Banking And Capital Markets Insight

Welcome to the February 2010 edition of Banking and Capital Markets Insight, which focuses on technical issues currently coming out of the banking, capital markets, securities and fund management arenas. Our focus for this edition is on the significant, and now much more imminent, proposals for regulatory change in respect of banks and investment firms, and the equally significant developments in the treatment of bank payroll taxes and the code of practice for bank taxation.

Our five pieces cover the following areas:

Clifford Smout on the Bank of England discussion paper issued at the end of 2009 on "The role of macroprudential policy" which considers the tools which policy makers have available to avoid procyclicality and the "too big to fail" concerns around a number of institutions, such as moving to an expected loss model for provisioning and capital surcharges for size and interconnectedness; Eric Wooding on the FSA's proposed changes to the large exposures rules for investment firms, which will on the one hand remove Limited Licence and Limited Activity firms from the LE regime, but which proposes the introduction of a much more restrictive treatment of large exposures for Full Scope firms from 1 January 2011; Debbie Masterton on the basics of the Bank Payroll Tax, introduced by HMRC in December 2009, which employees it applies to, how it is calculated, and which specific elements of relevant remuneration it captures; Mike Williams on the current issues arising for investment firms from the FSA reports and discussion papers on client money and the basis for calculation of the ICAAP, and the challenges that they pose at board as well as operational levels; and Tim Sharp/Mark Kennedy on the revised Code of Practice on Taxation for Banks, which was issued in December 2009 and amends the basis on which banks should approach HMRC to discuss individual transactions, and emphasises the need for "reasonable belief" that remuneration packages are not contrary to the intentions of Parliament. We look forward to your comments on the current edition.

Macroprudential requirements: What are they and what might this mean in practice?

There is currently no shortage of proposals on what must be done to reform the banking system. In broad terms these can be classified under three headings:

Changing banking structures (e.g. limiting links between commercial and investment banking; reducing bank size; greater use of central counterparty clearing). The intention is that in future firms will not be too "big" (or too interconnected) to fail, and that depositors will not be exposed to supposedly "risky" activities. Making individual firms more resilient (e.g. raising capital and liquidity requirements; improving risk management; re-examining remuneration structures). These amendments to the regulatory framework are intended to reduce the probability of failure. Improving the way in which failing firms are dealt with (e.g. by requiring them to draw up recovery and resolution plans). The intention is that when firms fail they do so in a way that does not impose undue costs on others. As part of the proposed changes to the regulatory framework, policymakers are also focusing on the system as a whole, and the interaction between firms: the so-called macroprudential perspective. As part of this debate, at the end of 2009 the Bank of England published a discussion paper on The role of macroprudential policy.

Financial stability and systemic risk

Although the FSA has responsibility for the prudential supervision of individual firms, the Bank of England has a statutory objective of financial stability. In order to make this concept operational, there needs to be a clear definition of what "financial stability" is, and a workable set of tools to help deliver it.

The paper suggests that the goal of financial stability policies should be "the stable provision of financial intermediation services to the wider economy", avoiding the sort of boom and bust in the supply of credit and liquidity experienced recently, although not necessarily preventing asset price bubbles as such. Importantly, this means that in a downswing, steps should be taken to sustain lending, whereas a microprudential supervisor might advocate a more conservative approach.

The paper notes that systemic risk has two components:

The first is a tendency of firms to become collectively overexposed to risk in an upswing and to over-react in a downswing, perhaps as a result of herding. The second is a failure to take account of the spillover effects from their actions on others. Both represent forms of market failure, which may reflect incentive problems, information frictions (including "disaster myopia" where the possibility of bad outcomes are eventually ignored) or co-ordination issues, where individually rational decisions (such as an attempt to sell assets) may result in a worse outcome for all.

Macroprudential tools: countercyclical requirements

What tools might make the financial system less cyclical? How can firms be encouraged to build up buffers of capital in good times, to be used when the going gets tough?

There has been much attention recently on moving from an "incurred" to "expected" loss model for provisioning, and also on eliminating procyclicality from risk measures. But the Bank notes that these merely reduce procyclicality. By contrast, some of the macroprudential tools it describes are countercyclical by design.

This could be done either by adjusting capital requirements across-the-board, or by doing so at a more disaggregated level, which would be more complex but potentially also more precise.

One difference between these alternatives, not explored in the paper, is that since capital requirements are the product of risk-weighted assets (which would alter in the disaggregated approach) and the capital ratio, a significant change in capital could occur even with an unchanged ratio. By contrast, in the aggregate approach the capital ratio would vary – which might be received negatively in a downswing, when the market would be nervous about apparently lower ratios. It would be simple, however, to recast the across-the-board approach into an overall levy or discount on all risk weights instead, if this were felt necessary to address the problem.

The paper also considers the role that judgment should play in making these adjustments. One approach would be to use a formula instead, based on asset prices or credit expansion, though there is no perfect early warning indicator: rapid credit growth for instance might reflect a structural change in the economy. Alternatively, policy might be set judgmentally, via a Committee that could take the full range of data into account, but which might be subject to lobbying from bankers and others reluctant to accept the case for more stringent requirements when the economy seemed to be in good shape. The Bank of England appears to prefer the latter approach, but accepts that it would require robust mechanisms to ensure accountability, transparency and predictability.

Capital surcharges for size and interconnectedness

Systemic risk can result not only from aggregate factors – i.e. the tendency of the sector to move together – but also from network risk: problems at one firm spilling over to others, or to the economy as a whole. These potential externalities are greater the larger the firm, the more connections it has to others and the less "substitutable" its products are. If a firm is "too big to fail" then the beneficiaries from the "rescue" are typically not shareholders or management, but wholesale counterparties and funders, who in effect benefit from a guarantee for which they have not (as yet) paid.

The Bank supports the FSA proposal to set a capital surcharge to address these issues. This would not only lower the probability of those firms failing, but also potentially encourage restructuring (e.g. to make the firm less interdependent on others) and the preparation of "living wills".

Making the regime operational

While there is no perfect early warning indicator for exuberance in credit markets, the Bank of England sets out a list of variables that might be considered by those setting variable capital requirements. Not all of this information currently exists – and some would require extensive data from individual firms to build up an aggregate...

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