Mr. Davies reviews current debates on regulatory structures governing the
financial system Speech by the Deputy Governor of the Bank of England, Mr. Howard
Davies, held on 22/2/97 at the Federal Reserve Bank of Atlanta's Financial Markets Conference
entitled 'Market and Regulatory Structures in a Global Environment'.
It is conventional, and polite to say, at the beginning of a speech of this kind, that
one is thrilled to have been asked to speak on the subject of the structure of financial regulation
and that the topic is, of all the many preoccupations of human kind through the centuries, the
one which generates the most enthusiasm and excitement in one's breast.
But I cannot bring myself to do it. You may think me ill-brought up to say this
if so blame my parents - but I find the question of the structure of regulation to be quite
resistible. I know that there are those who like nothing better than to draw new organigrams and
to explore the manifold interfaces between regulatory agencies. (There are also people who find
self-fulfilment collecting airline sick bags, or watching synchronised swimming. That is a
matter for them.)
But my lack of enthusiasm for the topic of regulatory structure is, I hope, not an
emotional response. It is rationally based on two prior beliefs. First, that the relationship
between structure and effectiveness is loose. I know of little evidence that structural reforms are
quickly followed by an enhancement of the effectiveness of the activity in which those agencies
are engaged. Secondly, my prejudice is to believe that regulatory structure should follow market
structure, rather than the other way round. Regulators should seek to respond to changing
markets which, in turn, respond to changing customer demand and new product availability,
rather than seeking to dictate either. So we should always ask ourselves whether the regulatory
framework we adopt makes sense to market participants, rather than requiring them to structure
their business to fit in with some governmentally imposed view of the way product delivery
should be organised.
But I recognise that, in practice, we cannot avoid constant attention to the
maintenance of the regulatory framework. Firstly, because while good structure will not
necessarily generate effectiveness, a faulty, out of date framework will certainly make it very
hard for regulators to do their jobs well. And, of course, the market is not in an 'original
condition'. The financial markets we have now are heavily conditioned by the legislative and
regulatory framework within which they have grown up. That is particularly true in the United
States. It is hard to imagine that, absent Glass-Steagall, regulation Q and all the rest, the
financial landscape in North America would look as it does today.
So I conclude that the debate on regulatory structure should be a constant
dialogue between the markets and the regulators, but with a prejudice in favour of the former.
Our ultimate task as regulators is to ensure that markets work efficiently, and in the interests of
consumers.
Against that background, how is this dialogue proceeding in the UK at present?
For we too are addressing the questions which preoccupy you in the United States, in our quaint,
olde worlde British fashion.
But before I review the current debate on regulatory structure in the UK, I should
say a little about the way we define the objectives of financial regulation. We think of five: to
protect the economy against systemic risk; to protect individual depositors, investors and
insurance policy holders against loss from the failure of their intermediary; to protect customers
against business misconduct; to assist society at large in the fight against crime (for instance by
making sure firms have in place systems to detect and report laundered drug money and other
proceeds of organised crime); and, last but not least, to create and sustain fair markets.
Described bluntly, these objectives make the job of regulators look impossibly
daunting. But of course they are not absolute aims. Regulators cannot, and should not, offer
blanket assurances to investors and depositors. They cannot, because the tools and resources to
do so are simply not available. And they should not, because it would be quite wrong to remove
from investors and firms the responsibility for assessing, taking and monitoring financial risks.
This is a very important point, which Alan Greenspan has helpfully underlined on a number of
occasions recently.
UK regulatory structure and proposals for change
Across the world we see a lively debate on how the regulatory cake should be cut.
There has been change in France. The Australian Government has set up the Wallis
Commission to look at the institutional arrangements there. Their first report has just been
published. Reforms are in progress in Japan. In the US the new legislative season is about to
open, with a number of runners and riders already saddled up in the financial regulation
steeplechase. Similarly, in the UK, a variety of think tanks, and the opposition Labour Party,
have produced proposals to amend, or in some cases fundamentally reorder, our regulatory
structure. But, before describing these exciting proposals, perhaps a brief description of the
British system would be in order.
Responsibility for financial regulation in the UK is divided between two
Government Departments.
