Financial Stability, Depositor Protection and Central Bank Independence

With a slight modification of the all-time classic referee’s report,  I can say the following of the Treasury’s recently released consultation document Financial stability and depositor protection: further consultation: this document contains much that is new and much that is good.  Unfortunately, what’s new is no good and what’s good is not new.

Deposit Insurance

A £50,000 upper limit (with no deductible) per person per bank seems fair and not too inefficient.  It must be recognised, however, that the three percent or so of account holders not covered by this limit could still be queuing outside a troubled bank.  As regards the “target of seven days for providing the depositors of a failed bank with access to at
least a proportion of their funds, and the balance within the following few days”
, this is seriously under-ambitious.  Even if seven days means seven days and not seven working days, if I feared I would not have access to my bank account for a week or more, I would make a B-line for the deposit withdrawal counter.  Anything over two working days could, in my view, trigger an individually rational run.

As regard pre-funding by the participating insured institutions, now is clearly not a good time.  When the banking sector is off life-support, pre-funding adequate to deal with the compensation of depositors of an individual bank or a few banks makes sense.  If there were to be a systemic banking sector insolvency crisis, the insured depositors will end up being protected and compensated by the Treasury and thus by the tax payer.

Whether the Financial Services Compensation Scheme (FSCS, the arrangement that brought you the run on Northern Rock) will disappear, continue as a scheme administered by some other institution (the Financial Services Authority (FSA), say), or will be given a stronger institutional identity is unclear.   In the USA, the Federal Deposit Insurance Corporation (FDIC, the grown-up version of the FSCS) actually manages and pulls the trigger for the US SRR (special resolution regime) for insured deposit taking Federal banking institutions.  This is clearly a road not taken by the government.


The FSA has (or ought to have) information on the solvency, liquidity and other relevant characteristics of individual financial institutions.  The Bank of England and the Treasury do not.  The proposal in the consultation document is perfunctory:

“D.2 The Government confirms its intention to legislate to facilitate the FSA
obtaining and sharing information that the Bank of England and the Treasury require
for purposes relating to financial stability.”


This is later on followed by:

“the Government confirms its intention to legislate to facilitate the FSA obtaining and sharing information that the Bank of England and the Treasury require for purposes relating to financial stability.”

This is rubbish.  All it means is that there will be no legal consequences for the FSA, the Bank and the Treasury when the FSA shares information with the two other parties in connection with their joint financial stability mandate.  It leaves to the FSA the decision on what information to obtain and share with the Bank of England and the Treasury.

Information is power.  Even if, as appears to be the intent of the government, the Bank (and the Treasury) can initiate binding requests for the FSA to collect and share certain kinds of information, how would the Bank and the Treasury know what to ask for?  They don’t have the information! The situation where you don’t know any of the specifics, but you know precisely what to ask for is highly uncommon.  The institutional interests of the FSA, the Bank and the Treasury are not well-aligned, and the incentives for hoarding information, keeping it private or even distorting it will always be there.   No doubt the public interest and the common good are powerful motivators for all concerned.  But so is institutional self-interest, including fights over turf.

“Send us everything you collect” would mean the Bank and Treasury end up duplicating the work of the FSA – and how would you every verify whether the request had been honoured?  The Bank of England can only get the individual institution-specific information it requires for its envisaged enhanced financial stability role, if it has a Bank employee tagging along on every site visit by the FSA to one of its regulated institutions.

The best way to align the incentives of the Bank and the FSA for better information sharing is to make them jointly reponsible for the decision to trigger the SRR.

Whose finger is on the trigger that activates the SRR?

Here’s what the consultation document proposes:

“D.15 The Government proposes that initiation of the regime would be subject to an
assessment by the FSA, as the firm’s supervisor, that the firm had failed (or was likely
imminently to fail) to meet its Threshold Conditions.

D.16 The Government proposes that the operation of the SRR and the resolution tools within it will be the responsibility of the Bank of England.

D.17 Any decision requiring the use of funds for which the Chancellor of the
Exchequer is responsible, or with implications for the public finances, would require
the authorisation of the Chancellor of the Exchequer.”

