, open and high level dialogue with the Bank when the markets started to unravel in the summer and autumn of 2007, such a dialogue requires continuous effort on both sides. The Banks output from this enhanced macro-prudential work should be both its biannual Financial Stability Reports and also new formal open letters to the micro-prudential regulator setting out its assessment of market-wide risk, including of trends in leverage. This is very much along the lines you proposed last year. The Bank should send such letters as often as it deems necessary but should do so at least twice a year. The micro-prudential regulator should make a public response to these letters, setting out how it intends to reflect the Banks findings in its conduct of regulation in the succeeding period. To the extent that the Bank wishes to draw the micro-prudential regulators attention to issues relating to particular institutions or to other commercially or market sensitive issues, there should be a parallel exchange of private letters. It will be for the micro-prudential regulator to decide what regulatory consequences should flow from the Banks letters and, of course, it may wish to challenge any of the Banks assessments. In order to ensure the integrity of this challenge system, any private letters should normally become publicly disclosable after a period of, say, five years. In carrying out this macro-prudential role, the Bank of England will also be equipped to engage more fully again in the critical European and global debates and negotiations on future regulatory and market structures. The Bank has retreated from such engagement in recent years it is now time for it to re-engage on a broad front. The Bank was at the forefront of many of the debates over the past decades that led to the current developed methodologies for the conduct of monetary policy globally. It should play a similar role, in tandem with the microprudential regulator, in what will be as important and protracted a development of truly workable financial stability methodologies. This work should focus, in particular, on influencing the European legislative programme which has the capacity to dictate much of the UKs financial stability system. With these changes to the way the Bank operates and how it interfaces with the microprudential regulator, the UK will maximise its chances of identifying threats to financial stability, there will be greatly enhanced consideration of regulatory responses to those threats and the UK will be more effective in influencing the global development of financial stability approaches over time.
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Appropriate instruments to mitigate emerging risks In his Economist lecture of 21 January, 2009, Lord Turner of Ecchinswell identified macroeconomic factors, including macro-economic imbalances and low real interest rates, as being at the core of the financial crisis. However, there has been little debate since the crisis started about what the appropriate linkages should be between the conduct of macro-economic and financial stability policy. This is even more striking, given that these linkages were already being explored in a series of lectures and papers by senior officials at the Bank for International Settlements as early as 2001. As Professor Charles Goodhart, former member of the Bank of England Monetary Policy Committee, put it in his evidence to the Treasury Select Committee on 13 January, 2009: the Bank of England ..... knew that risk was underpriced and they were worried before the event that there would be some kind of severe reversal. They did not know where it was going to come from, they did not know the exact trigger, but they were aware that there were problems, but I do not think that they were prepared to take the tough actions and they did not really have the instruments to do so. This is a complex issue that requires extensive debate. It is important that we should now ask, for example, about the relationship of the Monetary Policy Committee (MPC) to questions of financial stability. In response to this question, I have received a wide range of suggestions, from the idea that the MPC should have a formal remit to consider financial stability in setting the interest rate, through to the idea that the MPC should be asked to express publicly any concerns it has about financial stability threats arising from its monthly meetings. Even if it is accepted that one instrument (short-term interest rates) can deliver (at most) one target (inflation) that does not mean the instrument affects only one target variable. There is one straightforward way in which there could be more joined up thinking between those directing macro-economic policy and the guardians of financial stability. At present there is no formal channel for financial stability concerns to be transmitted to, and considered by, the macro-economic side of HM Treasury. In future, the remit of the macro-economic side of the Treasury should be broadened to include consideration of the financial stability consequences of developments in the economy, and of the consequences for economic management of financial market trends identified by the Bank and micro-prudential regulator in their work. The Treasury already attends meetings of the MPC. In addition, the Chief Economic Adviser or another senior official with macro-economic responsibilities, should meet regularly with the Standing Committee of the Tripartite authorities. It is also worth considering whether the microprudential regulator should write open letters to the Bank if it has concerns that macro-economic policy is threatening financial stability. As has been the subject of much recent debate, the macro-prudential framework described above needs to be complemented by an appropriate counter-cyclical capital regime, so that regulators have appropriate powers to impose a capital regime which dampens, rather than exacerbates, the credit cycle. This is now becoming orthodox thinking and it is beyond the scope of this report to carry the debate much further forward. However, the other recommendations of this report are intended to work with such a capital regime at its heart. The one country which is widely quoted as having operated such a capital regime is Spain. In order to further the debate, we have included in this report a short description of the Spanish regime. Other broad ideas which have been put to us include the suggestion that firms with a dominant market position in any particular market might be required to hold a proportionately higher level of capital than other firms, to reflect the additional systemic risk that comes with absolute size of institution. While it is clearly desirable that the capital and liquidity regimes are highly predictable and certain in their impact, there are likely to be some aspects of their operation which will require the exercise of judgement. It will be necessary to decide where responsibilities lie between the Bank and the micro-prudential regulator for the exercise of any such discretion. The micro-
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prudential regulator should exercise judgements that are institution specific (for example, by raising the liquidity or capital requirements of a firm with an aberrant business model) but the Bank should be responsible for any sector or market wide judgements in the operation of the capital regime. Some argue that a key way to address these issues is to insist on the division of activities by complex financial groups into separate subsidiaries for different classes of business activity that could be subject to separate capital regimes or to effect some fundamental split between retail or commercial banking, on the one hand, and other activities such as investment banking, on the other. This is often referred to as the Glass-Steagall debate. While it is something of an over-simplification to characterise the problem as one of a utility linked to a casino, a number of commentators are calling for the imposition of firewalls between different classes of business. This means deciding which financial services should be classed as utilities and which as part of the casino. It would seem odd to confine the former simply to the payment system, as some have suggested, when for example the intermediation of long-term savings would normally be regarded as a key function of the financial system. Arguments in favour of this division include that it would provide greater security to retail depositors in financial institutions and that it would provide an additional layer of protection to the taxpayer against exposure to costs associated with the failure of financial institutions. Some of those who advocate this model argue that it is only worth implementing if the ring fence is drawn in such a way that it includes substantially all of the systemic activity, which needs to be subject to tighter regulation, and that financial activity outside the ring fence should be in the main not of systemic consequence and so not subject to full prudential regulation. Much more debate is required on these issues and questions that need to be asked include whether regulatory lines or competition and clear information to consumers will better enable a range of retail deposit taking institutions to develop; how narrow banking prevents a bank getting into trouble from such traditional banking failings as concentrated lending; what the additional funding costs for the banking system will be if deposit taking banks are not allowed to finance or hedge their activities through a range of derivative structures; what economy of scale and diversification benefits might be lost; what the risks and consequences of regulatory arbitrage will be as banks look for domiciles where less restrictive regimes may exist; and whether the new capital regime could be able to deal appropriately with a range of different banking models without segregating activities into different legal entities. It is also argued that shadow banking activities, including hedge funds and other unregulated wholesale market operators, should be fully regulated. The guiding principle should be that a financial services entity, or a category of businesses, should be regulated either because there is an issue of consumer protection or because the failure of the entity would have systemic consequences. There also needs to be careful case-by-case consideration of the likely costs and benefits, particularly against the benefits that can be gained by increased transparency, before the scope of regulation is unthinkingly increased. One additional instrument that is available in the USA in the event of a banks impending failure is for the Federal Deposit Insurance Corporation to utilise its funds to facilitate some form of bail-out, if it is judged that this will be a less costly outcome than having to pay out depositors if the bank is allowed to fail. The debate about depositor protection in the UK has not explored this issue. It would be useful if it did. Although of only limited direct impact on financial stability, it has also been suggested to us that, in a period of very low interest rates and with quantitative easing becoming a tool of macroeconomic management, the remit of the Debt Management Office, which has responsibility for managing the Governments cash and sterling debt, should either be broadened out from one mainly concerned with least cost issuance to one that fully considers the economic implication, including for monetary conditions, of its activities and the structure of public debt, or that it should continue to be primarily a delivery mandate but one that is flexed to the new market realities. These suggestions merit further investigation by HM Treasury and the Bank.
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Conduct of the prudential regime The FSAs own report into the conduct of its supervision of Northern Rock provided a searching and candid exposure of the very significant lapses in the conduct of its basic supervisory regime. It is implementing a raft of reforms to bring its prudential regulatory regime up to the expected standard. The broader question that arises is whether the integrated regulatory model remains the best option to ensure both that micro-prudential regulation, that is regulation at the level of the individual firm, is properly conducted, and also that the competing demands of prudential versus conduct of business regulation can best be reconciled. As Lord Turner said on the BBC on 15 February, 2009: "The FSA at that time was more focused on the processes, the structures, the reporting lines, rather than simply saying 'when I look at this whole business model... it's all too risky'." Proper conduct of micro-prudential regulation is fundamentally about having the right sort of people carrying out the work under the direction of senior managers who are steeped both in the industry they are regulating and in the nature of the regulatory process. Although it would be an over-simplification to say that prudential regulators need a completely different mindset and training from conduct of business regulators, the focus of their work and the way it is carried out have significant differences. The reconciliation of the competing demands of prudential and conduct of business regulation has to be done both in the context of regulating the individual firm and in setting the broad direction and thrust of regulatory policy for the regulator as a whole. By its own admission, the FSA failed the former test. In retrospect, it is easy to see that the focus of the FSA on the development of policies to give the consumer of financial services a better deal (conduct of business) was not matched over the past decade by a similar focus on developing the prudential regime. The other fundamental issue is whether, if the Bank is the macro-prudential regulator and the FSA (or a successor body) the micro-prudential regulator, we can be certain that nothing will fall through the crack between them. The regular exchange of letters that I have proposed, together with better close working between the Bank and micro-prudential regulator, addresses this issue but it is for further debate as to whether this will be enough. We need to look at whether we can build in any safeguard to stop things falling down the crack, but without causing unnecessary overlap in the responsibilities of the different authorities. In deciding what regulatory structure best fits these fundamental requirements there are a number of other factors and trade-offs to be considered: Creating more regulators or having overlapping responsibilities between the Bank and FSA risks imposing additional burdens on individual regulated firms. The Bank has had difficulty in giving appropriate priority to its two objectives (monetary policy and financial stability) and the FSA has not found an appropriate balance between its prudential and its conduct of business work, so how would an authority with more than two objectives be expected to manage its priorities? Whether the conflicts between the two strands of regulation (prudential and conduct of business) are better handled by having two separate regulators or whether the situations of conflict between the two strands of regulation are overstated and are, in any case, better managed within one organisation. Combining macro- and micro-prudential regulation within the Bank would mean that the judgement on all prudential matters was in one body, clarifying accountability and enhancing the authority of the regulator. On the other hand, it would internalise the proposed challenge function between the macro- and micro-prudential regulator, risking a loss of clear focus on the distinct macro perspective and raising concerns over whether the conduct of monetary policy might be inappropriately influenced by concerns
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for the health of the financial sector. The cost of institutional change. If, for example, this involved breaking up the FSA, this could impose additional regulatory strain for a period. There is no one model that clearly deals with all these considerations and we have received some very divergent views on the best way forward. I believe that it would be wrong to rush to hasty judgements on this question. However, in order to take the debate forward in a structured way, I believe there are five options which merit particular debate: 1. The FSA should retain its present responsibilities but move to a new structure with Prudential and Conduct of Business divisions at its heart, rather than its present structure focused on Retail and Wholesale divisions. This would ensure that the FSA had a better balance going forward between its prudential and conduct of business activities; that prudential regulation was put at the heart of the organisation; that the FSA was better placed to grow individuals with the appropriate skills and mindset to be cutting edge prudential regulators; and that there was a head of Prudential on the FSA board who could speak for the organisation and who could act as the key interface with the Bank on financial stability issues. 2. The FSA should be reorganised as in 1 but, in addition, there should be new statutory powers for the Bank to take direct regulatory action in respect of individual regulated firms if it (or the Tripartite Authorities collectively) believed that there was a threat to overall financial market stability which was not being adequately addressed by action being taken by the FSA. This would create an additional safety net over what I have already proposed for the Banks new macro-prudential role. If this were to be a power of the Tripartite, rather than of the Bank, it would effectively be for the Treasury to decide in the face of a disagreement between the Bank and FSA. 3. The FSA should be abolished and replaced by two separate regulators, one with responsibility for prudential regulation and one for conduct of business regulation. This would give complete clarity of purpose and focus to the two regulators but would pose challenges in co-ordinating the regulation of individual regulated firms and would mean that most firms would have to deal with an additional regulator. 4. A combination of models 2 and 3, with the Bank or Tripartite having power to step in over the head of the micro-prudential regulator in exceptional circumstances. 5. Under options 3 and 4, the micro-prudential regulator, of banks or of the whole financial sector, could be folded into the Bank of England. To emphasise the preliminary nature of this report, I use the term the micro-prudential regulator" rather than the FSA in many places in the report, though this is not intended to suggest that I have reached any conclusions on the options available and what change is required. Under options 1 and 2, the conduct of prudential regulation will be improved to the extent that the regulator can shed any of its present policy areas. The two policy areas that have been identified as potentially capable of being transferred out of the FSA are Financial Crime and Consumer Education. More consideration needs to be given to possible alternative homes for these policy areas but I believe that the case for stripping them out of the FSA is strong. In the case of Financial Crime, the US shows that there is a workable model in which the Treasury takes the policy lead. The case for adopting a similar model in the UK bears further serious investigation. As well as helping the focus of the FSA, such a transfer would give HM Treasury a degree of delivery responsibility which could be helpful in embedding financial services as much more of a core activity of the Treasury than it has been treated at some periods in recent years. This could be linked to a wider review of the framework for tackling financial crime - where many argue that the UK system is failing.
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Expertise and preparation for crisis handling No one to whom we have spoken argues that the Tripartite authorities were properly prepared to handle the Northern Rock crisis in 2007. Those who have been close to the authorities since then say that the handling of the unfolding crisis if not necessarily the policy outcomes has improved at each succeeding stage. There remains, however, much to be done to ensure that the authorities are adequately prepared for future crisis handling. The first requirement is for the authorities to have suitably qualified people in the key financial stability positions at all times. For the Bank, the critical thing is that the whole organisation receives a clear message that the financial stability role really is an equal priority with monetary policy. A key change will be to embed a definition of the role of the Deputy Governor for Financial Stability post in such a way that there can be appropriate succession planning and market confidence that suitably qualified individuals will always hold the office. The guarantee that suitable appointments will be made in future should be the role description and forward planning by the Governor and Court of the Bank, in close consultation with HM Treasury; the final decision resting, of course, with the Chancellor. The formal public appointments process should be a backstop but not the driver. In the case of the FSA, there is a broad challenge, much discussed in recent months, to keep and develop sufficient expertise at all levels of the organisation so that the gap in expertise between regulator and regulated individual is kept to an acceptable level. With a much greater focus on prudential regulation at the heart of the organisation, or by creating a separate prudential regulator, the task should be clearer but it wont be easy and will take a number of years, involving a mix of growing talent internally and of hiring in people from the market, either on a permanent or secondment basis. In summer/autumn 2007 when the crisis was breaking, HM Treasurys group of special advisers and senior officials with direct responsibility for financial services lacked any significant financial market experience. In order to avoid such a situation arising in future, the Permanent Secretary to the Treasury should set out in the Treasurys annual report to Parliament how Treasury resources devoted to handling issues of financial stability have been maintained and developed during the year. More generally, the point has repeatedly been made that Treasury officials typically only spend two years in a post before moving on and that this contributes to a low level of expertise to handle complex financial market issues. Better ways need to be found to incentivise officials to build up expertise in one area for longer periods. Second, the authorities need to have suitable organisational arrangements to support their individual financial stability functions. I have already commented on fundamental aspects of the internal organisation of the FSA. In the case of the Bank, I agree with the Treasury Select Committee (TSC) and others that the new Financial Stability Committee is flawed. The management of a major financial crisis cannot be under the direction of a board including market practitioners. If this is to be an executive committee then it should be made up of a suitable sub-set of the Banks executive. If it is to have outsiders on it, then it should become an advisory board, contributing to the Banks closer liaison with market practitioners and including accountants and lawyers to capture their critical insights into financial stability issues. I am inclined to the view that the Committee should be advisory but that, in addition, the Banks existing executive structure is revisited to ensure that collective executive input from right across the Bank is contributed to all key financial stability decisions. A rather more radical idea is that, instead of the present Court/MPC governance structure, the Bank should be governed by one board looking somewhat like the present MPC but with additional members with expertise relevant to the financial stability objective. This board, similar to that of the Federal Reserve in the USA, would execute both the monetary policy and financial stability remits of the Bank. Although the challenge function of independent non-executive
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directors would be lost, I believe it is a model worth debating: I have never understood why public sector bodies, which usually have very different functions and accountabilities to private sector companies, should increasingly, and unthinkingly, have to ape the standard private sector corporate governance model. It is also somewhat of an anomaly that the Non-Executive Directors of the Bank report annually on the procedures of the MPC but that there is no similar requirement to report on the conduct of the Banks financial stability objective. I believe that there should be such a requirement. Indeed, it is striking that the Bank, unlike the FSA, has produced no public assessment of its own conduct in the period leading up to the collapse of Northern Rock. It should do so in order to assure the public that any lessons have been learnt and to strengthen public confidence in the Bank. For HM Treasury, one of the issues, as I have indicated, is to ensure that the macro-economic side of the department is linked in to the financial stability issues. For crisis handling, one of the Treasurys key resources should be its Corporate Finance team. This team also liaises with the Governments central repository of corporate advisory skills, the Shareholder Executive. The Corporate Finance team (and the Shareholder Executive) should be properly used in future developing crisis situations. Consideration should be given to putting the Corporate Finance team in the same Treasury division as financial services. Third, the Chancellor, Governor and Chairman of the FSA (or its successor body) need to have far more frequent meetings than they had before the present crisis started if they are to have a proper understanding of their respective positions on issues and a mutual sense of how they would react in a crisis. As far as I am told, there was only one formal session involving all three Principals in the ten years before the crisis - on the conference call with the US authorities in 2006 to which the Prime Minister referred in his evidence to the House of Commons Liaison Committee on 12 February, 2009. The three Principals should meet with the Standing Committee Deputies in formal sessions three times a year to have a full presentation and discussion on the issues which the Deputies and their teams have been working on in the previous trimester; the three Principals should have equally regular informal sessions; and they should participate in regular war games. While I do not think it is necessary for the Authorities to form a joint secretariat to manage Tripartite business, I do think that an increased flow of secondments between the three parties would enable them to develop a better shared understanding of the underlying issues and of their respective thinking about the issues, which would lead to better crisis handling. Also, while it will be for the Bank to form its own macro-prudential judgements, I would expect the Bank and the micro-prudential regulator to hold regular sessions at Executive Director level, perhaps for one day a quarter, to share their thinking on the macro-analysis. You have asked me to look at one specific co-ordination matter, the question of which authority should pull the trigger to make an individual firm subject to the Special Resolution Regime, or whether there should be a dual trigger. The issues are discussed at some length in the September 2008 Banking Reform report of the Treasury Select Committee. I agree with the TSCs conclusion that while the FSA should have sole responsibility for pulling the trigger, the Bank should have a statutory power to recommend to the FSA that a financial institution be brought within the Special Resolution Regime. One area on which the authorities continue to be criticised is in their handling of communications. This has two aspects. First, if critical messages on financial stability issues are to carry clarity and authority and to have a neutral or calming effect on markets, considerably more effort needs to be put in to the planning and co-ordination of messages that are put out. Second, the stream of leaks to the media at every critical stage of the developing crisis has been remarkable. I find it strange that the questions that are being asked are now mainly around whether the journalists should have reported leaked information. The real questions that require answers are around the level of training that members of the authorities handling sensitive information receive about the law on disclosure of price sensitive information; and why
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there is no evidence of investigations by the FSA or police into prima facie cases of leaks of highly price sensitive information. I have no evidence to suggest that the authorities have broken the law but without further public reassurance, I believe that the authorities are left with very considerable reputational taint around their ability to keep confidential matters confidential. Last, it has been suggested that there was some confusion in the handling of Northern Rock about whether the independence of the Bank of England was intended to cover financial stability issues or whether the Treasury could tell the Bank what to do in a crisis. This is a rather basic issue. It arises partly because certain activities of the Bank, including the provision of liquidity to the market, are relevant both to the implementation of monetary policy, where the Bank does indeed have independence, but potentially also to the maintenance of financial stability. For the avoidance of doubt, the Memorandum of Understanding governing the relationship of the three parties needs to clarify that, except where individual responsibilities for particular tasks are clearly defined, such as the Banks responsibility for handling the Special Resolution Regime or its operations in the money markets, the Treasury takes the final decisions on financial stability matters, having taken the appropriate advice of the Bank and of the micro-prudential regulator.
Other matters While I believe that the recommendations I have sketched out in this report, and on which I will continue to consult, represent a substantial package of measures which will materially improve the future handling of financial stability issues in the UK, there also need to be appropriate accountability structures in place to ensure the overall good working of the system. The Tripartite Authorities report to Parliament, their principal interlocutor being the Treasury Select Committee of the House of Commons. While the TSC has pursued its enquiries into the financial crisis since Northern Rock with considerable vigour, prior to that event it held no regular sessions on financial stability. I am well aware that it is not for me to tell Parliament how to go about its business so I merely observe that accountability of the Tripartite Authorities might be significantly improved if they had to face sessions with the TSC two or three times a year. I should end with some health warnings and acknowledgements. For the avoidance of doubt, I should point out that although I was the senior official directly responsible for financial services policy in HM Treasury from November 2002 until the end of 2005, and that until mid-2008 I carried out some specific advisory assignments for the Treasury, I was not involved as an insider in any matters relating to the handling of the financial crisis. The Treasury have not felt able to speak to me in connection with this report nor have I had access to any official papers. The opinions expressed in this report are entirely my own but I should like to thank the team from PricewaterhouseCoopers for the great support they have given me in the research and writing of the report. I am also grateful to all those in the Bank, FSA, academic institutions and the private sector who have taken the time to speak to me or who have contributed to the research that underpins the report.
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Terms of reference and review process
Terms of reference
1. George Osborne, Shadow Chancellor of the Exchequer, has commissioned me to conduct an independent review into the UKs Tripartite system of financial regulation so far as it relates to financial stability. The purpose of the Review is to inform Conservative Party policy on reforming the Tripartite system, particularly with a view to implementing reforms should the Conservatives enter Government following the next General Election. The trigger for this reappraisal of the UKs Tripartite system was the systemic failure exposed in the period preceding and subsequent to the nationalisation of Northern Rock in February 2008, combined with questions around the Tripartite Authorities handling of the crisis. Following these events, a range of stakeholders have stated that the Tripartite arrangement should be reformed to mitigate the weaknesses of the existing system in minimising the risk of financial crises and in dealing with them when they occur. I was asked to look broadly at the Tripartite system and make appropriate recommendations. These recommendations take into account the various changes already made, or proposed to be made, by the Tripartite Authorities; and of other review work already conducted, notably that of the Treasury Select Committee of the House of Commons. PricewaterhouseCoopers recognise the importance of this issue and have provided support to help me deliver the Review.
2.
3.
The Review process

