The Future Prospects for British Banks
The Future Prospects for British Banks
The final decade of the twentieth century and the beginning of the twenty first century offered a window of opportunity for global cooperation in the regulation of banking. Much is being made of the need to design an effective architecture for banking, particularly for the twenty-first century. This implies that the existing architecture is not working as well as possible and is in need of repair or possibly a thorough overhaul. Many are lobbying for such changes. Numerous articles on this topic have been written by academic economist and presented at professional meetings. Bankers and bank competitors have complained almost daily of the inefficiencies and inequities of the current structure. The focal point of this work is future leading trends in regulation of the financial industry, in particular, the new rules which will become necessary and are currently under development in connection with reporting practices because of the huge transformation taking place in banking and in the financial industry at large. A second objective is to compare how authorities of Britain deal with the supervision of derivatives exposure, and a third is to identify the new frontiers in financial reporting and explain what more could
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To understand the rationale for regulating British banks, it is first important to review the history of the regulation of domestic banks. The earliest banks were not the same kind of institutions that we have today. Currently, banks serve both deposit and lending functions; that is, they issue liabilities that are a convenient medium of exchange, and are intermediaries between borrowers and lenders. The great early banking houses loaned out their own capital, not other people’s money. There existed other specialized institutions that accepted deposits for safekeeping. It is only later that the two functions, lending and deposit taking, were fused into banking institutions – usually connected to the needs of the sovereign for financing expenditures. The intertwining of these two functions necessarily implies that banks are subject to the problem of banks runs, since the funding source for assets is mostly depositors’ funds and, to a much lesser extent, the bank’s capital. In the early nineteenth century, banks operated with capital ratios in the 40 percent range in Britain.
The optimal bank regulation is regulation designed to assure a minimum level of prudential soundness. This view is based on the assumption that banks manage risks and, at the same time, play an important role in the payment system. Given this view of banks, the regulators must supervise banks to control risk to prevent a systemic crisis. Banking regulation should seek to mimic the operation of free markets. Optimal regulation would involve a policy whereby regulators would invoke prompt corrective action when capital-asset ratios reach specified levels. Mathias Dewatripont and Jean Tirole (1994) have developed a model of optimal regulatory behavior based on a double moral hazard dilemma. (Blount 2004) Optimal regulation involves an incentive structure which leads regulators to intervene only when bad management results in underperformance by a bank manager.
In its strictest sense, however, banking regulation refers to the framework of laws and rules under which banks operate – these are the rules of the game. Supervision in its strictest sense refers to the banking agencies’ monitoring of financial conditions at banks under their jurisdiction and to the ongoing enforcement of banking regulation and policies. Optimal supervision would promote alocative efficiency in the carrying out of the regulations, assuming, if we wish, self-interest-motivated behavior of the regulatory agencies. In the regulation of banking, regulators must balance the problems of prudential regulation, market discipline, and moral hazard. In practice, this implies regular examinations, greater transparency, and capital adequacy standards.
There are three basic approaches to banking regulation in the future: the first would be a move toward greater reliance on the discipline of the market system, the second would be the establishment of a supranational regulatory agency, and the third would be a continuation of what we have – a combination of reliance on market discipline, an expandable role for banks’ internal controls, and international supervisory cooperation. The third appears to be the preferred approach for the foreseeable future.
The increased difficulties of banking regulation and supervision will require that regulators ensure that banks have their own internal control mechanisms in place. The logic of this strategy is that, today, international markets are so instantaneously interconnected that intervention by regulators when a crisis erupts is always a second-best solution. The way to minimize problems in the future is to make banks take all precautions to protect themselves in a competitive environment. This view is consistent with those who believe that there should be a greater reliance on market forces in disciplining banks.
Undoubtedly, bank examiners must be well trained. Recent changes in examination procedures at the U.S. bank regulatory agencies have placed Ph.D. economists on the examination teams. This, together with greater reliance on competition, may promote more effective supervision that also minimizes the problems of systemic risk. Will there indeed be a greater reliance on market discipline? The lesson from history is that we will continue to need a lender of last resort, and the nonbank institutions that compete with banks in the payment system will eventually be regulated as banks. History has also shown that the move toward greater regulation and supervision has often occurred during periods of financial distress.