“D.19 Any decision involving the temporary public ownership of an institution will be
for the Chancellor of the Exchequer.”

The proposed arrangement is as follows: a bank screws it up, the FSA calls it, the Bank of England manages it and the Treasury owns it.  This won’t work.  The FSA, as regulator and supervisor of the bank, is likely to be affected by what Mervyn King calls ‘regulatory forbearance’ but what would in the economics profession be called ‘regulatory capture’.  Regulators are supposed to contrain their industry in the public interest.  They often end up acting as advocates, lobbyists or spokespersons for the sectional, special interest they are supposed to regulate in the public interest.  The phenomenon is universal and almost unavoidable.

When an institution is put in an SRR (especially if this involves the creation of a so-called bridge bank), its top management and board will typically be fired, its directors and shareholders will lose their decision-making powers (including the shareholders’ voting rights) and they will be put firmly at the back of the queue of claimants to the assets of the institution.  Creditor rights will be suspended.  This will not be popular with the top brass of the bank.  The FSA is therefore likely to pull the trigger late and reluctantly.

The Bank of England is given responsibility without power under the Treasury proposal. That is a poison chalice.

I can see only one solution, and that one is not very elegant.  There should be two fingers on the SRR trigger, that of the Bank of England and of the FSA.  The agreement of both institutions ought to be required to put a bank into the SRR.  In case of disagreement between the Bank of England on whether or not to put a particular institution into the SRR the Treasury decides.    The Treasury will end up carrying the fiscal can for any recapitilisation of the troubled bank that may be deemed necessary for systemic stability reasons.

The alternative of assigning the SRR trigger to the Bank of England alone won’t work because the institution does not have the information and cannot obtain the required information in a timely fashion unless it duplicates the regulatory and supervisory activities of the FSA towards individual financial entities.  In that case, make the Bank of England the sole regulator and supervisor of banks and other highly leveraged institutions.

Threshold ratios

What criteria will trigger the invocation/activation of the SRR for an institution? This  remains a black hole.  The consultation document says:

“D.3 The FSA will publish a consultation paper, setting out proposals on the
provision of additional information by banks to demonstrate that they are meeting
threshold conditions, on an ongoing and forward looking basis.”

The government also proposes that the trigger for the SRR should be regulatory, exercised by the FSA and “linked to regulatory guidance material”.  The footnote dealing with threshold condition in the consultation document is less than helpful: “The Threshold Conditions are set out in Schedule 6 to FSMA and include: legal status; location of offices; close links (that might prevent effective supervision); adequate resources; and suitability. Supporting guidance can be found in the FSA handbook: The three conditions most relevant for this ongoing assessment are close links (COND 2.3), adequate resources (COND 2.4) which includes adequate financial resources, and suitability (COND 2.5).”

Presumably this refers to such criteria as capital ratios, liquidity ratios, other indicators of leverage and mismatch, likely to trigger balance sheet insolvency or cash-flow insolvency.  However, the whole point about introducing the SRR is that there may, for systemic stability reasons, be a case for declaring regulatory insolvency before the conditions for balance sheet insolvency and cash-flow insolvency have been met.  This makes it, in my view, impossible to rely on firm and objectively verifiable prescriptive triggers.  It instead requires the trigger puller to retain a degree of flexibility that could easily lead to opportunistic abuse (forbearance or capture again!).  For that reason, it is essential that it be not just the FSA that pulls the trigger.

What institutions are covered?

The answer is simple: all higly leveraged financial institutions (HLIs) characterised by material asset-liability mismatch (maturity, liquidity and currency) and deemed to be too large or too interconnected to fail  should be subject to the SRR. That means not just deposit-taking banks and building societies, but in principle also institutions like investment banks, hedge funds, private equity funds, and whatever off-balance sheet institutions and shadow banks may have been or will be invented.  Capital adequacy requirements, liquidity requirements and any other constraints imposed on the balance sheets or on other aspects of the financial structure and operations of banks, should be applied symmetrically to all HLIs that are too large or too interconnected to fail.

