Identifying and Addressing Weaknesses in UK Financial Regulation - Coursework Example

Identifying and Addressing Weaknesses in UK Financial Regulation Introduction This paper examines the regulatory weaknesses in the UK banking system as identified by a report of the Independent Commission on Banking (ICB), which was begun in June 2010 and published in September 2010.1 The arrangement of this report mirrors that of the ICB paper. A brief summary of the present environment of the UK banking and financial sector is given to provide the context for the regulatory issues identified by the ICB report. Following that, the issues are individually studied. To conclude the paper, the recommendations of the ICB for reforming banking regulation are assessed, and possible alternatives to those recommendations described. Present State of the UK Banking & Financial Sector The area of responsibility for the ICB is divided into two broad categories, retail/commercial banks, and wholesale/investment banks, with other non-banking entities such as hedge funds and securities managers not ordinarily regulated to the same degree as the banking sector monitored to the extent that their activities affect banking regulation.2 Europe-based financial institutions, in particular HSBC, now dominate the international financial sector, taking over from American banks in terms of total revenue through 2009 and 2010.3 Compared to the US and other European countries, the banking sector in the UK is small in terms of numbers of banks; there are only about 340 banks in the UK, with just six of those accounting for nearly 90% of the deposits in the retail & commercial category; in the wholesale & investment sector, the top ten firms account for about 65% of revenues.4 General trends in the banking sector through 2009 and 2010 and so far this year are related to banks’ having to work through continuing lack of liquidity, high credit costs, and price volatility, with smaller and less leveraged institutions being seen as having somewhat of a competitive edge on larger and more diversified companies obliged to more comprehensively reconfigure their businesses.5 The unanimous opinion of the ICB and economic observers is that the current state of the financial sector is a reflection of the ongoing effects of the global financial crisis of 2007-2009, but there are differences in opinion as to its causes and the direction that government intervention – if any – should take in managing the recovery from the crisis. The ICB implies that the rapid growth in the trade of derivatives and credit default swaps was a direct cause of the crisis, because the underlying theory that instruments that allowed the securitisation of debt and the dispersal of credit risk helped to make financial markets more stable turned out to be wrong.6 To support this point of view, the ICB explains that the leverage position of the UK’s four largest banks increased significantly before the crisis, but that their overall risk levels actually declined, indicating that, despite the increase in leverage, the banks were taking on more assets with lower risk weights. The only way that would have possible would be if those risk weights were inaccurate, lower than the real level of risk they eventually revealed.7 The implication of inaccurate risk weights is that they were either deliberately misrepresented – a charge that the ICB does not make – or that there was something inherently wrong with the risk weighting model and its parameters when applied to debt securitisation. Others argue, however, that is was fundamental problems in the US housing market – the source of millions of mortgage loans later packaged and traded as mortgage-backed securities – and not the new financial product models that were directly responsible for “contaminating” the global credit markets.8 In other words, if all of the now well-known problems affecting the US mortgage market in the run-up to the crisis in late 2007 – mortgage loans being extended to people whose income could not support them, speculation-driven increases in property prices, and assorted instances of fraudulent business activities – had not happened, the model would have worked. A common point of view on what the ultimate cause of the financial crisis was is the trend of deregulation and regulatory reform begun in the US in the 1980’s9, significantly marked by the repeal of the Glass-Steagall Act in 1999, and followed up by further loosening of regulatory controls between 2000 and 2004. The Glass-Steagall Act was passed by the US Congress in 1933 in the wake of the Great Depression, and its major impact was to separate commercial and investment banking and prohibit banks from selling insurance.10 Investment banks were prohibited from accepting retail or commercial deposits, which allowed for lower regulation; as non-deposit institutions they were not at risk of bank runs, and so heavy regulation of the sort meant to prevent the crises at the beginning of the Great Depression were unwarranted in their case.11 In 1999, Glass-Steagall was repealed by the passage of the Gramm-Leach-Bliley Act (the “GLB Act”), which removed most of the separations between commercial and investment banking in the US. In some respects, GLB was simply an acknowledgment of the reality of the financial world; while Glass-Steagall was in force, the comparatively lesser-regulated investment banking sector had expanded greatly, and had found ways to offer many of the same products as commercial banks. Additionally, in 2004, the US Securities & Exchange Commission exempted investment banks from the net capital rule, which allowed institutions to take on increased levels of debt and invest in traditionally off-limits products such as derivatives and credit default swaps.12 In the same year, the Basel II Accord proposed risk management, regulatory controls, and minimum capitalisation requirements