Two highly readable Reports on the lessons learnt from the Northern Rock debacle have been published recently. The first is the Treasury Committee Report The Run on the Rock published on January 26, 2008. The second is Financial stability and depositor protection: strengthening the framework published jointly by HM Treasury, the Financial Services Authority (FSA) and the Bank of England on January 30, 2008. The publication of this document launches a consultation on the proposals contained in it for domestic and international action to enhance financial stability. This blog will deal mainly with the Treasury Report.
The Treasury Report covers five areas: (1) Strengthening the financial system through domestic and international actions; (2) Reducing the likelihood of banks failing; (3) Reducing the impact of failing banks; (4) Deposit insurance: and (5) Strengthening the Bank of England and improving the operation of the Tripartite Arrangement.
Strengthening the financial system
As regards the first of these, there is nothing substantive as regards unilateral or coordinated international action, just some pious platitudes about the need to strengthen risk management by banks and to improve the functioning of securitization markets by beefing up valuation methods and the performance of credit rating agencies. This is a missed opportunity, as the current financial crisis has been a reminder of the fact that when finance is global and regulation is national, accidents are that much more likely to happen. Regulatory arbitrage and competitive deregulation to gain or retain footloose financial businesses within national jurisdictions have been important contributors to the excesses committed by financial institutions and to the mis-pricing and misallocation of risk by credit markets and other financial markets since (at least) 2003.
The proliferation of opaque complex financial instruments traded by opaque off-balance sheet financial vehicles calls for global action. Coordination between multiple institutions, especially in a crisis, is always problematic: panic moves at the speed of light and even well-intentioned, cooperatively minded parties will find it hard to engage in synchronised swimming while piranha fish and sharks lunge at their tender extremities.
The UK’s ‘light -touch’ regulatory approach has been found wanting and has been revealed as little more than soft-touch regulation. No doubt it has been successful in attracting financial sector activity to London – that is, it has been an effective competitor in the socially negative-sum global competitive deregulation game. It has made a material contribution to the race to the bottom of regulatory standards which has left much of the shadow banking sector outside the regulatory net altogether, and has reduced both the information available to the regulator in those market segments that remain regulated and the power of the regulator to prescribe or proscribe behaviour in the regulated sectors. 
At the European level, the need for the creation of a single EU regulator for any given market segment, responsible for all financial institutions engaged in significant cross-border activity (including foreign subsidiaries and branches) is now paramount. At the global level, a greater sense of urgency as regards the activities of the Financial Stability Forum is key. The IMF is waved around briefly in the Treasury Report, but what role it would play in the prevention of crises (‘enhanced multilateral surveillance anyone?) or in their mitigation is not developed.
It is also clear that Basel II has to go back to the drawing board. While some of the excesses of the recent past would not have been possible had Basel II been in effect (especially the ability of banks to make economic exposure disappear for reporting purposes through the creation of off-balance-sheet vehicles), Pillars I and 2 of Basel II have three flaws which are, I believe, collectively fatal. One is the procyclicality of the capital requirements directive. The second is the reliance on internal models of banks to mark-to-model (i.e. mark-to-myth and mark-to-the-short-term-requirements-of-the-banks’-profit-centres) illiquid and often complex financial instruments and structures. The third is the reliance of the risk-weightings on the ratings provided by discredited rating agencies.
The Report also mentions the need to improve the functioning of securitisation markets, including improvements in valuation and credit rating agencies but offers very little beef in these areas. It is clear that the credit rating agencies will have to be ‘unbundled’, and that the same legal entity should not be able to sell both ratings and advice on how to structure instruments to get a good rating. The conflict of interest is just too naked. Rating agencies will have to become single-product firms, selling just ratings.
The only two proposals for improving the operation of the securitisation markets I have seen are not discussed in the Report. The first of these is for the originator of the assets (home loans, say) underlying the securitisation process to be required to retain the equity or first loss tranche of the securities issued against the underlying assets. This strengthens the incentives for delegated monitoring and reduces the severity of the principal-agent problem in the securitisation process.
