Paul Fisher: The Financial Regulation Reform agenda - what has been
achieved and how much is left to do?
Speech by Mr Paul Fisher, Executive Director for Supervisory Risk Specialists and
Regulatory Operations of the Bank of England and Deputy Head of the Prudential Regulation
Authority (PRA), at Richmond, the American International University, London, 30 September
2015.
* * *
It is now 8 years since the start of the great financial crisis, and 7 years since the collapse of
Lehman Brothers and AIG in the United States, followed by the bailing out of HBoS and RBS
in the UK. The consequences were not limited to the financial sector - the economic
recession that followed in much of the developed world was both deep and prolonged. This
naturally created an imperative for changes to the regulation of the financial system to
prevent the same thing happening again in future. Since I became Deputy Head of the
Prudential Regulation Authority (the PRA) in June 2014, I have been asked a number of
times to comment on how far the regulatory reform agenda has advanced. How close are we
to ending "too big to fail"? How much more regulatory change can one expect?
In this lecture I will try to bring together in an accessible, structured way, summaries of the
most important reform initiatives that are in train - at least those that affect prudential
supervision - I will try to set out what they are aiming to achieve and how much further there
is to go. I will then reflect on how the regulatory jigsaw fits together and the key questions
that are being asked of it.
Alongside the statutory Financial Policy Committee in the Bank of England (the FPC) and the
Financial Conduct Authority (the FCA), the PRA was brought into life on 1 April 2013, as part
of a reshaping of the UK's financial regulation landscape. The PRA is the prudential regulator
for deposit takers (banks, building societies and credit unions), insurers and major
investment firms. It started with two objectives: (i) promoting the safety and soundness of its
authorised firms and (ii) specifically for insurers, to contribute to the securing of an
appropriate degree of protection for those who are or may become policyholders. A year
later, an additional secondary objective was added: to, so far as is reasonably possible, act
in a way which facilitates effective competition in the markets for services provided by
PRAauthorised persons in carrying on regulated activities.
The PRA's strategy is to deliver a resilient financial sector by seeking: an appropriate
quantity and quality of capital; effective risk management; robust business models and sound
governance, including clear accountability of a firm's management. The PRA does not seek
to operate a zero-failure regime. But when failure does occur, this should be with limited
disruption to the provision of core financial services and without spillovers to the wider
financial sector.
One of the main strategic challenges in building the PRA was to establish a new approach to
supervision. The key aspects of this are for the PRA to be judgement-based and forward
looking, proportionate in its actions, and efficient in its allocation of resources. The PRA's
supervisory approaches for banking and insurance are summarised in published documents
and updated regularly.
In the first 2 1⁄2 years of the PRA's life, much of the effort has been taken up with the
implementation of the regulatory reform agenda which is the main topic of this lecture. That is
likely to continue to be the case until at least 2019. As I will illustrate, the main planks of the
regulatory platform have been put in place and it is difficult to conceive of there being space
to add many additional reforms to what is already a comprehensive design - neither the
regulators nor the regulated are likely to have much spare resource to support substantially
more regulatory change over the next few years than currently in train.
The FPC is increasingly focussed on implementation of the reforms for banks and insurers
and on understanding the risk from market-based finance. In response to its Remit set by the
Chancellor, the Governor replied on behalf of the FPC in August that:
"The progress made in fixing the fault lines in the banking system means that the Committee
is now more able to broaden its focus to potential risks emanating from and associated with
non-bank activities. By balance-sheet size, nearly half of the current UK financial system
consists of non-bank financial institutions. Capital markets are an increasingly important
source of financing for the UK corporate sector and beyond, and globally almost all net
finance growth since the crisis has been in market-based finance. A broad agenda
encompassing non-banks is necessary to ensure that any potential systemic risks from
market-based finance are identified and also that risks do not migrate from one part of the
financial system to another."
"The Committee will (also) review a number of activities in the non-bank financial system
over the next year, to consider potential systemic risks posed by: the investment activities of
open-ended investment funds and hedge funds; securities financing transactions; the
nontraditional, non-insurance and investment activities of insurance companies; and derivative
transactions. These reviews will complement the Committee's annual stocktake of risks
outside the core banking system."