The Financial Stability Committee

It does not look to me as though the key issue of the role and powers of the proposed FSC has been settled yet. The consultation document only says the following:

“D.44 The Government intends to legislate for the creation of a Financial Stability
Committee (FSC) to support the Governor and Bank of England, drawing upon external

D.45 The Government plans to give the Court a formal role in overseeing the Bank of
England’s performance on financial stability.”

The government proposes that the FSC will be a subcommittee of the Court of the Bank of England (its Board of Directors) (see also the earlier statements and speeches the Chancellor on this subject Chancellor’s Mansion House Speech of June 18 2008 and the Chancellor’s letter of June 19 2008 from the Chancellor of the Exchequer to the Chairman of the Treasury Committee, John McFall). Even if this proposal finds its way into legislation, it does not mean that the FSC will be a relabeling of some existing toothless subcommittee of Court – one I had never heard of (and I believe I am not alone in my ignorance). I always thought that Court has only three subcommittees: Remuneration, Audit and Risk Policy.  None of these reviewed or oversaw the Bank’s financial stability activities.  Risk Policy just referred to the Bank’s own risk, rather than to systemic stability issues.  Whatever the precise role of the FSC, the painful fact is that anyone qualified to serve on it is likely to be conflicted, because he or she will be closely associated with some financial business or other finanicial institution with strong special/sectional/parochial interests.

The independence of the Bank of England

There remains a chance that the Chancellor will give the FSC serious supervisory and advisory  powers over the Bank’s liquidity management strategy and policies and over the Bank’s financial stability functions generally.  Whether its oversight role will be high-level and light-touch or will include operational oversight (possibly intrusive) and a role in day-to-day interventions during emergencies, remains to be determined.

It appears all but certain that the Bank in the performance of its financial stability duties will be less independent of the government and of interested outside parties (who are likely to be represented on the new FSC)  than the MPC is in the performance of its monetary policy responsibilities.  This, at any rate, is a threat hanging over the Bank.

Because the five executive members of the nine-member MPC (the Governor, the two Deputy Governors, the Executive Director Markets and the Executive Director, Chief Economist) are also in charge of the design and implementation of the Bank’s liquidity policy and of its financial stability role generally, a threat to the independence of the Bank in the area of financial stability is also a threat to the independence of the MPC in the area of monetary policy.

The fear that this threat may not be an idle one finds some support from the strange and rather economically illiterate open letter from the Governor to the Chancellor, written on the occasion of the second breach of the letter-writing inflation thresholds last month (the Governor’s letter to the Chancellor and the Chancellor’s reply can be found here. My discussion of the letters is here).  Until the financial stability role of the Bank is clarified and embedded in legislation, the Chancellor effectively has the Bank’s Executive by the short hairs. Is it possible that the executive members of the MPC can be induced to ‘play nice’ with the Chancellor until this threat is lifted? I hope not.

I get even more paranoid when I read statements such as the following paragraph in the letter from the Chancellor to John McFall, Chair of the Treasury Select Committee:

“The Bank of England has always had significant responsibilities for financial stability.  Since the establishment of the current arrangements, and as set out in the tripartite memorandum of understanding between the Treasury, the Bank of England and the Financial Services Authority (FSA), the Bank contributes to the maintenance of the stability of the financial system as a whole, through its independent role in ensuring monetary stability, and through other operational levels, such as the providison of liquidity….”

I note the reference to the Bank’s independent (my italics) role in ensuring monetary stability, but I am still concerned about the implications of the following train of thought: monetary policy contributes to financial stability.  The financial stability role of the Bank of England must be subject to oversight.  Therefore…..

This could imply a threat to the independence of the MPC in the area of monetary policy, based on the argument that monetary policy and financial stability are inextricably intertwined.  This threat would affect all MPC members, executive and external.

So am I paranoid when, because the Governor’s letter to the Chancellor reads as though it had been written by the Treasury, I attach non-zero weight to the possibility that this is because the letter was indeed written by the Treasury?  I hope I am.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website