Andrew Bailey: The case for an open financial system
Speech by Mr Andrew Bailey, Governor of the Bank of England, at the Financial and Professional
Services Address, Mansion House, London, 10 February 2021.
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As we look forward - and for so many reasons we must look forward - it is important to focus on
the future of financial services, and the important role they play in our economy and
internationally. This will be my focus today.
I am going to look forward with the benefit of history and context and set out why open financial
markets are in the interests of all - home and abroad - and something we should always strive
for. I want to start with the Bretton Woods agreement towards the end of the Second World War.
This was a fundamental and decisive commitment to an open world economy. This commitment
did not come free at the time - the adjustment was hard for this country - and of course the
more formal Bretton Woods system broke down in the 1970s. But that breakdown did not
compromise the commitment shared broadly across nations to an open world economy. There
have been times when the commitment has been sorely tested, but it has not been abandoned.
What followed the breakdown was a shift of emphasis, not a free for all. The shift was towards
managing the consequences of greater openness with much more emphasis on the stability of
the financial system and its ability otherwise to do harm, both domestically and internationally.
What was needed was not just openness, but safe openness. This emphasis was never more
evident than during and after the global financial crisis. There was a moment at the height of the
financial crisis when it might have been natural to consider forfeiting the commitment to an open
financial system in the face of damaging international linkages. That did not happen to our great
relief - the G20 nations stood firm to the principles of Bretton Woods and committed to
significantly reforming the international financial system and its regulation, by raising global
standards for regulating the system and reinforcing the institutional structure.
The Covid crisis has been the first big test of those reforms - and it has been a big test. The
scorecard to date is encouraging - by no means perfect, but the core of the system has stood
up well, which is needless to say a huge relief.
In order to preserve this public good of an open world economy and now also an open financial
system, has required a commitment to institution building both internationally and domestically.
Bretton Woods created the IMF and World Bank, and slightly less directly the GATT and then
WTO. Out of the financial crisis came the importance of the global Financial Stability Board with
a mandate to promote international financial stability underpinned by strong regulation,
supervisory and other financial sector policies, reinforcing thereby the importance of G20 nations.
The FSB works closely with, and is supported by, the four standard setting bodies of the
international financial system - the Basel Committee for banks, IOSCO for markets, the IAIS for
insurance, and the CPMI for payment and markets infrastructure. And, just to underline the
importance we see in these bodies, it is with pride that I can say that the Bank of England chairs
two of the four - Jon Cunliffe for CPMI and Victoria Saporta for IAIS.
These bodies are where the critical standards for governing the financial system get hammered
out, where safe openness is put into practice. They are very clearly global in reach, necessarily
so. They are not regional, they are global. We cannot participate in these bodies, and they cannot
function as they do, unless we are all prepared to enter into the process and listen to and accept
ideas from others. It requires us to give up some control over our standards and rules, because
the alternative of a narrow domestic control is illusory - it would jeopardise achieving the very
things we want, safe open markets, and likewise open economies. Above all, these bodies
enable us to build the trust that enable our financial systems to stay open.
But, we do not for a moment believe that we can maintain the arrangements we have without
change. As the world around us changes, so too do we have to adapt how we achieve these
public goods. Also, we do not participate in these global institutions with the intention to water
them down, misguidedly because we think this would preserve some notion of our
competitiveness as a nation. The UK could not be a global financial centre for long if we did.
Let me reiterate again, the public goods of open economies, an open financial system and the
stability of that system are global, not regional, in nature. The UK is one of the world's largest
global financial centres, and its financial stability - as the IMF have reminded us - is therefore a
global public good. We are deeply committed to financial stability and given that the success of
our financial centre. That is not because we are mercantilist in our outlook. As the City's long
history shows, that has never been the outlook of people in the City; rather it has been to trade
freely and compete and grow new markets, to face outwards. We see that today for instance in
the embrace of fintech.
The UK's financial markets and its financial system are therefore open for trade to all who will
abide by our laws and act consistent with our public policy objectives. The question then arises
of what sorts of safeguards and rules should apply to that trade?
I mentioned earlier that one of the offspring of Bretton Woods was the GATT, subsequently the
WTO. The focus of activity was for some considerable time on trade in goods not trade in
services. Both goods and services trade depend on robust standards and the regulation of those
standards, but trade in services is almost entirely about such standards. This trade has been
substantially supported by the global standards to which I referred earlier, and which has allowed
countries to defer to each other in terms of the prevailing rules and regulations.
This means deferring to the rules of others to protect our citizens or firms when they choose to
do business there. There is no doubt in my mind that the work done on global standards since
the financial crisis has made this process easier to support and safer and improved the level of
trust we have in each other.
The European Union has pursued the approach of so-called equivalence, which on the face of it
allows for deferring to other authorities where appropriate. The EU's framework of equivalence in
financial services is a patchwork across many different pieces of financial services legislation,
taking different forms in different sub-sectors, and in some not present at all. Nor do the
equivalence measures prescribe how the judgement should be made.
As is well known, the post-Brexit equivalence process between the UK and EU has not been
straightforward. It is, of course, two distinct processes - one for the UK to recognise the EU as
equivalent to the UK, and one for vice versa. The UK has granted equivalence to the EU in some
areas, but the EU has not done likewise to the UK. In a few areas - involving central clearing and
settlement - there has been agreement by the EU to extend temporary equivalence to the UK,
recognising, I think, the clear risks to financial stability that would have arisen had this not been
done at the outset.