STRUCTURE OF UK
Department of HM Treasury
FINANCIAL REGULATION
Trade and Industry
Insurance Banking Financial
Companies Act 1987 Services
Act 1982 Act 1986
Bank of England
Securities and
Investments Board
Personal Investment Authority Investment Management
Retail Regulator Regulatory Organisation
Securities And Futures
Authority
Banks Financial Securities
Insurance Fund
Companies Advisers Houses Managers
Most falls to the Treasury, but prudential supervision of insurance companies is
the responsibility of the Department of Trade and Industry (DTI). The DTI carries out its
supervisory responsibilities using its own staff; the Treasury, on the other hand, while setting the
legal framework and policy directions for regulation, leaves most of the detailed regulatory
functions to others. Under one piece of legislation - the 1987 Banking Act - the Bank of
England carries out prudential supervision of banks. Under another, the 1986 Financial Services
Act, the Treasury delegates its powers to the Securities and Investments Board, which in turn
recognises a number of front-line regulators. These front-line regulators cover different sections
of the market. One, the Securities and Futures Authority (SFA), is responsible for securities
houses; another, the Investment Management Regulatory Organisation (IMRO), for fund
managers. These two regulators undertake both prudential supervision and conduct of business
regulation. The third, the Personal Investments Authority (PIA), is responsible for the retail
sector, and has principally a conduct of business remit although it is responsible for the
prudential supervision of independent financial advisers (IFAs). So, in effect, there is a layered
approach to the regulation of financial services in the UK, with different powers held at each
level.
(To complete the picture, the Building Societies Commission supervises building
societies (Savings and Loans) - though the largest of them are now converting to bank status.
And the Department of Social Security is responsible for the supervision of occupational pension
schemes.)
This brief description of the legislative framework might lead one to suppose that
the UK system is primarily statutory - yet the securities side is often described, at least by
comparison with the US system, as one of self-regulation. Indeed, some argue that it is
excessively self-regulating and, therefore, unreasonably lax.
We would reject that last charge. And, in practice, the distinction between
statutory and self-regulation is not black and white. The UK system has elements of both.
Prudential supervision of insurance firms is carried out directly by a government ministry, which
is unambiguously Government regulation. Banking supervision is carried out by the Bank of
England. Constitutionally, this is not 'Government' regulation, but rather regulation by a public
body which is authorised by specific Act of Parliament. Certainly no one describes what we do
as self-regulation, even though the Bank of England is a bank.
On the investment side, the picture is more complicated. The Government has
delegated its powers to the Securities and Investments Board. The SIB's governing board
includes people who are active in financial services, but they are appointed by the Treasury and
the Bank of England (indeed I am one of them) and are required to act in the public interest.
Again, this does not look like self-regulation. However, the various front-line regulators are
called, in the Act itself, 'self regulating organisations' (SROs). Their boards include a high
proportion of active practitioners, elected by the industry to represent its views. Practitioners are
also heavily involved in policy discussions, rule-making and enforcement functions. But, like
the SIB, the SROs operate indirectly under statute, and have a duty to regulate in the public
interest.
We therefore have no self-regulation in the strict sense, rather a variety of
statutory and statute-backed bodies with practitioner involvement, each with different
relationships with the industry and with Government. Effective regulation needs the input of all
participants in the market if it is to offer appropriate protection without stifling innovation.
Regulators can benefit greatly from effective practitioner input but to retain the confidence of
the investing public they must persuade them that regulation puts their interests, and not those of
the firms and their shareholders, first.
The system we now have is undoubtedly capable of achieving an appropriate
balance between market sensitivity and consumer confidence; it has, in many respects, worked
well. But it has been stress-tested in a number of difficult episodes: the Maxwell affair, the
private pension mis-selling saga, the collapse of BCCI, Barings Bank and Sumitomo. These
episodes have taught us something about the strengths and weaknesses of our system, just as the
S&L crisis and the Daiwa New York problem have done in the US. Furthermore, markets
themselves have moved on. The financial landscape of today is almost unrecognisable from the
one which informed legislators' views in the early 1980s, before the Banking and Financial
Services Acts were put on the statute book. It is therefore not surprising that over there, as well
as over here, there is criticism of the existing structure, and pressure for change. Our own
system, with its monopolistic approach to the origination of legislation, does not generate
competing draft bills. But the marketplace for ideas on regulatory reform is, I can assure you,
just as well contested.
