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Introduction

The Open University — Wed, 18 May 2011 12:35:56 GMT

This unit examines the origins and consequences of the recent financial crisis – a crisis that brought many banks and other financial institutions to their knees.

The unit then looks back at aspects of changes in the financial services sector that occurred under the Conservative governments of the 1980s and 1990s. These changes laid the foundations for the boom in the financial services industry in the years up until the crisis in the late 2000s.

The unit moves on to look at certain features of the ways that financial firms are currently regulated. Financial services regulation has come under the microscope in the wake of the financial crisis and we will examine one case in particular where regulation appears to have failed – the near collapse of Northern Rock Bank in 2007.

The unit concludes by looking at the reforms to the regulation of the financial services industry that are unfolding in the wake of the financial crisis following the 2010 general election.

This unit is adapted from the Open University course Introduction to Financial Services (BD131).

Learning outcomes

The Open University — Wed, 18 May 2011 12:35:56 GMT

By the end of this unit you should be able to:

understand aspects of the recent historical evolution of the UK financial services
understand certain features of the current structure of the UK financial services sector
understand certain features of the regulation of UK financial firms
assess whether the regulatory environment for financial services is effective
understand the rationale for, and content of, current reforms to financial services regulation.

1.1 The banks on the precipice

The Open University — Wed, 18 May 2011 12:35:56 GMT

September and October 2008 turned out to be critical months for the global banking system as the slowdown in activity in economies around the world, combined with the collapse of asset prices (particularly for property and for financial assets such as mortgage-backed securities), resulted in huge financial losses for many financial firms. Those who had been the most ambitious in their lending activities during the years of economic expansion now stood most exposed as economic activity contracted.

The investment banking sector in the USA was particularly exposed. Investment banks specialise in arranging the issue of, and investing in, securities issued by financial and non-financial firms. As such, many of the investment banks were very active in the mortgage-backed securities business. Such banks normally have very limited dealings with individuals in the retail markets. Indeed, restrictions were placed on their ability to take deposits from the public.

In 2008, these investment banks all faced financial difficulties, albeit to differing degrees. In March 2008, the large US investment bank Bear Stearns had to be rescued by JP Morgan, a similar institution. As 2008 progressed, it became clear that the firm most exposed to the crisis unfolding in the financial markets and the wider economy was Lehman Brothers (commonly known as Lehmans). Yet, at a meeting in September 2008 of banking institutions, called by the Federal Reserve (the US central bank that performs a similar function to that of the Bank of England in the UK) to organise a rescue for Lehmans, another investment bank, Merrill Lynch, used the gathering to facilitate its own purchase by the Bank of America. Briefly, it seemed as though the UK’s Barclays plc might step in to buy Lehmans. However, after reviewing Lehmans’ financial position, it quickly became clear that no deal could be struck.

With no buyers for Lehmans, the Federal Reserve refused a state bailout, with the result that the bank collapsed. Perhaps the decision might have been different if Lehmans had had a clear interface with retail customers. Certainly many individuals were affected by Lehmans’ collapse, particularly if they had been holding shares in the bank, but no large retail customer base was directly exposed to the demise of the bank.

Figure 1 Lehman Brothers Bank

1.2 The deepening crisis

The Open University — Wed, 18 May 2011 12:35:56 GMT

The collapse of Lehmans sent shock waves around the global financial services industry because of the widely held (and ultimately false) assumption that it was too big a firm to be allowed to go bust. Shares in banks fell very sharply, and in the UK attention focused on those banks deemed to be most vulnerable to the impaired financial markets and the weakening economy.

The two banks perceived to be most at risk were Halifax Bank of Scotland (HBOS) and Royal Bank of Scotland (RBS). Their plight forced the tripartite authorities to intervene on a massive scale. The Bank of England provided £61.6 billion of emergency loans to RBS and HBOS at the height of the financial crisis – although this only became public knowledge in November 2009 when the Bank of England reported these details to Parliament’s Treasury Committee (Weir, 2009).