It would be reasonable to think that a common framework of global standards combined with the
common basis of the rules - since the UK transposed EU rules from the outset - would be
enough to base equivalence on global standards. Less than this was enough when Canada, the
US, Australia, Hong Kong and Brazil were all deemed equivalent. Continuing with the example of
central clearing, the EU has recently made the US SEC equivalent for CCPs, subject to certain
conditions. These conditions are already met by UK CCPs as they are a legal requirement in the
onshored legislation, but equivalence beyond the temporary extension remains uncertain.
The EU has argued it must better understand how the UK intends to amend or alter the rules
going forwards. This is a standard that the EU holds no other country to and would, I suspect, not
agree to be held to itself. It is hard to see beyond one of two ways of interpreting this statement,
neither of which stands up to much scrutiny.
The first interpretation is that the rules should not change in the future, and to do so would be
unwelcome. This is unrealistic, dangerous and inconsistent with practice. As the world around us
changes, so must the rules to accommodate these changes. As evidence of this, look at what
the authorities have had to do in response to Covid and the shock that created for financial
markets. The EU is almost constantly revising, or contemplating revising its own rules, and that's
a good thing. So, I dismiss this argument.
The second argument is that UK rules should not change independently of those in the EU. I am
being careful to phrase this point. It's not that UK rules might change independently - the
equivalence process provides for re-assessment of such decisions, so this should not be a
problem. So, it must be the stronger form that they should not change independently. But that is
rule-taking pure and simple. It is not acceptable when UK rules govern a system 10 times the
size of the UK GDP and is not the test up to now to assess equivalence.
It's worth considering why we would choose to change the rules. First, it would be rare to say the
least if such rules turn out always to work perfectly first time and thus need no amendment. As
an example of this, the EU itself is looking to amend MiFID2 to iron out areas that need further
work.
Second, as the world moves on, so the rules need to adapt. If they do not, we will be heading for
trouble. The key point here is that good practice means that authorities should be transparent at
the time in explaining rule changes, and those changes should be consistent with international
standards where appropriate.
Let me give three examples of areas of rule changes we in the UK are looking at, two involving
banks and one life insurance. First, the Basel regime for banks has, from the outset in the 1980s,
applied to so-called "internationally active banks". The EU has chosen to apply it to all banks and
relevant deposit takers. That was a matter of choice. But the Basel regime is heavy duty and
complicated when applied to small banks (I know many big banks will say the same, but sorry
that's life). So, we want to see if we can apply a strong but simple framework of rules for small
banks that are not internationally active. This is a sensible step in my view and not out of line with
the principles and practice of equivalence. Indeed, there are other countries, such as the US and
Switzerland that have regimes for small banks and have been determined equivalent to the EU in
many areas.
Second, the EU changes its rules in December to allow software assets to count as bank
capital. The Basel Standards do not include intangible assets in bank capital, which would
include software assets in the UK. We have not identified any evidence to support the notion that
software assets have value in stress. On that basis, including them in bank capital would give a
false picture of a bank's loss absorbing capacity. We are therefore intending to consult on plans
to amend this on-shored EU rule in order to maintain the previous requirements of excluding
software assets from bank capital. This is in line with global standards and will enhance the
safety and soundness of UK firms.
The insurance case rests on a different argument. Solvency 2 is an all embracing rulebook
covering both general/non life and life insurance. In practice, it probably works better for the non
life world, because the risks and activities are more common across different national markets.
Non life insurance is a broad and diverse sector, but each GI product occurs in different national
markets in a more similar form. But, I have never been convinced that the EU had a commonality
of forms of life insurance across its national markets. They are in some cases at least quite
distinct markets and products. Certainly that is the case in the UK, where annuity business is a
quite specific activity.
Some specific elements of Solvency 2 have not proved to work for that market as well as hoped,
so it is right that we should review it. There may also be reason to make changes that span both
life and non life, but that is not the point I want to emphasise here.
Let me be clear, none of this means that the UK should or will create a low regulation, high risk,
anything goes financial centre and system. We have an overwhelming body of evidence that
such an approach is not in our own interests, let alone anyone else's. That said, I believe we
have a very bright future competing in global financial markets underpinned by strong and
effective common global regulatory standards.
I want to finish with one further important area, that is, how the rules are applied - supervision as
we call it - and how we can be sure that this application of rules is effective across borders, and
particularly between the UK and the EU. It is of course critical that rules are applied effectively,
and that there is co-operation between the authorities in different countries.
With this in mind, we already have 36 MoUs agreed between the Bank of England / PRA and
supervisors across Europe. They ensure supervisory co-operation will be deeply engrained in the
relationship. And let me welcome the content of the joint declaration on financial services that
was contained in the UK-EU trade agreement. It provides for structural regulatory co-operation on
financial services, with the aim of establishing a durable and stable relationship between
autonomous jurisdictions based on a shared comment to preserve financial stability, market
integrity and the protection of investors and consumers.
This co-operation will be supported by a Memorandum of Understanding to be agreed by March,
and this will enable discussions on how to move forwards on equivalence determinations
"without prejudice to the unilateral and autonomous decision-making process of each side".
To conclude, there is no doubt in my mind that an open world economy supported by an open
financial system that respects the public interest objective of financial stability will bring the
greatest benefits all round. It needs to be supported by effective institutions and strong
international standards. But this must be a global, not a regional, regime to be effective. And that
is why we spend so much time and effort on the work of the global standard setting and oversight
bodies. What follows from that is much more a matter of implementation and how we each put
these standards into practice consistently.
We have an opportunity to move forward and rebuild our economies, post Covid, supported by
our financial systems. Now is not the time to have a regional argument.
Thank you.