4. Much of the content of this report have been based on the formal and informal meetings held between members of the Review team and a range of contributors. These contributors have included current and former officials of the Bank of England and FSA, former officials of HM Treasury, academic experts in financial markets and regulation, board members and senior executives of financial institutions and professional advisers on regulatory issues. All of these meetings were held on a confidential basis, although we have used many of the ideas raised by our contributors in this report. We were not able to meet with current officials of HM Treasury to discuss their views. This primary research was complemented by a desk-top research exercise, focusing on analysing the causes of regulatory failure in the UK, examining the various proposals for reform of the existing UK system and evaluating overseas models to learn from international experience. All of the evidence presented in this report was compiled from this desk-top research exercise, on the basis of publicly available information.
5.
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6.
In addition, we carried out an online consultation exercise which was open to any interested party during January 2009, where respondents were provided with an opportunity to give us their views on a range of issues relating to the current Tripartite system and potential reforms to the system. Respondents were provided with the option of replying on a confidential basis or allowing the Review team to quote their responses in this report. This preliminary report of the Tripartite Review can be accessed on our website (www.tripartitereview.co.uk). Interested parties are invited to comment on this preliminary report (on a confidential basis, if requested) until 30 April, 2009. Full details of how to submit comments can be found on the website.
7.
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Executive summary
Executive summary
Key findings
Why did the existing system fail? 8. The financial crisis that began in mid-2007 exposed a number of weaknesses in the UKs system of regulation in relation to financial stability, some of which were latent in the existing regulatory framework while others were related to the lack of expertise and preparation by the Tripartite Authorities for crisis handling. These weaknesses may be summarised under the following four broad headings:
Evaluation of and response to emerging threats to financial stability: The Tripartite Authorities recognised that certain of the economic and financial trends that underlay the crisis were unsustainable, but they did not fully anticipate the threat they posed to financial stability and did not take sufficient action to redress the observed imbalances. Lack of appropriate instruments to mitigate emerging risks: Regulators did not have appropriate instruments that would have allowed them to dampen the unsustainable growth in leverage and liquidity preceding the crisis, or more adequately to ensure that financial institutions were able to withstand losses resulting from the subsequent deleveraging when liquidity contracted. There was no adequate work-out regime for failing financial institutions. Inadequate prudential regulation: The FSA did not adequately pursue its existing prudential mandate, partly due to an excess focus on conduct of business regulation at the expense of prudential regulation. Expertise and preparation for crisis handling: The Tripartite Authorities had not devoted sufficient resources to crisis preparation and did not have appropriate mechanisms in 2007 to resolve an institutional failure. The Authorities weak handling of the Northern Rock crisis contributed to the threat to financial stability during this period.
The macro-prudential regime 9. To address the weaknesses identified above in relation to evaluating and responding to emerging systemic threats, and the lack of appropriate instruments to mitigate emerging risks, the regulatory system must significantly strengthen its macro-prudential remit. The Bank of England is the Authority best placed to evaluate emerging systemic threats to financial stability, due to its existing analytical capability, its remit in monetary stability and its role in the money markets and payment systems. The Bank should have primary responsibility for the evaluation of systemic threats and should also have a statutory right to access any data regarding individual financial institutions that is necessary for this analysis. The Bank must also deepen, across the institution, its engagement with financial markets in order to develop a closer understanding of financial institutions business models and risk exposures.
10.
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Executive summary
11.
In order to translate this analysis into regulatory action, the Bank should write public letters to the micro-prudential regulator setting out the Banks views on systemic risk, including leverage, to which the micro-prudential regulator should be required to make a public response. The letters should also include a confidential annex raising any concerns regarding specific institutions. This formal exchange must be supplemented by a strong day-to-day working relationship between the individuals responsible for Financial Stability at the Bank and those engaged in micro-prudential regulation. The Tripartite Authorities should also consider enhancing the toolkit of instruments at their disposal in relation to financial stability. At the macro-economic level, more consideration should be given to the role of interest rate policy in financial stability, whilst other tools such as the Governments macro-economic and fiscal policies and the use of counter cyclical capital requirements should be developed or enhanced. At the institutional level, more consideration should be given to the advantages and disadvantages of moving to a narrow/utility banking model and the regulation of shadow banking. Other tools that should be reviewed include the potential to use funds from the Financial Services Compensation Scheme to secure the sale of a failed institution and broadening the remit of the Debt Management Office to take account of its wider economic implications. Micro-prudential regulation
12.
13.
The FSAs conduct of the micro-prudential regime was weak in the period prior to 2007. Commentators have set out a wide range of proposals to address this, focusing on ways to strengthen the focus on micro-prudential regulation, including by moving to an FSA internal structure with Prudential and Conduct of Business divisions at its heart, or by splitting the FSA into separate regulatory agencies responsible for each activity. It has also been suggested that the Bank should have a greater role in micro-prudential regulation, either by being granted direct regulatory powers under exceptional circumstances, or by folding micro-prudential regulation into the Bank in the event that the FSA is split into separate agencies. These questions merit further debate. Having decided that fundamental reform to the regulatory structure is necessary, consideration would have to be given to the most appropriate time to implement these reforms and the most effective way in which to implement them, in order to minimise disruption to the ongoing efforts to deal with the financial crisis. Regulatory capabilities
14.
15. 16.
The Tripartite Authorities will need to strengthen significantly their current capabilities, to address the observed weaknesses that contributed to the regulatory failures outlined above. The Bank of England will need to strengthen the resource base, expertise and governance of its Financial Stability team. Critically, this will require the Bank to be explicitly and continuously engaged with developments in the financial markets and to broaden its engagement with the most senior market practitioners. The Financial Stability Committee may help the Bank in accessing sources of market expertise, although it should not have the executive functions currently envisaged. The Financial Services Authority, or its successor, will be able to increase its focus on its core regulatory remit to the extent that it can shed any of its additional responsibilities, and to this end it should consider, with the Government, whether some or all of its responsibilities for reducing financial crime and improving consumer awareness can be transferred to alternative public agencies. The FSA should also increase further its ability to recruit and incentivise highly experienced supervisory and policy makers from the private sector.
17.
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Executive summary
18.
HM Treasury should broaden the remit of the macro-economic side of the Treasury to include consideration of the relationship between financial stability issues and wider macro-economic management. In order to ensure no repetition of the lack of financial market experience of its senior officials which was evident in mid-2007, the Permanent Secretary to the Treasury should report annually on how HM Treasury resources devoted to handling issues of financial stability have been maintained and developed during the year. HM Treasury should also strengthen its crisis handling capability. This could be done by putting its Corporate Finance and broader private sector facing expertise back into the same division as Financial Services. Inter-authority and international relationships
19.
Decision-making on the Special Resolution Regime involves all three Tripartite Authorities. The quality of decision-making will be improved if the Bank draws up a list of systemic institutions, although this should not be made public. The Bank, as the macro-prudential regulator, should also have the statutory right to recommend that an institution be placed into the regime, although the final recommendation should continue to rest with the micro-prudential regulator. Each of the Tripartite Authorities will also play a role in communicating with the markets and general public during a financial crisis and should strengthen their capabilities in this regard. However the lead role should be taken by HM Treasury, since this will serve to emphasise the level of engagement by the political leadership to prevent systemic collapse. Relationships between the Tripartite Authorities need to be significantly strengthened at all levels. We have been told that there was only one meeting of the Tripartite Principals the Chancellor of the Exchequer, the Governor of the Bank of England and the Chairman of the Financial Services Authority in the ten years preceding the financial crisis. This situation should not be allowed to occur again. To strengthen the relationship between the Authorities, the Principals should meet formally with the Tripartite Deputies (at least) three times per year and informally (at least) an additional three times per year. At more junior levels, programmes should be put in place to encourage greater interaction, for example through secondments, joint training sessions, joint briefings and informal meetings. For the avoidance of doubt, the Memorandum of Understanding should state that except where individual responsibilities for particular tasks are clearly defined, HM Treasury should take the final decision on the use of public resources to address financial stability matters, having taken the appropriate advice of the Bank and FSA. Given the global dimensions of the current financial crisis, it will be critical for the UKs regulatory system to work with international counterparts at the national and supranational level to identify any emerging threats to financial stability. The Banks role in monitoring systemic risks to financial stability means that it should lead the UKs international working relationships in relation to this monitoring activity. The Tripartite Authorities must also contribute to the full in the European and global dimensions, which will take many years, for truly workable financial stability methodologies to be developed. It will be important for the Authorities to work together to prepare join contributions to international bodies, although the lead role should be played by the Bank of England in macroprudential matters and by the micro-prudential regulator on micro-prudential issues. Areas for further consultation
20.
21.
22.
23.
24.
25.
This Review has not attempted to make detailed recommendations in every area of financial stability regulation, and in several areas we have raised questions that should be resolved only after a more detailed analysis and consultation process. Several of these questions are summarised below:
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Executive summary
26. 27. 28.
Macro-prudential instruments: Consideration should be given to the link between the Monetary Policy Committee, interest rate setting and the maintenance of financial stability. Utility/narrow banking: A full analysis and debate is needed on whether some form of separation is required between different classes of banking business. Shadow banking: A clear, principle-based rationale needs to be established for determining what additional shadow banking or other unregulated activities should be brought within the scope of financial regulation. Governance of the Bank of England: The Governance structure of the Bank of England needs further consideration. The proposed Financial Stability Committee is flawed. Having clarified what the Committee was intended to achieve, it will be possible to define a more workable solution. The Financial Services Compensation Scheme (FSCS): The Authorities should clarify the constraints on the Financial Services Compensation Scheme funds being used to secure the resolution of failed institutions instead of liquidation and payout under the scheme. FSA responsibilities: Further consideration should be given as to whether the FSA should move to an internal structure in which the main division is between its prudential and conduct of business responsibilities or whether these two regulatory mandates should be handled by separate regulatory bodies. If these mandates are to be handled separately, consideration should be given to folding micro-prudential regulation into the Bank. The focus on microprudential regulation may also be strengthened to the extent that that the FSA, or its successor, is not required to retain the FSAs current roles in financial crime policy and in improving consumer awareness. The Authorities should review whether these responsibilities, in part or in full, could be transferred to other public agencies. Bank of England/Tripartite reserve powers: Consideration should be given to granting the Bank/Tripartite statutory powers to take direct regulatory action in respect of individual firms if it/they believed that there was a threat to overall financial market stability which was not being adequately addressed by action being taken by the micro-prudential regulator.
29.
30.
31.
32.
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Preliminary recommendations
The macro-prudential regime Recommendation (1): Recommendation (2): The Bank of England should have the primary responsibility for evaluating systemic threats to financial stability. The Bank of England should have a statutory right to receive such data as it deems necessary for its macro-prudential work; this data should be provided by the micro-prudential regulator. The Bank should have a formal duty in the Memorandum of Understanding to be continuously engaged with broad financial markets developments. The Bank should write a public letter at least twice a year to the micro-prudential regulator setting out its views on systemic risk. The micro-prudential regulator should submit a public response to the letter stating what actions it intends to take to address the risks identified. The letter should include a confidential annex raising any concerns in the Bank regarding specific financial institutions. The Bank of England should engage fully in international debates and negotiations on financial stability regulation. HM Treasury should consider what, if any, change should be made to the remit of the Monetary Policy Committee to reflect the fact that interest rate policy may impact financial stability. The macro-economic side of the Treasury should consider the impact on macro-economic policy development of financial stability concerns. Consideration should be given to the micro-prudential regulator writing a public letter to the Bank should it develop concerns that its conduct of macro-economic policy may threaten financial stability. In the conduct of a counter-cyclical capital regime, judgements at the market level will be for the Bank and at the firm level for the micro-prudential regulator. The Authorities should conduct a full study of the pros and cons of moving to a narrow or utility banking model.
Recommendation (3):
Recommendation (4):
Recommendation (5): Recommendation (6): Recommendation (7):
Recommendation (8):
Recommendation (9):
Recommendation (10):
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The macro-prudential regime (continued) Recommendation (12): The Authorities should give further consideration to the need for increased regulation of previously unregulated activities. Clear principles should be applied in each specific case; the relative benefits of transparency and of indirect regulation versus direct regulation should be considered. The Authorities should clarify the constraints on the Financial Services Compensation Scheme funds being used to secure the resolution of failed institutions instead of liquidation and payout under the scheme. The Tripartite Authorities should give further consideration to financial institutions, in the future, pre-funding the Financial Services Compensation Scheme on a risk-weighted basis. The Debt Management Offices mandate should be reviewed by the Treasury and the Bank of England.
Micro-prudential regulation Recommendation (16): Consideration should be given to the structure of the microprudential regime, with five options meriting particular debate: 1. Restructuring the internal organisation of the FSA to put prudential regulation at its centre 2. Restructuring the FSA as in 1 but giving the Bank/Tripartite additional statutory powers to take direct regulatory action in exceptional circumstances 3. Abolishing the FSA and replacing it with two separate regulators, one for prudential and one for conduct of business regulation 4. A combination of 2 and 3, with the Bank/Tripartite able to step in over the head of the micro-prudential regulator in exceptional circumstances 5. Under options 3 and 4, the micro-prudential regulator, of banks or of the whole financial sector, being folded into the Bank of England.
Strengthening regulatory capabilities Recommendation (17): Recommendation (18): Recommendation (19): The Banks executive should consider whether it requires more resources to deliver its enhanced Financial Stability mandate. The Bank should strengthen its governance in relation to Financial Stability. The Bank of England should produce a public assessment of its own conduct in the period leading up to the collapse of Northern Rock. The remit of the Banks Financial Stability Committee established under the Banking Act, 2009 should be amended to remove any executive function and to make it an advisory group of market experts.
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Strengthening regulatory capabilities (continued) Recommendation (21): The Bank should clarify the role and qualifications required for the Deputy Governor for Financial Stability and take steps to plan for the succession of future Deputy Governors. The Authorities should consider transferring responsibility for financial crime policy out of the FSA to HM Treasury. This could be linked to a wider review of the framework for tackling financial crime. The Government and FSA should review the latters role in relation to consumer awareness. The FSA should increase further its ability to recruit and incentivise highly experienced supervisors and policymakers from the private sector. HM Treasury should maintain a sufficient financial markets expertise at all times. The Permanent Secretary to the Treasury should report annually to Parliament on the appropriateness of HM Treasurys expertise and resources in relation to financial stability. HM Treasury should report every three years on the appropriateness of the legislative and regulatory framework for financial stability. HM Treasurys Corporate Finance team should be put into the same HM Treasury division as financial services policy.
Recommendation (23): Recommendation (24):
Inter-Authority and international relationships Recommendation (29): The Bank of England, in consultation with the micro-prudential regulator, should maintain a confidential list of systemically important financial institutions. The Bank of England should have a statutory right to recommend to the micro-prudential regulator that an institution be placed into the Special Resolution Regime. The Tripartite Authorities Principals should play an active role in communicating with markets and the general public in the event of institutional stress or failure, but the lead role should be played by the Chancellor of the Exchequer. Members of the Tripartite Authorities should be given regular training in the rules concerning the handling of price sensitive information. The Authorities should consider whether sufficient investigation has been carried out into the leaks of price sensitive information to the media since September 2007. The Tripartite Principals should meet formally at least three times a year and have an additional three informal meetings a year. The Authorities should strengthen links at more junior levels through a programme of secondments, training, joint briefings and informal meetings.
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Inter-Authority and international relationships (continued) Recommendation (36): Recommendation (37): The secretariat to the Standing Committee should continue to be provided by HM Treasury. The Memorandum of Understanding should reflect all the proposals in this report, making clear which Authority is responsible for each regulatory function. The Bank of England should strengthen its working links with international bodies, including contributing to the development of improved collaborative tools. The Bank of England should lead the UKs contribution to international policymaking of a macro-prudential nature, with the micro-prudential regulator continuing to lead the UKs contribution on micro-prudential matters, while HM Treasury should lead international political negotiations. The Tripartite Authorities should work closely with financial institutions to develop a consensus position to contribute to international regulatory developments.
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Introduction
Introduction
Overview
33. This chapter sets out the context of this Review in terms of the importance of the regulatory structure and the reasonable expectations of the regulatory structure in relation to financial stability. The chapter also presents a summary of the regulatory structure as it was in mid-2007 when the ongoing financial crisis began and sets out the changes to that structure under the Banking Act 2009.
34.
Why does the regulatory structure matter?