Clearly, the bailout of Northern Rock in 2007 had shown the need to be careful about the public disclosure of financial support for banks, given the impact such disclosures have on public confidence in the banking system. You will probably recall from the media coverage at the time that news about the bailout of Northern Rock led to the bank’s customers queuing up at its branches to draw out their savings. This accentuated the crisis facing the bank and forced the Bank of England to increase substantially the support it had to provide to Northern Rock to prevent it from collapsing.

As the financial crisis deepened, the UK government, together with the FSA and the Bank of England, sought the takeover of HBOS by Lloyds TSB Bank as the latter was perceived as being relatively less exposed to the crisis in the financial markets. The resultant merged institution was named Lloyds Banking Group. With a 28 per cent share of the UK mortgage market and a 25 per cent share of the UK personal banking market, such a takeover would not have been allowed by the Competition Commission during normal financial times. Given the crisis, however, the government allowed the merger to proceed without reference to the Commission.

Additionally, the government was forced to provide additional capital for the two banks in order to prevent any risk of their collapse. They initially took a 43 per cent share of Lloyds Banking Group (subsequently raising this to 65 per cent in March 2009) and a 70 per cent share of RBS. These injections of financial support were required because a huge volume of these banks’ assets had fallen substantially in value – these were the so-called ‘toxic assets’ (investments of a poor credit quality and where the default rate by those borrowing the money is high). In the case of Lloyds Banking Group, the support was needed to deal with the problems inherited via the takeover of HBOS rather than any inherent problems of Lloyds TSB itself. The latter had been a very conservatively run bank with relatively little exposure to toxic assets.

The scale of the investment by the government in the country’s financial firms was estimated at £37 billion in October 2008 (HM Treasury, 2008). This was in addition to the provision of short-term loans to financial firms. The government also had to insure the banks against losses on several billions of pounds of toxic assets in an attempt to salvage the UK banking system and to get the banks into a position where they could start prudent lending again to businesses and individuals.

The extent of the failings of these banks was revealed when their financial results for 2008 were published in early 2009. RBS reported a loss of £24 billion: the greatest loss in UK corporate history. HBOS losses amounted to £10.9 billion. These were far worse than anticipated and raised questions about whether Lloyds TSB had been prudent to take on the ailing HBOS.

Activity 1

What observations would you make on how the tripartite of regulatory authorities in the UK (the FSA, the Bank of England and the Treasury) handled the impact of the ‘credit crunch’? What do you think were the failings in their handling of the financial crisis?

Answer

There appear to have been failings in the FSA’s regulatory processes because, for example, they had not spotted the financial weaknesses at Northern Rock Bank. The negotiations on the Bank of England’s loan to Northern Rock were not kept secret – precipitating the run on the bank.

Additionally, the regulatory authorities appear to have underestimated the inter-relatedness of the business of financial institutions with the collapse of Lehmans, producing a ‘domino effect’ of a collapse in confidence in the entire banking sector.

Clearly, the credit quality of the investments held by certain banks had not been scrutinised closely given the scale of ‘toxic assets’ held by some institutions.

Although the Treasury and the Bank of England took rapid action when the financial crisis spread in 2008, many of the responses were clearly just reactive to the unfolding events.

For further information take a look at these Money and Management podcasts: ‘HBOS – the demise of two giants’ and ‘The end of the credit affair’. These were both recorded in late 2008, at the height of the financial crisis, and relate information and data current at that time.

HBOS – the demise of two giants

This podcast examines the circumstances leading up to the takeover of HBOS by Lloyds TSB.

Interactive content appears here. Please visit the website to use it.

Transcript

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The end of the credit affair

This podcast looks at how the financial crisis precipitated the end of the credit boom in the UK. It examines how the crisis led to a drying up in the availability of credit to businesses and households (the so-called ‘credit crunch’) and the resultant adverse impact on the UK economy.

Interactive content appears here. Please visit the website to use it.

Transcript

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2.1 Financial services industry pre-1980

The Open University — Wed, 18 May 2011 12:35:56 GMT

Prior to the 1980s, the financial services industry was an environment of demarcation. Although there were some modest overlaps in product offerings, the pattern prevailed of (informal) demarcation and clarity – in terms of where you went for a particular product. Banks provided cheque accounts, overdrafts and loans. Building societies provided mortgages for home buyers and savings accounts for savers. Insurance companies provided insurance products.