What does this imply for British banking regulation – which has also been driven by financial crises? In the first place, it implies that the domestic bank regulatory agencies will expand their turf to include financial institutions that today are not considered banks. Hence, in the United Kingdom the result of legislation to expand the scope of the operations of banks will lead to the regulation of the nonbank competitors. This will also require some restructuring of the activities and responsibilities of the various financial institution regulatory agencies.
In recent years, the IMF and the World Bank have placed increasing emphasis on the importance of financial systems as crucial infrastructure. Both agencies have enormously expanded staff in the area of banking regulation and supervision. At the same time, both agencies have come under criticism for continuing to exist when the reason for their existence is questionable. The BIS has seized the initiative in global arrangements on banking regulation and supervision. Though there is unlikely to be a global chartering agency, the IMF could conceivably provide expertise to examine global banks. It could do this under the authority granted by nation-states, or as part of the revised IMF Articles of Agreement. The IMF, even more than the World Bank, has searched for a new mission in the post-Bretton Woods era. As technological change and economic growth generate the potential for systemic crises, assuming domestic bank examiners are not up to the task, the IMF could find its new mission to include the examination of global banks.
Until the reorganization which took place in the UK and the Financial Services and Markets (FSM) Bill, published in draft by the Treasury on 30 July 1998, supervisory duties in the UK were divided between different agencies: the Bank of England had authority for the prudential supervision of banks, acting as their lead regulator; the Securities and Futures Authority (old SFA) was responsible for their securities activities; the PIA for the banks’ sales practices, also covering insurance; IMRO for fund management; and there were also five other authorities which have now merged into one organization.
With restructuring, all this comes under one new body, the Financial Services Authority (new SFA), which was set up in October 1997, with a mechanism permitting the co-ordination of all the regulatory activity concerning British financial institutions and their services which, as everywhere else in the G-10 countries, is becoming increasing complex. The new provisions also cover the UK operations of foreign institutions. FSA is a private company limited by guarantee, with regulatory functions conferred on it by statute. In addition to the responsibilities and powers of a financial services regulator, the FSA will also take over the authorization and supervision of financial services provided by those professions regulated by the recognized Professional Bodies and the statutory functions of mutual organizations.
To appreciate the evolution towards an integrated approach in the UK one has to remember that the financial regulatory system has attempted to keep up with the development of the banking industry, but this can hardly be done in an effective manner when the supervisory system itself is fragmented, and therefore costly and inefficient. Britain has seen four separate acts devoted to financial regulation during the 1980s: the Insurance Companies Act of 1982, the Financial Services Act of 1986, the Building Societies Act of 1986, and the Banking Act of 1987. In 1992 came the friendly Societies Act, the regulatory aspects of which have been included in the FSM Bill.
The government’s aim is to harmonize the provisions of the previous acts and create a single integrated regulatory agency which can eliminate present unnecessary distinctions between different sectors of the financial industry. This will reduce duplication. Ideally, it will also allow for a relatively flexible, quick and systematic introduction of new regulation. However, the regulatory functions of the exchanges and clearing house and of the Occupational Pensions Regulatory Authority still remain separate.
Since Barings collapsed in February 1995 after amassing £860 million ($1.4 billion) of trading losses, there have been many outside assertions that poor supervision by the Bank of England was partly to blame for the Barings bankruptcy. Arthur Andersen was hired as an external auditor in the aftermath of Barings. The Bank of England agreed to the report’s recommendations which constituted a program of change. The British bank regulators also commented that weaknesses existed in the way central banks and other financial control authorities keep watch over their charges, themselves included. A major reason why the old regulatory regime has been outdated, and this is true all over the globe, is that money centre banks and global securities firms have developed and use far-flung networks as well as employing lots of rocket scientists. National regulators simply do not keep up with the necessary technological resources that would allow them to control the funds traffic going through the networks of the commercial or investment banks, or to cope with the sophistication of their financial models. This is a ‘minus’ for regulation.
The trading risks that sank Barings occurred in Singapore and Osaka, not in London, and they were executed through networks. This underlines the need for closer co-ordination between regulators world-wide. In their Frankfurt meeting of 20 May 1996 the G-10 central bankers agreed to provide such co-ordination, but such initiatives should not stop at the G-10 level.