The objectives of financial regulation 35. The institutional framework of financial regulation has a significant impact on whether regulatory regimes succeed or fail in achieving their objectives. The objectives of financial regulation have been defined as: Safeguarding the system against systemic risk; protecting consumers against opportunistic behaviour by suppliers of financial services; enhancing the efficiency of the financial system; and achieving a range of social objectives [using the financial system to achieve social/political objectives such as supporting the housing market]
Herring and Santomero, What is optimal financial regulation, May 1999 (as quoted in Jeffrey Carmichael, The Development and Regulation of Non-Bank Financial Institutions, 2002)
36.
This Review is centred on the first objective, of safeguarding the system against systemic risk, and does not directly consider issues related to the other objectives of financial regulation, for example the most effective ways of protecting consumers of financial services through the use of conduct of business regulation, or of promoting the efficiency of the provision of financial services through competition policy. Specific objectives in relation to maintaining systemic stability are to maintain systemically important financial system infrastructure (especially payments and settlements systems); to protect the financial system from destabilising developments in domestic and international markets; and to limit the impact of financial shocks from causing contagion in other parts of the financial system or the wider economy.
37.
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Introduction
The importance of the regulatory structure 38. The regulatory framework influences the effectiveness of regulation in terms of the success of regulators in achieving the above objectives. David Llewellyn set out a number of reasons why the institutional structure is important in a 2006 paper to the World Bank (Institutional structure of financial regulation and supervision: the basic issues, June 2006). These can be summarised as:
Regulatory culture: The regulatory structure will have an impact upon the development of expertise, experience and culture of the regulatory staff who work in it. Clarity of responsibility: The regulatory structure will influence the clarity of responsibility for given regulatory functions or roles. This is important for the regulators themselves and for members of the public or oversight bodies (such as the House of Commons) in seeking to hold regulatory agencies to account. Conflicts between objectives: There may be scenarios where conflicts arise between regulatory objectives, for example between the need to maintain the safety of financial institutions and the need to protect consumers. The regulatory structure will determine whether these conflicts are handled internally within a single agency or externally between agencies, which either alternative presenting certain costs and benefits. Regulatory costs: The regulatory structure will influence the cost of regulation, both in terms of providing resources to regulatory agencies and the burden of regulation on financial institutions. Coverage: Some structures may create the potential for overlap or underlap, leading to overregulation of financial institutions or a lack of regulation, respectively. Regulatory arbitrage: Multi-agency regulatory regimes provide incentives for financial institutions to construct their business in order to minimise their compliance costs, which may reduce the overall quality of financial regulation.
Limits to a structural approach 39. Creating an effective regulatory structure is a necessary but not sufficient condition for a successful regulatory regime. Critically, the regulatory agencies within the structure must be adequately resourced with talented and experienced staff, enjoy an appropriate range of powers under the legislative framework and have a good working relationship with the financial institutions they oversee. New structures do not guarantee better regulation. More appropriate structures may help but, fundamentally, better regulation comes from stronger laws, bettertrained staff and better enforcement.
Prof. Jeffrey Carmichael, Australias Approach to Regulatory Reform, December 2003
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Introduction
Implications for the UKs system of financial regulation 40. The analysis of the reasons for the failure of the UKs system of financial regulation highlights that the existing UK system failed due to structural and non-structural factors. The recommendations set out in this report therefore include ways in which the UKs regulatory framework can be made more effective as well as ways to improve the functioning of regulation within that framework. It is particularly important that regulators, policymakers and financial market participants do not work to deliver an improved regulatory structure in response to the current financial crisis, but then fail to deliver the more day-to-day requirement to ensure that the resultant regulatory structure operates in an efficient and effective way to minimise the risk of another financial crisis in the future.
What are the reasonable expectations of the regulatory system?

41. The objective of this Review should not be to create a no failure regime, as this would be likely to stifle positive financial innovation and lead to excessive costs to financial institutions and financial services consumers. The regulatory framework should, however, be expected to enable regulators to maximise their chances of anticipating emerging threats to financial stability, of dealing with those threats appropriately and of ensuring that the regulatory authorities are adequately prepared to deal with any crises that do emerge in a professional and effective manner.
42.
The existing regulatory structure

Basis of the current framework 43. The division of responsibilities for financial regulation in relation to financial stability is set out in statute as well as in the Memorandum of Understanding between the Tripartite Authorities. The following overview sets out the division of responsibilities in mid-2007 when the current financial crisis started. The key pieces of legislation are:
44.
The Financial Services and Markets Act (2000): The Act gave the FSA regulatory responsibility for insurance, securities and banking in the United Kingdom. The Act established the four statutory objectives of the FSA as: maintaining market confidence; promoting public awareness; the protection of consumers; and the reduction of financial crime. The Bank of England Act (1998): The Bank of England was established by the original Bank of England Act in 1694. The Act of 1998 allocated responsibility for banking supervision to the Financial Services Authority and granted operational independence to the Monetary Policy Committee for achieving the inflation target.
45.
The original Memorandum of Understanding between the Treasury, FSA and Bank of England was published in October 1997 and was amended in 2006. The Memorandum outlines the responsibilities of each authority in relation to financial stability and is the key source for the current Tripartite framework.
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Introduction
The Bank of England 46. The Bank is responsible for contributing to the maintenance of the stability of the financial system as a whole. This is one of the Banks two core purposes, the other being to maintain monetary stability. The Banks specific duties are to:

47.
Act in the money markets to limit fluctuations in liquidity To oversee the payments system and financial markets infrastructure To maintain a broad overview of the state of the financial system To undertake operations to minimise the threat posed by an institutional failure
The Financial Services Authority 48. 49. The FSAs responsibilities are based on the Financial Services and Markets Act and cover the four statutory objectives of the FSA for the financial services sector. The FSA is also responsible for promoting the resilience of regulated institutions to operational disruption and for working with regulated institutions to resolve any problems that may prevent them from operating normally. HM Treasury 50. HM Treasury is responsible for overseeing the legislative basis of the Tripartite regulatory structure and for authorising any support operation in the event of a financial crisis. Changes since mid-2007 51. The most important change to the overall regulatory structure since mid-2007 is the increase in the role of the Bank of England under the Banking Act 2009, which gives the Bank a statutory objective to maintain Financial Stability. The Bill also introduces a permanent special resolution regime to address situations of bank failure, strengthens the Financial Services Compensation Scheme to facilitate faster pay-outs, formalises the Bank of Englands role in the oversight of inter-bank payment systems, and establishes the Financial Stability Committee (see Box 11).
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Why did the existing system fail?
Overview
52. 53. The following chapter describes the global and domestic background to the financial crisis and examines its key causes. Having discussed the origins of the crisis, the chapter goes on to evaluate the causes of regulatory failure in the UK, focusing on the evaluation of and response to emerging threats to financial stability; the lack of appropriate instruments to mitigate emerging risks; inadequate prudential regulation; and the lack of expertise and preparation for a financial crisis.
Background to the financial crisis

54. The following paragraphs set out a high level view of the causes of the financial crisis, based upon commentary by leading economists and market practitioners. We have not set out all the underlying analysis in detail, as this has been done elsewhere, however we have highlighted some important trends insofar as they help to illustrate key issues. For a more detailed review of the underlying causes of the financial crisis, see the recent speeches by the Chairman of the FSA, Lord Turner of Ecchinswell1, and the Deputy Governor for Financial Stability of the Bank of England, Sir John Gieve2. First, we must recognise that, while the current financial crisis has been a global financial crisis, the UK contributed to the imbalances in the global economy and exhibited a number of the same unsustainable characteristics as the US. Furthermore, the actions of British financial institutions meant that the UK was heavily exposed to the sharp correction in the global financial system that began in early 2007. Responsibility for the global financial crisis cannot be pinned at the door of the UK regulatory system, but understanding the extent to which developments in the British economy contributed to global imbalances and the reasons for the vulnerability of British banks to the financial crisis will have important implications for the UKs system of financial regulation.
55.
1 2
Adair Turner, The Economist's Inaugural City Lecture, 21 January, 2009 John Gieve, 2008 Europe in the World Lecture Panel Discussion, 19 November, 2008
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56.
An important enabling factor for the global financial crisis was the historically low real risk free rate of interest in Western economies, driven by the purchase of Western government bonds by oil and manufactured goods exporting economies (such as the Gulf states and China) to finance large current account deficits in some Western economies. Low real risk free interest rates had two consequences: a rapid increase in credit and an increasing search for yield among investors in high grade securities. These factors drove an asset price boom in Western economies, with a mutually reinforcing process of rising asset prices enabling individuals and corporations to take on more leverage to invest in assets. The macro-economic imbalances that were emerging in the period to mid-2007 were compounded by innovation in financial markets and products. A key element exacerbating the credit cycle and increasing risks in the financial system was the increasing use of the originateto-distribute model, where financial institutions making loan decisions were shielded from the risks associated with those decisions by securitising their loans. In an environment of high asset price growth and low interest rates, increasing numbers of high risk borrowers (such as sub prime borrowers) were offered loans, since lenders could limit their risk exposure through securitisation and investors in sub-prime mortgage-backed securities perceived them to offer attractive risk-weighted returns due to the limited risk of default when asset prices were rising. However, when house prices peaked in the US in early 2007, default rates rose and the value of mortgage-backed securities declined sharply. The decline in the value of mortgage-backed securities led to a significant contraction in credit. This was driven initially by a sharp decline in interbank lending, as the opacity of the mortgagebacked securities made it difficult for banks to evaluate exposure to losses and therefore the potential risk that a financial institution would fail. The weakness of the wholesale market, driven by a lack of interbank confidence, was clearly exacerbated by the failure of Lehman Brothers in September 2008. Furthermore, the securitisation markets shut down from August 2007 and have not recovered to date, removing an additional source of bank finance. International Financial Reporting Standards related to fair value accounting and international capital adequacy requirements have also contributed to pro-cyclical behaviour. While the move to increased use of fair value accounting has introduced greater realism and transparency in the reporting of banks results and the presentation of their balance sheets, in an environment where market prices in illiquid markets have been driven to unrealistically low levels, this move has caused significantly higher write downs of these assets than if alternative accounting treatments had been used. This has put pressure on banks core capital ratios, with the result that to conserve or repair their regulatory capital ratios banks have been forced to behave procyclically by further reducing their lending. A further source of systemic risk resulting from financial innovation has been the threat posed by shadow banking institutions, which conduct similar activities to banks but are unregulated (e.g. hedge funds, structured investment vehicles and other unregulated wholesale market operators). These unregulated financial institutions have taken advantage of the unsustainable macro-economic and financial environment, in particular the search for yield among investors in high grade securities, to fuel much of the innovation in complex financial products that has contributed to the current crisis. Many of these institutions have reached a sufficient scale or degree of interconnectedness in the financial system that they may pose a threat to financial stability. Recent moves in many countries have increased the transparency of their operations, but arguably the opaque nature of these operations in earlier years helped the impending crisis to be less visible to governments and regulators.
57.
58.
59.
60.
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61.
The systemic risks to financial stability resulting from these developments are two-fold. First, financial institutions that rely heavily on external sources of finance may be unable to secure sufficient liquidity to fund their obligations, as occurred with Northern Rock. Second, the very large write-downs in the value of mortgage-backed securities held by other financial institutions, particularly investment banks (and the investment banking arms of retail banks), has generated fears regarding their balance sheet solvency, although government-led recapitalisation schemes have avoided large scale bank failures due to insolvency. Developments in the UK economy and financial system during this period contributed to the emerging threats to global financial stability, as the UK exhibited many of the same trends as the US. For example, the supply of credit to UK consumers increased at 11.1% p.a. from 2000 to 2007, fuelling an asset price boom exemplified by the 12.2% p.a. growth in property prices over the same period (see Box 1). Consumer debt as a percentage of GDP was higher in the UK than in the US throughout the last ten years. Furthermore, UK banks were heavily exposed to the impact of the financial crisis as it developed, both in terms of their reliance on external sources of liquidity (the cause of the failure of Northern Rock) and their exposure to losses on the value of securitised assets in their trading books and outstanding assets in their loan books. The IMF estimated in April 2008 that total losses by British banks on sub-prime investments would amount to $40bn. UK banks also increased their leverage ratios significantly from 200208 (see Box 1); exposing them to greater risk during the subsequent downturn. We consider the extent to which the UKs regulatory regime should be held responsible for the UKs financial crisis in the following sections.
62.
63.
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Evaluation of and response to emerging threats to financial stability

64. The regulatory system was not able to anticipate effectively how macro-economic developments, together with innovation in financial markets and products, could pose a threat to financial stability. Although many of the symptoms of the emerging financial crisis (particularly asset bubbles such as in the US and UK housing markets) were recognised, regulators were not able to anticipate how these risks would impact financial stability and so did not translate them into regulatory action. For example, in its evidence to the Treasury Select Committees report The MPC, ten years on and in its Financial Stability Reviews from 2004 onwards, the Bank of England identified the emerging risks associated with macro-economic imbalances and their impact on credit availability: The questions are whether risk is being priced properly, and to what extent the search for yield is leading to excessive leverage
Bank of Englands Financial Stability Review, December 2004
The growth of UK-owned banks lending to households and firms continues to outpace the growth of funding from these sources.... liquidity management could become more challenging should any individual bank come under financial pressure
Bank of Englands Financial Stability Review, December 2004
[Some] aspects of the global economy look unsustainable, particularly the pattern of global current account imbalances and the low level of real interest rates and risk premia. So the macroeconomic context is likely to be somewhat less benign [in the next ten years]
Bank of Englands written evidence to Treasury Select Committee, February 2007
Strong and stable macroeconomic and financial conditions have encouraged financial institutions to expand further their business activities and to extend their risk-taking, including through leveraged corporate lending, and the compensation for bearing credit risk is at very low levels
Bank of Englands Financial Stability Report, April 2007
65.
A key weakness in regulators anticipation of the systemic risks to financial stability lay in their analysis of how these developments might pose threats to individual institutions. For example, the Bank and FSA did not take into account the potentially sudden impact of changes in asset prices and mortgage default rates on banks lending behaviour, due to a limited awareness of the issues surrounding mortgage-backed securities. Despite recognising that asset prices rises and low risk pricing were unsustainable, the Bank and FSA did not predict how declining asset prices and higher risk pricing might impact banks confidence in other banks. In recent interviews, the Bank of Englands Deputy Governor for Financial Stability, Sir John Gieve, has argued that the Bank failed to appreciate the impact of the trends it was observing in credit markets and asset prices:
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[We] did see something coming. We did spot the global imbalances, we worried about them. We did spot some crazy borrowing going on, asset prices looking unsustainable and we said actually for a couple of years before the crash that a correction was coming. [But] we didnt think it was going to be anything like as severe as its turned out to be ... I think thats because we hadnt kept pace with the extent of globalisation ...We saw the credit, we saw the house prices but we did see a fairly stable pattern of earnings prices and output.
Sir John Gieve, BBC interview, December 2008
66.
One factor that may have contributed to the Banks failure to keep pace with the extent of globalisation was the change in the structure and content of its biannual Financial Stability Review, then renamed as the Financial Stability Report, in 2006, when the Bank stopped including a section focused on international financial stability risks and shifted to a predominantly UK market focus. The Banks reduced research and analysis of global financial stability risks signals a narrowing of the Banks focus on international issues which may have contributed to its failure to anticipate the potential financial market consequences of the growing imbalances.
Lack of appropriate instruments to mitigate emerging risks

67. Regulators lacked instruments that would have enabled them to address emerging systemic risks, even if they had fully anticipated the potential threat to financial stability. In particular, regulators lacked an instrument that would have allowed them to dampen the growth in liquidity from 2000 to 2007. Since the Bank of England is currently only allowed to use interest rates to achieve its objectives in relation to monetary stability, interest rates cannot be used to promote financial stability when it is threatened by growth in credit during periods of low inflation. The difficulties associated with using interest rates as an instrument for financial stability have been highlighted by Sir John Gieve: [If] wed used interest rates to try and address this asset price/credit growth, we would have been holding down the level of activity elsewhere in the economy ... at a time when consumer price inflation and earnings were stable and reasonably low, and people would have said this is a wilful reduction in the prosperity of the country.
Sir John Gieve, BBC interview, December 2008
68.
Regulators do not have appropriate alternative instruments to control the liquidity cycle by constraining growth in bank lending during periods of low inflationary economic growth. Currently the only instrument at the disposal of regulators (excluding interest rates) is microprudential regulation of individual institutions, based on Basel II and the Capital Requirements Directive. This stipulates that lenders must maintain a level of capital appropriate to the size and risk of their liabilities, including a minimum capital requirement for credit, market and operational risk. However, since regulators are not able to vary capital requirements to reduce the supply of credit during periods of low inflationary growth (this is prevented by the Directive), regulators cannot currently use capital requirements to impact the liquidity cycle.
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Inadequate prudential regulation