A further feature was the nature of the relationships between the institutions and the public. These relationships were typically long term and conflicted with the contemporary pattern where individuals move from one provider to another much more regularly in order to secure the best deal. If you were seeking to obtain a mortgage from a building society prior to the 1980s, the normal expectation was for you to have been a saver with the same building society for a period of time – thus at least paying lip-service to the original mutual concept of building societies. Even when a mortgage was approved, it was possible that you would have to queue up for it rather than have the funds made immediately available to you. All of this is a far cry from the fluidity that now exists in the relationships between providers and product buyers. What caused the financial environment to change?

2.2 The liberalisation and consolidation of the financial services industry

The Open University — Wed, 18 May 2011 12:35:56 GMT

The overarching change was the liberalisation of the financial services industry that resulted from the Financial Services Act 1986, the Building Societies Act 1986 and the Banking Act 1987. These pieces of legislation provided greater freedom to banks and building societies to diversify their activities and to seek finance from the wholesale markets to support their lending. Subsequent years saw many of the larger building societies offer cheque accounts to customers, while banks moved more actively into the mortgage, savings account and insurance markets. This move into the insurance business gave rise to the term ‘bancassurance’, summarising the extended operations of these diversifying banks.

The enlarged scope to raise funds provided by wholesale funding meant that mortgage lenders could respond to the growth in mortgage demand that was stimulated by the expansion in home ownership. Additionally, subject to checks on the credit worthiness of customers, mortgages could be provided on demand. The requirement to be a saver with a building society before you could borrow from it quietly disappeared.

At the same time, changes occurred to the pricing of products. Previously, mortgage rates had been tacitly agreed by a cartel of the largest building societies, with the result that there was little to choose between the mortgage lenders in terms of price. The liberalisation of the industry saw the end of the cartel and the emergence of a more competitive market for mortgage offerings, to the benefit of customers. The liberalisation also saw new providers enter the market, with overseas financial firms such as MBNA entering the UK credit card market and with supermarkets such as Marks & Spencer, Tesco and Sainsbury commencing financial services business in partnerships with banks.

2.3 The boom in financial services

The Open University — Wed, 18 May 2011 12:35:56 GMT

By the 1990s, the preconditions for a boom in financial services – including a boom in the various forms of lending to individuals – had been created. Affluence and the demand for home ownership pushed at an open door of product availability that had been harnessed by the concurrent liberalisation of financial services.

Around the same time that the conditions were being set for a boom in financial services business major structural changes started to occur within the industry. One key feature was the conversion of most of the larger building societies to banking status – starting with the Abbey National Building Society in 1988, and then in the 1990s Halifax, Northern Rock, the Woolwich, Bradford & Bingley and Alliance & Leicester. Others, including the Leeds Permanent, National & Provincial and Bristol & West were acquired by these ‘convertors’ or by other banks, with the result that the size of the building society sector shrank dramatically.

Various reasons were proffered by the converting societies to justify the change in their status – including increasing access to finance, greater recognition in the international environment, more scope to diversify product offerings and even the greater capacity to attract and retain top-calibre staff. The executives of the building societies may also have been influenced by the prospect of the higher remuneration likely to arise through conversion to banking status. Membership approval had to be sought for the changed corporate status – although the offer of ‘free’ shares in the new companies to members (who, after all, owned the building societies) provided an incentive to forego mutual status.

In tandem with (and subsequent to) these conversions, the financial services industry witnessed a marked consolidation, with the Royal Bank of Scotland taking over the clearing bank, NatWest; Lloyds Bank taking over TSB; the Bank of Scotland amalgamating with the Halifax to become HBOS; and the international HSBC bank acquiring the clearer Midland Bank. Consolidation also occurred in what was left of the building society industry and in the insurance sector. One consequence of the 2007–2008 financial crisis was the takeover of HBOS by Lloyds TSB to form the Lloyds Banking Group, which, as a result, became a colossus in the UK financial services industry.

