The UK Financial Services Industry - Assignment Example

?Assignment 3: Discuss the banking regulatory and market framework in UK, address the strengths, weaknesses, opportunities and threats. The UK financial services industry The financial services industry in Europe is comprise of the subsectors shown in the table following. Of the four segments, the largest is that of banking, employing more than 400,000 employees, and contributing half of the industry’s output in GDP. The insurance industry accounts for 2% of GDP; it is the largest in Europe, and the world’s third largest. In 2009, collections for insurance premiums alone totalled nearly ?200 billion. The UK market for equities garnered 17% share of the global market in 2009, ranking only behind New York. Likewise, the fund management industry ranks among the world’s largest, managing some ?4.1 trillion for the year 2009. All in all, the financial services sector turned in the largest volume of corporate taxes for 2010, which comprised 11.2% of total tax receipts for the entire year. Contribution of output & employment to the UK economy from each financial services sector Financial Services Sub-Sectors Output (% of GDP) Employment Banking 5% 435,000 Insurance 2% 300,000 Fund Management 1% 50,000 Others including securities derivatives, commodities, and bullion 3% 208,000 Total 10% 993,000 Source: U.K. Parliament, 2011 Definition of financial stability The Bank of England is the statutorily designated entity to ensure the financial stability of the financial system of the UK, as pronounced in the Banking Act 2009. The specific definition of financial stability is difficult to delineate, because its context evolves over time. According to Adrian Coles, Director General of the Building Societies Association, articulated a definition for the proximate term, “monetary stability” in terms of a measurable objective, that is, the maintenance of a target inflation at 2%. In contrast, he highlights the elusiveness of the definition of financial stability: “How do we measure financial stability? How do we measure the success of the PRA? Is it one collapsed institution a year is okay but five, the Governor of the Bank has to write a letter to the Chancellor of the Exchequer?” (Coles, in UK Parliament, 2011). This is one of the problems that must be faced if an agency is to be created and charged with the monitoring and maintenance of financial stability in the UK financial services industry. A consensus must be arrived at concerning its meaning, the extent to which it shall be achieved, the powers needed to ensure it, whether other policy objectives may be traded off for it, and in the case of the latter, how such trade-offs may be carried out. The most likely measures are to institute tighter measures to ensure increased capital ratios and improved quality of capital; however, these may only mitigate the dire effects of a crisis, not prevent them. In the past, however, the economic shocks used to emanate elsewhere in the system, such as in trade or business operations, and sometimes as a repercussion of unforeseen events, and then trickle down to the financial system. The recent crisis, however, emanated from a cause principally within the system, as a direct consequence of the actions of financial institutions, and then transmitted through the financial network by contagion (UK Parliament, 2011). In a market based economy, uncompetitive and inefficiently managed corporations should be allowed to fail: such is the position of the UK financial authorities. In a stable financial system, though, other institutions should not be hard hit by contagion, or the adverse effects should be limited. The companies destined to fail should fail in such a way that it is the shareholders and creditors of the company that bear the risk of failure, not the public. “If necessary, an institution can be allowed to fail in a way that does not disrupt the financial system as a whole” (Treasury Committee, in UK Parliament, 2011). A major concern that must be addressed in the containment of contagion risks is the interconnectedness of modern banking and financial institutions among each other, both domestically and internationally. Any measures to improve financial stability must include this consideration, which is particularly difficult because while the problem may not have originated within the UK jurisdiction but across borders, it may still well affect the stability of the country’s banks and financial institutions. Insulating the domestic system from foreign interaction may contain contagion, but it will also certainly contribute to a laggard and retarded economic. Another complication in arriving at measures to assure the maintenance of financial stability is that it could not be achieved by mere adjustments in a few policies or tools. In contrast, monetary stability can be achieved by fine-tuning of policies to lower inflation by lowering or raising interest rates. Also, unlike monetary policy formulation where the parameters may be summed up and specified in terms of target interest rates and inflation rates, and tools used are well defined such as quantitative easing, financial policy targets are more difficult to measure and specify, and regulatory tools are still lacking (UK Parliament, 2011). The existing structure of UK financial regulation In the present tripartite system, financial regulation is shared by the Treasury, the Bank of England (BOE) and Financial Services Authority (FSA); under this system, there is no single institution that has been accorded the responsibility, tools and authority to monitor the entire UK financial system and to respond to problems that arise therein. The tripartite system has in the past proved to be insufficient in preventing the occurrences of events such as the collapse of Northern Rock and the subsequent shocks in the UK