69. Although the Tripartite regulators lacked the necessary instruments to mitigate the systemic risks associated with the growth in credit, the FSA also failed to deliver effectively its existing mandate in micro-prudential regulation. This can be attributed to the FSAs lack of focus on prudential regulation, as opposed to conduct of business regulation, and its lack of attention to liquidity issues when it did address prudential regulation. The FSA was excessively focused on conduct of business regulation and did not give sufficient priority to the prudential regulation of major UK deposit taking institutions prior to mid-2007. This stemmed from the wide range of responsibilities allocated to the FSA, and from FSA Board and management decisions, which meant that during periods of apparent financial stability resources and management time were focused on factors other than prudential regulation (see Box 2 for an overview of the FSAs organisational structure at the time the Northern Rock crisis emerged). The FSA implicitly accepted this view in its internal report into its handling of Northern Rock: "Our concern is that some of the fundamentals of work on assessing risks in firms (notably some of the core elements related to prudential supervision, such as liquidity) have been squeezed out as a result of prioritisation decisions and resourcing capacity issues"
FSA, The supervision of Northern Rock: a lessons learned review, March 2008
70.
The FSA [is] to increase its focus on prudential supervision, including liquidity and stress testing
FSA, The supervision of Northern Rock: a lessons learned review, March 2008
71.
Where the FSA was conducting prudential regulation, it devoted more time and resources to capital than to liquidity risks. While this was rooted partly in the failure of the Basel Committee to develop liquidity standards to complement its capital requirements standards, the FSA must be held accountable for its lack of focus on liquidity. This view has been set out in testimony to the Treasury Select Committees investigation into the failure of Northern Rock: The FSA is an institution that cares more about capital adequacy and solvency issues than about liquidity issues
Professor William Buiter, Evidence to Treasury Select Committee, November 2007
In the period prior to 2007, the ease with which banks could access a range of sources of funding meant that little attention was paid to the significant reliance of some banks on external funding. This meant that the risks associated with business models reliant on external funding were not taken into account by the FSA, allowing banks such as Northern Rock to take on more risk. However, had the FSA devoted more time and resource to liquidity regulation, it is likely that Northern Rocks outlying business model would have been identified as a significant risk: If we had a system of proper liquidity regulation, although Northern Rock would have shown up as doing very well on the capital side, it would have looked very flawed on the liquidity side, and that would have been picked up
Mervyn King, Governor of the Bank of England, Evidence to Treasury Select Committee, December 2007
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72.
The FSA also failed to ensure that financial institutions had conducted sufficiently rigorous exercises to prepare for a financial crisis, particularly by working with institutions to stress test their models against various potential threats. Although the duty to design and run stress testing scenarios lay with the institutions themselves rather than with the FSA, it remained the responsibility of the FSA to monitor firms activities in this area. Stress testing for liquidity risk was particularly weak. Despite frequent liquidity risk testing having been made compulsory for all deposit-taking institutions by the FSA in 2004, Northern Rock did not satisfactorily carry them out. Although the Board of Northern Rock undertook some stress testing of its own business model, it proved to have been thoroughly inadequate. It was the responsibility of the Financial Services Authority to ensure that the work of the Board of Northern Rock was sufficient to the task. The Financial Services Authority failed in its duty to do this
Treasury Select Committee, The Run on the Rock, January 2008
73.
The most compelling evidence that the FSA failed to enforce adequately micro-prudential regulation is in its failure to recognise that Northern Rocks outlying business model (see Box 3) left it dangerously exposed to the contraction in wholesale funding and securitisation markets that occurred in mid-2007. While the simultaneous closure of these sources of bank finance may not have appeared likely in early 2007, the FSA should have given greater consideration to the potential impact of weaker securitisation and wholesale funding markets on financial institutions, particularly in the light of its warnings regarding liquidity risk: The problem of NR was a business model that exposed it to a Low Probability High Impact risk. What emerges is that the supervisors of the bank did not address this feature of the banks strategy with sufficient rigour, though both the FSA and the Bank of England (and other central banks) had for several months been making general warnings about liquidity risk.
Prof. David Llewellyn, The Northern Rock crisis: A multidimensional problem waiting to happen, July 2008
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The FSAs organisational structure in mid-2007
Box 2
FSA Responsibilities The FSAs four statutory objectives consist of: maintaining confidence in the financial system; promoting public understanding of the financial system; securing the appropriate degree of protection for consumers; and reducing the extent to which it is possible for a business to be used for a purpose connected with financial crime In July 2007, the FSA was delivering this mandate by dividing its internal organisation between three core divisions: an operational division (Regulatory Services); a division focused on retail banking (Retail Markets); and a division focussing on wholesale banking (Wholesale and Institutional Markets) In practice, this meant that the Senior Supervisors responsible for the FSAs regulation of each firm made decisions regarding the relative prioritisation of prudential versus conduct of business regulation, and in many cases prudential regulation was not sufficiently prioritised
FSA Organisational Chart August 2007 (simplified)
Chairman
Chief Executive Officer
Regulatory Services
Retail Markets
Wholesale & Institutional Markets
Cross FSA sector

Auditing and Accounting | Asset Management | Banking | Capital Markets | Consumers Financial Crime | Financial Stability | Insurance | Retail Intermediaries
Regulatory Services Divisions
Retail Markets Divisions
Wholesale & Institutional Markets Divisions
Source: FSA website, FSA Annual Reports, FSA The supervision of Northern Rock: a lessons learned review
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Northern Rocks business model

How it worked A key feature of Northern Rocks business model was its reliance on securitisation and short-term wholesale funding, which enabled it to pursue a strategy of aggressively growing its share of UK mortgage lending without needing to increase its depositor base, since it could finance its lending externally Northern Rock was the only major bank to base its business model on securitisation Risks
Box 3
Northern Rocks reliance on wholesale funding meant that it was exposed to a low probability, high impact risk in the event of a contraction in inter-bank lending. Whilst this scenario appeared unlikely prior to mid2007, Northern Rocks business model left it particularly vulnerable to this risk when it materialised Following the closure of securitisation markets in August 2007, Northern Rock was unable to securitise its existing mortgages. This had two negative impacts: 1. Northern Rock faced unexpected additional funding requirements due to the need to finance mortgages it had intended to securitise 2. Northern Rock was forced to retain its existing portfolio of mortgage loans on its balance sheet, exposing itself to downside risk in the event of an increase in the default rate
Northern Rock has been the only major bank to have securitisation as the centrepiece of its business strategy
David Llewellyn, The Northern Rock Crisis, July 2008 Northern Rock was also unusual in the extent of its reliance on wholesale funding (see below)
Northern Rock's reliance on wholesale funding

70%
Percentage of funding
62% 60% 52%
50% 50% 42% 40% 38% 39% 48%
30%
RBS
Lloyds TSB
Barclays
Alliance&Leicester
HBOS
Bradford&BingleyNorthern Rock
Bank
Source: David Llewellyn, The Northern Rock Crisis: A MultiDimensional Problem Waiting to Happen, Press reports
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Expertise and preparation for crisis

74. The Tripartite Authorities were poorly prepared for a crisis, and, in particular had spent insufficient time conducting joint planning for a financial crisis. There was very little interaction between the Tripartite Authorities at the most senior level prior to mid-2007 in the absence of documented records of meetings, we have been informed that the Authorities met at the Principal level only once in the ten years preceding the financial crisis. This was when the Chancellor of the Exchequer, the Governor of the Bank and the Chairman of the FSA participated in a conference call with the US authorities in 2006. This was referred to by the Prime Minister in his evidence to the House of Commons Liaison Committee in February 2009. Basic crisis management tools that are used elsewhere in the Government and private sector, such as developing war games to understand potential weaknesses in crisis management capabilities, were used only rarely by the Tripartite Authorities. The Treasury was particularly short of relevant financial market and crisis handling expertise in mid-2007. The mechanisms to deal with financial institutions in the event of failure were also clearly inadequate, as the lack of a resolution regime for financial institutions meant that the Authorities had to utilise the corporate insolvency regime. This meant that, in the case of systemically important institutions, the Authorities had little option other than to provide ongoing liquidity support from the Bank of England or nationalising the institution. [Out of an exercise in 2005] came the very clear understanding that we had no adequate tools for dealing with a failing bank ... all three Tripartite Authorities felt that an urgent work programme on how to resolve the problems of a failing bank was necessary
Mervyn King, Evidence to the Treasury Select Committee, December 2007
75.
When overseas regulators/governments allowed an institution to fail, as with Lehman Brothers in September 2008, the inadequacy of the UKs wider insolvency regime was exposed. Given that this weakness in the UKs legislation was recognised in 2005, the failure of HM Treasury to have drafted an alternative legislative framework for a resolution regime should be acknowledged. 76. The arrangements for depositor protection in the event of an institutional failure were also inadequate and contributed significantly to the damage done to the UKs financial system following the run on Northern Rocks retail deposits in September 2007. Specifically, the lack of a 100% guarantee on retail deposits and the long delays in recovering deposits via the Financial Services Compensation Scheme meant that there was a rational incentive for deposit holders to join a bank run, factors recognised by the Governor of the Bank of England in the aftermath of the crisis: The system of administration for banks which means that retail depositors find their deposits frozen for months on end and they cannot access them is a system which is a direct inducement for retail depositors to take their money out at any sign of trouble
Mervyn King, Evidence to the Treasury Select Committee, September 2007
In the absence of a government guarantee, it was actually rational to queue up and take your money and it would have been dishonest for us to have pretended otherwise"
Mervyn King, Interview with the BBC, November 2007
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77.
In addition to the challenges associated with the lack of a resolution regime and weak depositor protection, the Tripartite Authorities failed to communicate effectively with the markets and general public to try to reduce the impact of the emerging crisis. The delays in making a public announcement regarding the liquidity support operation for Northern Rock left the bank in a precarious position with its depositors when news of the support operation was leaked in the media prior to the official announcement (see Box 4). The leaking of Government support operations prior to their announcement was not confined to the Northern Rock operation, as the market-sensitive news regarding the bank recapitalisation scheme in October 2008 was also leaked to the media before being officially announced. Furthermore, the Authorities failed to use communication to reassure financial markets and depositors, as it was not clear who was taking the lead in communicating with the public and official announcements used language that failed to reassure financial services consumers. There was no sign of a communications strategy of the Tripartite authorities during the crisis of September 2007. We believe that this was a contributory cause of the run on the bank
The Run on the Rock, January 2008
78.
Calling [the Bank of England liquidity support operation] emergency lending was I suppose asking for trouble
Geoffrey Wood, CASS Business School, Evidence to the Treasury Select Committee, November 2007
[Regulators] failed to speak plain English: assurances from the FSA that Northern Rock was, for example, solvent cut no ice with the bank's retail customers because it is not a term that is widely understood by non technicians
Building Society Association, Evidence to the Treasury Select Committee, December 2007
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79.
One of the specific reasons for the failure of the Tripartite Authorities adequately to resolve the Northern Rock crisis was the perception among key decision-makers within the Tripartite Authorities that a covert liquidity support operation for Northern Rock would constitute market abuse. I found it hard to believe that a public policy intervention that was in the interests of everyone in Northern Rock [a covert operation] could not go ahead because of a legal responsibility to disclose. There is wording in that [European Union] Market Abuse Directive which would give you the impression that in a case of financial distress it would be possible not to disclose but we had to take legal advice ... and we were advised finally that it could not be covert
Mervyn King, Evidence to Treasury Select Committee, September 2007
The FSA has subsequently clarified its interpretation of the Market Abuse Directive to allow for covert liquidity support operations so long as delays in disclosing such an operation do not mislead the public and confidentiality can be maintained, however the failure to determine this question prior to mid-2007 was very costly to the UKs financial system. Even if this issue had not been adequately addressed when the Market Abuse Directive was transposed into UK law and regulation, it is difficult to understand, without a clearer public account of the events leading up to the run on Northern Rock, how a simple defect in the FSA disclosure rules was allowed to prevent a covert support operation, when there was in fact no obstacle in the Directive. 80. The weakness in the Authorities communications may have reflected a deeper problem regarding leadership of the regulatory and Government response to the emerging crisis. Although formally the Treasury retained final responsibility for resolving a financial crisis under the Memorandum of Understanding, uncertainty regarding the implications of the Bank of Englands monetary policy independence may have limited HM Treasurys perceived authority to take decisions regarding support operations. [There was] insufficient clarity in the allocation of roles, responsibilities and authority of the parties to the Tripartite authorities
British Bankers Association, Memorandum to the Treasury Select Committee, November 2007
81.
People involved in successive stages of the crisis report that the Tripartite Authorities crisis handling has markedly improved in the period since the collapse of Northern Rock, with a swifter and more effective handling of Bradford & Bingleys nationalisation and the recapitalisation of HBOS, Lloyds TSB and the Royal Bank of Scotland although the same people may also question whether the right policy outcomes were achieved. . The challenge for the Tripartite Authorities will be to ensure that the current level of preparedness does not dissipate once the ongoing financial crisis has concluded.
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The macro-prudential regime
Overview
82. The previous chapter identified the weakness of the Tripartite regime prior to 2007 in identifying and acting on systemic threats to financial stability. In this chapter a proposed macro-prudential framework is outlined that would address many of the weaknesses identified. The chapter sets out the core issues in relation to the macro-prudential regime, considering in turn the most effective way to improve the evaluation of and response to emerging threats to financial stability; and the appropriate instruments to mitigate these risks.
83.
Evaluation of and response to emerging threats to financial stability

What functions will the regulatory system be required to perform? 84. 85. The regulatory system needs to develop a much more effective capability in monitoring emerging threats to financial stability and translating this into regulatory action. First, regulators must be able to collect and analyse economic and financial data at the systemic level. This will include analysing macro-economic and financial data for both the UK and the global financial system, in order to identify any imbalances that might lead to financial instability. Second, regulators must be able to anticipate how macro-economic and financial developments may impact upon the UKs financial stability, in particular by addressing the vulnerability of British financial institutions to emerging systemic risks. This will require regulators both to have access to institutional financial data, in order to quantitatively evaluate risk exposure and vulnerability at the institutional level, and to engage with senior market practitioners in order to understand how financial institutions business models may expose them to systemic risks. Third, this analysis must be translated into regulatory action. This will require regulators to develop mechanisms to effectively communicate internally within the regulatory community and externally with financial institutions, to ensure that financial institutions are adequately informed about and prepared for emerging systemic threats to financial stability. Responsibility for identification and analysis of systemic risks 88. Each of the Tripartite Authorities should play a role in evaluating emerging threats to financial stability, however the nature of this role will differ depending on the specific position, resources and existing capabilities of each Authority. The most significant change is that the Bank of England should in future be formally bound, in support of its financial stability objective, to be monitoring and assessing developments in UK and global financial markets and considering their implications for financial stability. Also, the macro-economic side of the Treasury should have a new role in considering the impact of financial stability issues on the conduct of macroeconomic policy, and, vice versa. The micro-prudential supervisor should continue to input into this analysis, given its detailed knowledge of financial institutions risk exposures.
86.
87.
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89.
The Bank of England should be primarily responsible for evaluating systemic threats to financial stability for the following reasons:
Capability: The Bank has an existing capability in monitoring and analysing macro-prudential threats to financial stability, with many of the systemic threats to financial stability that caused the financial crisis identified by the Bank in its Financial Stability Reports and other public statements. There is room, though, to strengthen this capability by building upon the analytical strength and access to macro-economic data that the Bank has developed to fulfil its monetary stability mandate. Access to markets: The Bank is actively involved in the money markets as part of its monetary stability and payment system functions. This enables it to have access to real time financial data and to build contacts and working relationships with market practitioners, allowing the Bank to gain an insight into developments in financial markets that the other regulatory bodies will find challenging to replicate. Creative tension: Giving the Bank an unequivocal mandate in macro-prudential analysis will enable there to be both a private and a public dialogue between the Bank and the microprudential regulator regarding the key systemic risks and their implications. This should engender a degree of creative tension between the Bank and the micro-prudential regulator on the nature of the systemic risks; it will ensure that the regulatory implications of systemic concerns are properly followed up; and it will add a new dimension of transparency to the Tripartite process.
90.
The strength of the Banks position with regard to financial stability was highlighted by Paul Tucker, who becomes Deputy Governor for Financial Stability in March 2009, in his recent written response to the Treasury Select Committees appointment hearing: [The Bank] can draw on a strong endowment, rooted in our being the UKs monetary authority. [This includes] analytical strengths, especially given the Banks position in the labour market for Masters and PhD economists; financial market/banking operational expertise, stemming from our role at the heart of the monetary and payment system; a wide range of contacts in, and so breadth of intelligence from, capital markets given our operational roles; goodwill towards the Bank across the international financial system; [and] the high standing of the six-monthly Financial Stability Report.
Paul Tucker, Written response to Treasury Select Committee, January 2009
91.
The increase in the role of the Bank in relation to macro-prudential regulation will require the Bank to have greater access to institutional financial data to complement its existing sources of macro-economic and financial data. The most important source of institutional data will be the micro-prudential regulator (the FSA under the current Tripartite framework), as its institutional regulatory role gives it access to a range of detailed information on institutions financial positions and risk exposures. It will therefore be critical that the Bank and micro-prudential regulator agree on what data is required to perform their roles in macro and micro-prudential regulation, with consideration given to avoiding additional new regulatory burdens on financial services institutions (including taking into account institutions existing management information systems and the costs associated with providing data in a different form). The Bank should specify what data is required for its analysis and the micro-prudential regulator should provide this data. The operating protocol between the Bank and FSA includes a commitment by the FSA to provide data on request. However, for the avoidance of doubt, the Bank should have a statutory right to receive such data as it deems necessary for its macro-prudential work.
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92.
Most importantly, the success of the Bank in fulfilling its macro-prudential role will be heavily dependent on the development of an ongoing, high level engagement with senior market practitioners, to enable Bank officials to gain a greater insight into different institutions business models and the risks to which these institutions are exposed. A number of people we have spoken to during the course of this Review have highlighted the Banks less market-focused outlook in the period preceding the financial crisis versus earlier periods. One factor that may have contributed to this shift is the Banks decision to drop its third core purpose relating to the efficiency and effectiveness of the financial system. The Bank had previously regarded this as an important underpinning for its two main objectives of maintaining monetary and financial stability, although it was sometimes characterised, erroneously or at least anachronistically, as conducting a lobbying role in Whitehall on behalf of the City. For the Bank to be effective in identifying emerging systemic risks, it should in future be formally bound, in support of its financial stability objective, to be monitoring and assessing developments in UK and global financial markets and considering their implications for financial stability. Having analysed the potential systemic risks to financial stability, it will be critical to ensure that the outputs of its macro-prudential analysis are translated into regulatory action. The key channel to achieve this will be via the micro-prudential regulator, with whom the Bank should be in constant informal dialogue on the relevant issues. The formal way in which the Bank should communicate its views on macro-prudential regulation to the micro-prudential regulator should be via a public letter from the Bank to the micro-prudential regulator, to be published in addition to the Banks Financial Stability Report and setting out the Banks views on the overall level of systemic risk in the UK, together with the source and nature of specific risks identified. The Bank should send such letters as often as it deems necessary but should do so at least twice a year, potentially in conjunction with its biannual Financial Stability Reports. The micro-prudential regulator would have a duty to submit a public response to the letter, setting out any areas of disagreement with the Bank regarding systemic risk and stating what actions the microprudential regulator will take in the following months to address them. This would enable Parliament (via the Treasury Select Committee) to hold the micro-prudential regulator to account regarding its response to systemic risks identified by the Bank. In addition to the public letter from the Bank to the micro-prudential regulator setting out systemic risks, the Bank should also include a confidential annex raising any concerns regarding specific institutions that it has developed during its macro-prudential work. This annex must remain confidential due to the need to preserve market confidence and prevent market abuse. In order to ensure the integrity of this exchange, confidential annexes should be publicly disclosed after five years. The micro-prudential regulator should also be required to respond to this letter, stating any disagreements and actions to be taken, and should be accountable to Parliament for carrying out these actions. In carrying out its macro-prudential role, the Bank will also be equipped to engage more fully in the critical European and global debates and negotiations on the future regulatory structures that will underpin much of the UKs financial stability regime. We have been told that the Bank is not as engaged in these debates as it was in previous years. It is important that this trend is reversed and that the Bank re-engages with the key international bodies. The Bank was at the forefront of many of the debates over the past decades that led to the current developed methodologies for the conduct of monetary policy globally. It should play a similar role, in tandem with the micro-prudential regulator, in what will be as important and protracted a development of truly workable financial stability methodologies. This work should focus, in particular, on influencing the European legislative programme which has the capacity to dictate much of the UKs financial stability system.
93.
94.
95.
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The Bank of England should have the primary responsibility for evaluating systemic threats to financial stability. The Bank of England should have a statutory right to receive such data as it deems necessary for its macro-prudential work; this data should be provided by the micro-prudential regulator. The Bank should have a formal duty in the Memorandum of Understanding to be continuously engaged with broad financial markets developments. The Bank should write a public letter at least twice a year to the micro-prudential regulator setting out its views on systemic risk. The micro-prudential regulator should submit a public response to the letter stating what actions it intends to take to address the risks identified. The letter should include a confidential annex raising any concerns in the Bank regarding specific financial institutions. The Bank of England should engage fully in international debates and negotiations on financial stability regulation.
Recommendation (3):
Recommendation (4):
Use of macro-prudential instruments

