Andrew Bailey: The future of banking regulation in the UK
Speech by Mr Andrew Bailey, Executive Director of the Bank of England, at the British
Bankers' Association Annual Banking Conference, London, 17 October 2012.
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It is a great pleasure to be here this morning. I am going to talk about what has become the
hot topic of the time, namely the role of bank regulation in macroeconomic policy. But before
I do so, just a few words on progress towards creating the new system of regulation in the
UK. The Treasury announced on Monday that they expect that the new regime will formally
come into existence at the start of April next year. I expect that the PRA's new home, near to
the Bank of England in Moorgate, will be occupied by our supervisors shortly before then.
On Monday, we published two important documents on the PRA's approach to supervision,
covering banks and insurers respectively. Next Monday, we are holding conferences at the
QE2 Centre, covering banks in the morning and insurers in the afternoon. Please do come
along. You can access the documents now on the Bank of England and FSA websites. I
should add that Martin Wheatley and his colleagues in the FCA-to-be have also issued an
approach document this week and are holding a number of events too. We are doing our
best to keep you entertained!
Let me turn now to the issues around bank regulation and macroeconomic policy. The
financial crisis has emphasised the close links between the health and behaviour of banks
and the state of the economy. We are remembering a very uncomfortable lesson from
history that should not have been forgotten. But, forgotten it was. 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. At the heart of this programme we are trying to knit together
monetary policy and financial stability in both its macro- and micro-prudential forms,
something that has not been done properly for a long time. I say that quite deliberately,
because such coherence was not present prior to the reforms of 1997, so this is more than a
change to recent arrangements.
The new macro-prudential approach to financial stability will see the establishment of 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
macroprudential role.
These two objectives contain the same "subject to that" language used in 1997 in the
Monetary Policy Committee's objectives. It means that there is a hierarchy of objectives
which the FPC must observe. But, two further points are relevant here. First, resilience and
economic growth interact, so they are not fully independent. An economy that displays stable
growth is more likely to have a stable financial system, and vice versa. Second, policy is
necessarily forward-looking, in that we are concerned with stability and growth in the future,
since today's outcomes are so to speak, "baked in". This means that, in thinking about the
hierarchy of objectives, in my view we have to take a forward-looking assessment of the
probability of success, rather than saying we should complete one and then do the other.
Financial stability is more complicated than monetary policy in at least one respect, namely
that it does not reduce to a single target expressed as a number. Rather, it comes in the
form of recommendations, in the plural, expressed as words. You would think that as central
bankers and public officials we should love that, spending our time crafting language in a
form that only we really understand. Let's not get carried away here - there is a danger that
by doing so we create uncertainty about our intentions. This danger of creating uncertainty
exists because we are finding our way in a new and difficult area of policy. I want to try to
cast more light on the issues here. But, I would note that, in the history of monetary policy,
regime changes have had to deal with the challenge of crafting communication that avoids
creating more uncertainty.
We have two, hierarchical, objectives: simply put, the resilience of the financial system, and
the objective of encouraging growth (the counter-cyclical objective). These two can point in
opposite directions, for instance in terms of banks' ratios of capital to assets. The FPC has
recommended that banks should strengthen their buffers of capital.
What is meant by this? Let me tell you what we have concluded, and what we have not yet
concluded. We are in a quite extended transitional phase, whereby the capital buffers of the
banks are being increased to the Basel III levels. This process has around six years to run
on the transition timetable. The FPC has recently said that it thinks banks should take steps
to build up those buffers more rapidly than most firms have done recently under the Basel
transition policy. (I say "most" because some firms have already made the transition.) But,
we are not defining this objective as requiring banks to reach a level such as a 10% Core
Tier One ratio in the next year or so on the new Basel III measure. Why not? It would run
the big risk of encouraging banks to reduce their loan books - in other words, it would affect
the interaction of our two objectives, or incentivise the banks to reduce/"optimise" their risk
weights. We are, instead, defining the growth of capital in terms of the increase in the
nominal stock of Core Tier One, or equity, capital. This makes it easier to find a transition
path that allows more capital and more new lending to co-exist.
But, this begs three big questions: by how much do we want to see the nominal capital
bases of banks grow in short order; why do we want this to happen; and what form do we
want the capital to take? The first two of these questions, how much and why, are best taken
together. Here, in my view, we face uncertainty that we have to find a way to resolve
adequately. What we have done so far is to ask the major banks to try to maintain the
projected growth of nominal Core Tier One capital over the next 18 months, according to the
projections for this growth that they provided to us earlier this year. This is, their Basel III
transition path.