Critics of the existing British system object on three counts:
1 that the failures of the last decade demonstrate its inability to cope with
strains and crises;
2 that it is unnecessarily complex, with overlapping and sometimes even
conflicting responsibilities; and
3 that it has failed to keep pace with changes in institutional and market
structures; the distinctions on which it was based no longer effectively
apply.
It is not my aim today to give a comprehensive assessment of the validity of all
these arguments. And, in any event, just as in the US, there is a heavy political dimension to this
debate. But I would make a few observations on the arguments advanced for change.
The UK system is complex, although it is no more complicated than the
equivalent arrangements in some other countries with similarly sophisticated financial markets.
(Indeed, were I not a guest here, I might say that the US system was rather more labyrinthine
than ours.) Those who argue for simplification point to duplication of function and cost,
especially between the SIB and the front-line financial services regulators. There is
undoubtedly a case to answer in that area, as both the SIB and the SROs would acknowledge.
But the legislation we have explicitly dictates a two-tier structure.
It is also true that institutions now tend to be involved in a variety of different
businesses. Banks own securities houses, fund managers, and insurance companies. Insurance
companies are diversifying into banking, and so on. So that even though there should always be
a lead regulator, looking at the overall position of the business, institutions still face the costs of
complying with the requirements of several regulators.
But the question underlying these arguments about complexity and overlap is
more fundamental. Should regulation be based around institutions (it is institutions which fail,
after all) or around functions or types of business which call for specialist regulatory
knowledge?
The UK system is organised neither along wholly functional nor wholly
institutional lines. In today's markets, where firms are a mass of subsidiaries and business units,
no major market participant deals with a single regulator across all its businesses. Similarly, no
regulator has unique responsibility for regulating one function of each business. The insurance
operation of a firm, for example, is covered by separate prudential and conduct of business
regulators.
Most people involved in financial regulation would recognise this description of
the problem. But determining how to resolve it is not straightforward, as evidenced by the wide
variety of proposals for change which have been advanced.
Some proponents of reorganisation would like to begin by making all financial
regulation the responsibility of a single Government Department - the Treasury. They suggest
that this would clear up accountability for the legislative framework, and for the powers and
sanctions in the regulatory regime and create consistency of regulatory approach across sectors.
Straightforward administrative tidiness may also be a factor. While there may be merit in both
these arguments, such machinery of Government questions are for the Government to determine,
and I happily leave such matters to them.
Most of the discussion about regulatory structure in the UK has concentrated on
the area covered by the SIB and the front-line financial services regulators. It is in this part of
the system that the arguments about duplication of function, unnecessary cost and poor
communication are most often heard. The various alternative models all feature some degree of
consolidation, and some would go as far as to fold all the main financial services regulators into
a single body. Others propose two bodies, each reporting directly to the Treasury, with one
covering wholesale business and one covering retail, acknowledging the different regulatory
imperatives, especially in the conduct of business field, of the two sectors. The aim would be to
reduce the number of domestic regulators large institutions would have to deal with, and to
improve the match of regulation to function.
Even more radical changes have been proposed, encompassing not only the SIB
area, but the prudential supervision of banks and insurance companies as well. One model,
colloquially known as 'Twin Peaks', would replace the whole of the present system with two
Commissions: a Financial Stability Commission, with responsibility for systemic risk, the
prudential supervision of all major institutions, and conduct of business regulation of wholesale
activities, and a Consumer Protection Commission, which would be in charge of conduct of
business regulation in retail markets, as well as detecting market manipulation and insider
dealing. It would also carry out prudential supervision of those stock brokers and fund managers
who deal with private clients, and of independent intermediaries.
The advocates of this model argue that it would better match regulation with both
institutions and functions, in particular on the wholesale side. The underlying contention is that
the traditional separation between banking, securities and insurance is breaking down, so that
there is now a less meaningful difference between institutions and functions.
I am not persuaded of the merits of this case. Although the activities of banks and
securities firms do overlap at the margin, this is not true of the core activities.