96. The earlier analysis of the causes of financial instability and systemic risk centred on the problems associated with financial innovation and unsustainable macro-economic developments. Proposals to respond to these challenges have fallen into two broad categories, including those that seek to reduce the potential for unsustainable macro-economic imbalances to develop and those that address problems at the financial institution level. Instruments to address macro-economic imbalances 97. The linkages between macro-economic policy and financial stability have been explored in a series of speeches and papers by officials at the Bank for International Settlement since 2001. In a UK context the first question to be asked is about the relationship of the Banks Monetary Policy Committee (MPC) to questions of financial stability. The range of views that should be considered includes:
Dual mandate for the MPC: This approach would see the MPC being given an explicit objective of maintaining financial stability as well as hitting the inflation target. MPC consideration of financial stability implications: The MPC might be required to give consideration to the financial stability implications of its interest rate decisions. This covers a range of options in practice, from requiring the MPC to lean against the wind during periods of high liquidity growth by raising interest rates (this might be justified by asking the MPC to take a longer term view of the inflation target time horizon), to requiring the MPC under exceptional circumstances to prioritise issues relating to financial stability over its monetary stability objective.
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Including asset prices in the inflation basket: This would enable the MPC to take into account increases in asset prices whilst preserving its single mandate in relation to inflation targeting. Work on including owner-occupied housing costs (a metric for house price asset inflation) is currently being conducted by Eurostat, although in evidence to the House of Lords Economic Affairs Committee in 2006 the Governor of the Bank of England stated that he did not expect this to be completed during his lifetime. Sir John Gieve, in his speech of 19 February, 2009, argued that house prices are of such importance to UK households budgets and wealth that the UK should consider incorporating this measure into the inflation basket, even if action is not taken at the European level. MPC comments on financial stability implications of decisions: Requiring the MPC to comment on the implications for financial stability of its decisions in setting interest rates will not enable the MPC to explicitly use interest rates to promote financial stability, but will increase the level of focus on particular financial stability issues discussed by the MPC.
98.
Among the commentators putting forward the view that the role of the MPC in relation to financial stability need to be reconsidered are Sir John Gieve: We must be willing to lean against the wind of asset price booms and credit expansion and to tolerate somewhat weaker growth and lower employment in doing so
Sir John Gieve, Speech to the London School of Economics and Political Science, February 2009
99.
A more straightforward way in which the Authorities can use levers to influence financial stability would be to make greater use of wider Government policy options to promote financial stability. In particular, strengthening the links between the Governments wider economic management toolkit and its consideration of financial stability issues should be a high priority, not least in relation to fiscal policy. At present there is no formal channel for financial stability concerns to be transmitted to, and considered by, the macro-economic side of HM Treasury. To strengthen HM Treasurys role in relation to financial stability, the remit of the macro-economic side of the Treasury should be broadened to include consideration of the financial stability consequences of developments in the economy and the consequences for economic management of financial market trends identified by the Bank and micro-prudential regulator. In addition it is worth considering whether the micro-prudential regulator should write an open letter to the Bank should there be concerns that its conduct of macro-economic policy may threaten financial stability. The third lever that might be used by the Authorities as a part of their macro-prudential toolkit is an appropriate counter-cyclical capital regime that would allow regulators to dampen the liquidity cycle and to minimise the threat to financial institutions during periods of deleveraging. The need for such a counter-cyclical regime has been highlighted by Paul Tucker: My provisional view, which may prove wrong, is that it will be insufficient to rely on the design of micro rules. I therefore think it will be worthwhile exploring whether a macro instrument could be devised. Candidates include varying across-the-board capital ratios for banks during the upswing part of the credit cycle
Paul Tucker, Written response to Treasury Select Committee, January 2009
100.
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101.
The only country which is widely quoted as operating such a capital regime is Spain, with its dynamic provisioning approach (see Box 5), although there have been a number of criticisms of its effectiveness. It is clear that the dynamic provisioning did not prevent a strong cyclical expansion of credit in Spain, with corresponding problems in housing and other markets. However, it has been argued that it left Spanish banks better prepared for the financial crisis, enabling them to call on provisions amounting to 1% of total assets during the downturn3. It is beyond the scope of this report to determine the exact nature of this regime, including whether it should be applied separately to individual institutions or across the system as a whole. In the absence of a clearly defined counter-cyclical capital regime, it is not possible to say which Authority should be responsible for operating it. However it is possible to set out which Authority will be best suited to operating different a regime that operates at the systemic level versus one that operates at the institutional level. Given the Banks role and capabilities in relation to the analysis of systemic threats to financial stability, the Bank is the Authority that is best placed to exercise judgements over the countercyclical capital regime at the sector or market wide level. As the institution primarily responsible for conducting the analysis of systemic risks to financial stability, the Bank should also be required to act on those risks using a counter-cyclical capital regime. If, on the other hand, the counter-cyclical capital regime is designed to operate at the level of individual financial institutions, the micro-prudential regulator is best placed to operate the regime. Other broad ideas that have been suggested to us include the concept that firms with a dominant share in any particular market might be required to hold a proportionately higher level of capital than other firms, to reflect the additional systemic risk that comes with absolute size of institution; that firms with an aberrant business model might be required to hold more liquidity or capital; that financial institutions should be required to hold more liquid assets during cyclical upturns; or that constraints on lending, such as loan to income and loan to value ratios, should be introduced.
102.
103.
104.
Speech by Sir John Gieve to the London School of Economics and Political Science, Seven lessons from seven years, 19
February 2009
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Dynamic Provisioning in Spain

Background
Box 5
Spain is currently the only country utilising the dynamic provisioning instrument. The Bank of Spain introduced dynamic provisioning requirements in mid-2000 due to concerns regarding the cyclicality of banks lending and risk pricing Banks provisions for loan defaults tend to be inversely correlated to economic growth, as default rates are typically low during periods of economic growth and high during recessions. This leads to pro-cyclical behaviour as banks make more loans when the economy is growing and limit lending during recessions Dynamic provisioning requires banks to take a more conservative view during periods of economic growth, setting aside provisions to mitigate losses from rising defaults during downturns. The dynamic provision requires banks to recognise credit risk in their balance sheets and to set aside reserves to cover it This prevents banks gearing up during a period of economic upturn on a capital base that has been inflated by ignoring the longer run losses associated with their lending, and provides a buffer which will cover the exceptionally high losses incurred in the subsequent cyclical downturn
How it Works The Dynamic Provision is a balancing number, and equals the difference between the expected default risk for loans throughout the economic cycle and the actual default risk in any given year (this is summarised below) Relatively low annual default rates during periods of economic growth will result in a positive dynamic provision being charged to the income statement and added to reserves, whereas relatively high default rates during recessions will lead to a release of dynamic provision reserves from the balance statement to the income statement to offset losses However, there is a limit on the total level of dynamic provision reserves required to be held by any individual bank, set at 1.5% of total assets
Criticisms of dynamic provisioning The first criticism of dynamic provisioning is that it is costly and complex to administer. For example, it requires regulators to develop an expertise in assessing the default risk for loans across a number of asset classes and hold detailed historical data on default rates across these each of these classes (this is particularly problematic where banks operate internationally). On the other hand, there are similar concerns regarding the Internal Ratings-Based approach set out under Basel II Dynamic provisioning in Spain does not take into account the losses that may be realised on marked-tomarket assets, which have been the primary sources of bank write-downs in the UK Dynamic provisioning is also inconsistent with International Accounting Standard 39 on the impairment of assets
Dynamic Provision = Average annual provision (Loans x Default risk across the cycle) Provisions in a given year (Loans x Default risk for year)
Impact in Spain Dynamic provisioning did not prevent a significant increase in credit and a resultant asset price boom in Spain. Lending to households grew at 19% p.a. between 2000 and 2007, whilst house prices grew at 13% p.a. during the same period Total dynamic provisions are believed to have equalled 1% of total banking assets at the starts of the downturn
However, Banco de Espana emphasise that dynamic provisioning was not intended to dampen down the liquidity cycle, but to ensure banks were better prepared for a downturn by recognising credit risk and setting aside reserves during economic upturns. In this respect dynamic provisioning may have been successful in ensuring Spanish banks were better placed to withstand losses in the current financial crisis
Sources: Banco de Espana, Thomson Datastream, Press reports
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Addressing threats to financial stability at the institutional level 105. One proposal set out by a number of commentators to address issues at the institutional level would be to enforce a division of activities by complex financial groups into separate subsidiaries for different classes of business activity that could be subject to separate capital regimes, with the traditional deposit taking and lending activities of financial institutions (retail or commercial banking) separated from their trading operations (investment banking). This means deciding which financial services should be classed as utilities and which as part of the casino. The imposition of fire-walls between different classes of business has some intuitive appeal in the light of the very substantial losses by the trading arms of large deposit-taking institutions, however much more debate is required regarding the implications of such a change. Some commentators have suggested confining the utility to the payment system, however this may be problematic given that for example the intermediation of long-term savings would normally be regarded as a key function of the financial system. Arguments in favour of a division include that it would provide greater security to retail depositors in financial institutions and that it would provide an additional layer of protection to the taxpayer against exposure to costs associated with the failure of financial institutions. Some of those who advocate this model argue that it is only worth implementing if the ring fence is drawn in such a way that it includes substantially all of the systemic activity, which needs to be subject to tighter regulation, and that financial activity outside the ring fence should be in the main not of systemic consequence and so not subject to full prudential regulation. Among the wide range of issues associated with a separation of financial activities are concerns regarding whether regulatory lines or competition and clear information to consumers will better enable a range of retail deposit taking institutions to develop; how narrow banking protects a bank from traditional prudential risks such as concentrated lending; what the additional funding costs for the banking system will be if deposit taking banks are not allowed to finance or hedge their activities through the repo market, and a range of derivative structures; what economy of scale and diversification benefits might be lost; what the risks and consequences of regulatory arbitrage will be as banks look for domiciles where less restrictive regimes may exist; and whether the capital regime could be able to deal appropriately with a range of different banking models without segregating activities into different legal entities. A second proposal at the institutional level that merits more consideration than it has to date is the recommendation that shadow banking institutions should be fully regulated. The guiding principle should be that a financial services entity, or category of businesses, should be regulated either because there is an issue of consumer protection or that the failure of the institution(s) would have systemic consequences. This merits careful case-by-case consideration of the potential costs and benefits associated with such a development, particularly against the benefit that can be gained by increased transparency. However, it will be challenging to regulate these institutions directly, as their limited size (in terms of staff and operational footprint) and ready access to global financial markets means that they are highly geographically mobile. The approach that has been adopted in recent years, for example, with hedge funds, is for regulators to focus on the prime brokerage activities of the regulated investment banks which provide the brokerage service to the unregulated hedge funds. It is perhaps too early to conclude that this approach has proved wholly effective but it provides a reminder that direct regulation may not always be the right answer and that we need to find a clear rationale for determining which institutions are subject to prudential regulation. It will be important to bear in mind the lessons of the Sarbanes-Oxley legislation in the USA following the collapse of Enron: that additional regulation can impose a cost on business running into hundreds of millions of pounds without achieving much except the growth of the box ticking industry.
106.
107.
108.
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Additional instruments 109. One further instrument available to authorities in the US is the use by the Federal Deposit Insurance Corporation of its funds to facilitate the transfer of parts of an ailing institution to another financial institution, where it judges that the ultimate cost to the scheme will be lower than compensating the depositors in the insolvent institution through a liquidation (see Box 6), with a different set of criteria in systemic situations. This represents a practical additional tool for dealing with bank insolvencies. The UK Authorities should clarify the constraints on the Financial Services Compensation Scheme funds being used to secure the resolution of failed institutions instead of liquidation and payout under the scheme. There will remain a number of practical issues associated with such an instrument in the UK, where compensation of depositors in the event of a bank failure is currently managed by the Financial Services Compensation Scheme (FSCS), an independent body funded by the financial services industry and accountable to the FSA (see Box 7). The Banking Act 2009 allows for the FSCS to move to a pre-funded model, whereby financial institutions would fund a build up of the FSCS to pay for any potential claims, rather than the current post-funded model. More consideration should be given to financial institutions pre-funding the compensation scheme in the future, and in particular there should be more work done to evaluate the various options for a risk-based contributions framework (where financial institutions whose depositors are most at risk must pay higher premiums to the FSCS). In this context the existing crosssubsidy arrangements between financial industry sub-sectors should be revisited.
110.
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The Federal Deposit Insurance Corporation

Background
Box 6
The Federal Deposit Insurance Corporation (FDIC) was created in 1933 by the Glass-Steagall Act. It is a government corporation, devoted to maintaining confidence in the banking system through insuring deposits at American banks. These deposits are then guaranteed by the government The FDIC is funded by premiums from banks, and insures approximately 5,160 banks in the United States, representing over half of the institutions in the US banking system Purchase and Assumption Agreements A purchase and assumption agreement is an agreement entered into by the FDIC, the failed bank and an institution which wishes to acquire the failed bank. The acquiring institution would then be allowed to purchase the bank subject to it assuming some or all of the failed banks liabilities. Purchase and assumption transactions are the most common resolution method for the FDIC The FDIC can draw upon the funds paid to it from insured institutions to reduce the cost of a takeover to acquiring institutions, where the overall cost to the FDIC will be lower than if it pays out insurance to an insolvent institutions depositors Recent purchase and assumption transactions with the FDIC includes the acquisition of 1st Centennial Bank by First California Bank in January 2009, where First California agreed to acquire the deposits and $293m of 1st Centennials assets. The estimated overall cost to the FDIC of this transaction is $227m, but it did not disclose the projected alternative cost of allowing the institution to fail Other recent purchase and assumption agreements with the FDIC include the acquisition of Downey Savings and Loan Association and PFF Bank and Trust in California by US Bank, as well as Branch and Banking and Trusts assumption of Haven Trusts deposits in November and December 2008 respectively
The FDICs powers and remit FDIC insurance covers savings, checking and other deposit accounts Normally, FDIC insured depositors are guaranteed up to $100,000 per bank; however this was temporarily increased on 3 October, 2008 to $250,000 per depositor per bank The FDIC finances its operations by charging a riskbased premium to the institutions it insures, with higher risk banks required to pay a higher premium. The FDIC is pre-funded, mitigating the problem of low risk institutions having to pay for high risk institutions failing in a crisis FDIC assesses the riskiness of an institution by a twostep process looking first at capital ratios and secondly at other relevant information gathered during supervision The FDIC is the agency responsible for handling bank insolvencies in the United States
Dealing with insolvency The FDIC uses three resolution methods to deal with bank insolvency: purchase and assumption transactions (see below), where the banks operations are sold to another institution; deposit payoffs, where the FDIC pays insured depositors the value of their deposits and liquidates the institution; and open bank assistance transactions, where the FDIC provides an institution with financial assistance to keep it from failing
Source: The Federal Deposit Insurance Corporation
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The Financial Services Compensation Scheme

Overview The Financial Services Compensation Scheme (FSCS) compensates consumers of failed authorised financial institutions for financial loss It was created under the Financial Services and Markets Act in 2000. The scheme covers deposittaking institutions, investment business, general insurance and insurance mediation, as well as mortgages Funding
Box 7
The Scheme is post-funded in the form of levies. The two costs covered through the levies relate to management expenses and compensation payments For purposes of compensation payments, firms are divided into five classes: deposits, life and pensions, general insurance, investments and home finance. With the exception of deposits, each class is then divided into two sub-classes of provider/intermediation activities Different classes have different levy tariffs. Compensation is paid from a sub-class up to the threshold, after which other sub-classes within the broader class contribute. For deposits, compensation is paid up to the threshold of 1,840m, which represents the amount the FSA has judged that the deposits class can afford Should the broader class reach its annual threshold, funds will be used from a general retail pool of funds which sits above the five broad classes Should even this not be sufficient, funds are borrowed from HM Treasury and the interest from those funds is then paid by class
Accountability The FSCS is an independent body, but accountable to the Financial Services Authority (FSA) and the Treasury The Financial Services Authority appoints the Directors for the Scheme, and appointment and removal of the FSCSs Chairman is subject to Treasury approval The levy rules for the FSCS are written by the FSA

Source: The Financial Services Compensation Scheme
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111.
It has been suggested that, in a period of very low interest rates and with the prospect of quantitative easing becoming a tool of macro-economic management, the Debt Management Office (DMO) (see Box 8 for a brief description), which has responsibility for managing the Governments cash and sterling debt, should have its mandate reviewed by the Bank and HM Treasury. The DMOs mandate is to carry out the Government's debt management policy of minimising financing costs over the long term, taking account of risk, and to minimise the cost of offsetting the Government's net cash flows over time, while operating in a risk appetite approved by Ministers in both cases (DMO web-site). Suggestions for changing this mandate include the thoughts that either it should be broadened to one that fully considers the wider economic implications, including for monetary conditions, of its activities and of the structure of public debt; or that it should or that it should continue to be primarily a delivery mandate but one that is flexed to the new market realities. The DMOs mandate should be reviewed by HM Treasury and the Bank of England.
The UK Debt Management Office

Overview
Box 8
Structure and Accountability
The Debt Management Office (DMO) was created on the 1st of April 1998 to carry out the Governments debt policy with the aim of minimising financing costs over time Until 1998 debt management had been the responsibility of the Bank of England. However, with the decision to grant the Bank of England operational independence for monetary policy the DMO was made a subsidiary of HM Treasury
Although the DMO is legally part of HM Treasury, as an executive body it operates at arms length. The policy and framework of the DMO is determined by the Chancellor of the Exchequer, but operational decisions are delegated to the Chief Executive of the DMO The DMO reports to the Debt and Reserve Management team at HM Treasury. The Debt and Reserve Management team also provides the DMO with policy advice As an agency of the Treasury the DMO produces an annual business plan detailing its objectives for the coming year The DMO is operational rather than policy-making, and as such does not interact on a day-to-day basis with the rest of the Treasury, but may offer advice channelled through the Debt and Reserves Management team. The affiliated minister for DMO is the Economic Secretary to the Treasury
Responsibilities The DMOs responsibilities include debt and cash management for the UK government, lending to local authorities and managing certain public sector funds. It has also been appointed by the Department of Energy and Climate Change to conduct the auction of EU allowances in the UK for Phase II of the EU Emissions Trading Scheme The DMO conducts its cash management operations through a combination of trades in the sterling money markets and the issuance of Treasury bills Before the end of each financial year, the DMO is given its financial remit for the following year by the Treasury, specifying the annual total gilt sales planned for the financial year and the break-down between indexlinked and conventional gilts. The remit is usually revised in November/December with the publication of the pre-Budget report
Source: The Debt Management Office
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Recommendation (7):
HM Treasury should consider what, if any, change should be made to the remit of the Monetary Policy Committee to reflect the fact that interest rate policy may impact financial stability. The macro-economic side of the Treasury should consider the impact on macro-economic policy development of financial stability concerns. Consideration should be given to the micro-prudential regulator writing a public letter to the Bank should it develop concerns that its conduct of macro-economic policy may threaten financial stability. In the conduct of a counter-cyclical capital regime, judgements at the market level will be for the Bank and at the firm level for the micro-prudential regulator. The Authorities should conduct a full study of the pros and cons of moving to a narrow or utility banking model. The Authorities should give further consideration to the need for increased regulation of previously unregulated activities. Clear principles should be applied in each specific case; the relative benefits of transparency and of indirect regulation versus direct regulation should be considered. The Authorities should clarify the constraints on the Financial Services Compensation Scheme funds being used to secure the resolution of failed institutions instead of liquidation and payout under the scheme. The Tripartite Authorities should give further consideration to financial institutions, in the future, pre-funding the Financial Services Compensation Scheme on a risk-weighted basis. The Debt Management Offices mandate should be reviewed by the Treasury and the Bank of England.
Recommendation (8):
Recommendation (9):
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Micro-prudential regulation
Overview
112. The previous chapter outlined the macro-prudential issues and the potential instruments to mitigate these under the regulatory regime. However, there remains a challenge in determining how to ensure that regulation is delivered effectively at the institutional level. This chapter sets out the key challenges in determining the appropriate framework for microprudential regulation and discusses the advantages and disadvantages of alternative responses to these challenges, setting out five potential options to be considered during further consultation.
113.
Key challenges in micro-prudential regulation