for international banking institutions, but these standards have not been fully-adopted in the US, or for that matter, many other countries either.13 The result of all this is a world-wide financial industry that is interconnected in a complex and intimate way. A crisis in one sector very quickly causes a knock-on effect throughout other areas of the banking and investment businesses, and becomes a systemic crisis. In the most recent crisis, a downturn in demand and prices in one particular area, home sales in the US, eventually led to near-catastrophe for economies across the globe. The background of the US experience with deregulation and the GLB Act is relevant to the assessment of issues and recommendations for reform in the UK banking sector because separating commercial and investment banking, essentially developing a version of Glass-Steagall, is at the heart of the proposals for regulation that are being considered.14 The issues guiding that consideration are examined in the following section. Issues Identified by the ICB The context in which the ICB has looked at issues in banking reform is the need to promote financial stability and an appropriate level of competition and consumer choice, while encouraging the wider economic recovery, minimising risks to the government’s fiscal position, and supporting the competitiveness of UK institutions in the wider international banking business.15 While recognising that these issues are closely connected, it may be helpful for the sake of clarity to address them individually. Financial Stability The primary issue relating to financial stability is the concept of institutions that are “too big to fail.” Because large and diverse firms are so connected to other parts of the financial system, their failure due to bad management or poor strategic choices, which would be considered a normal outcome in any other business, poses a systemic risk.16 The reason that non-bank institutions or lesser-regulated investment banks can even pose a systemic risk in the first place is at least partly due to the lack of separation between banks that are forced to operate under stricter rules of capitalisation and risk management and other types of institutions. Since the banks are not prevented from operating businesses such as hedge funds that are subject to looser regulations, they can practise regulatory arbitrage: shifting business activities to other parts of their enterprise to take advantage of the least-monitored conditions.17 What makes this a systemic risk is that in most countries commercial and retail banking has a safety net – mostly for the protection of depositors – of a “lender of last resort” in the government treasury and some form of deposit insurance, which implicitly places the institutions under state support and shifts the credit risk of bank activities to the taxpayer.18 With no separation between commercial/retail and investment banking activities, the institutions’ assets are spread across both categories and a crisis in the investment banking area, such as what was experienced from late 2007, poses a risk to the more closely-regulated and government-supported traditional depository banking area. The growing globalism of the financial industry only aggravates the problem, because institutions can practise regulatory arbitrage on an international scale, not only shifting business activities from one regulated area to another in their home countries, but operating in countries where the overall regulatory environment is less restrictive as well.19 Any failure within the firm then becomes generalised, and represents a failure of the supported deposit-banking part as well, obliging the government to intervene to prevent total collapse. Competition In the view of the ICB, “It bears emphasis that what matters is not competition per se, but competition to provide what customers want.”20 In other words, the competitive environment must encourage competition in the right contexts. One area that represents “competition for the wrong reasons” and has attracted wide public and regulatory attention is in the matter of compensation for bankers and other agents in the financial system, which is often incentive-based and encourages unwise levels of risk-taking.21 Until the onset of the worst effects of the financial crisis – i.e., the inevitability that it could not be ameliorated without great public cost – compensation was not addressed by most regulatory frameworks. For example, the first principle outlined by the Basel II Accord states, “A bank’s board of directors and senior management are responsible for ensuring that the bank has appropriate credit risk assessment processes and effective internal controls commensurate with the size, nature and complexity of its lending operations to consistently determine provisions for loan losses in accordance with the bank’s stated policies and procedures, the applicable accounting framework and supervisory guidance.”22 but allows for a great deal of flexibility in the bank’s determining what those “appropriate credit risk assessment processes and effective internal controls” should be, and does not explicitly (or implicitly, for that matter) prohibit the linkage between incentive-based compensation and credit risk judgment protocols. What makes this an even bigger dilemma is that the ability to provide compensation to attract skilled talent is also a competition issue; in order to encourage competition, an environment must be provided that allows firms to do this. Another criticism of the “too big to fail” concept relates to competitiveness as well. In its written submission to Parliament in September 2010, the Paragon Group of companies complained about the damage the current economic environment has done to the competitive position of non-deposit lenders, and the unfair advantage they saw being provided to the mainstream banking sector in the form