Andrew Bailey: Prudential regulation - challenges for the future
Speech by Mr Andrew Bailey, Executive Director of the Bank of England, at the University of
Edinburgh Business School, Edinburgh, 4 October 2012.
* * *
It is a great pleasure to be in Edinburgh again and to have the opportunity to set out progress
on the reform of financial regulation as we approach the formal introduction of the new
arrangements. Scotland is home to a very important financial services industry for the UK
and Europe and although it may at times seem like the changes taking place in regulation
appear through London and Whitehall bubbles, they are clearly as relevant to you as they are
to your counterparts in the City of London and Canary Wharf. All of us witnessed the costs
associated with the failures of banks. We have learnt the lessons of that experience and that
is why the reforms we are making to the way we regulate will affect us all and will create a
system that is safer and stronger for every part of the UK.
One thing I should emphasise is that this is a reform of the whole of financial regulation. I
say that because it is easy to conclude from observation of the issues we face as regulators,
and the public debate, that we are just dealing with reforming the regulation of banks. That is
not the case, and what we are doing is not about dragging the rest of the financial services
industry into reform to solve a problem that is in essence only about the banks. We have to
design a system that works effectively for all sectors of the industry.
On that theme, I would like to start by reflecting for a few moments on the lessons of history.
My main theme is that I think integrated regulation - by which I mean regulation which
combines Prudential and Conduct of Business in one regulatory body with single teams of
supervisors covering both - has not worked as effectively as it would need to do, for reasons
that are deep-seated in the structure.
I think there are a number of closely related reasons for this. First, on a rather practical point,
I think it is hard for a single organisation to balance, particularly during a period of crisis, a
wide range of very demanding issues which are individually rightly of great concern to the
public and can come from anywhere in a landscape of around 25,000 authorised firms.
Second, I think the evidence suggests that, over the last 15 years, there have been periods
when either conduct or prudential supervision has been more in the ascendancy to the
detriment of the other. In the years leading up to the start of the crisis there was a dearth of
prudential supervision, but I am quite prepared to acknowledge that there have been periods
where the opposite has been true. My point here is that I don't think the system of integrated
regulation demonstrated the ability to deliver a stable equilibrium of conduct and prudential
supervision.
Third, there is something of an inbuilt tendency within integrated regulation to play down the
active debate of issues where conduct and prudential regulators find themselves with
potentially conflicting objectives. Of course, it can be said that the "twin peaks" approach that
we are introducing could lead to endless debate and no outcomes. My own view is that that
is not correct, and that the benefits of clarity in defining the objectives of the PRA and the
new Conduct Authority, the FCA, will dominate any other consequences.
There are several important reasons why reform of financial regulation will, in my view, be an
important step forward, starting with establishing very clear public policy objectives for
financial regulation to which we, as the regulators, are fully committed.
For both banks and insurance companies, the PRA will have the objective of promoting the
safety and soundness of firms. Consistent with this objective, it will focus on the potential
harm that firms can cause to the stability of the financial system in the UK. We define a
stable financial system as one that is resilient in providing the critical financial services that
the economy needs. And this supply of services is a necessary condition for a healthy and
successful economy, as demonstrated by the costs imposed by the financial crisis on the
public and society at large.
For insurance companies, the PRA will have the second objective of contributing to securing
an appropriate degree of protection for those policyholders. Why do we need a second
objective for insurance? For me, it rightly emphasises that in taking out some forms of
insurance policies, the public can become locked into very long-term contracts, much longer
often than is the case in banking with deposit contracts. Bearing this in mind, the public
interest I think justifies a second objective for insurance, which is more directly targeted at
the situation of individual policyholders.
In contrast as bank deposits are redeemable on demand at par value, and as banks lend the
deposits at longer maturities, so they are inherently fragile and vulnerable to contagion, so
protecting the system protects depositors.
There are a number of important points in this description of the PRA's objectives. First, the
emphasis on economic well-being as an ultimate goal aligns the supervision of banks and
insurers more closely to the field of macroeconomic policy. This is in line with the definition
of "financial stability" as the continuity of supply of critical financial services which are
important to the functioning of the economy. Three services stand out here: the provision of
payment services including access to funds; credit extension; and, risk transfer.
This definition is critical to clarifying the public interest-objective in a stable financial system,
and that this public interest can diverge from the private interest of a firm in profit
maximisation without reference to the public interest. One of the biggest lessons I take from
the financial crisis is the need to ensure that the boards and management of firms appreciate
and act consistent with the public interest. To achieve this end, we need a much better
definition of the "public interest", which will come from the legislation.