The second prescribes a ‘gold standard’ for simple and transparent securitisation, as proposed recently by the UK Treasury, but unlikely the Treasury proposal, one with teeth. In a revised collateral framework, the Bank of England would only accept as collateral at the standard lending facility (discount window) or in open market operations through repos, asset-backed-securities conforming to the ‘gold standard’.
One of the key drivers of the excesses of the most recent (and earlier) financial booms has been the myopic and asymmetric reward structure in many financial institutions, including banks and commercial banks. Clearly not all is well when the CEO of Citigroup, after marching his institution to the edge of the abyss, is let go with a golden handshake worth in excess of $130 million. If that is the punishment for failure, what could be the reward for success? And this is just an extreme example of poorly structured reward systems that encourage excessive risk-taking and the pursuit of short-term profits. Where action to prevent such outrages in the future should be focused is not clear. It is fundamentally a problem of general corporate governance, not restricted to the financial sector: where were the shareholders of Citigroup? But there clearly is an urgent need for intelligent design here.
Reducing the likelihood of banks failing
As regards proposals for reducing the likelihood of banks failing, there are some sensible proposals for enhancing the ability of the FSA to demand information at short notice.
Provision and disclosure of liquidity assistance
This part of the Report is hamstrung by a failure to distinguish clearly between funding liquidity and market liquidity. Funding liquidity, which refers to the cost and availability of external finance (including the speed with which it can be accessed) is a property of economic agents and institutions. Market liquidity, which refers to the speed and ease with which an asset can be sold at a price close to its fair value and with low transaction costs, is a property of assets or financial instruments and of the markets in which there are traded.
Funding liquidity and market liquidity are not independent; the funding liquidity of a market maker or trader will influence the liquidity of the market he makes; the funding liquidity of a trader will depend on the market liquidity of the assets he holds or the liquidity of the markets in which he intends to borrow, secured or unsecured. There are private and public sources of both funding and market liquidity. When push comes to shove, only the public sector can provide instruments with unquestioned liquidity. Funding liquidity is provided by the authorities at the discount window (on demand against suitable collateral) and, in extreme circumstances, through lender of last resort (LoLR) facilities. Market liquidity is provided by the authorities through open market operations (OMOs), both repos/reverse repos and outright purchases/sales, and, when markets become illiquid, by the authorities acting as market maker of last resort (MMLR), buying normally liquid but temporarily illiquid instruments at punitive prices and discounts.
Funding liquidity and market liquidity need not be provided by the same agency of the government, both in normal times and in extraordinary times. Only the central bank can realistically provide market liquidity, but the central bank need not be the active party deciding on the provision of funding liquidity, even if it is likely to be the (passive) source of such liquidity.
Covert operations: James Bond at the Central Bank
Quite a lot is made of proposals to allow the authorities (specifically the Bank of England), to provide covert liquidity assistance or other ‘good offices’. There are three sets of conditions under which covert assistance may be desirable.
First, there may be a use for secrecy surrounding assistance provided by the authorities during short-term windows of extreme vulnerability, say, just after a major fraud has been discovered. Of course, with the sophisticated control systems in place since, at least, Nick Leeson’s destruction of Barings, a major-institution-threatening fraud is surely a thing of the past…
Second, there may be a use for secrecy surrounding the authorities’ involvement in attempts to find a ‘private sector solution’ for troubled/failing bank. Under the current UK Take-over code, such covert assistance is problematic.
Third, there could be a need for secret lender of last resort assistance. Although the Bank of England’s belief that covert LoLR assistance would fall foul of the UK’s transposition of the EU Market Abuse Directive, this turns out to have been a chimaera. In any case, with effective deposit insurance and an effective ‘special resolution regime’ for troubled or failing banks, the need for both the second and the third kind of covert operation would vanish.