114. Proper conduct of micro-prudential regulation is fundamentally about having the right sort of people carrying out the work under the direction of senior managers who are steeped both in the industry they are regulating and in the nature of the regulatory process. Although it would be an over-simplification to say that prudential regulators need a completely different mindset and training from conduct of business regulators, the focus of their work and the way it is carried out have significant differences. This reconciliation of the competing demands of prudential and conduct of business regulation has to be done both in the context of regulating the individual firm and in setting the broad direction and thrust of regulatory policy for the regulator as a whole. By its own admission, the FSA failed the former test. In retrospect, it is easy to see that the focus of the FSA on the development of policies to give the consumer of financial services a better deal (conduct of business) was not matched over the past decade by a similar focus on developing the prudential regime. The other fundamental issue is whether, if the Bank is the macro-prudential regulator and the FSA (or a successor body) the micro-prudential regulator, we can be certain that nothing will fall through the crack between them. The regular exchange of letters proposed in the previous chapter, together with better close working between the Bank and FSA, addresses this issue but it is for further debate as to whether this will be enough. Considerations should also be given to the development of safeguards to stop things falling down the crack, but without causing unnecessary overlap in the responsibilities of the different authorities.
115.
116.
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Improving the efficacy of micro-prudential regulation

117. The key criticism levelled at the FSA regarding its regulation of financial institutions in the period prior to the crisis was that it was insufficiently focused on prudential regulation. One structural change that has been debated to address this issue is to divide responsibility for prudential and conduct of business regulation between separate regulatory agencies (the twin peaks model commonly associated with Australia and the Netherlands (see Box 9). The most compelling justification for this structure is that it reduces the risk that one element of financial regulation will be prioritised at the expense of the other. This has been highlighted by a range of sources, including the US Treasury, with specific reference to the FSA, and leading academic commentators: [Housing] all regulatory functions related to financial and consumer regulation in one entity may lead to varying degrees of focus on these key functions. Limited synergies in terms of regulation associated with financial and consumer protection may lead the regulator to focus more on one over the other. There may also be difficulties in allocating resources to these functions
US Treasury, Blueprint for a modernised regulatory structure, March 2008
[There] is a potential conflict of interest between prudential and conduct-ofbusiness regulation and supervision because of the different nature of their objectives. The former is focused on solvency while the focus of the latter is on consumer interests. The unified agency might give priority to one over the other. It might be judged that separate agencies responsible for dedicated types of regulation and supervision (i.e. prudential and conduct-of-business) might be more effective at focussing on their respective objectives and mandates.
Prof. David Llewellyn, Institutional structure of financial regulation and supervision: the basic issues, June 2006
118.
There are several further arguments in favour of a twin peaks model, which are set out below:
Conflicts between prudential and conduct of business regulation: There may be instances where the mandates in relation to prudential and conduct of business regulation lead to a conflict. For example, a conduct of business regulator might argue for early and full disclosure of a firms problems while a prudential regulator might put greater weight on the potential threat to market confidence in the institution of an early announcement. It may be argued that any decision which involves a trade-off between these two objectives is a political decision that must be taken openly and in the public interest, rather than being determined behind closed doors within a single regulator. Clear mandates and accountability: Under the twin peaks model each agency has dedicated objectives and a clear mandate, enabling them to be held to account more easily. Reputational risk: It may be argued that dividing prudential and conduct of business regulation limits the potential for contagion, where problems in one area of regulation contaminate the reputation of the regulator in the other area.
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Twin Peaks
Background
Box 9
The twin peaks model divides regulation on functional rather than sectoral lines. Regulation is divided between prudential regulation, which focuses on institutions financial viability, and conduct of business regulation, which centres on customer protection. The twin peaks approach assigns each of these areas to separate regulatory agencies.
Conduct of Business
Prudential
Central Bank
Function
Responsible for promoting transparency and for consumer protection It designs and enforces standards for behaviour in the financial market place
To prevent banks and other financial institutions from failing This includes monitoring capital reserves, enforcing legislation, and developing prudential standards and guidance
Lender of last resort in a crisis
Australia
Australian Securities and Investments Commission Autoriteit Financiele Markten
Australian Prudential Regulation Authority
Reserve Bank of Australia
The Netherlands
De Nederlandsche Bank
Relationship with Central Bank Both the Dutch and Australian central banks are responsible for safeguarding systemic stability and exercising lender of last resort functions In Australia, the prudential regulator is separate from the Reserve Bank, whereas in the Netherlands prudential regulation is managed by the Nederlandsche Bank. Certain writers therefore classify the Australian system as not two but three-peaked The Australian decision not to give the Reserve Bank prudential responsibilities was based on the belief that the Reserve Bank was ill-equipped to deal with institutions other than banks; that it voided the expectation that the central bank would automatically provide liquidity support in the event of a crisis; and that separation of the central banking and prudential functions would enable each institution to become more focused and efficient The Dutch decision to keep prudential regulation within the central bank was based on the view that there is a strong connection between prudential regulation and systemic stability, and that the information gathered through prudential regulation is important for effective systemic supervision
Information Collection/Sharing In Australia, the prudential regulator is also responsible for data collection for the financial sector. Other agencies may request the APRA to collect financial sector data for them, and the APRA estimates that approximately 80% of the data it collects is for other agencies APRA and ASIC maintain regular meeting and contacts at senior executive and operational levels. The AMF and the Dutch Central Bank are statutorily obliged to maintain regular contact
Relative Sizes/Capabilities The budget for APRA in the 2007-2008 budget was AUS $ 144.4 million, whilst the budget for ASIC for 2007-2008 was AUS $ 274 million
International Links The Dutch central bank represents the Netherlands in the Basel Committee and in the European Central Bank Australia is not a member of the Basel Committee, however APRA represents Australia on the International Liaison Group, which is the main channel of communication between the Committee and nonmembers
Source: The integration of financial regulatory authorities the Australian experience, APRA, De Nederlandsche Bank, AMF, Global Financial Regulation: the Essential Guide
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119.
However, there are also a number of costs associated with a shift to a twin peaks regulatory structure. The most important of these costs are highlighted below:
Managing conflicts: The advantages of publicly managing conflicts between conduct of business and prudential regulation may be outweighed by the disadvantages of this approach, including the potential for delays in resolving conflicts; the desirability of covert regulatory activity in some instances where an optimal response (from both a prudential and consumer interest perspective) depends on non disclosure; and the potential for separate agencies to blame each other for any mistakes made. Regulatory burden: Dividing micro-prudential and conduct of business regulation may lead to a duplication of regulatory oversight, for example by requiring banks to have multiple visits from separate regulators rather than a single visit from an integrated regulator. This duplication is likely to lead to an increased cost of regulation in terms of the regulatory burden on financial institutions and a need for greater resources within regulators. Splitting regulation across two agencies may also lead to the loss of economies of scale associated with costs such as IT systems, staffing and knowledge sharing. Quality of regulatory staff: It may be more difficult to recruit and retain the most talented and motivated staff to either institution under a twin peaks model. The possible impact on the quality of regulation would need careful consideration.
120.
An alternative option to splitting the FSA into separate regulatory agencies along the lines of the twin peaks model would be to reform its internal structure, with the main organisational division becoming the split between prudential and conduct of business streams in terms of management and oversight, resources, and links to the market and other Tripartite Authorities. This would broadly reflect the structure that was in place at the FSA from its creation until April 2004 (see Box 10) and would have the following benefits:
Management/executive oversight: The FSA does not currently have representation at the Board level for the individuals responsible for prudential policy and standards or conduct of business. Instead, the FSA Board reflects its organisational structure, with a split between Operations, Retail Markets and Wholesale/Institutional Markets. This shift would ensure any conflicts between prudential and conduct of business regulation, whether in terms of policy or resourcing, would be considered at FSA board level. Balance of resources: By internalising the twin peaks model within the FSA, it would be possible to allocate an appropriate balance of staff resources between the two strands of regulation, thus reducing the possibility that one strand will be more heavily resourced than another. By encouraging supervisory staff to become more specialised in a given area, this might have additional benefits of increasing the level of staff expertise in the FSA. The FSAs recruitment of specialist prudential and conduct of business senior advisers is a positive step in this regard. However, senior advisers are not intended to provide a day-to-day supervisory resource and therefore this will not be sufficient to address the wider resourcing issue within the FSA.
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Links to the market, general public, and other Authorities: A further benefit of this approach would be that the FSAs contacts within financial markets, the general public and the other Tripartite Authorities would have a greater degree of visibility regarding the individual responsible for prudential versus conduct of business regulation within the FSA. At the Board level, the head of prudential policy and standards could liaise with the management of the largest financial institutions, act as an FSA spokesman, and liaise with his/her counterparts in the Bank and HM Treasury on prudential issues. At lower levels, there could be greater visibility for financial institutions regarding the relevant individual within the FSA addressing prudential versus conduct of business issues for their firm.
121.
While, under this model, separate pools of supervisory staff within the FSA would be necessary if the advantages of a new internal structure are to be achieved, lead supervisory teams should be established for each financial services firm or group, to coordinate supervisory interaction and manage relationships. There should be a far stronger degree of co-operation than exists or is proposed for international supervisory colleges, but it should nevertheless be on similar principles. The lead team would then be the principal contributor to international supervisory colleges, strengthening appropriate specialisation and skills among supervisors. Transfers of staff between teams, together with common training and quality control processes, would assist. both in ensuring that the regulatory burden on firms was minimised and that supervision of the highest quality was maintained. Notwithstanding the relationship between the macro- and micro-prudential regulators, there remains a potential risk of underlap between them. One response to this risk could be to give the Bank, or the Tripartite Authorities collectively, statutory powers to take corrective action in the event that the micro-prudential regulator was not adequately addressing a threat to financial stability. For example, if, in the course of its analysis of market, sector and institutional data the Bank identified a threat to financial stability from certain risk exposures, then it might have the power to require that financial institutions limit or more carefully monitor risk exposures to certain asset classes or counterparties. If this were to be a collective power of the Tripartite Authorities, then in the event of a disagreement between the Bank and micro-prudential regulator, HM Treasury would effectively make the final decision. The potential advantages and disadvantages of combining macro- and micro-prudential regulation within the Bank should also be considered. On one hand, this would mean that the judgement on all prudential matters was in one body, clarifying accountability and enhancing the authority of the regulator. On the other hand, it would internalise the proposed challenge function between the macro- and micro-prudential regulator, risking a loss of clear focus on the distinct macro perspective and raising concerns over whether the conduct of monetary policy might be inappropriately influenced by concerns for the health of the financial sector. The main practical question with this model is how, in a world of integrated financial services firms which, for example, combine banking and insurance groups, the micro-prudential regulatory function could be split either along old-style bank, insurance, asset management etc. lines, or between systemic and non-systemic institutions. In addition to this concern, there would be a risk that making the Bank responsible for micro-prudential regulation would lead to challenges associated with prioritisation and management focus in relation to the Banks other responsibilities of maintaining monetary stability and maintaining financial stability from a macro-prudential standpoint.
122.
123.
124.
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FSA organisational charts February 2009 and June 1998

FSA Organisational Chart February 2009 (simplified)
Box 10
Chairman
Chief Executive Officer
Operations
Retail Markets
Wholesale & Institutional Markets
Cross FSA sector teams

Industry Sectors: Banking Sector | Insurance | Retail Intermediaries & Mortgage | Asset Management Thematic Sectors: Auditing and Accounting | Capital Markets | Financial Stability
Operations Divisions
Retail Markets Divisions
Wholesale & Institutional Markets Divisions
FSA Organisational Chart June 1998 (simplified)
Chairman
Managing Director & Managing Director & Chief Operating Officer Chief Operating Officer Managing Director & Managing Director & Chief Operating Officer Managing Director & Chief Operating Officer Chief Operating Officer Managing Director & Chief Operating Officer Human Resources & Human Resources & Business Planning Business Planning Divisions Divisions Human Resources & Human Resources & Business Planning Business Planning Divisions Divisions
Chairman Chief Executive Officer Chairman Managing Director & Head Managing Director & Head of Financial Supervision of Financial Supervision Managing Director & Head Managing Director & Head of Financial Supervision Managing Director & Head of Financial Supervision of Financial Supervision Managing Director & Head of Financial Supervision Financial Supervision Financial Supervision Divisions Divisions Financial Supervision Financial Supervision Divisions Divisions
Managing Director & Head Managing Director & Head of Authorisation, of Authorisation, Enforcement & Consumer Managing Director & Head Enforcement & Consumer Relations Managing Director & Head of Authorisation, Relations Managing Director & Head of Authorisation, Enforcement & Consumer of Authorisation, Enforcement & Consumer Relations Managing Director & Head Enforcement & Consumer Relations of Authorisation, Relations Enforcement & Consumer Authorisation, Relations Authorisation, Enforcement and Enforcement and Consumer Relations Consumer Relations Divisions Authorisation, Divisions Authorisation, Enforcement and Enforcement and Consumer Relations Consumer Relations Divisions Divisions
Source: FSA website, FSA Annual Reports, FSA The supervision of Northern Rock: a lessons learned review
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125.
The decision on restructuring the UKs system of financial regulation must be based on an analysis of costs and benefits of such a change. Under ordinary circumstances, structural reform is likely to lead to a number of costs and uncertainties, with particular risks including the loss of key personnel and the risk of unexpected problems during the change management process. [Change may introduce a] Pandoras Box effect: a bargaining process is opened between different interest groups; the legislative process might be captured by vested interests; loss of key personnel; [and] managerial diversion from the core activity of regulation and supervision
Prof. David Llewellyn, Institutional structure of financial regulation and supervision: the basic issues, June 2006
Having decided that fundamental reform to the regulatory structure is necessary, consideration would have to be given to the most appropriate time to implement these reforms and the most effective way in which to implement them, in order to minimise disruption to the ongoing efforts to deal with the financial crisis. 126. There is a very wide range of views regarding the ideal structure of prudential and conduct of business regulation in the UK and as the analysis above indicates there are arguments in favour of each proposal. However, in order to take the debate forward in a structured way, the following five options have been set out as meriting particular debate during the further consultation phase of this work:
1 The FSA should retain its present responsibilities but move to a new structure with
Prudential and Conduct of Business divisions at its heart, rather than its present structure focused on Retail and Wholesale divisions. This would ensure that the FSA had a better balance going forward between its prudential and conduct of business activities; that prudential regulation was put at the heart of the organisation; that the FSA was better placed to grow individuals with the appropriate skills and mindset to be cutting edge prudential regulators; and that there was a head of Prudential on the FSA board who could speak for the organisation and who could act as the key interface with the Bank on financial stability issues.
2 The FSA should be reorganised as in 1 but, in addition, there should be new statutory
powers for the Bank to take direct regulatory action in respect of individual regulated firms if it (or the Tripartite Authorities collectively) believed that there was a threat to overall financial market stability which was not being adequately addressed by action being taken by the FSA. This would create an additional safety net over what I have already proposed for the Banks new macro-prudential role. If this were to be a power of the Tripartite, rather than of the Bank, it would effectively be for the Treasury to decide in the face of a disagreement between the Bank and FSA.
3 The FSA should be abolished and replaced with two separate regulators, one with
responsibility for prudential regulation and one for conduct of business regulation. This would give complete clarity of purpose and focus to the two regulators but would pose challenges in co-ordinating the regulation of individual regulated firms and would mean that most firms would have to deal with an additional regulator.
4 A combination of models 2 and 3, with the Bank or Tripartite having power to step in over the
head of the prudential regulator in exceptional circumstances.

