Paul Tucker: The reform of international banking - some remaining
challenges
Speech by Mr Paul Tucker, Deputy Governor for Financial Stability at the Bank of England,
Member of the Monetary Policy Committee, Member of the Financial Policy Committee and
Member of the Prudential Regulation Authority Board, at the Oliver Wyman Institute
Conference, London, 1 October 2013.
* * *
Over the next few years the international regulatory authorities will move towards completing
the programme of reforming the global financial system. Domestically, that will mean
implementing those reforms, as discussed in the Record of the Financial Policy Committee's
latest meeting published this morning.
Today, I plan to sketch a few of the issues in banking regulation that I think will confront
policymakers as they take this forward. I should stress at the outset that these are my views
and do not necessarily represent the views of any of the domestic or international bodies of
which I am a member.
Just as a scene setter, let me recap the central components of the international reform
programme, led by the "G20" Financial Stability Board. They are essentially as follows.1
To make banks more resilient to stress - the essential steps are, of course, new regulatory
requirements for capital and liquidity. Second, to ensure that banks and other financial firms
can fail in an orderly way without taxpayer solvency support - that's the resolution agenda.
Third, to simplify the network of counterparty-credit exposures amongst banks and others
that arises from derivatives transactions - central counterparties (CCPs). Fourth, to ensure
that those CCPs are not themselves Too Important To Fail - resolution again, plus rules to
allocate losses amongst bank clearing members and others so that a distressed CCP can
recover without going into resolution. Fifth, to ensure that the reregulation of banks does not
simply cause the systemic risks associated with excess leverage and liquidity mismatches to
be reinvented outside banks - the shadow banking reforms. And sixth, to make securitisation
safer and more efficient - a complicated raft of reforms, including overdue steps to remove
mechanistic reliance on Credit Rating Agency ratings.
Cumulatively, those reforms will change the face of global finance - for the better. But no
doubt there will also be effects that have not been anticipated, resulting in a need for running
repairs - a point to which I will return. The work to produce the reforms has also revealed
conceptual gaps and flaws in the inherited regulatory framework that will, sooner or later,
need to be addressed. That is where I shall begin.
The capital framework: going concern v. gone concern loss-absorbency
Perhaps most important, policymakers have focused more closely than ever before on what
happens when a bank or dealer fails. Regulatory policy needs to work backwards from that,
since banks are regulated in order to reduce the costs of failure. Policymakers are, therefore,
now engaging with the crucial distinction between those parts of a bank's capital structure
that absorb losses in a going concern - namely, equity - and those that can smoothly absorb
losses in resolution or liquidation. The recent G20 Leaders Summit called on the Financial
Stability Board to produce plans over the coming year for the level and location of
goneconcern loss-absorbing capacity (or GCLAC) in global banks and dealers. In a nutshell, this
will be a policy for the amount of term bonded debt issued by banks, and where in the group
structure it is issued from.
I believe that in time the Basel Capital Accord could usefully be recast so that it has distinct
components for going-concern and gone-concern requirements. That would replace what to
my mind is the fuzzy distinction between what are termed "Common equity tier 1", "Additional
tier 1" and "Tier 2" capital - not all of which is capital in the ordinary sense of the term that it
can absorb losses outside of liquidation.2
The other element of this policy - which, again, the FSB will be addressing - is where in a
group GCLAC should be issued from, ie whether from the group holding company, from
intermediate regional or national holding companies, or from operating banks and dealers.
This turns on the type of resolution strategy most appropriate for a particular group; ie
topdown or Single Point of Entry (SPE) where a whole-group resolution is executed from the
topco, or Multiple Point of Entry (MPE) where a group is split into parts which, as necessary,
are resolved separately.
Of course, it is in operating companies - banks and dealers - that life-threatening losses are
generated. Where those losses exceed the equity base of an operating subsidiary, they need
either to be absorbed by debt issued into the external market or to be passed up the group
structure via intra-group debt or guarantees. The first - GCLAC, ie term debt, issued to the
market - is associated with Multiple-Point-of-Entry resolutions. The latter, where losses flow
to the top of a financial group, are associated with Single-Point-of-Entry resolutions.3 The
choice of how equity and gone-concern loss-absorbing capacity should be distributed across
a group is, therefore, part and parcel of deciding its preferred resolution strategy. That was
not understood as international banking policy was developed over recent decades, and sets
up my next issue.
Reconciling the Basel Concordat, the Core Principles of Banking Supervision, the
Capital Accord, and resolution policy
The development of international policy on resolution is, arguably, exposing an underlying
need to reconcile the provisions of various international agreements in banking regulation
and supervision. There are three that are relevant: the Concordat, the Core Principles and
the Capital Accord. Bear with me for a moment while I set up the point I want to make.