financial system. With hindsight, the Treasury Committee expressed its concern that “to outside observers, the Tripartite authorities did not seem to have a clear leadership structure” (UK Parliament, 2011). It subsequently recommended that such an authoritative structure be thus created and be integrated into the reforms that the UK financial system shall undergo. The proposed new structure of UK financial regulation In an effort to correct perceived weaknesses in the financial regulation of the UK banking system, the Government has proposed its replacement with a new regulatory framework. In light of the weaknesses of the tripartite system, the regulatory power has been officially delegated to the Bank of England, for which the Government is to create a new Financial Policy Committee (FPC) within the Bank. It is the job of the FPC to “look at the wider economic and financial risks to the stability of the system” (HM Treasury, 2011a), and it shall be empowered to discharge the “primary statutory responsibility for maintaining financial stability” (UK Parliament, 2011). Presently, pending the necessary legislation, an interim FPC is already operative, established by the joint efforts of the BOE and the Treasury. The Committee will be equipped with the necessary macro-prudential capabilities to identify and respond to risks and potential crises. As for the present Financial Services Authority (FSA), it will cease to exist and two new financial regulators shall take its place, namely: A Prudential Regulation Authority (PRA) which shall take responsibility for daily supervision of financial institutions which are under prudential regulation. It shall employ a “judgment-focused approach” to regulatory enforcement, to more capably challenge new business models, identify risks and act to preserve the stability of the financial system. A Financial Conduct Authority (FCA) which will act as independent conduct of business regulator. The FCA shall adopt a tough approach in the regulation of the manner in which firms conduct business. It will be backed by a powerful mandate in order to promote confidence and transparency in the financial industry, and for greater protection to be afforded its consumers. The new regulatory framework is envisioned to conform to a “twin-peaks” model, which separates the prudential regulation of financial institutions from the oversight of consumer protection and markets conduct (UK Parliament, 2011). Proposed FPC membership and macro-prudential tools The proposed FPC, which is the body within the BOE charged with the overall stability of the financial system, will most likely include: Governor Deputy Governor for monetary policy Deputy Governor for financial stability Deputy Governor for prudential regulation Bank executive on Markets, under the Deputy Governor for monetary policy Bank executive on financial stability, under the Deputy Governor for financial stability Head of the Consumer Protection and Markets Authority (CPMA) 4 external members Non-voting representative from HM Treasury The role to be played by the four external members is strategically important, because the FPC, to be effective, must be perceived as credible, so the four external members must be highly respected and of good standing in the financial industry, as well as commanding deference within the BOE itself. The principal reason for the inclusion of the four members, and that will guide the choice of whomever will be chosen for the position, will be “ ‘to liberate the internals from a monolithic line management structure,’ and that having the externals there meant that you just don’t go along and say, ‘Well, it’s absolutely clear what we ought to do and we all agree’.” (Paul Tucker, in U.K. Parliament, 2011). There are a host of macro-prudential tools which the FPC may decide to employ once it is in full operation. The Treasury (cited in UK Parliament, 2011) enumerate some of these as: (1) Countercyclical capital requirements, to add a “buffer” to capital requirements in response to the cyclical position of the economy; (2) Variable risk weights, to effect an increase in capital requirements to balance off the risks of different types of lending, and to hedge against exposure to particular asset classes; (3) Leverage limits, to impose an overall limit on the volume of debt that financial institutions could employ to backstop capital requirements that are risk-weighted; (4) Forward-looking loss provisioning, wherein banks would be compelled to allocate provisions for possible future losses incurred on their lending activities Different means can be employed for loss provisioning to function as a macro-prudential tool, citing as example the “dynamic provisioning” system in Spain. In this system, the credit cycle is linked to the loss provisions such that when credit growth is high, banks are forced to increase their level of provisions to a more conservative coverage level. (5) Collateral requirements, the purpose of which would be to limit certain kinds of lending by requiring higher restrictions on collateral when growth in that particular lending becomes unsustainable. For instance, such measures are loan-to-value limits on secured lending, margin requirements on stocks or purchases, or the application of haircuts on repurchase transactions undertaken by investment banks; (6) Quantitative credit controls and reserve requirements, that would impose limits on lenders and on increasing short-term liquidity requirements of financial institutions, thereby putting a cap on additional lending. There are various socio-economic consequences that are expected from resorting to these macro-prudential tools. Such measures are generally categorized into two broad classes: those that target the fundamental weaknesses in the system, and those that promote the resilience of the system by setting off and compensating