Banks in particular continue to have a number of distinctive characteristics. First,
there are the risks associated with the maturity transformation seen in their balance sheets.
Banks experiencing a drain in their liquidity, perhaps because of a classic 'run', could be driven
into insolvency through the forced realisation of illiquid assets at 'fire-sale' prices. Second,
there is the risk of contagion - problems at one bank can spread to others - not just through direct
financial linkages but also because, in the absence of timely, transparent information on bank
assets, depositors become concerned about other banks which they see as similar. Finally, banks
play a central role in payments systems, including payment flows generated by FX trading.
The conclusion I draw is that there is enough that is special about banks for their
prudential supervision to be retained as a separate activity in any new regulatory structure, and
that this argument at present outweighs the case for change.
Whether prudential supervision of banks should be a function of the central bank
is a separate question. Some argue that other central banking responsibilities (such as the
conduct of monetary policy) make for conflicts of interest and therefore that supervision should
not be carried out by the central bank.
I am not persuaded by these arguments either. Nor am I aware of many examples
where the suggested conflicts between a supervisory role for the central bank and its other
responsibilities have arisen in practice. Indeed, there are important synergies between the
supervisory function and other central bank responsibilities. It makes sense for the 'micro'
supervision of individual banks in the system to be carried out by the same body that carries out
the 'macro' function of maintaining the stability of the financial system as a whole, stability
which is essential if monetary policy is to be executed effectively and efficiently.
It is no accident that in all major countries the central bank has a significant role
in the supervision of banks, even if in some cases others have been given the legal powers to
carry out the front-line tasks. Having as supervisors tried their best to limit the likelihood of
failure, when faced with it central bankers are uniquely well placed to provide assistance,
whether to the institution in trouble, to the market at large, or both. Those who wish to separate
banking supervision from central banking must acknowledge that there are certain things that
only the central bank can do, and that therefore there needs to be a strong link between the
central bank and any new regulator. In Germany, for instance, the Bundesaufsichtsamt is the
supervisor of commercial banks. But the Bundesbank has an important role in the day-to-day
job of collecting prudential returns, and must be consulted on liquidity and capital requirements,
which bear most directly on its role in an emergency.
The logic of these arguments might point instead to a 'Holy Trinity', rather than a
'Twin Peaks' model, based on three agencies, focused respectively on financial services,
banking and insurance. That might allow the most sensible match - albeit not complete - of
regulation to function and institution. It would also have the advantage of evolving fairly
readily out of the present structure.
- 7 -
HM Treasury
Consolidated Securities
Insurance and Investments Bank of England
Supervisor Supervisor(s)
Insurance
Investment Firms, Markets Banks
Companies
and Exchanges
This last is not a trivial point, since the cost and disruption caused by
reorganisation would be considerable, and higher in proportion to the degree of change. The
process would inevitably generate uncertainty among firms and the public, and make the
regulatory system more difficult to manage in the meantime. This argues for building on the
present arrangements, if at all possible, rather than beginning again with an entirely new
structure that could take years to settle down.
Furthermore, what matters to the financial system, and to the public, is that
regulators are effective. Effectiveness necessitates good communication, consolidated
supervision and close co-operation to maintain protection across the piece. Whether structural
change (including bringing functions together under one umbrella) would improve
communication and co-operation and so increase effectiveness, is a key question, and the answer
is far from clear.
We have been making considerable efforts recently to enhance communication
between different supervisors in the UK. That has involved, as you would expect, the usual
paraphernalia of Memoranda of Understanding. But, in addition, we have sought to achieve
cross-membership of some of our most important institutions. For example, Sir Andrew Large,
the Chairman of the Securities and Investments Board, has become a member of the Bank of
England's Board of Banking Supervision and, reciprocally, I have joined the SIB. Of course
one should not exaggerate the importance of individual appointments of this kind. But they do
help to create a climate of co-operation, and give a signal to the respective staffs of the two
institutions that they are expected to work together as closely as possible, and a signal to the
outside that they can expect this to happen.
The Approach to Regulation in the UK
The discussion of regulatory approaches is often phrased in terms of rules versus
judgement or, as academics tend to put it, rules versus discretion. Should supervisors simply set
the rules, and shoot those who break them? Or does that create too rigid a framework, one
which stifles initiative and imagination?