In the rest of this lecture I am going to focus on deposit takers and, to a lesser extent,
insurance firms, which are the sectors most subject to regulatory reform to date. I should
note that insurance represents a very large part of the PRA's activities - at the end of the
financial year 2014/15 the PRA had around 550 front-line supervisors and risk specialists
working on various deposit taking firms compared with over 300 on insurance firms.
Most of the regulatory reforms that the PRA are implementing have not actually originated in
the PRA itself. Rather, they have arisen from a variety of external sources. Some are UK
initiatives: for example, the new Senior Managers Regime and Senior Insurance Managers
Regime implement the recommendations of the Parliamentary Commission on Banking
Standards (PCBS) and the structural reform of the major banks (ring-fencing) emerged from
the Independent Commission on Banking (ICB, also known as the "Vickers Commission").
A number of key reforms are European initiatives such as the Solvency II regime for insurers.
The banking capital regime, CRDIV, is a European implementation of agreements made in
the global Basel Committee on Banking Supervision (BCBS). The development of
international insurance standards is being driven by the Financial Stability Board (FSB) via
the International Association of Insurance Supervisors (IAIS).
The UK authorities, including the Bank of England and PRA, play a full part in negotiating
these reforms, so I wouldn't claim that they are entirely external, even though there are
usually aspects of the final agreements which represent the middle ground in negotiations.
The main point I want to make here is that, even though there are international agreements
arising out of the alphabet soup of committees, most of these initiatives require detailed
interpretation, rule-making and implementation by the PRA, even after transposition into EU
or UK law. Since the PRA was created in April 2013 (to 30 September 2015), I count that the
PRA has issued 70 consultation papers, 82 supervisory statements or updates thereof and
44 policy statements setting out final rules.
The UK financial regulatory system is not solely about the PRA of course. Those firms that
are authorised and supervised by the PRA are the banks, building societies, credit unions
and major investment firms. Those firms are also regulated by the FCA for conduct matters.
The remaining firms and persons within the regulatory perimeter of the financial system are
then solo regulated by the FCA for prudential matters as well as conduct. The PRA and FCA
arrangement is an example of the modern "twin peaks" model for financial regulation,
pioneered in Australia in 1998, which separates out the prudential regulator - which covers
the larger, more systemic firms - from the conduct regulator. That gives the latter a very long
tail of small firms and financial advisors within its net. For comparison, the PRA authorises
some 1,700 firms and groups and has a budget for some 1,200 staff, plus support services
from the wider Bank of England. The FCA regulates over 73,000 firms and employs over
3,000 staff.
The FCA has a strategic objective to ensure that the relevant markets for financial services
function well. Its formal operational objectives are to secure an appropriate degree of
protection for consumers; to protect and enhance the integrity of the UK financial system;
and to promote effective competition in the interests of consumers in relevant markets.
It is obviously important that the FCA and PRA work closely together even though they have
separate, differing objectives. Perhaps the most crucial aspects joining us are (i) that all
PRA-authorised firms are dual regulated by the FCA as well for conduct purposes (ii) that the
FCA has a primary objective to promote effective competition and the PRA has a secondary
objective to facilitate it, and (iii) the FCA and PRA depend on shared data to carry out their
roles.
The close co-operation of the PRA and FCA is built into the system in part through cross
membership of boards. The CEO of the FCA sits on the PRA Board (and is an FPC member
ex officio). The CEO of the PRA sits on the FCA Board (and is also an FPC member).
The PRA has a Board because it is currently constituted as a formal subsidiary of the Bank
of England. It has been proposed that this arrangement changes so that the PRA becomes
an authority within the Bank, and the PRA Board would become a new Prudential Regulation
Committee. These proposals are subject to public consultation and will be debated in
Parliament before being finalised. These changes should have no impact on the reform
agenda and so I won't pursue them further in this lecture.
The PRA Board is independently responsible for delivering the PRA's statutory objectives. It
does this by making policies and rules, supervising authorised firms, giving directions,
issuing guidance and carrying out other legislative functions. In practice the Board is the
senior supervisory committee in the PRA, but delegates some of its functions to the PRA
Chief Executive who in turn delegates to the management and staff. In 2014/15 the Board
met physically 32 times and had one additional teleconference.
That's enough scene-setting. Let's get on to the reforms themselves.