Dealing effectively with failing banks
Here the authorities are effectively proposing to put in place the kind of legal and regulatory arrangements currently found in the US and a number of other countries. A special resolution regime (SRR) would be created, led by a new authority (I shall call it the special resolution regime authority or SRRA, not to be confused with SSRI, lest we get some very depressed bankers), who could take control of a troubled bank before it hit the normal insolvency buffers – inability to service its debt.
The assets of the pre-failing bank, or any of its activities and business, could be transferred to one or more healthy banks or some other third party; a ‘bridge bank’ could be created to allow the SRRA to take control of all or part of a bank or of its assets and liabilities; a ‘restructuring officer’ could be appointed by the SSRA to carry out the resolution; and finally, if the judgement is reached that pre-insolvency resolution is not feasible, a special bank insolvency procedure can be invoked to facilitate swift and efficient payment of insured depositors.
Public ownership of all or part of a bank as a last resort is also part of the package. The Treasury document refers to its as temporary public ownership, but unless this means that a fixed time table has to be provided, the word ‘temporary’ only indicates hope or intent, and is not operational.
The government proposes that the FSA would be the SRRA, and I agree with that. It should not be the Bank of England (because the job of the SRRA is too political) or the Treasury (because the Treasury is even more political than the job of the SRRA). A new separate entity would be possible, but further balkanisation of the responsibility for financial stability in the UK would seem undesirable (anyone really wants a Quadripartite Arrangement?).
The key issue is the specification of the circumstances under which the SRRA would be able to impose the SRR on a bank. What will be the threshold conditions or triggers (quantitative or qualitative) that would cause the SSRA to compel a bank to enter the SRR? If the threshold is set too low, competition is distorted. If the threshold is set too high, there may be risk of systemic instability. Of course, with adequate deposit insurance and an appropriate bank insolvency procedure, contagion effects and other systemically destabilising manifestations of panic ought not to happen. Even the failure of a large bank should not be of greater public interest than the failure of a ball-bearings manufacturer in Coventry with equal value added.
The Treasury believes the decision on whether and when a bank should be ordered into the SRR should be based on a regulatory judgment exercised by the FSA after consultation with the Bank of England and the Treasury. Provided it is clear that the ultimate decision lies with the FSA, I would agree with this proposal.
I believe that the new deposit insurance arrangements should be located in the same institution that has the SRRA, that is, with the FSA. The existing Financial Services Compensation Scheme should either be moved into the FSA or wound up. In its current form, it is useless.
As regards the limits of the insured amount, the current UK figure of £35,000 (since October 1, 2007, the idiotic run-inducing 10% deductible after the first £2000 has been abolished) appears to be in the middle of the 19-country pack Reported in the Treasury document. Eyeballing the Charts, it looks at though about 97 percent of all retail deposit accounts hold less than £35,000. At the same time, the top three percent of deposit accounts hold about 50 percent of total deposits in the UK. This means that an increase in the limit would raise the value of the deposits covered by significantly more than it would raise the number of depositors covered. I cannot see a strong case for raising the limit, and no case for raising it above £50,000. What matters is the speed with which insured deposits can be paid out should a bank get into trouble.
Strengthening the Bank of England
It is apparent that the Bank of England, since it became operationally independent for monetary policy and lost banking supervision in 1997, has done a much better job as regards its monetary policy mandate of price stability than it has as regards its financial stability mandate. There has been really only one serious test of the UK’s Tripartite Arrangement for financial stability between the Bank, the FSA and the Treasury. It failed the test. Much of the blame lies with current and past Treasuries and with the FSA, but the Bank contributed to the problems through its mismanagement of market liquidity. The Treasury Report does not address this issue at all.
It is key that the Bank of England should follow the example of the ECB and extend its list of eligible collateral at the standing lending facility and in open market operations to include routinely private securities, including asset-backed securities. It should also extend the maturity of its standing lending facility loans from overnight to up to one month, taking a leaf from the Fed this time.