The pattern of a smaller number of larger financial services providers has now emerged. Indeed, the current focus on maintaining the stability of the banking system means that the competition laws that previously inhibited large-scale consolidations may again be sidestepped when further amalgamations are considered.

Activity 2

What is the potential impact on customers of consolidation within the financial services industry?

Answer

Fewer providers of products means less competition for business. This is potentially disadvantageous to customers because the lack of competition may be reflected in less favourable pricing of products. However, customers could benefit if larger organisations secure cost efficiencies through consolidation. These savings might be passed on, in part, to the customers in the pricing of products.

3.1 Understanding the regulation of financial firms: the ‘authorisation’ process

The Open University — Wed, 18 May 2011 12:35:56 GMT

We have already seen in this unit how the regulation of financial firms in the UK was revealed as having shortcomings during the financial crisis in the late 2000s. This raises the question about how regulation actually takes place and what activities are undertaken by the Financial Services Authority when supervising financial firms. This is a vast subject area but to provide some insights we can look at some of the rules applied to firms whose business has to be authorised by the FSA.

Note that not all financial firms are regulated by the FSA – some have exemptions if, for example, they are regulated by other supervisory bodies.

If authorisation is required to conduct business in a regulated activity, ‘permissions’ must be granted by the FSA. Such authorisations are governed by Part IV of FSMA (Financial Services and Markets Act) 2000 and so are referred to as ‘Part IV permissions’.

It is rare for permissions to be given for all the regulated financial activities. Normally, permissions are only granted to undertake business in specific regulated activities (where the firm has the required skills).

3.2 The FSA’s five checks before granting permissions

The Open University — Wed, 18 May 2011 12:35:56 GMT

Before granting permissions, the FSA checks that the applying person or firm meets five compulsory ‘threshold’ conditions:

Location

Firms established under UK law must have their registered and head offices in the UK.

Legal status

Although various forms of legal status – including individuals, partnerships and firms – are acceptable for the granting of permissions, some activities (e.g. deposit taking) are not permitted for certain legal status entities (e.g. individuals and partnerships).

Adequate resources

Applicants must have appropriate financial and non-financial (e.g. human) resources to undertake business in the relevant regulated activities.

Absence of ‘close links’

Applicants must not have close links with other entities to the extent that the FSA might find it difficult to supervise their business activities (due to, for example, a lack of clarity as to which entity was responsible for a particular activity).

Suitability

The applicant must prove to the FSA’s satisfaction that it is ‘fit and proper’ to be granted the sought permissions. The FSA has to be satisfied that, in the light of the range of activities intended to be undertaken, the relevant firm or individual has the capacity to operate correctly and prudently.

(Adapted from Turner, 2008, p. 46)

‘Fit and proper’ test

The ‘fit and proper’ test does not apply just to the firm as a whole – it is also applied to specific employees who perform certain key controlled functions. These controlled functions are divided between:

significant influence functions, where the activities of these individuals can materially impact upon their firm’s business affairs

and

the consumer function, which relates to arranging transactions and managing investments where there is contact with customers (e.g. investment advisers).

To undertake these controlled functions, individuals have to be designated as ‘approved persons’.

In applying the ‘fit and proper’ test to these individuals, the FSA will be particularly checking for evidence about their competence and experience – specifically in relation to the controlled function that they wish to fulfil. The FSA also assesses these individuals’ integrity and reputation.

Finally, the FSA checks the financial soundness of the individuals by seeing if they have ever been made bankrupt or if they have ever had a court judgement made against them in respect of their indebtedness. On passing these tests, the individual is deemed to be competent to perform the designated approved person role.

Once the FSA is satisfied that the ‘fit and proper’ test has been passed by those who are to undertake the controlled functions, and is also satisfied that the five threshold conditions have been met by the firm, permissions to undertake the specified regulated activities can be given. The applicant therefore becomes authorised to conduct those areas of financial services business that fall within the scope of their permissions.

Activity 3

After the 2007–2008 financial crisis, there was reportedly an increase in the proportion of proposed holders of controlled functions who were deemed by the FSA not to be ‘fit and proper’ to hold the relevant function. What may have been the reasons for this?