Capital: banks
Arguably the single most important objective of a prudential regulator is to make sure that
firms have an appropriate level of capital. The objective is two-fold. First, there must be
sufficient capital to absorb the losses that a firm might make, even under relatively
pronounced stress. Second, after the stress, there should be sufficient capital left such that
the firm can either (a) carry on its critical economic functions, with customers and market
counterparties believing it remains safe and sound, enabling market access to funding and
capital or (b) be safely wound up.
It was evident during the financial crisis that the point at which a financial firm is no longer
trusted by customers or counterparties can come before it runs out of capital completely or
even approaches that level. Also, once a firm has run into trouble, in part because it is in
trouble and/or markets are dysfunctional, the marketable value of its assets are often found
to be substantially less than valued in accounts - so losses are usually greater than originally
expected, once a stress has occurred.
Prior to the financial crisis, firms appeared to hold substantial capital to meet their then
regulatory requirements, but in many cases this was illusory - the rules on what could count
as capital had been weakened over time and much of it was not properly or easily
lossabsorbing in the event. So the quality of capital is also of interest. There is also a challenge
of what the minimum level of acceptable capital is, and how to meet it, post-stress. Suppose
X is the appropriate level of capital pre-stress, then substantial losses will always leave a firm
with significantly less than X. And raising extra capital in the market in those circumstances is
not always feasible, nor can a balance sheet be quickly run down to reduce capital
requirements. So how can a firm meet the ongoing requirements for the normal level of
capital after a stress event? The answer is usually to start with a buffer above the minimum
acceptable and/or to have some way of creating extra capital in a crisis. This latter solution
could be implemented in part by restricting distributions such as dividend payments or staff
bonuses, but it is also where the concept arises of having eligible debt that can be "bailed in",
whereby some debt instruments can become loss-absorbing capital under stress, to
recapitalise the firm.
For banks, building societies and investment firms the main capital reforms come under the
umbrella of CRDIV which is the EU implementation of the internationally agreed capital
requirements, as determined by the Basel Committee for Banking Supervision (BCBS). The
Basel agreements are ultimately agreed and signed off by a meeting of central bank
governors and heads of supervisory authorities. CRDIV is made up of the fourth Capital
Requirements Directive (2013) which must be implemented through national law; and the
Capital Requirements Regulation (2013), which is directly applicable to firms across the EU.
Amongst other things, CRDIV enshrines enhanced requirements for the quality and quantity
of capital and gives the basis for new liquidity and leverage requirements; new rules for
counterparty risk; and new macroprudential standards including a countercyclical capital
buffer and capital buffers for systemically important institutions. In general, it is fair to say that
the implication of CRDIV is that banks will substantially strengthen capital standards relative
to pre-crisis. That will mean that the cost of required capital to support banking activity could
be higher than it was previously. However, this is not certain. By making firms safer, it is
possible that the required risk premia in bank capital and funding instruments will be lower,
and hence the effect on the overall cost of funding is uncertain.
In addition CRDIV also makes changes to rules on corporate governance, including
remuneration, and introduces standardised EU regulatory reporting. These reporting
requirements will specify the information firms must report to supervisors in areas such as
own funds, large exposures and financial information. CRDIV will take until 2019 to be fully
implemented.
In addition to CRDIV, there are a number of other reviews and developments affecting the
banking capital framework. The PRA has been undertaking a review of its approach and
application of Pillar 2A requirements to ensure consistency of application across firms. That
will be complete in 2016H1. The BCBS is also continuing its work including reviews of the
capital held against the trading book, sovereign risk, and securitisation, and more generally
reviewing the use of models and Pillar III disclosures.
Leverage
The capital requirements for a bank are generally calculated by first weighting together the
assets of a firm, reflecting the underlying risks of each type of asset. Hence the key metric is
the capital held relative to "risk weighted assets" or RWAs. Whilst the general approach of
being risk sensitive is widely accepted, it does raise issues around consistency. Different
firms can assess risk by different methods and models, using different data sets or applying
different judgements: assessments undertaken by the BCBS1 have shown firms can generate
quite different RWA calculations for an identical hypothetical portfolio. And firms may choose
to optimise both their choice of assets and the weights attached to them to minimise capital
requirements. It has been shown that differences in capital ratios calculated on an RWA
basis have historically had little or no correlation with whether firms were able to survive a
stress2. A leverage ratio offers an alternative approach, which is not risk sensitive but simply
calculates total capital in relation to total assets. The degree of leverage has historically been
a much better indicator of likely firm failure (although we can't be sure that correlation will
survive if firms start to manage to a constraint!).