of bail-outs and other government support.23 Mortgage lenders relying on securitisation for funding, asserted Paragon, provide a vital consumer choice, and the reluctance of banks to engage in lending in the aftermath of the crisis has been detrimental to customers. This perspective complements that of the ICB, which recognises that one argument against increased consolidation of the financial industry and the creation of entities “too big to fail” implicitly gives those entities an unfair competitive advantage by providing them with the safety net of critical systemic importance. By contrast, however, high levels of competition encourage increased risks for the sake of attracting customers, who have far more choices in products and providers.24 Thus “stability” and “competition” becomes a matter of finding and maintaining the proper balance to achieve the overall best results. Proposals for Reform The reforms presented in the ICB report do not in that document take the form of certain recommendations, but rather options that may be considered. This section will go beyond the scope of the ICB report by selecting certain options as recommendations for the most likely successful reforms that could be implemented. Separation of Retail and Investment Banking Although the experience of the US in repealing the Glass-Steagal Act was earlier described in order to provide some background to the economic crisis which has inspired the search for banking reforms, it is important to note that the same degree of separation has not existed in the UK, and would represent a fundamental reconfiguration of the financial industry. The ICB sketches out the broad arguments for and against separation of retail and investment banking. On the positive side, separation is said to increase stability by removing the risk that depositary institutions will be jeopardised by the activities of their investment-banking components. Likewise, more prudent management will be encouraged by removing the backing for investment activities from publicly-guaranteed deposit assets, and competition will be encouraged by limiting the scope of activities by any one company.25 The arguments against separation are that it may be less efficient than the current arrangement, and may in fact not serve to prevent the sort of problems that occurred in the recent financial crisis. Customer-oriented competition may be better served by allowing consolidation, because customer costs will be lowered.26 The notion that separation will not really prevent credit or liquidity problems is based on the reality that banks operating on an international scale can practise regulatory arbitrage. While regulatory frameworks such as Basel II hypothetically should prevent this, another reality is that in order for these international standards to be followed by a large number of independent, national regulatory bodies, the standards must be fairly general in nature. For example, Basel II provides just four risk-weighting categories that determine appropriate capitalisation levels for banks – 0% for OECD governments, 20% for OECD banks and non-OECD governments, 50% for mortgage loans, and 100% for all other loans. The problem is that within these broad categories different loans carry different risks, and so a bank can shift to higher-risk loans within a category, effectively taking on an overall higher risk level, and still be fully compliant with the Basel II standard.27 Therefore, the argument against separation essentially comes down to an assertion that banks will simply find a way around it, and that the overall shape of the financial industry will not really change. Limited Banking Another proposal that is described is “limited banking,” which effectively separates retail deposit activities from all other bank activities for the purposes of providing safe public insurance for those funds. While a limited banking facility could be part of a larger bank holding company, in the event of a crisis the “bail-out” would only be applied to the retail deposits, since they would be backed by safe liquid assets, specifically short- to medium-term government bonds.28 There are a number of obvious flaws with this proposal. Limiting the investment by banks of deposited assets to a single, narrow option might amount to restraint of trade from the banks’ point of view, and encourage them to react in one of two ways: either to avoid the deposit-banking business altogether, or to take on even more risk in other areas of their business to make up for the loss of opportunity in deposit banking. The impact on customers would be less competitive choice in banking services in the first case, and in the second, likely unattractive interest rates on traditional savings. In the sense that limited banking appears to actually discourage savings one way or another, it tends to work against the ICB’s objectives of supporting overall financial stability and national economic competitiveness, and is an idea that should therefore be discarded. Limits on Proprietary Trading This proposal mirrors the so-called “Volcker Rule” already being partially applied in the US, which prohibits deposit-taking institutions from engaging in proprietary trading business, such as taking part in hedge funds or private equity trades.29 This has the same effect of preventing the potentially unwise investment of deposits as limited banking does, but without restricting the bank from accessing investment options. The practical problem with this concept is that what constitutes “proprietary trading” may be difficult to determine; as the ICB points out, there are some conceivable legitimate deposit-banking activities, such as risk-hedging, that function in very much the same way as proprietary trading activities but would not necessarily be regarded as such. Recommendations While the ICB is seeking to find ways to reform the structure of the banking