Answer

It is possible that the FSA may have toughened up the application of its ‘fit and proper’ test, given that the financial crisis raised key questions about the management and governance of financial firms and, by inference, of the quality of some of those undertaking ‘controlled functions’ within them.

4.1 Northern Rock: a banking model unravels

The Open University — Wed, 18 May 2011 12:35:56 GMT

The origins of Northern Rock were as a building society – a mutual body owned by its members. It came into existence in 1965 as a result of the merger between the Northern Counties Permanent Building Society (formed in 1850) and the Rock Building Society (formed in 1865). By the 1990s, helped by the takeover of 53 other building societies, it had grown to become one of the top 10 UK building societies in terms of its asset size. Northern Rock had a strong regional presence and franchise in the North-East of England and a more limited profile outside this area.

Like all building societies, its core business was in mortgages and retail savings. Its treasury operations – like those for most building societies – were fairly modest, concentrating on the management of Northern Rock’s liquid assets and on the raising of wholesale funds from other institutions, largely in the UK money market. Under the terms of the Building Societies Act 1986, and up until 1997, building societies were not able to raise more than 40 per cent of their total funding from the wholesale markets – thus requiring the focus on fundraising to be placed on retail money provided by the public. This limit was raised to 50 per cent in 1997 by an amendment in the Building Societies Act 1997. However, building societies were kept under a tighter rein than that permitted by the legal limit by their regulator – the Building Societies Commission prior to 2001 and subsequently by the FSA. Bilateral informal limits were applied to building societies’ wholesale borrowing, normally well inside the legal limit. The result is that, even now, few building societies have more than 25 per cent of total funds drawn from wholesale sources.

In the late 1990s, Northern Rock decided, in line with most of its building society peers, to convert to a bank. The rationale for this was that it believed it would then gain greater access to wholesale funds – since the 50 per cent limit on taking funds from wholesale sources did not apply to banks. Additionally, it was hoped that, by operating under banking legislation, it would have greater scope to diversify into new product areas than if it remained as a building society. The switch to banking status was approved by Northern Rock’s members in 1997 – and the members were duly rewarded by receiving free shares in the new bank.

The subsequent years saw a rapid expansion of Northern Rock’s business. It moved extensively into the wholesale markets to finance its expansion, to such an extent that by 2007 nearly 70 per cent of its funding came from wholesale sources. To find a home for the funds it had raised, Northern Rock competed aggressively in the UK mortgage market, offering attractively priced products and high loan-to-value mortgages. It also packaged up a high proportion of its mortgage assets into mortgage-backed securities and sold these to investors as a means of financing further mortgage lending. A significant proportion of its wholesale funding was short term, continually having to be refinanced over periods of weeks or months. Yet this funding was supporting long-term mortgage advances with terms of up to 25 years.

In the 2000s, Northern Rock expanded rapidly – but the business model had two interrelated risks. First, there was the dependence on the wholesale markets; second, there was the mismatch between the short-term nature of its funds and the long-term nature of its mortgage assets.

These risks crystallised in 2007. The collapse of the sub-prime mortgage market in the USA resulted in a collapse of confidence within the global banking markets. Banks became reluctant to lend to each other because they were unclear about the degree to which each was exposed to the sub-prime market. Northern Rock, with its reliance on wholesale funds, quickly found that it had a liquidity crisis – in effect, it was running out of funds to support its business. In September 2007, it turned to the Bank of England, the lender of the last resort, for an emergency loan to boost its cash position. However, when this was announced to the public, it triggered a run on Northern Rock by retail customers who queued up to withdraw their savings. Understandably, wholesale lenders – other, mostly financial firms – ceased lending to Northern Rock. The upshot was that the Bank of England was required to lend more and more money to Northern Rock to prevent its collapse, a move that was approved by the government and the FSA.

The graph below highlights the rapidly growing use of, and dependence on, wholesale funding by Northern Rock. Whereas the volume of retail funding grew only slowly during the bank’s rapid business expansion, the use of a variety of forms of wholesale funding ballooned.

Figure 2 The road to the London Summit. (Source: HMG, 2009)

Following a failed attempt to sell the bank to a private sector buyer, the government was reluctantly forced to nationalise Northern Rock in 2008.