As alternatives, the RWA and leverage approaches would generate different incentives for
firms to be capital efficient. Under RWAs the incentive can be to expand the balance sheet
with assets that carry low risk weights. Under a leverage ratio, the incentive can be to limit
balance sheet size but choose riskier assets. Ideally, the two measures would work in
tandem to ensure sufficient capital to support both balance sheet size and risk taking.
Even a simple leverage ratio requires some agreement as to what to include in each
component (e.g. how to value derivatives for this purpose) and the details of an
internationally agreed measure are still being negotiated: they are due to be decided in 2017.
A harmonised EU-wide measure will then be implemented.
In advance of that, the FPC in the UK have already decided on a requirement for major UK
banks, and on 6 April 2015, the Government gave the FPC the power to set a leverage ratio
by direction to the PRA. The initial ratio of capital to unweighted assets was chosen by the
FPC to complement the risk-weighted capital framework and to be in line with the level
endorsed by the BCBS. The precise requirements were calculated to be consistent with a
minimum average risk weight of 35%. This gives a minimum leverage ratio of 3%, with
addons for individual firms to reflect any systemic risk and counter-cyclical buffer requirements,
at 35% of the relevant buffer rates. Details on what capital can be used to meet these
requirements have also been specified. The FPC plan to extend the leverage ratio to all the
remaining authorised banks, building societies and investment firms from 2018, subject to
the outcome of the anticipated 2017 international agreement.
Stress testing
It can be difficult to set capital requirements to meet possible losses, without specifying the
likely extent of future stress. Stress testing addresses this by a process of modelling losses
under a range of macroeconomic scenarios, to ensure that a firm holds sufficient capital ex
ante to withstand shocks of a specified degree of severity. An example might be to assume a
recession, with an attendant housing market fall which would stress a portfolio of mortgage
loans. In 2014 the FPC, supported by the PRA, undertook and published simultaneous,
standardised stress tests for the major UK banks for the first time, following a partial exercise
in 2013.3
Meeting minimum prudential requirements after a stress may not be sufficient to ensure
financial stability. If a financial firm needs to rebuild its capital ratios then it can do so either
by raising more capital or by reducing its assets. In the event of an economy wide stress, this
latter approach could amplify the cycle if, say, all banks responded to lower capital by
reducing their lending. The stress tests are therefore seeking to ensure that the banks have
sufficient capital to at least maintain their levels of lending to the real economy and the stress
tests are calibrated assuming that lending is not reduced beyond that which is driven by
reductions in demand.
The UK is not the only country with stress testing as part of its supervision tool kit: the US
undertakes regular public stress tests of the major banks operating there and the European
Banking Authority has also orchestrated stress tests across the major European banks. The
UK supervisors had previously undertaken such tests, but not necessarily the same stress
for each firm, and not at the same time and not as publicly. Further details on the 2015
concurrent stress test can be found on the Bank's website.4
Concurrent stress testing for the major banks is an established part of the UK supervisory
process, and is also used by smaller banks to perform their own assessment of risks. The
stress testing of the major banks is planned to be a regular annual exercise, as it is in the
US, although the strategy and details will likely continue to evolve.
Capital: Insurers
Assessing the minimum level of capital for insurers can be an even trickier business than for
banks. Any single regime is complicated in part by the three different basic types of insurer:
general insurers, life insurers - who in fact often sell what are essentially savings products
under an insurance wrapper - and re-insurers. The UK has had a successful capital regime
in place for all its authorised firms for around 10 years known as ICAS (Individual Capital
Adequacy Standards). Under ICAS, UK insurance firms coped reasonably well during the
financial crisis.
The most uncertain risks for general insurers tend to be in the policies they have written and
therefore on the liability side of the balance sheet, not the asset side. On the other hand, life
insurers tend to be more exposed to market (including credit spread) risk on their assets.
And although they are less likely than a bank to have a liquidity mismatch, the risk
management challenge for an insurer is to try to match the maturity between assets and
liabilities (and hence manage their rate of return). That is particularly necessary for life
insurers whose liabilities tend to extend well into the future i.e. tens of years for many
products.
