UK Banking Sector Reforms: Merits and Uncertainties
Over the last few weeks, a number of important policy documents have been released by both the labor government and the opposition conservative party, setting out plans for the reform of the UK banking sector:
UK Treasury; July 17, 2009
The Conservative Party; July 20, 2009
UK Treasury; July 08, 2009
Financial Services Authority; March 2009
This post reviews some of the proposals.
The global banking crisis demonstrated that the conduct of monetary policy and the goal of maintaining financial stability are very much interconnected. Therefore, the Tory plan proposes an unambiguous chain of supervisory authority anchored at the central bank, with a clear financial stability mandate and direct accountability. This likely would improve the effectiveness of the regulatory set up. Opponents of this view rightly point to banking sector crises of the last decade, for example the BCCI and Barings affairs, which led to Britain to institute the current tripartite system comprising Treasury, the Bank of England (BoE) and the Financial Services Authority (FSA) in 1997. Moreover, as in the United States, skeptics of the unitary system point to the possibility of regulatory capture and concentration of power in a single entity. Vesting primacy in the BoE in this matter also leaves unresolved the question of securities regulation. Nevertheless, the debate shows the necessity of establishing a clear link between regulating systemic risks and monetary policy coupled with the need for a clear authority in times of crisis in order to reduce the likelihood of coordination failure.
As argued by Dr. Nouriel Roubini, central banks do seem well suited for the task of managing systemic risks, but the significant increase in authority will demand a change in mentality. For example, in the past, central banks have abstained from leaning against asset market bubbles, a practice likely to change going forward. Concerns of over-concentration of power, on the other hand, can be addressed by establishing a clear line of accountability for the more powerful BoE. In addition, the idea that the governor should be appointed for a single non-renewable term (a proposal supported by LSE’s Willem Buiter) can also mitigate these concerns. Such an arrangement will also help secure the central bank’s independence from the government which is responsible for renewing the appointment of the governor.
The Tory proposal to abolishing the FSA at a time when the Labour government wants to strengthen the tripartite system has created a lot of uncertainty regarding the regulatory landscape. Some commentators (for example, the FT) have argued for adjusting government proposals by giving the BoE a veto over FSA plans with the goal of linking the conduct of monetary policy to the stability of the financial system. Others point out that this adjustment alone will not guarantee the institutionalization of the linkage between monetary policy and financial stability.
In sum, the timing of the announcement before the general election in 2010 has indeed increased uncertainty in the interim period, by blunting the effectiveness of government plans and potentially undermining the FSA’s authority. Already media reports suggest that private sector is reacting to the increased uncertainty by delaying important decisions to next year. It would have made more sense to release these plans a few months down the line (i.e. closer to the elections), but the prospect of gaining political leverage has likely edged out practical implications in this instance.
Reforms Need to Focus More on Risk Management
The remuneration policies of UK financial institutions is another area of reform which has attracted a lot of attention from policymakers.. Specifically, both the government and the Tory party have proposed to penalize banks for putting in place remuneration policies which create incentives for excessive risk-taking in the short-term. One of the reasons why banks have incentives to put in place lucrative remuneration policies is the contingent insurance provided by the taxpayer for too-big-to-fail banks. The emergency measures taken by policymakers in both advanced and emerging economies to tackle the crisis have done little to blunt moral hazard concerns given that the broader financial stability was at stake. However, going forward, a comprehensive review of risk management practices is warranted. Risk-adjusted remuneration policies represent only a part of that process.
The key to forestalling excessive risk-taking is robust risk management. To that effect, the government must introduce stricter capital requirements and limits on leverage. None of the proposals put forward in the UK have adopted the Glass-Steagall view of the world which envisages a clear separation between traditional commercial banking with utility-like features and risk taking activities such as proprietary trading. It is therefore important to adopt rules that internalize the public costs associated with systemic risk produced by financial institutions (i.e. a macro-prudential framework).
Arguably, as stricter capital requirements are put in place together with limits on leverage, the outlook for the profitability of the financial sector will fall going forward, bringing down remuneration as a result. However, tighter supervision, counter-cyclical capital requirements, limits on leverage, and some separation between traditional banking and trading activities would reduce the likelihood of another systemic crisis. Among the more innovative steps taken to deal with the moral hazard problem is the “living will” idea whereby big financial institutions will be required to produce wind-down instructions without major disruptions to the broader system. It will be interesting to learn the details of such proposal.
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