4.2 Lessons from the unravelling of Northern Rock’s business model

The Open University — Wed, 18 May 2011 12:35:56 GMT

Clearly, Northern Rock’s reliance on wholesale funding, and the ‘borrow short, lend long’ approach to managing its business risks, were both huge risks. In fact, most banks do have a ‘borrow short, lend long’ profile, although most tend to rely less on wholesale funds and more on retail money – which tends to be a stable source of funds.

The 2007–2008 financial crisis clearly indicated that Northern Rock was not alone in taking on risks to boost its market share and profitability – so clearly its banking business model was not the only bad one. Indeed, by the end of 2008, all the building societies that had converted to banks had lost their independent status – either by being acquired by other banks or by being partly or fully nationalised. Another converted building society, Bradford & Bingley, had to be nationalised prior to its imminent collapse, exposing a business model not too dissimilar to that of Northern Rock.

4.3 Supervisory failures

The Open University — Wed, 18 May 2011 12:35:56 GMT

But what does the episode reveal of the FSA? Northern Rock’s approach to business was hardly a secret and could be easily detected from its financial statements. Yet the FSA seems to have required no modification to Northern Rock’s business model up to the crisis point in 2007. The last review by the FSA’s ARROW risk assessment panel took place in February 2006, over 18 months prior to the near collapse of the bank in September 2007.

The recommendations made by the FSA’s supervisory team to the ARROW panel implied that there were no material business risks being run by Northern Rock. The panel agreed with the proposal of the supervisory team that there was no need to issue Northern Rock with a Risk Mitigation Programme (RMP), and that the length of time between formal ARROW risk assessment reviews should be lengthened from 24 months to 36 months – which was the upper limit for the time between ARROW reviews. In terms of its risk assessment, the ARROW panel assigned Northern Rock ‘low risk’ (the lowest risk category), which set the seal for the subsequent ‘light touch’ supervision of the bank.

In their report on Northern Rock, the FSA’s Internal Audit Division lays the blame for failure in the regulation of the bank very much on the FSA’s supervisory team, rather than on the ARROW panel that opined on the team’s findings. The report states that:

… the ARROW panel would have had a fuller insight into the firm if it had received from the supervisory team, or probed in the meeting for, a more comprehensive analysis of the risks inherent in the business model at the time; but we consider that the firm’s planned growth should have led to an RMP being agreed.

(FSA Internal Audit Division, 2008, p. 5)

The report continued:

… it was understandable that the ARROW panel reached a view that Northern Rock was low-probability risk, based on the material provided to it. … the situation was compounded by the level of engagement and oversight by supervisory line management which was lower than expected for a high impact firm.

(FSA Internal Audit Division, 2008, p. 5)

However, to be fair to the team, the report refers to the pressures on supervisory staff at the time. Additionally, there were three different heads of department of the supervisory team during Northern Rock’s review period. Given such circumstances, and the fact that it is the responsibility of the FSA’s management to ensure that its supervisory teams are both resourced and forensic in their work, placing so much blame on Northern Rock’s supervisory team does seem unfair.

The report concludes:

… we cannot provide assurance that the prevailing framework for assessing risk was appropriately applied in relation to Northern Rock, so that the supervisory strategy was in line with the firm’s risk profile.

(FSA Internal Audit Division, 2008, p. 5)

The supervisory failures identified in respect of Northern Rock raised general issues about the robustness of the regulatory regime for banks – particularly those that had converted from building societies to banks in the 1980s and 1990s. Clearly, there were systemic weaknesses within the financial system that were soon fully exposed by the subsequent global financial crisis. Additionally, there were issues of governance – did the boards of the banks that came to the brink of collapse really understand both the nature of the business their institution was undertaking and the risks associated with it?

A further story about Northern Rock subsequently came to light in April 2010. At the time of its near collapse, it was thought that Northern Rock’s mortgage book had a credit quality in line with that of the mortgage-lending industry as a whole.

However, it transpired that the bank’s mortgage arrears had been misreported, leading analysts to form the view that its mortgage book had a higher credit quality than was actually the case.