The Concordat4 establishes the division of labour amongst home and host authorities - the
foundation stone of international co-operation amongst bank supervisors. First agreed in
1975 in the wake of the failure Herstatt, updated after Banco Ambrosiano in 1983 and again
in 1992 following the closure of BCCI, the Concordat was most recently spring cleaned in
1996. It is premised upon "consolidated supervision" of a banking group as a whole. What
that means is that so long as the host supervisors of local outlets of an international banking
group are satisfied that the home supervisor is capable of supervising the consolidated group
as a whole, the distribution of capital resources across the group, both within and across
jurisdictions, can be unfettered. In principle, legal entities within the group can be lightly
capitalised so long there is adequate capital in the group as a whole.
Meanwhile, the (1997/2006/2012) Core Principles for Effective Banking Supervision5 set out
minimum standards for prudential supervision. Supervisors are required to look at a bank on
a solo basis; on a consolidated basis covering all related banking entities in a group; and on
a group-wide basis, ie taking into account non-banking related entities as well. Under
Principle 12, a home supervisor should supervise a bank on a consolidated basis, but "in
addition ... the responsible supervisor supervises individual banks in the group. The
responsible supervisor supervises each bank on a stand-alone basis and understands its
relationship with other members of the group." Under Principle 16, jurisdictions may - I
stress, may - also opt to be assessed by the IMF for compliance with the Principles against
the "additional" criterion6 that a supervisor should ensure an adequate distribution of capital
within a banking group. But, to repeat, that is not an obligation. So summing up, as with the
Concordat, a country's prudential regime could be judged as complying with the Core
Principles even though it does not ensure that the distribution of capital across a banking
group leaves its individual entities adequately capitalised.
Finally, the Capital Accord7 - now in its third incarnation - applies to banking groups on a
consolidated basis (or at a sub-consolidated basis for different tiers of a group). The Accord
gives jurisdictions an option to apply capital requirements on a solo-basis to individual legal
entities as an alternative to applying the requirements to consolidated groups of legal
entities8, but there is no requirement to exercise that option. Again, then, there is no hard rule
that ensures a sensible distribution of capital across individual entities within a group.
If you cannot fit all that together, you can be excused!
Here's an attempt to make sense of it. There appears to be a disconnect between the
Concordat (consolidated supervision); the Core Principles (both consolidated and solo
perspective recognised as important, but no mandated solo capital requirements); and the
Capital Accord (consolidated and sub-consolidated, with solo subject to deductions allowed
but not required).
Or, put another way, each of the three BCBS documents does an important job but none of
them addresses the distribution of capital across a group. That is a gap.
Do not assume that this is a theoretical point. It is one reason there have been attempts by
regulators to shore up the financial soundness of local subsidiaries during the crisis. In a
crisis, sovereign countries care about the international distribution of losses. Standard setters
should look into this.
They should do so in the light of the principles and policies that have been agreed on how to
improve the resolvability of banks - at both the consolidated and solo level. Because, quite
simply, it is legal entities that fail.
5
For the most recent version see BIS (2012), 'Core principles for effective banking supervision', available online at:
http://www.bis.org/publ/bcbs230.htm.
6
Paragraph 33 of the foreword to the Core Principles states that "countries undergoing assessments by the IMF and/or the
World Bank can elect to be graded against the essential and additional criteria. It is anticipated that this will provide
incentives to jurisdictions, particularly those that are important financial centres, to lead the way in the adoption of the
highest supervisory standards. As with the essential criteria, any assessment against additional criteria should recognise the
concept of proportionality."
7
See BCBS (2013), 'Basel III: A global regulatory framework for more resilient banks and banking systems', available online
at: http://www.bis.org/publ/bcbs189.pdf.
8
To understand the difference of applying capital requirements on a solo basis relative to a sub-consolidated basis, imagine
Bank A owns Bank B which in turn owns Bank C. Under both approaches, capital requirements apply to the group on a
consolidated basis. Under the solo-approach, capital requirements are also applied to each of Bank A, Bank B and Bank C
individually, after having deducted from Bank A's capital, its investment in B, and from B's capital its investment in C. Under
the sub-consolidation approach, capital requirements would be applied on the consolidated accounts of Bank B, ie after
adding the assets and liabilities of B and C and eliminating any intra-group exposures.
For groups for which Single-Point-of-Entry - broadly, bail in of debt issued through a holding
company - is the preferred resolution strategy, local subsidies need a combination of equity
and intragroup GCLAC (ie intragroup bonds) that permits losses to flow smoothly to the
topco. By transferring losses upwards, an ailing subsidiary is recapitalised. Whether that
suffices for the host authorities will depend on their confidence in the capacity and
willingness of the group's home authorities to execute an effective resolution of the topco. By
contrast, for groups for which Multiple-Point-of-Entry - breaking up a group - is the preferred
resolution strategy, the host authorities of a subsidiary identified for "separation" must ensure
that it has a capital structure and sufficient operational independence to enable them to
resolve it themselves with their particular set of powers. Put simply, for firms within a group
for which SPE is the preferred resolution strategy, the group as whole is a source of strength
on which local supervisors can place weight. That is less true for groups for which MPE is the
preferred resolution strategy.