Finally, it should extend the list of eligible counterparties at the standing lending facility and in its repo operations to include not just banks and similar deposit-taking institutions. Currently, open market operations are open to non-Cash Ratio Deposit-paying banks, building societies and securities dealers that are active intermediaries in the sterling markets Access to the standing facilities is restricted to participants in the Bank of England’s Reserves scheme and a few others. Both OMOs and standing facilities should be accessible to all financial institutions regulated in a manner approved of by the Bank.
While in a first-best world, the Bank would not be the active player in LoLR operations, it will always be involved in funding liquidity matters through its standing facilities. It is therefore key that the use of the standard lending facility be de-stigmatised. This can be achieved by abolishing the unbelievably complex operational procedures for setting the Official Policy Rate or Bank Rate (official policy sets the target for the overnight unsecured sterling interbank rate) and managing short-term liquidity.
The current framework has three main elements: rather plain-vanilla standing facilities and OMOs and a mysterious and pointless reserve averaging scheme (from the Bank’s Redbook):
‘Reserves-averaging scheme. UK banks and building societies that are members of the scheme undertake to hold target balances (reserves) at the Bank on average over maintenance periods running from one MPC decision date until the next. If a member’s average balance is within a range around their target, the balance is remunerated at the official Bank Rate.’
The Reserves-averaging scheme should go. There should be no reserve requirement at all. The Bank should stand ready to repo (against eligible collateral) or reverse repo any amount at any time at the Official Policy Rate. That, after all, is what it means to set the Official Policy Rate. Anything else is an attempt to set both price and quantity – and is doomed to failure.
Commercial banks would therefore be borrowing from the Bank of England all the time, as a matter of routine, and no stigma would be attached to such operations. This would also keep the overnight interbank rate closer to the Official Policy Rate than it is under current procedures, decoupling the Monetary Policy Committee’s interest rate decision from the liquidity policy not managed by the MPC but by the Bank’s Executive.
The Bank still could retain its standing lending facility by accepting a wider range of assets as collateral at the standing lending facility than it accepts in repos to peg the Official Policy Rate.
In its open market operations, the Bank should act as market maker of last resort, by standing ready to purchase, at a properly conservative/punitive price, normally liquid assets that have become illiquid through a systemic flight to quality and liquidity caused by fear, panic and other contagion effects. As for the securities acceptable for rediscounting at the standing lending facility, there should be a positive list of securities (including private securities and indeed private ABS) that are acceptable as collateral by the Bank. This would help concentrate the minds of (the supervisors of) those maniacal financial engineers generating ever more complex and opaque financial structures, which would be unlikely to figure on the list of eligible collateral.
What becomes of the Tripartite Arrangement?
It is obvious that, whenever tax payers’ money is put at risk, the Treasury must be consulted and should have a veto over the operation. The Treasury document makes this clear. The Treasury is also ‘in charge of’ the whole arrangement, although it appears obvious that there are certain things it cannot instruct the two other parties to do without risking damaging resignations.
I doubt whether it could give the Bank instructions on its collateral policy, OMOs and standing facilities operations. In my view it ought not to be able to do so. It is also unclear as to whether the Treasury expects to be in a position to instruct the SRRA (that is, the FSA) to invoke or not to invoke the SRR for a particular bank. I would hope it would not be able to do so. What the role of the Treasury would be in the decision to invoke the new bank insolvency procedure remains unclear. Obviously, nationalisation could only be authorised by the Treasury.
In the proposals of the Treasury, the FSA continues to be the regulator and supervisor of the banking sector (and of most other financial institutions). It remains responsible for the default risk (solvency), the funding liquidity of the institutions it supervises and other risks, including operational and reputational risk. It will lead the SRR and act as the SRRA. I assume it would also be responsible for the management of the deposit insurance scheme, although the Treasury document is not clear on this. The Bank of England does get its nose into the tent for most of these activities and responsibilities, however. To my mind this further troubles the allocation of responsibility and authority.