industry to prevent a repeat of the 2007-2009 crisis, it seems that most of the most promising potential reforms are procedural, rather than systemic in nature. The root cause of the crisis, after all, was in the US mortgage industry; the housing bubble and its subsequent bursting was largely outside the control of the banking industry, but the poor credit-risk assessments, compensation based on short-term manager performance that encouraged risk-taking, and the development of exotic derivatives based on highly-suspect debt assets were not. The crisis became as deep as it did as quickly as it did because of the complex interconnectivity of the financial world, but that interconnectivity was not the cause of the crisis – the crisis would have only been smaller, but would still have occurred without those connections. From that perspective, a number of practical recommendations that recognise the realities of the banking industry yet provide greater protection against a system-wide failure can be made: Implement fundamental changes to the way credit ratings agencies do business: Conflicts of interest and poor information caused the big three ratings agencies – S & P, Fitch, and Moody’s – to give inaccurately high ratings to derivatives and other debt assets before the crisis, leading to a bubble in those prices. The major problem here is that the agencies are paid by issuers rather than the investors, and so the obvious incentive is to provide credit ratings that are as positive as they can be made.30 Reversing this arrangement, along with new regulatory powers provoked by the Greek and Irish crises in the EU to oversee credit ratings and rating methodologies31 can help the banking industry to maintain sound, consistent credit rating standards as well. UK regulators should follow the lead of the European Commission, and then extend the regulatory safeguards by prohibiting retail and commercial issuers from soliciting ratings. Implement a version of the Volcker Rule: Banning certain types of dangerous derivatives – such as mortgage-backed securities – and prohibiting the participation in proprietary trading by deposit institutions seems to be a reasonable middle-ground between full separation of commercial and investment banking or limited banking and regulation that is too loose. The largest challenge here will be to very specifically and narrowly define what constitutes a proprietary trading activity and what does not, and is likely to be a contentious issue. However, it does seem to be the best way to ensure that a reasonable competitive environment is still available to banks and their customers while providing a number of safeguards against a systemic crisis. Provide regulators with powers to oversee compensation in the financial industry: The terms and levels of executive and manager compensation have proven to be unpalatable to the public, and are widely held to have encouraged poor management and excessive risk-taking. While removing incentive-based compensation entirely would be unfair to banking businesses trying to attract the best talent available, incentives should focus on long-term, sustainable performance measures and should be limited to reasonable levels. Again, this will prove to be a contentious issue, but the recent experience of the financial crisis and the public backlash against unjustifiably high compensation packages should encourage the concerned parties to find a workable solution. References Basel Committee on Banking Supervision. (2006) “Sound credit risk assessment and valuation for loans”. Basel: Bank for International Settlements, June 2006. Business Insights. (2009) The Outlook for Retail Banking in Europe and the US. London: Business Insights, Ltd., June 2009. [Internet/Summary version] Available from: http://www.globalbusinessinsights.com/content/rbfs0073m.pdf. Hume, N. (2011) “Shaking up the UK banking sector”. ft.com/alphaville, [Internet] Financial Times, 12 January 2011. Available from: http://ftalphaville.ft.com/blog/2011/01/12/ 456576/shaking-up-the-uk-banking-sector/. Iannuzzi, E., and Berardi, M. (2010) “Global financial crisis: causes and perspectives”. EuroMed Journal of Business, 5(3): 279-297. Available from Emerald: www.emeraldinsight.com/1450-2194.htm. Independent Commission on Banking. (2010) Issues Paper: Call for Evidence. London: Independent Commission on Banking, 24 September 2010. Mazumder, M.I., and Ahmad, N. (2010) “Greed, financial innovation or laxity of regulation? A close look into the 2007-2009 financial crisis and stock market volatility”. Studies in Economics and Finance, 27(2): 110-134. Available from Emerald: www.emeraldinsight.com/1086-7376.htm. Mullineux, A. (2009) “The regulation of British retail banking utilities”. Journal of Financial Regulation and Compliance, 17(4): 453-466. Available from Emerald: www.emeraldinsight.com/1358-1988.htm. Oatley, T. (2000) “The Dilemmas of International Financial Regulation”. Regulation, 23(4): 36-39. Paragon Group of Companies. (2010) “Competition and choice in the banking sector”. Written testimony to the Treasury Select Committee (UK), 21 September 2010. [Internet] Available from: http://www.publications.parliament.uk/pa/cm201011/cmselect/cmtreasy/memo/banking/ m17.htm. Roubini, N. (2008) “Ten Fundamental Issues in Reforming Financial Regulation and Supervision in a World of Financial Innovation and Globalization”. RGE Monitor, 31 March 2008. Vittas, D. (1992) “Policy Issues in Financial Reform”. Policy Research Working Paper WPS 910, May 1992. Washington: Country Economics Department, The World Bank. Waterfield, B. (2010) “European Commission's angry warning to credit rating agencies as debt crisis deepens”. The Telegraph (UK), 28 April 2010. [Internet] Available from: http://www.telegraph.co.uk/news/worldnews/europe/greece/7646434/European-Commissions-angry-warning-to-credit-rating-agencies-as-debt-crisis-deepens.html. Read More