Summing up, from a resolution perspective, the distribution of loss-absorbing capacity (the
sum of going-concern and gone-concern loss absorbency) is crucial. Yet, from a regulatory
and supervisory perspective, there is as yet no international standard that requires a banking
group to ensure a sensible distribution of equity (and debt) within the group. The international
standards on banking will need to catch up.
The calibration of capital requirements: stress testing
But how much capital (equity and gone-concern loss-absorbing capacity) should a bank
have, and how should regulators decide? I will conclude by saying something about how
stress testing can help.
minimum
The minimum standard set in the Basel Capital Accord is just that: a standard.
There has to be provision for add-ons for individual banks' particular circumstances; and also
for temporary across-the-board increases when the environment has become more
threatening than anything envisaged when the Accord was calibrated, ie when the world has
become extraordinarily risky. In the United Kingdom, the Financial Policy Committee (FPC)
has the power to recommend, or direct, the micro-supervisors to vary capital requirements
temporarily in order to protect against just such unusual threats to stability.
But in order to use those degrees of freedom, policymakers need a good framework for
assessing banks' capital adequacy in different circumstances, both at the level of the system
a whole and for individual firms. The Bank of England - Financial Policy Committee and
Prudential Regulation Authority - believe that a regime of concurrent stress testing of banks
is an important part of the answer.
Following a recommendation from the FPC earlier in the year, the Bank has today published
a Discussion Paper setting out plans, to be implemented progressively over a number of
years, for just such a stress-testing regime for the United Kingdom. In broad terms, each
year the FPC would design a (set of) common scenario(s) that it judges the banking system
needs to be able to survive; the PRA would apply those scenarios to the major banks,
dealers and building societies, alongside more firm-specific scenarios; drawing on analysis
from across the whole institution, Bank staff would analyse capital adequacy under stress
drawing on a range of models, including firms' own models. The results would inform
judgments by the FPC and the PRA Board on whether remedial measures were needed. In
some degree, both the stress scenarios and the results would be published.
That very brief summary leaves a lot of questions unanswered, but suffice to say that we
believe that a stress-testing regime can enhance the quality of the Bank's macro and micro
prudential supervision and, over time, underpin confidence in the banking system.
In addition, I believe that a stress-testing regime will be very important for another reason:
accountability to the public via Parliament. The Bank of England now has extensive powers
as a micro supervisor of individual firms and a macro supervisor of the financial system as a
whole. Parliament has set objectives for both - primarily, safety and soundness for the PRA,
and the resilience of the system for the FPC. But unlike in monetary policy, we do not have a
quantified target - and, to be clear, we do not think that that would be possible. To have such
power with limited transparency would be uncomfortable. If nothing else, it would leave the
Bank in a position where supervision was of interest only when it obviously goes wrong. We
need to engage society - public, Parliament - in debates about the resilience of the financial
system and how we are supervising it in the good times as well as in bad times. The FPC
and PRA have already taken various steps to help with this - the six-monthly Financial
Stability Review, the published Record of FPC policy meetings, the Committee's statement
on the use of its directive powers, the PRA's Approach document and annual report, and so
on. But stress testing can provide a quantum leap in transparency and accountability.
For example, the FPC will need to be able to defend its choice of stress against questions
and criticisms that the scenarios are too extreme or not tough enough. That will implicitly be
a healthy debate about objectives. At the micro-supervisory level, the PRA Board will need to
explain some of its remedial measures using the published stress tests. This can make for a
richer public discussion of prudential supervision, as well as encouraging firms to address
latent vulnerabilities promptly.
That brings me back to resolution. Occasionally a firm will be revealed to be so feeble that
major surgery is needed. Sometimes recovery measures, overseen by the supervisors, will
suffice. Sometimes they will not, with a firm having to go into resolution instead. A sensible
stress-testing regime - indeed effective supervision in general - cannot work without a
welldesigned resolution regime. That should not be a surprise, but is in fact one of the great
lessons of the crisis.
Conclusion
Over past decades, banking, and banking supervision, somehow got detached from the most
essential truth: that banks can fail. Thus, we have banks using brands that do not represent
any legal entity, as if banks were simply trying to sell something, not running a business in
borrowing and lending. We have an international regime that encourages but does not
require adequate loss-absorbency in each and every entity within a banking group. We have
had a regime that is focused on the capital needed in a going concern, but not on the
organisational and capital structures that would help the authorities to contain disorder in the
face of chronic distress. All those issues are now, I believe, in the open. There is a clear way
forward on resolution. But there will have to be some consequential recasting of the
international regulatory regime.
Of course, none of the reforms will be fool proof. Mistakes will be made; mistakes we cannot
see. In future, it has to be possible to make running repairs to the regime where faultlines are
exposed.
Stress testing - not only of banks but of CCPs and, in time, of other intermediaries - can
help to expose those faultlines. It can help to calibrate macro and micro prudential policy.
And a good stress-testing regime will make it easier to explain and defend the standard of
resilience that the Bank requires. And for that, the Bank can be held to account.