From 1 January 2016 a new European-wide capital standard will come into force under the
Solvency II directive. Solvency II is largely maximum harmonising and should establish a
more level playing field between European insurers. In part it embodies some of the basic
principles of the UK's ICAS regime, being based on holding sufficient capital to meet an
event of such severity that might happen only once in every 200 years. In other aspects it is
different, most noticeably in that the UK has a "gone concern" regime - i.e. under ICAS firms
hold sufficient capital to run off their liabilities. Solvency II is to be a "going concern" regime -
firms have to hold an additional risk margin to allow their business to be transferred to a
surviving entity. Similar to banking, insurance firms can choose to use a standard formula or
an internal model approach (or a partial model). But it seems to me personally, that both are
more complex that their equivalent concepts in banking.
Most insurance firms covered by Solvency II in the UK and elsewhere will be on the standard
formula. But, relative to the rest of Europe, the UK has more insurers applying this autumn
for approval of internal models for all or part of their capital assessment. Another wave will be
applying in the following year or so, potentially giving the UK around 50 insurers using an
internal model approach, compared with a handful in most other European countries, even
the larger ones. The internal models are complicated, covering all aspects of a firm's risks
and setting capital to prescribed rules. The high number of applications to use models in the
UK in part reflects the size and complexity of insurance businesses in the UK market, which
includes Lloyd's and the London market. The PRA considers the standardised approach is
appropriate for the large majority of UK firms. However, for firms with more complex or
unusual risk profiles, the standard formula will not be appropriate and an internal model will
be needed.
Although Solvency II is a European directive, with the vast majority of the technical rules in
place, a review is planned of the standard elements in 2018, as is typical with many
directives post-implementation.
In addition to establishing a European-wide regime, work is also underway to try and
harmonise at least some elements of a global capital standard for insurers5. A simple Basic
Capital Requirement (BCR) for Global Systemically Important Insurers (GSIIs) has already
been agreed. The UK currently has two GSIIs - Prudential and Aviva - out of the 9 globally.
Work is now ongoing on a Higher Loss Absorbency (HLA) Standard which will reflect the
degree of systemic importance of the firm/group. The plan is that all GSIIs should meet
capital requirements based on the BCR plus HLA by 2019. The third step in the international
plan is to develop a risk-based global International Capital Standard which would apply to all
Internationally Active Insurance Groups (IAIGs). That is likely to be challenging, not least
because of the different accounting principles used in different jurisdictions, but that is the
long-term direction of travel. Work is also ongoing in the IAIS to identify the assessment
approach which most accurately identifies whether or not reinsurers pose systemic risk.
The final element on insurers is that stress testing is also being applied to the sector. Last
year the UK participated in EU-wide tests carried out by the European Insurance and
Occupational Pensions Authority (EIOPA), conducted for the first time on a Solvency II basis.
This exercise focussed on the overall impact of an adverse market scenario and a low yield
scenario. The tests covered 60 groups and 107 companies from across Europe, including the
larger UK firms and from some non-EU countries6. In 2015/16 the PRA is currently
conducting a stress test on its own authorised General Insurers, covering a range of stresses
such as natural catastrophes, terrorism and cyber-attack.
Liquidity
CRDIV covers liquidity requirements as well as capital requirements. The two are quite
different in nature and liquidity is, in my personal view, more controversial. Most firms -
including banks - if they fail will actually do so when they run out of cash, before they
become insolvent. And banks are structurally vulnerable to a liquidity run because their
assets, such as mortgages or company loans, are longer maturity than their liabilities, such
as corporate or retail deposits. One reason why liquidity requirements can be more
controversial is because of the business impact. Capital, in whatever form - whether equity
or bonds that could be converted into equity - is actually a source of funding and sits on the
liabilities side of the balance sheet. Capital may be more expensive than debt for tax
reasons, but both provide funding to be used.
Liquidity requirements usually take the form of a specified minimum holding of liquid assets.
They need to be funded by liabilities and may have capital requirements to hold against them
- they therefore compete directly with other, less liquid assets on the balance sheet such as
loans to the real economy. So holding more liquid assets will usually squeeze out less liquid
lending. And assets which are liquid in normal times (i.e. can be easily sold or lent against
cash), may become sharply less liquid in a financial crisis. These concerns give one reason
why a central bank is usually willing to supply extra liquidity to the banking system in a crisis.