The FSA fined two former directors who were responsible for mis-reporting this mortgage and financial information. They also banned them from working with regulated financial firms in the future.

Activity 4

The failures of Northern Rock have been ascribed (in part, at least) to poor regulation. What aspects of the FSA’s regulatory approach seem to have particularly failed?

Answer

It would seem that the ARROW process either failed to perceive or to address the weaknesses in Northern Rock’s business model. You may also ask whether those who held approved persons positions at the bank were sufficiently knowledgeable about the risks that Northern Rock was running.

5.1 Key regulatory initiatives since 2008

The Open University — Wed, 18 May 2011 12:35:56 GMT

At the height of the financial crisis in October 2008 the then Chancellor of the Exchequer, Alistair Darling, asked Lord Turner (the FSA’s Chairman) to review the causes of the crisis and make recommendations for reforming the regulation and supervision of the financial services industry.

The Turner Review 2009

The Turner Review (FSA, 2009), published in March 2009, focused on the failings of governance, liquidity and capital regulation, and FSA supervision that had contributed to the crisis and which consequently should be subject to reform to prevent repetitions.

The Turner Review, the FSA’s subsequent consultation process and the government’s own analysis of the financial crisis culminated in the Financial Services Act 2010. The Act introduced a new financial stability objective for the FSA, gave the FSA new rule-making powers, including those in respect of remuneration in the industry, and strengthened consumer protection. The 2010 Act also established a consumer financial education body to raise public understanding of financial matters.

Walker Review 2009

A further development at the same time was the publication of the Walker Review of corporate governance in UK banks and other financial institutions (HM Treasury, 2009). The review found that the significantly different outcomes experienced by the banks during the crisis had to be attributed to differences in the ways in which they were run. The review’s recommendations included improvements to the quality of board members and greater emphasis on the understanding and management of risk.

Other consultation and discussion papers

At the same time these developments were taking place, the FSA published a number of further consultation and discussion papers on the future of regulation in the UK financial services industry. Although a number of issues were explored within these publications, the focus was on the liquidity and capital held by financial firms.

5.2 Liquidity

The Open University — Wed, 18 May 2011 12:35:56 GMT

Liquidity constitutes the amount of funds that institutions hold to deal with unexpected adverse movements in cash flows affecting their business. So if a bank has difficulty raising funds in the retail and wholesale markets, it can – temporarily at least – fall back on its holdings of liquidity as a cushion against such an adverse move in its cash flow. Typically, liquidity is held by institutions either in cash form or in assets that can be readily turned into cash if required.

It should be clear that the greater the amount of liquidity held by an institution, the greater (and longer) its protection against adverse cash flows. Much focus was therefore being placed by the FSA during 2008 and 2009 on the amount of liquidity held by institutions – and on how readily these liquid assets could be disposed of to obtain cash if financial difficulties arose. Generally, financial firms have come under pressure to increase liquidity holdings. Additionally, the FSA has required institutions to undertake Individual Liquidity Adequacy Assessments (ILAAs) to assess whether they had sufficient liquidity when taking into account the specific features of their business (see Box 1 below). Not all financial firms have similar exposure to liquidity weakness – for example, those who have limited access to various markets to fund from are more at risk than those with wider sources to draw on. So the new regulations for liquidity are likely to be more reflective of the relative financial strengths and weaknesses of institutions.

Box 1 Strengthening liquidity standards

Following the near collapse of Northern Rock and the 2007–2008 financial crisis, considerable attention was paid by the FSA and regulatory authorities overseas to policy in respect of the liquidity that financial firms should be required to hold.

The emphasis was on both the determination of the total amount of liquidity that should be held and the quality of assets comprising the liquidity – because it may not be easy to sell poor-quality liquid assets to turn into the cash needed during a liquidity crisis. It is always easier to sell high-quality assets such as government bonds than lesser-quality assets such as corporate bonds. The FSA’s approach involved institutions undertaking Individual Liquidity Adequacy Assessments, where the specific features of the institutional business and balance sheets are taken into account in determining the amounts of liquidity that should be held.