The second major outcome of the 20 May 1996 meeting of the G-10 bank governors has been a co-operation accord between central bankers, regulators, and securities and exchange commissions. Barings, like many other modern financial conglomerates, owned both a bank (which took deposits) and a securities firm which assumed trading risks. However, most regulators are still divided along traditional industry lines (a condition which, in the UK, changes with the new FSA). At the same time, the different supervisory groups are struggling to understand the complex trading risks that banks run with derivatives and other instruments in full evolution. According to an official report into Barings’ collapse published in July 1995, regulators admitted to Barings executives in February 1993 that they did not really understand Baring Securities (Brealey 2001). This is indeed something which needs to be corrected. Because the banking business changes so rapidly, it is absolutely necessary to have intensive life-long training programs for regulators. Training bankers and supervisors for the real world is a demanding business.
A fast-evolving financial market wants professionals who not only understand fundamentals but are also familiar with new product development, risk control and high technology, making bankers capable of multi-disciplinary work. While traditional education provides the basic theories bankers need, it has been less successful at teaching other skills which historically have not been learned in the classroom. The mastery of these requires training at every step of the financial process, from the conception of a new product idea, to its design, implementation, and operation, and to its measurement and control. All bankers, no matter what their specialization, need to be given an understanding of complex market behavior, the interactions involved in multiple disciplines, and the practice of working in a modern team-based financial environment where commitments are made in a split second.
I see these requirements as part of the supervisory authority’s responsibilities. To educate bankers for the real world, it is not enough to change a list of topics to be covered from time to time, or to choose a new syllabus. The traditional education in banking and finance is based on the breakdown of knowledge into disconnected pieces. It only becomes more focused and specific in the longer term through practice. But the pressure of everyday practice does not permit the banker to appreciate that today’s financial world is not only globalize and increasingly interactive but also non-linear. The fact that the Bank of England recruited more supervisors and technical experts is positive. Less well known is whether these new recruits were appropriately trained in non-linear thinking. The Bank also developed new ways of monitoring the risks that institutions take. Still, this is only part of the measures required.
Regulation and supervision is bound to be weak and ineffectual without high-technology supports. Risk modeling is a new culture and therefore it has to be evaluated through a multiple perspective. Is the sophistication of the model used by the bank commensurate with the instrument? With the timing of the transactions? With the volume of the transactions? With the financial commitment these transactions represent? Only recently have people started to appreciate that spotting weak management and poor internal controls is also a very important task for regulators. This type of qualitative analysis is not yet part of all central banks’ culture, and neither is rocket science an integral part of the supervisory armory. Judging the quality of a bank’s internal controls and management skill requires much more than supervisors visiting their charges more often. There should also be regulatory procedures explaining how the central banks might better control the exposure undertaken by commercial and investment banks through their international operations.
The FSA will become the single regulator for UK financial services. In addition FSA is responsible for the recognition of investment exchanges and clearing houses; the listing and supervision of money market institutions providing settlement arrangements under section 171 of the Companies Act 1989; and the authorisation and supervision of certain investment firms which include nine service companies providing services to the financial sector as part of the infrastructure that supports markets (for instance, as information vendors or clearing entities). FSA will authorize commercial and investment entities to carry on specific classes of financial services. Should a company wish to expand its business into a different field, it will have to apply to FSA for further authorization, with the regulators retaining the power to decide whether or not to grant such authorization based on the company’s past record.
Bankers and financial analysts in London were also to comment that the creation of an integrated FSA with the power to police its huge constituency is a complex and demanding task. It was stated that the experts who helped to draft the Financial Services Bill were well aware of the perils that they face, particularly (Brealey 2001):
• the risk of leaving loopholes which some people and companies might slip through; and
• the opposite risk of being too heavy handed in constricting financial markets.
In fact, some senior executives in the City are concerned that the new legislation gives the regulators too much power, while it does not insist on a proper separation of their role as investigators of market abuse, prosecutors of rule breakers, and disciplinary authorities.