In order to go beyond that path, we have to ask why we want to do so? In my view, there
could be at least four reasons why new lending by banks might be restrained by lack of
capital as represented by low price to book ratios. First, there is a possible shortfall in asset
values relative to their book values, which is exacerbated by the accounting standards
preventing provisions being taken against expected future losses. Second, there could be
inadequate capital to protect against tail risks, most obviously a disorderly break-up of the
euro area, which has negative consequences for banks and their valuation. Third, the impact
of higher funding costs and the constraints on the ability of banks to re-set rates on longer
maturity assets could mean that banks cannot earn the previously expected rate of return on
them, which, like the first reason, is amplified by widespread loan forbearance, in both the
household and corporate books. And, fourth, there could be a market value adjustment to
reflect more structural uncertainty about the future business model of banks, for instance due
to uncertainty about the final shape and impact of regulations, for instance the likely cost of
implementing the ring-fence.
Any of these four could contribute to the market value of banks' capital being less than the
book value of tangible equity capital. This is not currently true for all banks, but among the
UK banks, more often than not, they are valued by the market at quite a sizeable discount to
book value. If the market value diverges from the tangible book value, we know that
investors are likely to be at least unsure that a firm's net assets are valued correctly in the
published accounts. Consistent with this, we can see that in their published accounts, banks
are placing a fair value on some of their assets which is below the book value.
This evidence, while informative, does not, for me at least, get to a conclusion on the need to
add more nominal capital, or more particularly how much capital to add. To do that, we need
to know more about the contribution of these various possible causes of market values of
banks' capital, and that must be the key next step in the work. On this, I would ask for the
insights of banks themselves and analysts, because as I always say, I know one thing for
sure, we don't have a monopoly of wisdom, and this is a tough question.
But, it is a key question, because the danger of a very slow resolution of the capital gap is
that new lending to the economy is seriously restrained. This is the Japanese threat, based
on the recent history of Japan, and the basis of the argument that a more aggressive
approach to re-capitalising banks will create more support for new lending. Moreover, it does
illustrate why we see a close interaction of the FPC's two objectives, of resilience and
growth. I need to see more evidence and analysis of why market values of banks' capital are
low before I can determine what and how much needs to be done. This is the immediate
task ahead because we need to do all we can to clear up uncertainty here.
Before going on, let me deal with two points that are related to this argument. First, it is said
that this stance on capital is unnecessary because banks have stronger capital positions now
than they did in the height of the crisis. This statement on the capital position now relative to
the past is true but on its own that part does not tell us whether they have enough capital
now. UK banks have made substantial progress over the last four years in building their
resilience, but from a low base, it has to be said. There is further to go, but we should not
forget the distance that has been travelled.
The second point I want to deal with here concerns forbearance, namely the extension by
banks of a variance in the terms of loans, which involves forgiveness of various forms. It is
easy to imply that forgiveness is a bad thing, turning Japanese in the unfortunate sense of
that term. Rather, we should deal with the consequences of forgiveness, not prevent it. The
reason for that is because forgiveness has a very good side to it, namely that fewer jobs are
lost and fewer homes re-possessed where it takes place. And we can see evidence of both
of these in the latest recession relative to previous ones. Let me say something unusual
now: I think that the banks deserve a thank you for the way in which they have sought to use
forbearance. When I was Chief Cashier of the Bank of England, I was responsible for our
work on the so-called London Approach whereby we seek to use our powers of persuasion to
facilitate company re-financings which are in difficulty. That brought me into regular contact
with the corporate loan restructuring bankers and I was always impressed by their
commitment to helping companies in trouble. Sometimes the medicine could be hard, but
there are many companies around today that would otherwise not be employing people.
Now, I said earlier that we need to understand more not only about the size and cause of the
capital gap but also how best to fill it. The choice of solutions matters because it can
influence subsequent lending behaviour. It is often said that raising new capital dilutes
existing shareholders. That is not really true in a literal sense if existing shareholders have
written down the market value of the capital they own. But is true in the sense that it dilutes
their claim on any future upside to the current market value reflecting the inevitable
uncertainty about the future. This would be the effect of raising new equity. An alternative
could be to raise the capital in the form of contingent equity, or "Co-Cos" for short. The
attraction of this is that existing shareholders will retain some of any upside, though they will
pay via lower returns for the risk premium on the cost of Co-Cos. I am quite attracted to
CoCos, but we need to think through whether they will create the necessary incentives to new
lending. I should add that, while we are seeking to discourage banks from deleveraging in
the form of lending to the real economy, we are not against releasing existing capital to
support new lending where that capital is currently tied up in non-core assets, which can
either be sold or run off because they are not needed on the balance sheets of banks to
support the real economy, such as trading book proprietary assets.