There is no simple answer. The Bank of England imposes an increasing number
of rules: it has, for example, implemented detailed regimes for capital adequacy introduced by
the Basle Committee and the European Union. We set capital requirements to cover the more
readily quantifiable risks; we enforce limits on banks' large exposures to individual
counterparties; we have rules on banks' liquidity; and we seek to ensure that banks have robust
systems and controls, as well as management with the skill and integrity to ensure, in that
delightful US phrase, that the bank is 'safe and sound'.
But our judgmental approach - allowing supervisors the discretion to exercise
informed judgement within approved guidelines - still contrasts with that of many other
regulators. This flexibility allows us to be tough where appropriate, but to avoid inappropriate
requirements - tailoring the requirements to the nature of the bank's activities. Most
fundamentally, perhaps, we can ask questions, and attempt to take advantage of all the
information at our disposal to form a judgement of the risks facing depositors and investors, as
well as of the quality of a bank's management. So in addition to enforcing rules and looking for
problems, we can help management. We can spread knowledge of best practice: asking banks
about the full range of risks they face (including those - like reputational and settlement risk
that they would often rather ignore); and pointing out to complex groups the extent to which
their managerial and organisational systems have moved away from their legal structure.
It is true that, in addition to being less rule-bound than most other supervisors, the
Bank is commonly viewed as doing relatively little on-site supervision. Of course, this depends
on how you define the term. Accountants are well aware that the Bank does, for example, make
extensive use of reports prepared by auditors - who, of course, operate on-site - in order to assess
the adequacy of internal controls. In particular, the Bank regularly instructs banks to appoint
reporting accountants to report on systems and controls and on the accuracy of prudential
returns.
The Bank's supervisors also spend a growing amount of time on-site. Since
1986, Review Teams have carried out focused visits to banks to evaluate the level of risk in an
institution as well as the risk management systems in place to identify, monitor, and control
these risks. And in 1995 we introduced a Traded Markets Team to focus on banks'
pre-processing models which can be recognised under the CAD (Capital Adequacy Directive) as
well as sophisticated risk modelling techniques used by the banks to manage treasury activities.
These teams spend on average about three days on banks' premises, which may seem short, but
the visits are highly focused, reflecting a great deal of work carried out in advance, not just
between team members and the line supervisors of the bank in question but also by the bank
itself in providing detailed answers to a series of questions.
At the same time, the Bank has recognised the need to be more systematic in its
approach to risk assessment and has announced its intention to introduce a more formal approach
based on a common approach, known as the RATE model, to identify - using a series of
qualitative and quantitative measures - the risks faced by the bank. RATE is an acronym for the
three stages of the process: of supervision and
Risk Assessment, Tools Evaluation.
In the future, by performing periodic risk assessments, we aim to gain a better
understanding of the quality of management, the characteristics of the business and the risks the
banks face. The greater degree of consistency across banks embodied in the new approach will
allow the Bank to be more focused in performing its supervision. The tools of supervision, such
as Review Team Visits and Reporting Accountants Reports on internal controls, will be targeted
at the areas of greater risk and concern in individual banks. We shall very shortly be issuing a
consultation paper setting out how we plan to implement the model in practice. That paper will
show that we have tried to model parts of our approach on best practice in the US. The City of
London may not always have been a preferred habitat for camels, but you may well see some
genetically modified examples on the streets there quite soon.
A better understanding of the risk profile of each supervised institution will assist
the Bank in setting risk asset ratios. As you all know, Basle sets a minimum capital ratio of 8
percent of risk weighted assets. The 8 percent ratio is sometimes interpreted as a
'one-size-fitsall' standard. The Bank, however, sets the trigger capital ratio for each authorised bank at, or
above, the 8 percent floor and considers an adjustment to that trigger ratio whenever we see a
substantial change in that bank's risk profile.
Where does this all leave us in comparison with other regulators? I suggested
earlier that our flexible, judgmental approach is somewhat distinctive. But we are no longer, if
indeed we ever were, outliers on the supervisory spectrum. While the Bank has decided to
implement a more systematic approach to risk assessment, other supervisors - who traditionally
operate a rule book - are (in a fast moving marketplace characterised by rapid product
innovation) moving towards a regime that gives more scope for supervisory judgement.