The second important point regarding the meaning of the PRA's objectives is that it will not
be the PRA's role to ensure that no firm fails. Rather, the PRA will seek to ensure that any
firm it regulates that does fail should do so in a way that avoids significant disruption to the
supply of critical financial services.
Nevertheless, failure is not without cost and there is inherent uncertainty about whether a
firm can fail without damaging the financial system and the supply of critical services.
Consequently, the PRA will expect a given level of resilience to failure from all firms. Now, I
recognise that we have a lot to do still on resolution planning to be comfortable about our
objective of avoiding a "no failure" regime. For large banks, we are making progress on
resolution planning, and this world is different to five years ago, but we are not there yet by
any means. I have a background in resolving banks, and I regard having the capacity to
resolve failed large banks - including the largest - as the Holy Grail of resolution.
Unlike the legendary Holy Grail, I think there is a good reason to believe that the objective of
being able to resolve large banks that fail can be within our grasp.
But the challenge of resolving PRA-regulated firms goes beyond banks. Insurers raise
exactly the same issue of continuity of provision of critical financial services. Moreover, in a
line of business such as with-profits life, the business model involves pooling many vintages
of long-term contracts in a single fund for the benefit of policyholders. A typical resolution
involves run-off over a long period, which remains a sensible approach. But the public policy
interest is reasonably directed towards ensuring a process of resolution, which is fair to those
various vintages and more broadly which allows more rapid payout to policyholders, since
the current arrangements can involve long delays and pressure for policyholders to accept
lower payouts in return for greater speed. This is a different, but nonetheless important,
public policy interest in orderly resolution.
I am very clear that when firms mess up, they should be allowed to fail, and by doing so they
are putting at risk the money of their shareholders and if necessary after that, those who
provide debt funding according to levels of seniority. But I am also very clear that really
achieving the objective of avoiding a no failure regime requires a fundamental change of
mindset both inside the PRA and in society more broadly. Fear of failure is an important
conditioner of behaviour in a financial regulator, and achieving a change on this front
depends on establishing a wide acceptance of our approach that orderly failure that does not
compromise our public policy objectives is an acceptable outcome. To be clear, we should be
criticised where failure compromises those objectives and we could have taken steps to
avoid it, and we will be required to report on such failures. But if failure is orderly, and does
not compromise our public policy objectives, the responsibility should rest with the board and
management for failing to serve the private interest of their shareholders and creditors.
Last on the theme of failure, having firms that are either too big or too important to fail is bad
for competition in the industries that we regulate. An industry where exit is too difficult is one
where entry is likewise inhibited. Put simply, if we don't know how to deal with a failed firm,
we will inevitably set a higher barrier to entry. This is what we see in the banking industry.
Embedding resolution into the public policy objectives of financial regulation matters for two
reasons relevant to competition: first, because, to repeat, exit enables entry; and, second,
because if, as we will, we require new entrants to satisfy us on their resolvability in order to
be authorised, we can lower the barriers and costs of opening for business. We have
already started to put this new approach into operation.
Resolution of failed firms consistent with the public policy objectives is one key plank of the
new approach to financial regulation. Another key plank concerns the macro-prudential
approach to regulation. The legislation will establish the Financial Policy Committee (FPC),
charged with the primary objective of identifying, monitoring and taking action to remove or
reduce systemic risks with a view to protecting and enhancing the resilience of the UK
financial system. In June, the Chancellor announced that the government would amend the
Bill to give the FPC a secondary objective so that subject to being content on the first
objective, it should support the economic policy of the government, including its objectives for
growth and employment. Currently, the FPC is acting in an interim capacity to undertake, as
far as possible, the future statutory FPC's macro-prudential role.
Macro-prudential regulation is focused on protecting the financial system as a whole. In a
very "big picture" sense, there is nothing new about this activity. The problems of the last five
years have emphasised the close links between the health and behaviour of banks and the
condition of the economy. This is a lesson of history, and one that should not have been
forgotten. But, forgotten it was.
At present the FPC is pursuing two important objectives: seeking to increase the resilience of
the UK banking system, including to the threats emanating from the euro areas; and, subject
to being content with the path towards greater resilience, supporting the creation of credit in
the UK economy.