Finally on this subject, let me briefly describe what we have done so far. The government
and the Bank of England have introduced the Funding for Lending Scheme (FLS). FLS is in
large part a response to developments in financial markets, notably the increase in the cost
of bank funding which was, inevitably, being passed on in the form of higher costs of lending.
In the twelve months up to the middle of this year, business lending and mortgage rates rose
and the evidence we had suggested that there was an accompanying tightening in the terms
and conditions of new lending. The Bank of England's Credit Conditions Survey suggested
that household secured lending and corporate lending rates were expected to rise further and
all of this on the back of two years of flat GDP growth and three years of broadly flat credit
growth to households and business in the UK. This was notwithstanding the MPC's action on
quantitative easing. FLS is designed to provide banks with medium-term funding at a more
reasonable cost, with incentives that reduce the cost if banks lend more. This should improve
credit creation in the economy through lowering rates on new lending, but to some degree it
may also enable banks to improve their net interest margins and thus build more capital. At
the same time the FLS was introduced, the Bank of England signalled its willingness to
enhance its provision of liquidity insurance through the activation of the Extended Collateral
Term Repo Facility.
For its part, recognising the need to balance macro-prudential objectives in the way that I
described earlier, the FSA has taken two steps. We have allowed banks to reduce the
capital buffers they hold over the minimum Pillar One requirements in line with new lending
that is consistent with the objectives of FLS, though to be clear, we do not require banks to
use FLS to get this benefit. Our view here is that we have enabled the use of the additional
capital buffers built up since the height of the crisis by anticipating what will be in the future
their partial use as the Basel III counter-cyclical buffer. What we have done on capital is
consistent with the intent of Basel III. Last year, the major UK banks had total so-called
Capital Planning Buffers of just under £100bn, so we could see a change in the course of
credit creation by those banks without going far into the buffers.
I want to develop this point a bit more because it has a broader relevance. One of the
features of the Basel arrangements which is insufficiently appreciated is that, since the outset
of the Basel Capital Accord in the 1980s, there have been three pillars to the framework.
Pillar 1 is the rules on capital adequacy. Pillar 2 is where supervisory judgement is applied to
overlay the rules. And Pillar 3 is the requirement for transparency in order to enhance market
discipline. Since 2008, Pillar 1 capital in the major UK banks has increased from £151bn to
£186bn. Pillar 2 capital, in all, increased during the same period from just under £20bn to
£150bn, of which the £100bn I mentioned is part. Put simply, in the regime up to 2008, there
was no judgmental overlay of capital buffers, now there is such a buffer. There are two very
important points on Pillar 2 capital. First, when I read commentaries which go something like:
"You wouldn't believe how low Bank X's modelled risk weights on, say, mortgages are". I do
note that the commentator can only observe the Pillar 1 capital requirement. They are not
observing the judgmental overlay in in Pillar 2 which, as you can tell from the numbers I
quoted, has gone up. The trouble is, this tends to suggest that Pillar 3 transparency is not
working as it should do. This is all I am going to say today on models and RWAs, I will save
that for another day.
The second point on Pillar 2 is that, having built it up, we think that we can allow a relatively
small part to be used to support the second objective of the FPC. Now, in terms of how we
justify this, given the hierarchy of objectives that I described earlier, I believe that it is
important to look at the interaction of resilience and lending as I set out. I think it is
reasonable to conclude, and the FPC supported this action, that a reduction in the risk arising
from this new lending caused by an improvement in credit conditions should help to offset the
risk from lower capital buffers. In other words, if such extra lending boosts economic growth,
it will enhance resilience in the financial system. This means that while banks will, where
needed, have to hold some capital above the Basel III transaction path for the reason that I
set out earlier, the FSA is allowing those banks that increase lending to a lower Pillar 2
capital buffer to recognise the benefits of such lending.
I should add that the FSA has also altered its guidance to banks on the liquid asset buffers
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 action, too, has been
endorsed by the FPC, and I hope it will support credit availability.
In conclusion, I have tried this morning to set out how we are thinking about and then
applying macro-prudential policy, going back to first principles. This is a new field, and as I
said earlier, please bear in mind that in the early days of the low inflation monetary policy
regime in many countries, it took time to refine the communication. But, beyond that, we also
need to fill in what for me is the big gap at present, namely how we explain and calibrate the
resilience objective in terms of capital. The FPC will focus on this at its next meeting.
It is therefore too soon to assess the impact of 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 for me is that we are applying judgement to our decisions on regulation and within a
framework that quite explicitly defines and seeks to balance the objectives of resilience, the
primary objective, and, subject to that primary objective, supporting credit conditions and
economic activity. To be clear, in this approach 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 are building a framework in which we can apply judgement more
consistently and be held to account for these judgements in a more open way.
Thank you.