5 Under options 3 and 4, the micro-prudential regulator, of banks or of the whole financial
sector, could be folded into the Bank of England.
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Consideration should be given to the structure of the microprudential regime, with five options meriting particular debate: 1. Restructuring the internal organisation of the FSA to put prudential regulation at its centre 2. Restructuring the FSA as in 1 but giving the Bank/Tripartite additional statutory powers to take direct regulatory action in exceptional circumstances 3. Abolishing the FSA and replacing it with two separate regulators, one for prudential and one for conduct of business regulation 4. A combination of 2 and 3, with the Bank/Tripartite able to step in over the head of the micro-prudential regulator in exceptional circumstances 5. Under options 3 and 4, the micro-prudential regulator, of banks or of the whole financial sector, being folded into the Bank of England.
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Strengthening regulatory capabilities
Overview
127. 128. This chapter discusses each Authority in turn and sets out the key areas in which they may strengthen their capabilities in delivering their proposed regulatory roles. The discussion emphasises areas where changes to the role of the Authority or previous observed weaknesses in their handling of regulation imply a need for improved capabilities.
Bank of England
Strengthening the Banks Financial Stability capability 129. The proposed regulatory framework will require the Bank of Englands Financial Stability function to play a greater role because of its responsibility for macro-prudential regulation. However, the resources available within the Financial Stability Directorate have declined significantly in recent years, with staff numbers reduced from approximately 180 in June 2003 to 120 in April 2008. This has been highlighted by Sir John Gieve in his recent speech to the London School of Economics and Political Science: [Financial Stability] was not mentioned in the 1998 Act and appeared something of an orphan in the Bank when supervision moved to the FSA
Sir John Gieve, Speech to the London School of Economics and Political Science, February 2009
130.
While we recognise that the quality of oversight depends primarily on the effectiveness of people involved rather than on the level of resource available, staff numbers in the Banks Financial Stability team may need to be increased in light of the proposed extension of the Banks role. It will be a matter for the Governor and Court, on the recommendation of the Deputy Governor for Financial Stability, to decide what additional quantity and quality of resource will be needed to fulfil this remit. Strengthening the Banks governance and access to external advice in relation to Financial Stability
131.
The Banks delivery of its financial stability remit including its macro-prudential responsibility and its role in relation to the resolution regime will be supported to the extent that the Bank can strengthen its governance in relation to Financial Stability and improve its access to advice from expert outsiders.
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132.
The Financial Stability work of the Bank is not currently subject to the same level of oversight and accountability as for Monetary Stability. There remains a discrepancy in the governance responsibilities of the Banks Non-Executive Directors in relation to Financial Stability and Monetary Stability. According to the Bank of Englands 2007 annual report, the Non-Executive Directors are responsible for: Reviewing the performance of the Bank in relation to its objectives and strategy, monitoring its financial management, and reviewing the procedures of the MPC
Bank of Englands 2007 Annual Report
133.
The problems associated with the absence of a stated role for the Non-Executive Directors in relation to the Banks Financial Stability work were recognised by a formal Board evaluation in 2006. During 2006/07, [the Committee of non-executive Directors] considered how it could increase its engagement and familiarity with the Banks financial stability work ... Greater engagement is desirable so that non-executive Directors can assess the approach, processes and resources employed more effectively, consistent with their responsibilities to review performance against objectives.
Bank of Englands 2007 Annual Report
134.
Progress was subsequently made, with the introduction of quarterly financial stability reports to the Court of Directors and the introduction of regular attendance of the Risk Policy subCommittee of the Court at Financial Stability Board meetings. However, the Risk Policy Committee was dissolved in 2007 and the Banks 2007 Annual Report contains relatively little reference to financial stability oversight. The apparent weakness of the Banks internal oversight of its financial stability is also reflected in the lack of a public assessment of its own conduct in the period leading up to the collapse of Northern Rock, which is striking given the FSAs internal review of its performance. The Bank should produce such a report in order to assure the public that any lessons have been learnt and to strengthen public confidence in the Bank. Given the proposed increase in the Banks financial stability role, it is desirable to strengthen the Banks governance in relation to financial stability to ensure that a transparent process is followed when making financial stability decisions, with clear lines of accountability between executive decision-makers and the non-executive Directors responsible for overseeing the work of the Bank. There will also be an increased need to ensure that decisions on financial stability are taken with input from across the Banks executive, in order to ensure that insight from the Monetary Stability, Financial Stability, Markets and Banking directorates at the Bank are taken into account. The Bank would benefit from an advisory board that would provide its executives responsible for financial stability with a formal channel to access independent sources of expert advice. The Financial Stability Committee (FSC) to be established under the Banking Act, 2009 (see Box 11) has been developed with the intention of increasing the Banks access to sources of expert advice. However, there has been a significant degree of confusion regarding its potential executive powers. For example, references by the Chancellor to the similarity between the FSC and the Monetary Policy Committee, as well as the FSCs structural position as a subcommittee to the Court of the Bank, suggest that it will have executive functions:
135.
136.
137.
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[We] will build on the very positive experience of the Bank's Monetary Policy Committee
Alastair Darling, Mansion House speech, June 2008
Submissions by HM Treasury to the Treasury Select Committee have not clarified whether the FSC will be advisory or executive in nature: The primary function of the committee will be advisory, providing an effective source of expertise and guidance to the Banks executives and staff on the execution of the policy levers it has, relating to financial stability such as the SRR... It will also advise Court on the overall strategy for developing and implementing the Banks financial stability objective. The legislation is appropriately flexible, allowing for the role of the Committee to evolve, and for Court to delegate further responsibilities to it, for the purpose of pursuing the Financial Stability Objective
HM Treasury, Written response to Treasury Select Committee, October 2008
138.
The FSC in its proposed form will conflate the objectives of strengthening the workings of the Banks executive in relation to financial stability and providing it with access to independent expert advice. These issues should be dealt with separately and we have discussed potential reforms to the Banks executive above. The Banks Board of Banking Supervision was used in the past as a means of ensuring that senior officials within the Bank were able to call upon expert advice from market practitioners (see Box 12).
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Board of Banking Supervision
Box 12
Background The Board was created following the 1987 the Banking Act. It comprised the Governor of the Bank of England, the Deputy Governor, the executive director of the Bank responsible for banking supervision, and six independent members, who were primarily bankers active in the market place and jointly appointed by the Governor and the Bank of the Exchequer It was set up with the objective of bringing in external expertise to inform the Banks decisions on financial stability The responsibilities of the Board included giving advice to the Bank in matters relating to financial sector supervision, justifying the advice it has given to the Bank to the Chancellor, and producing an annual report explaining any disagreements between the Board and Bank of England that were reported to the Chancellor
Composition of the Board
Chair (Governor of the Bank of England)
Other exofficio members of the Board
Independent Members
Deputy Governor (BoE)
Executive Director (BoE)
Six independent members
Source: Bank of England, Banking Supervision: Regulation of the UK Banking Sector under the Banking Act 1987
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139.
The Board of Banking Supervision, which operated in the period prior to the creation of the FSA, provides a model for creating a new advisory board. The Bank should consider developing an analogous solution to its ongoing requirement for expert advice or reconstituting the Financial Stability Committee to be a truly advisory panel. The advisory board should be chaired by the Deputy Governor for Financial Stability and should meet quarterly. In order to ensure that the advisory board has an appropriate mix of skills and experience, and to reduce the potential for conflicts of interests to prevent particular members from participation, consideration should be given to the appropriate mix of current and retired market practitioners, as well as the range of skills between those members with financial, legal and accountancy backgrounds. A rather more radical idea is that, instead of the present Court/MPC governance structure, the Bank should be governed by one board looking somewhat like the present MPC but with additional members with expertise relevant to the financial stability objective. This board, similar to that of the Federal Reserve in the USA, would execute both the monetary policy and financial stability remits of the Bank. Although the challenge function of independent non-executive directors would be lost, this is a model worth debating: it is difficult to understand why public sector bodies, which usually have very different functions and accountabilities to private sector companies, should increasingly, and unthinkingly, have to ape the standard private sector corporate governance model. There is also a need to clarify the role of the Deputy Governor for Financial Stability, and the qualifications required of applicants to the position. This role is central to the Banks engagement with financial markets, as well as its overall financial stability work, and therefore it may be desirable for the Deputy Governor to have had previous experience outside the Bank. On the other hand, we recognise the value of creating opportunities for internal promotion within the Bank, in order to ensure it can recruit and retain the most talented staff, and therefore the Bank should take steps to ensure that its own staff have opportunities to gain this direct market experience via a programme of secondments. There should be a published definition of the role and the skill set required of a prospective Deputy Governor for Financial Stability. This will then allow for proper succession planning which should start soon after the appointment of the Deputy Governor.
140.
141.
Recommendation (17): Recommendation (18): Recommendation (19):
The Banks executive should consider whether it requires more resources to deliver its enhanced Financial Stability mandate. The Bank should strengthen its governance in relation to Financial Stability. The Bank of England should produce a public assessment of its own conduct in the period leading up to the collapse of Northern Rock. The remit of the Banks Financial Stability Committee established under the Banking Act, 2009 should be amended to remove any executive function and to make it an advisory group of market experts. The Bank should clarify the role and qualifications required for the Deputy Governor for Financial Stability and take steps to plan for the succession of future Deputy Governors.
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Financial Services Authority

Financial crime and consumer education 142. The potential changes to the FSAs role, responsibilities and internal structure were outlined in the previous chapter. With a much greater focus on prudential regulation at the heart of the organisation, or by creating a separate prudential regulator, the task should be clearer but it will not be easy and will take a number of years, involving a mix of growing talent internally as well as hiring in people from the market, either on a permanent or secondment basis. Should the FSA retain its role in prudential regulation, its focus will be improved to the extent that it can shed any of its present policy areas. The FSA currently has two further statutory objectives in addition to its micro-prudential and conduct of business responsibilities: reducing financial crime; and promoting public understanding of the financial system. Allocating these responsibilities to other regulatory or public bodies would allow the FSA to focus more resources and management time on its core regulatory responsibilities. Further analysis is required before making a definitive commitment to reallocate these responsibilities, however we have included a brief overview of the FSAs role in both of these areas below, along with commentary on the issues associated with allocating these roles to another body. Such an analysis could be linked to a wider review of the framework for tackling financial crime which many argue is currently failing. The FSAs role with respect to reducing financial crime is complex, as there is a wide range of public authorities engaged in reducing financial crime in the UK and there is also a greater degree of overlap with some areas of the FSAs regulatory responsibilities. However, the FSA, in consultation with other public authorities involved in reducing financial crime, should consider ways in which it can limit its role in order to increase the focus on prudential regulation without undermining the UKs response to the threat of financial crime. The FSAs responsibility for monitoring financial institutions systems and controls to prevent financial crime (primarily money laundering) is one area where the FSA may be able to reduce its responsibilities without materially undermining the UKs capabilities in reducing financial crime. In the US, the Treasury is responsible for working with financial institutions to reduce money laundering (see Box 13), and it would be possible to build up the existing HM Treasury Financial Crime team in the UK to take on this role. The FSA also has a role in working to prevent criminal fraud from boiler room schemes, where groups of professional criminals seek to defraud consumers, although this role has been challenged in the High Court. There are very limited synergies between this work and the FSAs regulatory role, while transferring responsibility to law enforcement agencies such as the Serious Organised Crime Agency might be expected to yield benefits by pooling expertise in combating organised financial crime. The FSAs responsibilities as market supervisor mean that it would continue to have clear responsibilities in relation to market related financial crime, with a statutory duty to prosecute insider dealing and the offence of making misleading statements about the price or value of investments with a view to inducing others to trade. Other prosecutors appear to accept that the FSA has the lead responsibility in this area, and have not initiated any new proceedings relating to these crimes committed after 2002. The FSA is able to apply a range of financial, civil and criminal sanctions in this area that other agencies cannot and therefore may be better resourced to retain its role in reducing market related financial crime.
143.
144.
145.
146.
147.
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148.
This issue was the subject of an article by Sir Ken Macdonald, QC, former Director of Public Prosecutions, in The Times on 23 February, 2009, in which he wrote: In Britain, no one has any confidence that fraud in the banks will be prosecuted as crime. But it is absolutely critical to public confidence that it should be ... So we need a single powerful authority to take the place of the failed Financial Services Authority and the embattled Serious Fraud Office. Independent and strong, it should have responsibility for both regulation and prosecution
Sir Ken Macdonald, Article in The Times, February 2009
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Financial Crime
US Model
Securities and Exchange Commission Location Independent agency of the government Holds primary responsibility for regulating and enforcing laws related to the securities industry Financial Crime Enforcement Network Operates under the US Treasury Collects and analyses information on financial transactions in order to combat financial crimes Office of Terrorism and Financial Intelligence Operates under the US Treasury Consists of Office of Terrorist Financing and Financial Crime and the Office of Intelligence and Analysis. Focuses on combating money laundering and terrorist financing domestically and internationally Asset Forfeiture and Money Laundering Section Department of Justice, Criminal Division Focuses on legislative and policy proposals affecting asset forfeiture
Box 13
Federal Bureau of Investigation Law enforcement agency Promotes the investigation and prosecution of money laundering across the US
Main functions in relation to financial crime
Further/other responsibilities
Has the power to bring civil enforcement actions against firms or individuals in breach of federal law
Also responsible for developing and enforcing regulation relating to the Bank Secrecy Act
Coordinates investigations and prosecutions and manages the centralized asset forfeiture programme
UK Model
City of London Police The Serious Fraud Office (SFO) Government Department Fraud Prosecution Service Part of the Crown Prosecution Service Has as its mandate to pursue and prosecute those involved in serious and complex frauds. Cooperates closely with the SFO, but generally deals with cases involving lower monetary values (starting from 750k) HM Revenue and Customs Prosecution Office Government Department Department of Business, Enterprise & Regulatory Reform Government Department Financial Services Authority
Location
Law Enforcement Agency
Independent Regulator
Main functions in relation to financial crime
The lead force for investigating economic crime across the UK and especially in the City. Is involved in investigating and prosecuting cases involving fraud and money laundering
Has as its mandate to pursue and prosecute those involved in serious and complex fraud. Primarily focuses on frauds where the amount in issue is larger than 1m
Prosecutes cases of financial crime investigated by HM Revenue and Customs and the Serious Organised Crime Agency (SOCA). Handles cases involving tax fraud and money laundering
Investigates cases of suspected fraud that arise from its general work. Investigations into suspected crime are conducted by its companies investigation branch. Leads on action to close firms which persistently fail to meet the requirements of the Companies Acts
Investigates insider dealing, money laundering, forgery and more specific offenses under the strategy of credible deterrence. It may apply three penalties: financial, civil penalties or criminal prosecution. Although its marketrelated duties are clear under the 2000 Act, recently it has also been reviewing its status in prosecuting nonmarket crimes
In addition, the National Fraud Strategic Authority was created on the 1st of October, 2008. However, this agency is still very much in its infancy, and its role and responsibilities vis--vis the existing financial crime agencies remain unclear.
Sources: Securities and Exchange Commission, Financial Crime Enforcement Network, US Treasury, Financial Action Task Force, Financial Services Authority, HM Revenue and Customs, The Serious Fraud Office, Fraud Prosecution Service, Department of Business, Enterprise and Regulatory Reform, City of London Police
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149.
The FSA is currently the only UK body with a statutory objective to promote public understanding of the financial system. The FSAs role in this respect has been enhanced following the Thoresen Review of generic financial advice, which recommended that the FSA should be made responsible for the provision of Money Guidance, in addition to its ongoing role in promoting public understanding of the financial system. The FSAs capability and effectiveness in consumer financial education is widely recognised and there are no other public bodies in the UK with a significant existing capability in this area, so carving out the FSAs consumer education team represents a risk in terms of costs of change and potential impact on the quality of provision. However there are limited synergies with the remainder of the organisation and there are successful alternative models for the provision of financial education internationally (see Box 14). As a short to medium term recommendation, we believe that the FSA should continue to take steps to ensure that the consumer education team, including FSAs responsibility for Money Guidance, is managed and resourced separately from its regulatory teams, with a view to minimising the potential for the FSAs consumer education role to reduce the FSAs focus on prudential regulation and to reduce the potential costs of a future carve out of consumer education from the FSA.
Financial Education
Background
Box 14
Under the New Zealand system, consumer financial education is separate from the financial regulator, and is primarily the responsibility of the Retirement Commission. The Ministry of Consumer Affairs supplements the education provided by the Retirement Commission by providing further educational resources for school children The Retirement Commission The Retirement Commission is an autonomous entity funded by the government and delivering financial education to New Zealanders is one of its key functions The Commission has been involved in developing personal financial education programmes since the mid-1990s.The Commissions status as an autonomous entity means that it has a degree of independence from the government, although it is required to have regard to government policy The Commission focuses on financial literacy, which it defines as the ability to make informed judgments and take effective decisions regarding the use of and management of money The Commission runs a web-site called sorted.org.nz for the purpose of assisting adults in managing their finances. The web-site targets all demographic groups In addition, the Commission also runs surveys to assess financial literacy among adults, evaluates its impact on consumer awareness, and designs strategies for reaching the most vulnerable groups The Ministry of Consumer Affairs The Ministry of Consumer Affairs, which is a part of the Ministry of Economic Development, also has the provision of appropriate, accurate and accessible information, education and advice for consumers and businesses as part of its remit This primarily involves advice on consumer representation, administration of consumer legislation, and development of consumer policy In terms of financial education, the Ministry focuses on supplementing the Retirement Commissions work with school children by providing further educational resources for teachers
Comparison with the UK In the UK financial education is the responsibility of the financial regulator, the FSA. The FSA is currently the only agency responsible for consumer education The FSAs Financial Capability team (in charge of consumer awareness) is part of Retail Markets The FSA similarly runs a financial education web-site: moneymadeclear.fsa.gov.uk The FSA has also been made responsible for the governments scheme to provide generic financial advice following the Thoresen Review
Source: New Zealand Ministry of Consumer Affairs, New Zealand Retirement Commission, Financial Services Authority, OECD
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Resources and expertise 150. There appears to be confusion among many regulated institutions and market participants regarding the steps being taken by the FSA to strengthen its regulatory capabilities; the FSA has not yet convinced financial institutions that its ongoing work to build its capability is delivering results. We have been heard concerns expressed regarding the level of remuneration, expertise and market experience of FSA supervisory staff, with the head of one major UK financial group expressing a willingness to incur greater costs through the regulatory levy to help the FSA build its capability. The FSA should increase further its ability to recruit and incentivise highly experienced supervisors and policymakers from the private sector and maintain the attractiveness of a career in regulation for its most talented junior staff by offering clear avenues for rewarding career progression. The recommendations set out within Reconstruction: Plan for a Strong Economy in September 2008 to increase the levy on financial services firms to fund an increase in FSA remuneration and to require financial institutions to participate in a secondment scheme will help in this regard. The FSAs business plan for 2009/10 also clearly recognises these issues: In response [to the Internal Audit report], the FSA designed and launched a Supervisory Enhancement Programme which entails important changes in our internal processes, a significant intensification of our supervision of large systemically important firms, and major investment in the number and skills of our staff devoted to that supervision. In total, about 280 additional staff will be recruited We will have appointed around 280 staff involved in the supervisory process in the first half of 2009/10, through external recruitment and staff deployment. External recruitment will be used to fill specific skills or knowledge requirements and ensure the right mix of regulatory and market experience
FSA Business Plan 2009/10
151.
The Authorities should consider transferring responsibility for financial crime policy out of the FSA. This could be linked to a wider review of the framework for tackling financial crime. The Government and FSA should review the latters role in relation to consumer awareness. The FSA should increase further its ability to recruit and incentivise highly experienced supervisors and policymakers from the private sector.
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HM Treasury
152. HM Treasury will continue to play a pivotal role in maintaining the UKs financial stability, due to its role in developing the Governments fiscal policy and its decision-making role as part of the Tripartite Authorities, particularly where the Authorities are required to make decisions involving public finances in the event of an institutional failure. It has been suggested by a number of parties that HM Treasury lacked the resources and expertise to fulfil these roles in the period preceding and immediately following the start of the financial crisis in mid-2007. While we recognise that HM Treasury has strengthened its capabilities since that time, there remains scope for further improvement, particularly in the quality of HM Treasurys financial markets expertise. There remains a risk that HM Treasurys capabilities with regard to the financial stability are downgraded when the current crisis subsides, as other issues take greater priority. The evidence from the current crisis demonstrates that financial stability is of such centrality to the UK economy that HM Treasury must retain sufficient resources and capabilities to participate as an equal in the decision-making process with the other Tripartite Authorities in the event of a future financial crisis. To preserve this capability, the Permanent Secretary should set out in HM Treasurys annual report to Parliament how HM Treasury resources devoted to handling issues of financial stability have been developed and maintained during the year. Related to this point is the short duration of many HM Treasury postings, where it is desirable to incentivise officials to spend a greater amount of time in a post in order to build up their expertise in financial stability issues. In addition to reporting to Parliament on the appropriateness of its capabilities, HM Treasury should also evaluate the overall financial stability legislative and regulatory framework every three years. The Treasurys internal organisation may need to be strengthened in order to support this financial stability role. One of HM Treasurys key resources for crisis handling should be its Corporate Finance team, which also has a working relationship with the Governments central repository of corporate advisory skills, the Shareholder Executive. These resources need to be used effectively to manage the Governments response to future financial crises, and as such consideration should be given to putting at least the Corporate Finance team into the same Treasury division as Financial Services. The Government should also consider placing all the private sector facing policy areas of the Treasury, including financial services, corporate finance and enterprise, into a single directorate in order to more effectively coordinate the Government response to future financial crises. Recommendation (25): Recommendation (26): HM Treasury should maintain a sufficient financial markets expertise at all times. The Permanent Secretary to the Treasury should report annually to Parliament on the appropriateness of HM Treasurys expertise and resources in relation to financial stability. HM Treasury should report every three years on the appropriateness of the legislative and regulatory framework for financial stability. HM Treasurys Corporate Finance team should be put into the same HM Treasury division as financial services policy.
153.
154.
155.
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Inter-authority and international relationships
Overview
156. This chapter discusses the links between the Authorities that will be required to operate successfully under the proposed new framework and considers the respective responsibilities of the Authorities for international negotiations and relationships.
Placing an institution into the Special Resolution Regime