Questioning the ‘obvious’ is also the best strategy in regard to pricing sophisticated financial products. Price testing may be defective not only because the pricing model is inadequate but because the assumptions bankers make are incorrect, simply lenient, or designed to promote sales without accounting for risk. An example is the often used volatility simile, which is much more wishful thinking than a fact. When they test the output of the models of commercial and investment banks, supervisors should ensure the institution’s management realises that models are approximations to reality and contain assumptions which do not necessarily hold true when compared against facts. This brings about the need for stress testing, both of models and of the assumptions underpinning them. These are crucial aspects of modern bank supervision which interest all regulators. They fit well with proposals which a few years ago were established by the FSA, that senior executives of banks and securities firms have to demonstrate that they will not fall down on the job if something goes catastrophically wrong. Integrating such concepts into the rule-book of supervisors requires a thorough review of their own responsibilities and those of the bank’s top management and board of directors.
The old FSA’s plan to reverse the burden of proof when something calamitous happens, such as the Barings collapse, and make top management more accountable for financial failures, can serve as a guide. Within this is embedded the principle that there can be more than one senior executive officer responsible for mistakes, or an outright collapse, and that the Chief Executive Officer is not immune to prosecution. One of the objections advanced by the securities industry to that concept has been that the obligations imposed on senior executive officers, and most particularly the chief executive, were so heavy that they would have had to spend most of their time checking up on what was happening within their organization. But as Nick Durlacher, then FSA chairman, was to say, ‘When (we) get a catastrophic failure, the very least we should be able to do is get the very senior figures in front of a tribunal (Tootell 2002).
Forecasts for the UK economy index (2006) suggests that the MPC will continue to reduce interest rates, eventually converging on German interest rates. Of key importance here is the level of the exchange rate at which EMU entry might take place. Experience in the ERM demonstrated conclusively the importance of choosing the right rate. An appropriate rate for sterling is about 2.50 DM to the pound, or lower. However, sterling will be as low as this by the time the government is otherwise ready to fix the exchange rate. As a consequence, it is expected that sterling will join EMU at a rate of DM 2.70. In order to join EMU at this rate, it will be necessary for the exchange rate to trade at around this level. As the Maastricht Treaty implied, it would be unwise to consider entering a monetary union without a reasonable prior period of exchange rate stability. This allows the prospective partners to judge whether their economies are sufficiently convergent for there to be a good chance that the union will be a success.
Second, there is the danger of a credit squeeze. There is evidence that the losses made on domestic lending by banks and other financial institutions in the early 1990s caused them to act in such a way as to intensify the recession (Kneller 1998). By raising the cost of credit, usually indirectly by insisting on more demanding terms or closing credit channels altogether, the recession was made worse than it might otherwise have been. Information in this area is so far very patchy, but there is no evidence that the major British banks have sustained losses in any way comparable to those of the early 1990s. It has been suggested unofficially that the losses made by one of the major British banks in emerging markets are of a similar magnitude to their profits elsewhere; losses of this order are easily manageable and would not be expected to impact on the bank’s domestic operations. However, if the major British banks have incurred substantial losses on their overseas lending, then there is a risk that this could lead to increases in the cost of intermediation similar to those experienced in the early 1990s.
Third, there is the danger that domestic spending declines further because of a delayed response to earlier policy tightening. In previous forecasts, before the recent turmoil in world financial markets, Forecasts for the UK economy has drawn attention to the risks that the domestic economy might go into recession. These risks are still present.
Against these dangers there are a number of grounds for optimism. First, unlike in the early 1990s, private sector balance sheets are very strong. Then, companies and households had borrowed heavily in the expectation of further growth in profits and asset prices. The combination of falling property prices and higher interest rates required a large correction in balance sheets, involving lower spending and more saving. The private sector is not now vulnerable to shocks to underlying credit conditions. Second, and most important, is the awareness of policymakers in the UK and abroad, of the dangers faced by the global economy. The recent cut in interest rates in the UK suggests a willingness on the part of the Monetary Policy Committee (MPC) to act in response to these dangers (Interest and Exchange Rates Forecast 29 September, 2006, Table 2). This is in marked contrast to the policy reaction in the last two recessions, when there was no easing of policy because of the monetary regime then in force (the ERM in the early 1990s and monetary targets in the early 1980s). Additionally, the new public spending plans announced in July, allowing a fiscal expansion, provide a counterpart to any fall in private demand. Thus, the combination of healthy private sector balance sheets and a willingness to ease monetary and fiscal policy reduces the risks of a very hard landing for the UK economy.