The financial cost of the deposit insurance scheme can only be borne by the participating institutions (either through pre-funding or ex-post funding) if the banking sector trouble causing the scheme to be called upon for a pay-out is a ‘local’ problem affecting only a minority of the banks. When there is a systemic bank run (or bank default), only the Treasury can credibly meet the insurance claims. This should be recognised. Any serious deposit insurance scheme represents a contingent claim on the Treasury.
The Bank of England remains responsible for market liquidity, both in normal times and, under disorderly market conditions by acting as market maker of last resort. It is involved in funding liquidity through the (on demand against the proper collateral) standing lending facility.
The Treasury Report (and even more strongly the Treasury Committee Report) favour an enhanced role of the Bank of England in the LoLR process. The Treasury Report wants the Bank to spend time and resources becoming and remaining informed of the liquidity situations of the individual UK banks. This clearly would also require it to be aware of the solvency-related aspects of the balance sheet and operations of individual banks. The Bank and the FSA would effectively become joint supervisors with shared responsibility for funding liquidity and solvency. I doubt whether such an arrangement would work well.
As far as I can tell, the Treasury Committee wants all of banking supervision and regulation to be returned to the Bank of England, with the FSA taken completely out of the game. A new Deputy Governor and Head of Financial Stability would take the lead in all financial stability matters, and could even order the FSA around.
It is clear that the Treasury Committee’s proposal would put strains on the Bank of England’s independence in monetary policy. The Committee therefore raises the possibility that the new Deputy Governor/Financial Stability Czar might not be a member of the MPC.
I still cannot see this working well. What would be the authority relationship between the new Deputy Governor/Financial Stability Czar and his/her notional boss, the Governor? If the Bank of England is to be put in charge of (the operational end of) Financial Stability, better not to appoint a new Deputy Governor but to give the job to the Governor and to take MPC out of the Bank of England. The Governor of the Bank would, under this model, not necessarily be the Chair of the MPC or even a member of it.
Rather than putting money and individual bank-specific information together in the same institution by making the Bank of England responsible for banking supervision again, I would move in the opposite direction. The lender of last resort (which would not be the Bank of England although the lender of last resort, if it is not the Bank of England should have an open-ended uncapped credit line or overdraft facility with the Bank of England, guaranteed by the Treasury), should be the SRRA, that is, the FSA. It would make liquidity available to a troubled bank that could not longer fund itself in the interbank markets, the repo markets or at the standing lending facility. The collateral that would be accepted, the terms on which it would be accepted, and the other terms and conditions attached to LoLR funds would be decided by the SRRA (the FSA) on a case-by-case basis.
The current Tripartite arrangement is sketched in Figure 1. The Treasury Committee’s proposal is in Figure 2, the Treasury’s proposal in Figure 3 and my own proposal (for a minimalist central bank) in Figure 4. Finally, Figure 5 shows how, under my proposed arrangement, a potentially troubled bank would be handled.
With effective deposit insurance and a sensible insolvency regime for banks, all proposals share the feature that it could, at last, become conceivable that a non-trivially small bank in the UK might fail. That would be the best guarantor of greater future financial stability.
 The shadow banking sector consists of the many highly leveraged non-deposit-taking institutions that lend long and illiquid and borrow short in markets that are liquid during normal or orderly times but can become illiquid when markets become disorderly. They are functionally very similar to banks but are barely supervised or regulated. They hold very little capital, are not subject to any meaningful prudential requirements as regards liquidity, leverage any other feature of their asses and liabilities. They also have very few Reporting obligations and have to meet few governance standards, as many are privately or closely held. Examples are hedge funds, private equity funds, money market funds, monolines, conduits, SIVs and other special-purpose, off-balance-sheet vehicles.