The particular forms of liquidity requirement being introduced by CRDIV are the Liquidity
Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR).
The LCR has been agreed and will be implemented on 1 October 2015 in the EU. It basically
requires banks to hold liquid assets to cover one month of projected outflows, assuming that
markets are closed to the raising of new funding. As you might expect, a lot of international
negotiating time was taken up with deciding what to count as liquid assets! The liquidity
requirements will be increased over time until the full requirement is in operation on by
January 2019 at the latest.
The NSFR is a somewhat different calculation designed to incentivise banks to hold
longermaturity funding: different liabilities are weighted together according to estimated maturity
(reflecting, among other things, their degree of stickiness) and a minimum standard is
applied. The NSFR was agreed internationally in the BCBS and announced in October 2014.
All jurisdictions have committed to implement by January 2018. The EU is to make legislative
proposals based on a report by the European Banking Authority (EBA) due in December
2015.
Recovery and resolution, MREL, total loss absorbing capacity
As described above, having sufficient capital to meet both anticipated and unexpected losses
may still not be enough for a firm to continue trading. Part of the reform agenda is to put in
place requirements for greater loss absorbing capacity such that, after a stress, a firm can be
recapitalised sufficiently to continue to supply its critical economic functions. To deliver this,
the firm's management team needs to have put together a credible plan for recovery, to
return the firm to a stable footing. And if even that is not enough, then we want firms to be
easily wound down by the authorities i.e. for firms to be able to fail in an orderly fashion, with
as close as possible a continuing provision of financial services, minimal spillovers to other
firms and no public money involved. That process of managing the failure of a financial firm
is what we call resolution.
There are judgements to be made here about how much to rely on these different
approaches. If a firm is easily resolvable as described, then the authorities may care less
about the potential for recovery. That could be a matter left for the shareholders. The more
difficult a resolution would be, the more interest the authorities have in removing any barriers
to resolvability in advance.
Failure is usually more problematic for banks than for other commercial firms. When a bank
is known to be in trouble, its customers may withdraw funds quickly, creating a liquidity run
that might spillover to similar institutions. That places an emphasis on speed of action. In
2009 the UK government introduced permanent legislation that enables banks to be resolved
by the authorities, and designated the Bank of England as the UK resolution authority. For
the EU as a whole, the Banking Recovery and Resolution Directive (BRRD) took effect at the
start of 2015, and brings European legislation on recovery and resolution into line with the
FSB's international standards. It requires there to be a resolution authority in every EU
country and, amongst other things, specifies how decisions are made to put banks into
resolution, how resolutions may be conducted, and what tools should be available to
resolution authorities. But there is not yet a special resolution process for insurers. That
remains on the wish-list for now.
Effective resolution can be greatly enhanced if the authorities have prepared for the event,
with the assistance of the firms concerned. The larger and more complex a firm, the more
complex and challenging such planning is likely to be. For large international groups, typically
the most complex, the most important decision is whether resolution is going to be
addressed at the group level, by the home resolution authority (Single Point of Entry - SPE)
or whether each part of the group is looked at separately, usually by the host resolution
authority (Multiple Point of Entry - MPE). The choice between SPE and MPE will have
implications for resolution planning, including steps that the firm may need to take to be
resolved under that strategy - for example in which entities the capital will be held.
The BRRD requires that all banking firms should have recovery plans, and that resolution
authorities should develop resolution plans for all firms, based on assessments of their
resolvability. The resolution planning that the UK has already carried out has identified some
common barriers to resolvability, such as a lack of loss-absorbing capacity in the right legal
entities, that need to be addressed.
The BRRD also establishes that resolution authorities should determine a minimum
requirement for own funds and eligible liabilities (MREL) that will be available to absorb
losses and form new capital, if the authorities need to carry out a bail-in. The BRRD
demands that the MREL requirement will have to be met at all times. It is being introduced
from January 2016, but will be phased in over four years (i.e. until 2020). The precise rules
for setting MREL in the UK firm by firm are currently being formulated.
Separately, in November 2014, the FSB announced an international agreemen