I am in no doubt that if banks take reasonable steps to enhance their resilience, they will be
better placed to sustain the availability of credit to the economy by lowering their cost of
funding and reducing their vulnerability to unanticipated events.
Macro-prudential regulation takes a system-wide view of the risks we face and the buffers of
capital and liquidity that banks should hold against possible stress events. This is very
clearly the resilience objective for the system, to which the FPC attaches great weight. Banks
in the UK have made substantial progress over the last four years in building that resilience,
from of course a very low base. We believe that there is further to go on capital, and the
FPC has set this position out, but in doing so we should not forget the distance that has been
travelled. We should also remember that more capital cannot be conjured from thin air,
particularly as there are at present quite severe constraints around the rate of return earned
by banks due to low interest margins and redress for past misdeeds on conduct issues.
Credit growth in the UK economy continues to be weak. The latest Bank of England credit
conditions survey indicates early signs of an increase in the amount of mortgage lending
available to households, though much less evidence of a change in credit conditions for
businesses. But it is very early days for the recently announced policy measures - in
particular the Funding for Lending Scheme - which are intended to have a positive impact on
domestic credit conditions.
So, we can see a picture of gradually improving resilience in the banking system but with
further to go, but also credit growth which remains weak. In that context, and recognising the
balance of objectives within macro-prudential policy, the FSA has taken a number of steps.
We have allowed banks to reduce the capital buffers they hold over the minimum
requirements in line with new lending to the UK economy. Our view here is that a reduction
in the risk arising from this new lending caused by an improvement in credit conditions
should offset the risk from lowering capital buffers. If such extra lending boosts economic
growth, it will enhance resilience in the financial system. Likewise, we have altered our
guidance to banks on the liquid asset buffers that they need to maintain. This reflects the
Bank of England's stance on the potential access of banks to liquidity from the Bank, and a
wider desire to reduce the incentives for banks to hold excessive liquid asset buffers for
precautionary reasons. This, too, we hope will support credit availability.
It is too soon to assess the impact of all these changes on the resilience of the financial
system and on credit creation. We will monitor the results of these actions very carefully, and
we will be prepared to amend our judgements in the light of experience. The key point here
is that we are applying judgement to our decisions on regulation and within a framework that
quite explicitly defines and seeks to balance our objectives of resilience, the primary
objective, and, subject to that primary objective, supporting credit conditions and economic
activity.
To be clear, in this world of judgement-based regulation, we will not get all the calls correct,
not least because the future is uncertain. But, I am a lot more comfortable that we have a
framework in which we can apply judgement more consistently and be held to account for
those judgements in a more open way.
There is one further element to the package of reforms, namely the measures proposed by
the Commission chaired by Sir John Vickers, which the government intends to place into
legislation in the near future. I fully support the Vickers proposals. The key plank of this is to
ring-fence commercial from investment banking and, in doing so, define the scope of
commercial banking that can be inside the ring-fence. This will be a major structural change
for the banking system, and will have important implications for us as regulators. There are
two key points for me in the Vickers reforms. First, in the last ten years or more, the nature of
investment banking has changed to include a much larger element of proprietary position
taking. The incentives and risks of this activity are quite different from commercial banking,
and I do not believe that the two should be mixed in the same legal entity. Regulators
around the world have struggled to regulate this mixture, and will continue to do so even
though we have raised the cost of doing investment banking business through changes to
the regulatory regime.
Second, in a world where we will not accept banks being too big or complicated to fail, it is
sensible to be able to resolve commercial and investment banks separately, and to achieve
this we need the ring-fence approach. This will support the continuity of provision of financial
services.
In conclusion, we have a very big programme of reforms under way, with the central
objective that we must not let a financial crisis of this scale happen again. The reform
programme is founded on very clear public policy objectives. We are absolutely committed to
the reform programme and knitting together the various parts. We expect financial
institutions to abide by the spirit of it too. There are big changes in what we are doing, and it
is an exciting time to be putting these changes into effect. We will get a much clearer focus
from splitting prudential and conduct regulation for banks and insurers, from introducing
macro-prudential regulation to help to protect the financial system as a whole, and from
focusing our regulation on applying judgement in a transparent way. Firms that mess up
should, and will, be allowed to fail, but it must not be at the cost of damaging the financial
system and economy. Ringfencing commercial and investment banking will help to achieve
that objective. And, out of these reforms I hope we can encourage a banking system that is
more open to competition and serves the public more effectively and, more broadly, a
financial system that delivers the public policy objective of financial stability.
Thank you.