the effects of cyclical developments. Eventually, the use of macro-prudential tools will have an effect on the general economy, and ultimately the individual consumers. During a time of strong growth and a booming economy, such tools may become highly unpopular due to their tendency to slow down and dampen the fast-paced economic activity – for instance, by controlling the amount of credit that may be generated in the real economy. Also, by increasing the capital reserve requirements, banks will be compelled to either raise additional capital, or reduce risk-weighted assets, which will be seen as a dampener in a bullish economy. Strengths, Weaknesses, Opportunities and Threats In light of the foregoing, the following is a summary of the strengths and weaknesses of the new system vis-a-vis the old, the opportunities that may emerge, and threats it may be compelled to confront. Strengths Establishment of a new Financial Policy Committee (FPC) responsible for macro-prudential regulation to monitor system-wide market risks Devolution of micro-prudential regulation to the Prudential Regulation Authority (PRA), an operationally independent BOE subsidiary, to monitor and control firm-specific risks Monitoring of conduct of business regulation by the Financial Conduct Authority (FCA), hitherto called the Consumer Protection and Markets Authority (CPMA), which is tasked with the regulation of the entire spectrum of financial services. Weaknesses The Bank of England is equipped with limited tools to address financial stability, although it was statutorily mandated to stabilize the financial system The FSA had a very broad mandate that included consumer protection, public awareness, market confidence, and reduction of financial crime (HM Treasury, 2011b) and could not focus on stability. As with all financial regulatory systems worldwide, the UK’s system was ill equipped to monitor, understand, and arrest systemic instability issues, aggravating the firm-specific weaknesses before the risks were recognized. Opportunities There are better opportunities now for regulatory reforms to succeed. State and institutional feedback in the local environment indicate the general assent to comply with the new regulations. Internationally, there is also general move towards adopting similar macro-prudential tools to complement micro-prudential regulation, because of the Basel III provisions. This will enhance UK efforts to stabilize its financial system, with less susceptibility of contagion than if reforms were only adopted locally. Financial institutions see a chance for recovery by expanding into emerging markets less affected by the recent crisis. With the international safeguards in place, this should prove a viable option. Threats The greatest threat so far for the European system in general is the current financial crisis in Greece, which is causing systemic vulnerabilities in the rest of the European Union. While the UK is not part of the monetary union, it is nevertheless a part of the community and is therefore prone to economic shocks. The UK is also prone to shocks from external markets, particularly the United States, with which many of its financial institutions are still strongly affiliated. The internal vulnerability of the UK economy still hinges on the strength of its bailout programs, the effects of which will only be evident in the long-term. It will continue to be a source of instability for the near term References: BBC News Staff (2009) Q&A: UK Banking Regulation. BBC News 18 June 2009. Accessed 18 October 2011 from http://news.bbc.co.uk/2/hi/business/8104813.stm Bell, S. (2011) UK Banking Industry Encouraged By Continued Drops In Fraud Losses. CardLine, 3/11/2011, Vol. 11 Issue 10, p32 Duncan, H. (2008) Santander Grabs 10% Of UK Savings With B&B Deal. Evening Standard, 9/29/2008, p1 Financial Services Authority (FSA) (2009) A Regulatory Response to the Global Crisis. Accessed 18 October 2011 from http://www.fsa.gov.uk/pubs/discussion/dp09_02.pdf Hamalainen, P.; Howcroft, B.; & Hall, M. (2010) Should A Mandatory Subordinated Debt Policy Be Introduced In The United Kingdom? Evidence From The Issuance Activity Of Banks And Building Societies. Contemporary Economic Policy, Apr2010, Vol. 28 Issue 2, p240-263, 24p, 15 Charts; DOI: 10.1111/j.1465-7287.2009.00174.x Harris, L. (2001) The IT productivity pardox--evidence from the UK retail banking industry. New Technology, Work & Employment, Mar2001, Vol. 16 Issue 1, p35 HM Treasury (2011a) The structure of UK financial regulation. Financial Services. Accessed 18 October 2011 from http://www.hm-treasury.gov.uk/fin_stability_regreform_structure.htm HM Treasury (2011 b) A new approach to financial regulation: building a stronger system. Accessed 18 October 2011 from http://62.164.176.164/d/consult_newfinancial_regulation170211.pdf Industry Overview. Black Book - UK Banks: Still in the Doldrums or Poised to Pick Up the Trade Winds? 1/1/2007, p13-41 Office of Fair Trading (2008) The legal and regulatory framework behind personal current accounts. Accessed 18 October 2011 from http://www.oft.gov.uk/shared_oft/reports/financial_products/oft1005a.pdf Papasolomou, I &Vrontis, D. (2006) Using internal marketing to ignite the corporate brand: The case of the UK retail bank industry. Journal of Brand Management, Sep 2006, Vol. 14 Issue 1/2, p177-195; DOI: 10.1057/palgrave.bm.2550059 Sunderland, R. (2010) Will banks be tamed at last? Daily Mail, 9/21/2010, p75 UK banking industry: hold your branches! MarketWatch: Global Round-up, Dec 2009, Vol. 8 Issue 12, p149-150 UKFI job sounds like a nightmare. Evening Standard, 9/2/2009, p32 UK Parliament (2011) Financial Regulation: a preliminary consideration of the Government’s proposals – Treasury. Accessed 18 October 2011 from http://www.publications.parliament.uk/pa/cm201011/cmselect/cmtreasy/430/43004.htm#a2 Read More