Economic Survey of the United Kingdom 2009: Financial stability: banking on prudence

 

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The following OECD assessment and recommendations summarise chapter 4 of the Economic Survey of the United Kingdom published on 29 June 2009.

 

Contents

 

While the imperative in the short term is to restore the capacity of the banking system to supply credit, in the longer term it is a well functioning regulatory framework that will ensure a well-functioning and stable banking system, which is essential to sustained economic growth. The UK banking sector is among the largest, most internationally open and highly developed. Sound regulation and supervision of banks is necessary to ensure that the financial system works well. Although UK banking regulation is based on European and international standards, the UK authorities have taken a distinctive approach to the regulation and supervision of banks. This appeared to have some advantages in terms of innovation and development of the financial sector. The turning of the credit cycle, however, has underlined the weaknesses of this approach as well as the more intrusive “bank examiner” model practised in other countries. Some UK banks relied heavily on funding from the interbank market and via securitisation, and have experienced large losses on holdings of asset-backed securities. The UK housing and credit cycles were particularly pronounced and UK-owned banks held assets that were a relatively high multiple of GDP. Dealing with these problems has required comprehensive public intervention to support the banking system through guarantees, injections of capital and nationalisations. It will therefore be important for everyone to learn the lessons of this crisis for banking regulation and supervision, particularly in areas such as liquidity where previous policies were out of line with international practice. The UK has throughout the crisis maintained its open approach to financial markets.


Major UK banks’ customer funding gap and foreign interbank deposits

1. Customer funding gap is customer lending less customer funding, where customer refers to all non-bank borrowers and depositors
2. Data exclude Nationwide
Source: Bank of England

 

The regulation of banks should provide a high level of stability for individual institutions and, just as importantly, the system as a whole. Capital adequacy standards influence the overall level of risk taken by banks and the shareholders’ incentive to monitor risks. The overall regulatory framework in this area is determined by international standards (and within Europe by EU directives) but national authorities have substantial discretion to go beyond minimum standards. By setting individual capital guidance at which more intensive supervision is applied at a higher level than international minimal standards, the UK authorities managed to achieve what appeared to be relatively healthy levels of bank capitalisation during the upswing of the credit cycle. But, the effectiveness of this approach was partially undermined by banks’ use of off-balance sheet vehicles to hold securitised assets, even though the UK (like some other EU countries) has for many years applied detailed capital requirements in respect of off balance sheet, securitised assets and facilities to special purpose investment vehicles. Capital adequacy standards should be strengthened in the United Kingdom and internationally and banks required either to hold more capital for off-balance sheet risks or required to bring these risks fully on to their balance sheets. The role of external credit rating agencies for the assessment of risk should be reconsidered in the light of problems revealed during the current crisis as regards the rating of securitised products.


Other aspects of the regulatory framework are also important to achieving a high level of stability. The quantitative regulation of liquidity has a number of recognised weaknesses that are being addressed by the UK authorities. The proposed new liquidity regime will be a marked advance and set a high standard for UK and international banks active within the United Kingdom. Over time, the legal and regulatory framework should be monitored to ensure that there are no undue barriers to the development of a covered bond market, which could contribute to creating a more balanced mix of funding sources for the banking sector. To manage risk, bank lending standards should be subject to tighter regulation. In particular, limits should be imposed on high loan-to-value mortgages or capital requirements raised on these loans. Greater scrutiny and control should be applied to risky and fast-growing activities. To improve risk management, poorly-designed remuneration policies in banks that increase risk taking should be subject to greater regulatory and supervisory intervention. The authorities should increase information gathering in this area and provide clearer guidance about good practice, while intervening where practices are risky, including by raising capital requirements.


More effective banking supervision may help to limit the reoccurrence of the problems that have emerged in this financial crisis (although it must also be recognised that other countries, with more intrusive regulatory approaches, have also experienced significant problems). To achieve this, more resources need to be devoted to supervising major institutions and gathering more supervisory information, with a greater engagement by senior management of the Financial Services Authority (FSA). The FSA has taken actions to increase the resources that are directed to supervising major institutions and increasing senior management engagement with such firms. The quality of financial analysis should be improved, including greater comparative analysis, and macro-prudential considerations better integrated into supervisory assessments. More supervisory information about specific institutions should be made public to enhance transparency and encourage market discipline; this can be done by supervisors requiring institutions to publicise information, in line with international best practice. Consideration should be given to any lessons that can be learnt from more rules-based supervisory approaches applied in other OECD countries, while recognising that they also have weaknesses and limitations.


The financial crisis, particularly the failure of Northern Rock Bank, pointed to a number of weaknesses in the crisis management and resolution framework. The Special Resolution Regime introduces a new pre-insolvency trigger for failing banks and more clearly defined mechanisms for resolution of such a situation. This is useful for dealing with failing banks and, by making it less costly to trigger a failure, reduces moral hazard. For the new regime to work, the Bank of England needs to allocate sufficient resources to deal with the possibility of multiple bank failures. Consideration should be given to numerical targets for prompt corrective action, alongside qualitative judgements. The pre-crisis deposit insurance scheme did not work well, but the regime has been strengthened since 2007 by raising the coverage ceiling, removing coinsurance and improving operational aspects including reducing payment delays. The system should be pre-funded to a greater extent and consideration given to risk-based premia along the lines of schemes in some other countries.


The high economic, fiscal and social costs of the financial crisis underscore the need for greater focus on systemic risks and to contain such booms in the future. Experience of using banking regulation and supervision to address system-wide macroprudential concerns is limited, although a few countries have applied explicit counter-cyclical policies. The Bank of England did warn of risks in its twice-yearly Financial Stability Review but this failed to have a material impact on risk-taking. The Banking Act 2009 strengthens the role of the Bank of England in this area, expanding its responsibilities and the financial system information at its disposal, as well as clarifying the role of the FSA. The OECD welcomes the Turner Review and the UK authorities’ accompanying Discussion Paper, and encourages the UK authorities to develop the ideas contained in the paper. The new framework should be monitored to ensure the relationship between the central bank and the financial regulator work effectively and that there are no gaps in information or responsibility, and a fine-tuning of the new arrangements may be necessary. Options for reducing the pro-cyclicality of financial markets should be investigated. These could include, for instance, the introduction of an overall leverage ratio covering all relevant assets, and dynamic provisioning or counter-cyclical adjustments to capital ratios. The Bank of England and the FSA should work closely together in the detailed evaluation of regulations covering new areas that might have a systemic impact.

 

How to obtain this publication

 

The complete edition of the Economic Survey of United Kingdom is available from:

The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.

 

Additional information

For further information please contact the United Kingdom Desk at the OECD Economics Department at eco.survey@oecd.org

The OECD Secretariat’s report was prepared by Petar Vujanovic, Sebastian Barnes, Philip Davis and Peter Smith under the supervision of Peter Hoeller. Statistical assistance was provided by Joseph Chien.

 

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