Determining whether an institution is systemic 157. One of the key areas of overlap under the Tripartite system concerns decision-making when a financial institution fails or is at risk of failing. This requires the Tripartite Authorities to make a decision regarding whether an institution is systemic and whether/when to put an institution into the Special Resolution Regime (SRR). An assessment of whether an institution should be provided with liquidity support or placed into the SRR in the event of its failure depends upon a judgement regarding whether a disorderly failure could have systemic effects. There is currently a lack of transparency around the criteria used to determine whether an institution is systemic, leading to the risk that decision-making may become politicised in the event of an institutional failure. In order to limit this risk, the Authorities should maintain a list of systemically important institutions at all times, based on clear published criteria (see Box 15 below for an overview of the US CAMELS criteria for determining the ongoing viability of a bank). To avoid concerns around moral hazard, this list should not be made public but should be subject to Parliamentary scrutiny in the event of a decision to support an institution or to allow it to fail. While it is recognised that the question of which institution is or is not systemic will, to some extent, be situation specific, the existence of a standing list will form a useful starting point for discussions by the Authorities. It should go some way to heading off, for example, the perhaps understandable assumption of some politicians for whom financial stability is not an every day concern that if a financial institution has, say, a concentration of customers in a particular geographic region of the UK that, in itself, makes the institution systemic. The creation and maintenance of a list of systemic institutions should be the responsibility of the Bank of England, because of its responsibility for systemic stability and its additional roles in relation to the payments system. The Bank should compile and maintain this list in consultation with the micro-prudential regulator, as the micro-prudential regulator will have a greater level of familiarity with individual institutions management and financial data.
158.
159.
160.
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US CAMELS ratings
Background
Box 15
The United States does not keep a general list of criteria to draw on in deciding which institutions to recapitalise in the event of financial crises however, in dealing with the most recent downturn, the US Treasury has made use of CAMELS ratings to form an impression of which institutions may be financially viable in the longer term CAMELS ratings are a number from one to five which reflects an assessment by regulators of the institution, and provides a snapshot view of a banks financial condition The United States does not keep a list of systemically important institutions Use of ratings CAMELS ratings are used by the three federal banking supervisors (the Federal Reserve, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency) and other financial supervisory agencies to provide an overview of a banks financial condition. CAMELS ratings may be used to assess a banks current condition as well as to help assess the probability of bank failure In order to prevent bank runs, an institutions CAMELS score is not made public but made available only to top management of the institution and the appropriate supervisory staff. Institutions receive a number from one to five, with 1 being the most favourable An institutions CAMELS score also determines the risk-based premium it pays to the Federal Deposit Insurance Corporation and deposits in institutions with a score less than 3 will not be insured In the case of the recent US bank support operations, which were approved through the Emergency Economic Stabilization Act, CAMELS ratings were among the criteria used to decide which institutions should qualify for support
CAMELS ratings CAMEL ratings were introduced by the Federal Reserve in 1979, with the S for Sensitivity added in 1996 CAMELS ratings are based on financial statements provided by the bank as well as inspections by the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation. CAMELS stands for Capital adequacy, Asset quality, Management, Earnings, Liquidity and Sensitivity to market risk Each one of the criteria under CAMELS is assessed following a number of evaluation factors outlined under the revised Uniform Financial Institutions Rating System (UFIRS)
Sources: Federal Reserve Bank of San Francisco, US Treasury, Federal Deposit Insurance Corporation
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The trigger mechanism 161. There has been considerable debate regarding which Authority should be responsible for the trigger mechanism, the decision to put an institution into the SRR. Under the Banking Act 2009, the FSA will be the sole institution with the right to pull the trigger, although it must consult the Bank and HM Treasury before doing so: [Initiation] of the regime would be subject to an assessment by the FSA ... [although this decision would] only be taken following intensive discussion and consultation between the Treasury, the Bank of England, and the FSA through the Standing Committee
Tripartite Authorities, Financial stability and depositor protection: special resolution regime, July 2008
162.
However, the Governor of the Bank of England and other respondents to the Treasury Select Committee have expressed concern that giving the FSA the exclusive right to recommend that an institution should be placed into the resolution regime may lead to the risk of regulatory forbearance and have argued that the Bank should also be able to recommend that an institution be placed into the resolution regime: I do not think that [a recommendation to place an institution into the resolution regime] should be left entirely with the supervisor, because, as many of my overseas colleagues never cease to point out, the reason why they have someone other than the supervisor with the ability to pull the trigger is because of their concerns about regulatory forbearance, the natural reluctance of a supervisor to announce publicly that the supervision regime has not been successful
Mervyn King, Evidence to the Treasury Select Committee, April 2008
163.
We recommend, in line with the Treasury Select Committee, that the FSA (or its successor body responsible for micro-prudential regulation) should retain sole responsibility for pulling the trigger, but that the Bank should be given a formal power in statute to recommend that an institution be placed into the resolution regime.
The Bank of England, in consultation with the micro-prudential regulator, should maintain a confidential list of systemically important financial institutions. The Bank of England should have a statutory right to recommend to the micro-prudential regulator that an institution be placed into the Special Resolution Regime.
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Strengthening public communication

164. A further critical function during periods of institutional stress or failure is to manage communications with financial markets and consumers, to minimise the risks of contagion prior to or following an institutional failure. The central importance of confidence in the financial system requires that a premium is placed on maintaining confidence in systemic stability, as a loss of confidence can lead to systemic collapse and the inability of the banking system to perform its maturity transformation role. Regulators have a key role in maintaining confidence in the financial system during periods of institutional stress or failure, to avoid creating the (potentially self-fulfilling) impression that an institutional failure might cause systemic failure, and this role requires them to communicate effectively with financial markets and consumers to maintain confidence. Each of the Tripartite Authorities will have a significant role to play in communicating with the public and markets in the event of institutional stress or failure; by communicating in an integrated way the Authorities can have a positive impact on maintaining confidence in the UKs financial system and the effectiveness of its regulatory agencies. However, the lead role in communicating with the public in the event of an emerging threat to financial stability should be played by HM Treasury, specifically the Chancellor of the Exchequer, since this will serve to emphasise the level of engagement by the political leadership to prevent systemic collapse and to protect depositors. The continuous stream of leaks of market sensitive information to the press during the crisis emphasises the need for members of the Tripartite Authorities to be given regular training in the rules concerning the handling of price sensitive information. The Authorities should also consider whether sufficient investigation has been carried out into the leaks of price sensitive information to the media since September 2007, including the leaking of the liquidity support operation for Northern Rock in September 2007 (see Box 4) and the bank recapitalisation package in October 2008.
165.
166.
The Tripartite Authorities Principals should play an active role in communicating with markets and the general public in the event of institutional stress or failure, but the lead role should be played by the Chancellor of the Exchequer. Members of the Tripartite Authorities should be given regular training in the rules concerning the handling of price sensitive information. The Authorities should consider whether sufficient investigation has been carried out into the leaks of price sensitive information to the media since September 2007.
Improving the co-operation between the Tripartite Authorities

Meetings between the Tripartite Principals 167. There are no publically available records or minutes of meetings between the Tripartite Principals. However, we have been told that there was only one formal meeting of all three Principals in the ten years prior to the collapse of Northern Rock. The lack of a personal working relationship between the Principals may have contributed to the slowness and uncertainty of the regulatory response to the crisis in mid-2007 and should be avoided in the future. There should be much more frequent meetings of the Principals, consisting of:
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At least three formal meetings of the Principals and the Standing Committee Deputies per year, at which the Principals would be fully briefed on issues discussed by the Deputies and their teams in the previous three months At least three informal sessions between the Principals per year, to allow them to develop a common understanding of each others perspectives regarding key issues in relation to financial stability
168.
A model for regular principal interaction can be found in the US Presidents Working Group (see Box 16). Although this particular model may not be applicable for the UK, it provides a useful example of institutionalisation of interaction at the most senior level. Relationships at other levels
169.
In addition to the working sessions between the Tripartite Principals and Deputies, it will be valuable for the Executive Directors of the Bank and the micro-prudential regulator to hold regular sessions, perhaps for one day a quarter, to share their thinking on the macro-analysis. Efforts should also be made to build stronger links between staff at more junior levels of the Tripartite Authorities. The detailed operational plans to strengthen links between the Authorities should be made by the leaderships of each Authority, however they should consider:
170.
Secondments: Staff should be seconded between the Authorities (as well as to financial institutions). These secondments should typically be for a sufficiently long time to allow secondees to build up a detailed understanding of the workings of the other Authorities and to develop sustainable working relationships that can be maintained following the conclusion of the secondment. The Authorities should consider making it a prerequisite for promotion to senior executive level for candidates to have completed a secondment to another Authority or financial institution, unless they have been hired externally. Training: Regulatory staff should be given training regarding the responsibilities and functions of the other Authorities as part of their basic training programmes. Where staff are required to develop similar skills or expertise, the Authorities should also consider running joint training sessions to enable junior staff to develop contacts and shared patterns of working across the Authorities. Briefings: In addition to the regular interaction between senior officials regarding current financial stability issues, more junior staff should be given joint briefings on a regular basis. Informal meetings: The Authorities should take steps to encourage informal meetings between staff at various levels of their organisations, by organising lunch meetings or away days to facilitate relationship building.
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Presidents Working Group on Financial Markets

Background
Box 16
The Presidents Working Group on Financial Markets (PWG) was established by executive order after the 1987 stock market crash. It was created with the purpose of making recommendations regarding "enhancing the integrity, efficiency, orderliness, and competitiveness of [United States] financial markets and maintaining investor confidence (Executive Order 12631) The Group consists of the Secretary of the Treasury, who chairs the Group, and the Chairman of the Federal Reserve, the Chairman of the Securities and Exchange Commission, and the Chairman of the Commodity Futures Trading Commission. However, other federal financial supervisors such as the Office of the Comptroller of the Currency and the Federal Reserve Bank of New York may be invited to participate in discussions as appropriate
Roles and Responsibilities
Since 1987, the PWG has interpreted its role broadly and issued reports and recommendations on areas covering terrorism risk insurance, hedge funds and other pools of capital, over-the counter derivates, the Commodity Exchange Act and financial contract netting, with a view of informing policymakers and market participants The PWG is often called upon by Congress to provide a view on current financial events, both formally and informally. It also serves as an informal mechanism for various regulatory agencies to discuss relevant policy initiatives
Advantages

Frequent interaction between the heads of the four agencies through meetings, discussion groups and joint research means there is a shared understanding of current developments in the financial market place Maintaining a close relationship and understanding of current thinking within the different agencies also increases the probability of presenting a successful and swift response in the event of a financial market crisis The institutionalisation of a separate group of senior financial regulators with a mandate for coordination and communication also increases certainty in the market place, as PWG issues joint statements during crises
Areas to Improve
In the US Treasury report Blueprint for a Modernized Financial Regulatory Structure from March 2008, the Treasury suggests a number of measures should be taken to clarify the mission and reinforce the purpose of the group as a mechanism for coordination and communication First, this includes having a new Executive Order reinforcing PWG as an ongoing financial policy coordination and communication mechanism, and giving the PWG a mandate to focus on the financial sector more broadly rather than just addressing financial markets Second, it would clarify the PWGs objectives: mitigating systemic risk to the financial system; enhancing financial market integrity; promoting investor and consumer protection; and promoting capital markets efficiency and effectiveness Third, it should expand its membership to include the heads of the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Office of Thrift Supervision Fourth, the Order should clarify that the PWG should have the ability to issue reports or documents to the Presidents and others as appropriate
Source: US Treasury, Blueprint for a Modernized Financial Regulatory Structure
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Creation of a secretariat to the Tripartite Authorities 171. The Treasury Select Committee has recommended that the Tripartite Authorities create a permanent secretariat for the Standing Committee on Financial Stability: We believe that it is essential that, if the Tripartite Standing Committee is to function effectively, it must have distinct staffing arrangements to ensure appropriate levels of continuity and expertise. We recommend the establishment of a small central secretariat for the Standing Committee on Financial Stability, including staff drawn from the Treasury, the FSA and the Bank of England as well as from other organisations. This secretariat would play a crucial role in ensuring the capacity of the Committee to undertake the functions identified in this Report. We would expect all three Principals on the Standing Committee to have a say in the appointment of the Head of the Secretariat
Treasury Select Committee, Banking Reform, September 2008
172.
In its response to the Treasury Select Committee, HM Treasury has stated its opposition to the creation of a permanent secretariat to the Standing Committee, as the staffing resources to the Standing Committee are already provided by HM Treasury: The secretariat for Standing Committee is currently provided by the Treasury. The Treasury will consider whether additional staffing is required for this function. The Government notes that, in the last year, the Bank of England, FSA and Treasury have all significantly increased resources in the area of financial stability in response to recent events. The Authorities will need to consider what an appropriate steady state level of staffing should be.
HM Treasury, Response to Treasury Select Committee, October 2008
173.
We do not believe it is necessary for a new secretariat to the Standing Committee to be created, as staffing support is already provided by HM Treasury. Decisions on the appropriateness of the resources available to the Standing Committee should be taken by HM Treasury in consultation with the Bank and FSA. Recommendation (34): Recommendation (35): The Tripartite Principals should meet formally at least three times a year and have an additional three informal meetings a year. The Authorities should strengthen links at more junior levels through a programme of secondments, training, joint briefings and informal meetings. The secretariat to the Standing Committee should continue to be provided by HM Treasury.
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The Memorandum of Understanding (MoU)

174. The MoU is currently unclear on a number of basic issues, not least whether the independence of the Bank of England should include financial stability issues. The difficulty arises partly because the same action (provision of liquidity to the market), implemented using the same or similar operational instruments (outright purchase by or repo to the Bank of certain securities), is relevant both to the implementation of monetary policy, where the Bank does indeed have independence, but potentially also to the maintenance of financial stability. A partial resolution of the problem, in the context of an amended MoU setting out a revised general framework for dealing with financial stability issues, might lie in determining that operations which fall within the scope of the Bank's Red Book - the public statement of its monetary operating procedures would be matters for decision by the Bank while operations outside that framework would be matters for HM Treasury. But this would in turn raise a number of questions which deserve further consideration.
The Memorandum of Understanding should reflect all the proposals in this report, making clear which Authority is responsible for each regulatory function.
Working relationships with international regulatory bodies

175. The global origins of the current financial crisis were highlighted in the earlier analysis of the causes of the crisis. Given the highly globalised nature of the financial system, it is likely that future financial crises in the UK will be triggered at least partly by international developments and therefore the UKs Tripartite Authorities need to develop closer working relationships with international regulatory bodies (both supranational and national). The Authority primarily responsible for analysing international macro-economic and financial trends and evaluating their impact on the UK will be the Bank of England, so the Bank should be the main point of contact regarding macro-prudential stability. To the extent that existing arrangements for data sharing are inefficient, the Bank should be willing to take on a leadership role in developing global platforms/functions to facilitate data sharing, where it can do so without incurring excessive cost. It is also critical that the Bank maximises its dialogue with international regulators and other central banks, to further its own understanding of any emerging systemic risks to financial stability. Such a dialogue may also have some impact in encouraging international action to redress unsustainable macro-economic imbalances. While the Bank clearly has only limited international influence, the absence of a global macro-prudential regulator means that action to correct macro-economic imbalances will remain primarily within the remit of national central banks and governments, and therefore the Bank should discuss any emerging threats to financial stability with the key national bodies involved. If the proposals of Jacques de Larosires High Level Group on Cross-border Financial Supervision for a European body to monitor and issue warnings in respect of macro-prudential risk (the European Systemic Risk Council) are adopted, the Bank should be responsible for dialogue with such a body. The Bank is, of course, engaged in the G20, G30, Financial Stability Forum and other fora but it needs to consider what bilateral or other discussions should complement the formal groups. Recommendation (38): The Bank of England should strengthen its working links with international bodies, including contributing to the development of improved collaborative tools.
176.
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Contribution to the international regulatory response

177. There has been a significant amount of work at the international level to address international financial regulation, notably by the G30 Working Group on Financial Reform, the Financial Stability Forum, Jacques de Larosires High Level Group on Cross-border Financial Supervision and the ongoing work by the G20 leaders. There will continue to be a strong emphasis on an international response to the current financial crisis, as well as developing an international framework to reduce the threat from future financial crises. It is essential that the Tripartite Authorities should continue to contribute their expertise to the ongoing international response, particularly at the European level, in order to avoid outcomes that may be detrimental to the UKs position in the financial markets and/or a regime that is inconsistent with the UKs preferred regulatory framework. Where the international regulatory response is focused on macro-prudential issues, the Bank of England is the Authority best placed to lead the UKs international contribution on the basis of the international relationships discussed above in relation to its macro-prudential role, its high level of international prestige and credibility, and its political impartiality. On micro-prudential issues, it remains appropriate that the micro-prudential regulator should lead the UKs contribution, including the development of accords by the Basel Committee of Banking Supervisors in relation to prudential supervision, working level discussions with the European Commission, and representation on the Committee of European Banking Supervisors, the Committee of European Securities Regulators, and the Committee of European Insurance and Occupational Pension Supervisors, or the successor authorities as proposed by the Jacques de Larosires High Level Group on Cross-border Financial Supervision. The Bank of England should, nevertheless, remain able to influence the UKs contribution on such micro-prudential issues and should work with the micro-prudential regulator and HM Treasury to form a common position in relation to financial stability matters. The Tripartite Authorities should consider submitting joint papers to international bodies setting out the UKs view on issues relating to financial regulation. In preparing these submissions, the Authorities should actively work with financial institutions in order to develop, as far as possible, a consensus position based on the views of all stakeholders in UK financial markets.
178.
The Bank of England should lead the UKs contribution to international policymaking of a macro-prudential nature, with the micro-prudential regulator continuing to lead the UKs contribution on micro-prudential matters, while HM Treasury should lead international political negotiations. The Tripartite Authorities should work closely with financial institutions to develop a consensus position to contribute to international regulatory developments.
Compatibility of UK regulation with potential international models

179. Throughout our research, a number of people have argued that the UK must be prepared for a potential shift to an international model of financial regulation, potentially based on a single European regulatory structure. It is not within the scope of this preliminary report to assess the likelihood or desirability of an international regulatory structure. However, it is important to comment briefly on the potential impact of such a structure on the UKs system of financial regulation.
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180.
The UKs continuing position outside the Euro zone means that the international regulation of financial stability will not be of direct relevance to UK fiscal or monetary policy. It is questionable whether international regulation should extend to micro-prudential regulation or conduct of business regulation, since these activities are most effectively conducted by local regulators with a more detailed knowledge of the financial institution in question. There has been some discussion of developing an international regulatory function for systemic institutions at the European level. If any key regulatory function was to be transferred to an international body it would likely be macro-prudential regulation. For example, it is possible that a body analogous to the Basel Committee could be given control of a macro-prudential instrument such as counter-cyclical capital ratios, leaving national micro-prudential regulators to enforce any changes. The regulatory structure set out earlier, with the Bank responsible for macro-prudential supervision and the micro-prudential regulator for micro-prudential regulation, would ensure that any transition to an international macro-prudential regime could be handled with the minimum disruption to the UKs system of financial regulation, limiting the risk of such a change to the UKs financial stability and to the competitive position of the UKs financial markets. However, it is only within the UK that macro-prudential judgements can be made which will take full account both of UK financial system issues and of relevant European and global market developments. For example, the credit cycle in the UK may be at a different point to that elsewhere in Europe. In the final analysis, prime responsibility for financial stability regulation must remain with the political authority which has access to taxpayers money to fund any crisis resolution. This means that for the foreseeable future, the UK authorities will have to retain prime responsibility for UK financial stability.
181.
182.
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Terms of reference and review process

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The Review process

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26. 27. 28.

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Recommendation (5): Recommendation (6): Recommendation (7):

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Recommendation (23): Recommendation (24):

Recommendation (25): Recommendation (26):

Recommendation (34): Recommendation (35):

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Why does the regulatory structure matter?

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What are the reasonable expectations of the regulatory system?

The existing regulatory structure

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Why did the existing system fail?

Why did the existing system fail?

Background to the financial crisis

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Why did the existing system fail?

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Why did the existing system fail?

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Why did the existing system fail?

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Why did the existing system fail?

Evaluation of and response to emerging threats to financial stability

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Why did the existing system fail?

Lack of appropriate instruments to mitigate emerging risks

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Why did the existing system fail?

Inadequate prudential regulation

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Why did the existing system fail?

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Why did the existing system fail?

The FSAs organisational structure in mid-2007

FSA Organisational Chart August 2007 (simplified)