But the fact that regulators internationally are converging in their approach does
not necessarily mean that they are right. They may all be converging on an inappropriate model.
Indeed some would argue that regulators do as much to create problems as to solve them: that
regulators create perverse incentives - even as we speak bankers may be designing products
whose whole rationale is to exploit anomalies in our rules. Perhaps we would all be far better
employed elsewhere, leaving the market to regulate itself. Why should we not facilitate that
process by concentrating on rules of disclosure, obliging banks to publish accurate information
on their capital adequacy and risk profiles, and leaving the rest up to the market - perhaps with
some safety net for small depositors and investors? As you know, the New Zealanders have
made an interesting move in this direction in the last couple of years.
Should we then get out of the business and leave it all to the markets? To answer
that question, it may be helpful to go back to first principles. Back in 1958, Modigliani and
Miller demonstrated that in a frictionless world a firm's capital structure cannot affect its value.
In the real world, however, departures from the M&M assumptions - such as taxes, bankruptcy
costs and agency costs - may influence the capital decision of any firm; capital may after all be
costly. But banks differ substantially from most other firms because their soundness and safety
is crucial to maintaining systemic stability; without capital requirements some will exploit this
fact by taking large risks with little of their money, in the hope that the taxpayer will bail them
out. In other words, some may believe that they are (partially) insulated from potential market
discipline. From a regulatory perspective, banks must therefore be required to have capital to
absorb the possible losses that result from risk-taking and still remain solvent.
What is our position in this debate? It is tempting to conclude that the only
problem is a perception of a government-funded safety net for large banks; remove that and our
problems will be solved. But systemic risk cannot be wished away as easily as that, even though
we in the UK have demonstrated by our actions that we do not rescue every bank which gets into
problems. So, while we try to stay clear from ever more detailed rules, we do not believe
everything can be left to the market; certain minimum 'regulatory' capital standards are in our
view necessary. Of course, we must aim for a credible and comprehensible regime which does
not require constant updating and elaboration, is not immensely costly, and is reasonably
consistent. The value-at-risk approach is an attempt in that direction. It recognises that there is
a crucial role for judgement in supervision, and that one size really will not fit all. It does not
prescribe the key qualitative factors in legalistic detail. But it does set out the parameters so as
to ensure that there is a framework in place which will deliver broad consistency and also some
degree of prudence.
Some have argued that regulators should go further than the value-at-risk
approach: rather than defining the key parameters and endorsing particular model types, why
not leave it to the banks, and give them an incentive to improve their internal models as much as
possible? Under this pre-commitment approach a bank would specify the maximum portfolio
loss on its trading activities and this would become the institution's market risk capital
requirement. Banks exceeding their pre-committed maximum loss (that is breaching their
capital commitment) would be penalised in one way or another. Such penalties could be
financial, or could entail corrective supervisory action.
In some ways pre-commitment can be seen as an extension of the model-approval
approach we already adopt. The aim, which we endorse, is to ensure that supervisors work with
the grain of the business, and monitor ratios which are seen as meaningful by those who run
banks themselves. To that extent, we support it. But there are potential drawbacks. It could
amplify the moral hazard problem: if the bank wins, its shareholders - as well as its traders
under their bonus packages - pocket the profit, and if it loses, the regulator/tax-payer ends up
with the bill. A penalty would not act as a deterrent to a bank prepared to gamble its capital
because that bank would not be affected by such a penalty when it was 'down and out'.
Furthermore, regulators could over time become less familiar with banks' risk management
systems, which might make them less effective in a crisis. Early supervisory intervention is
more difficult if supervisors only become aware of problems ex-post, after the limit has been
breached.
It may be possible to devise an approach to pre-commitment which avoids these
potential handicaps. But for the time being our attitude remains somewhat hesitant.
Finally, a discussion about rules is not complete without touching on the question
of a 'level playing field'; an odd analogy, I think, since in field sports there is no such thing. If
there were, why would teams change ends at half time? (In American football, of course, te