As with equity prices, exchange rates have been particularly volatile in recent months. Since the last forecast the exchange rate has fallen by about 5 per cent in effective terms, rising 3 per cent against the dollar and falling by 6 per cent against the DM. By the estimates, the pound is still substantially over-valued, although not by as much as in July. With underlying inflation now at 2 1/2 per cent, and with an increasing likelihood of even lower inflation, there appears to be ample scope for large cuts in interest rates. This forecast is based on there being a further quarter point cut in interest rates to 7 per cent in November, with more cuts throughout 2005 so that rates end the year at 5 3/4 per cent. Further reductions to 5 per cent are then assumed to take place in 2007, bringing UK interest rates broadly into line with those in Euroland (Table 1).
The objective of monetary policy is to achieve underlying inflation, measured by the RPI excluding mortgage interest payments (RPIX) of 2 1/2 per cent at all times. Since monetary policy is believed to act with a lag, interest rate decisions are based on the prospects for inflation up to two years ahead. If recorded inflation turns out to be a percentage point higher or lower than the target, then the Governor of the Bank of England is expected to write an open letter to the Chancellor explaining why this occurred and what is to be done about it. Evidence from the National Institute model suggests that, with the best will in the world, it is only possible to keep inflation within such a narrow range for 50 per cent of the time. The changes have caused considerable disruption to users of the accounts, including the re-specification and re-estimation of models, once the relevant data series have been identified and collected. In conclusion, there are differences in prudential regulatory requirements between current rules and those the bank’s income, assets and financial staying power.
All this enters into the algorithm of management control which must consider not only exposure in derivatives and in loans but social and other issues as well. In the drive to become bigger and bigger, few board and chief executives pay enough attention to the fact that a major problem with mega mergers in the banking industry is that organization is wanting, and this has a very significant impact on efficiency, all the way from management results to client handling and risk control. These approaches have to change because with credit derivatives credit risk volatility and debt are today globally traded commodities.
Apart from the fact that they buy money rather than depend on deposits, big banks invest depositors’ money almost immediately in the stock market, in their own brand of mutual fund, or a retirement annuity issued by their insurance subsidiary. Just the same, most of the loans they give out are going into options and swaps, bundled with other loans and sold off to institutional investors such as money-market funds and pension funds.
Some financial analysts believe that a new generation of superbanks may be built around the Fidelity and Vanguard mutual funds, General Electric Capital or giant brokerage houses, rather than the more classical former commercial banks. Some experts also think that eventually only five to ten of these trillion-dollar giants will dominate the global financial services industry, and at the other end of the spectrum there will be lots of small players. This bifurcation will pose a number of major challenges for regulators.
Table 1. Probability distribution of growth and inflation forecasts Inflation: probability of 12 month RPIX inflation falling in the following ranges
Less than 1.5 per cent 16 29
1.5 to 2.5 per cent 50 21
2.5 to 3.5 per cent 31 21
more than 3.5 per cent 3 29
Growth: probability of annual growth rate falling in the following ranges
less than 0 per cent 24
0 to 1 per cent 26
1 to 2 per cent 10 26
2 to 3 per cent 53 16
3 to 4 per cent 34 6
more than 4 per cent 3 2
Blount Ed. (2004). “A European View of Global Banking Standards: Dr. Tommaso Padoa-Schioppa of the European Central Bank Talks about Payments Systems, Systemic Risk, and Functional Regulation.” ABA Banking Journal. Vol.: 96 (4).
Brealey, Richard A. (2001). Financial Stability and Central Banks: A Global Perspective. Routledge: London.
Forecasts for the UK Economy: Index. Available from: http://www.hm-treasury.gov.uk/economic_data_and_tools/forecast_for_the_uk_economy/data_forecasts_index.cfm
Interest and Exchange Rates Forecast 29 September, 2006. Available from: http://www.rbs.com/content/media_centre/rbs_and_the_economy/downloads/uk/forecast.pdf
Kneller, Richard. (1998). “The UK Economy.” National Institute Economic Review,166.
Tootell, Geoffrey M.B. (2002). “The Bank of England’s Monetary Policy.” New England Economic Review.