Between December 2008 and July 2009, the FSA published three Consultation Papers on liquidity:

CP08/22: Strengthening Liquidity Standards
CP09/13: Strengthening Liquidity Standards: Liquidity Reporting
CP09/14: Strengthening Liquidity Standards: Liquidity Transitional Measures.

Following the completion of the period of consultation, the FSA issued a Policy Statement (PS 09/16) detailing the new liquidity requirements. This required financial firms to undertake a detailed (‘granular’) assessment of their liquidity needs and for the liquid assets to be marketable and of high credit quality.

So one major outcome from the Northern Rock episode and the 2007–2008 financial crisis is the need for financial firms to hold more liquidity and for it to be of high quality – a move that hits their profitability because the returns obtained on such assets are well below the cost of financing their purchase.

5.3 Capital reserves

The Open University — Wed, 18 May 2011 12:35:56 GMT

The regulatory authorities also focused on the amount of capital held by financial firms. Capital is not the same as liquidity. Capital reserves are held by financial firms as cover against losses in their business – for example, if a borrower defaults on a loan.

Clearly, the greater the amount of capital held relative to the amount of loans and investments it has made, the greater a financial firm’s capacity to bear the losses that could arise from defaults by its customers – defaults that inevitably rise when the economy experiences a period of weakness.

The 2007–2008 financial crisis raised the issue about whether financial firms had sufficient capital in place. The fact that several banks had to seek additional capital from the government and private investors during the financial crisis suggests quite forcibly that at least parts of the financial system had insufficient capital to ride out the financial crisis.

The UK regulatory authorities, in consultation with other national regulatory bodies, are therefore re-addressing the means for determining the volume of capital held by financial firms. Discussion has also taken place about whether financial firms should seek to build up extra capital during periods of strength in the economy, when loan defaults are low, in readiness for accommodating the higher defaults that inevitably occur when the economy goes into a downturn.

One outcome, with wide implications, was the announcement in 2009 by the Basel Committee on Banking Supervision (the body that takes the lead in regulating the international capital framework for banks) of plans to strengthen the regulatory capital framework. These plans require:

the establishment of capital buffers to be used by banks during times of financial stress
improvement in the quality of assets in which banks invest their capital reserves
the introduction of an additional ‘leverage ratio’ requiring additional capital to be held by those banks with riskier balance sheets.

Subsequently, the Basel Committee’s work led to the development of the ‘Basel III’ capital framework, which will place further requirements on financial firms to hold capital to support their business activities.

A further, and more specific, outcome from this review of capital strength was the FSA’s requirement that the Tier 1 capital ratios of Lloyds Banking Group and RBS had to be raised. This forced Lloyds Banking Group to turn to its shareholders for more capital through a ‘rights issue’ in December 2009 and for RBS to raise some £25 billion of capital, mostly from the government. This move raised the government’s shareholding in RBS from 70 per cent to circa 84 per cent of total share capital.

5.4 EU regulator for credit rating agencies

The Open University — Wed, 18 May 2011 12:35:56 GMT

One other regulatory development to emerge from the chaos of the financial crisis was the announcement, in June 2010, of plans to establish an EU regulator for the credit rating agencies. These agencies, who provide credit assessments of the investments held by banks and other financial institutions, had much criticism levelled at them for their role in the crisis. This was because of their apparent inaccurate assessment of the credit risks associated with certain investments like ‘asset-backed securities’. The proposed new body – the European Security Markets Authority – would regulate the ratings agencies with the potential for these powers to be broadened in the future. In announcing the move, Michel Barnier, the EU’s Internal Markets Commissioner, also called for a pan-European banking regulator to be established.

5.5 Pay, bonuses and profits

The Open University — Wed, 18 May 2011 12:35:56 GMT

A highly controversial issue that the tripartite regulatory authorities had to address in the wake of the financial crisis was how much blame should be placed on the high salaries paid to those making investments and undertaking other financial transactions – and specifically the ‘bonus culture’ within the major banks and other financial firms.

The observation widely made at the time was that the bonus system encouraged excessive risk-taking. If the gambles made by the dealers in their investments came off, they got high bonuses. If the gambles failed, then the resultant losses had to be absorbed by the banks – or, more specifically, the banks’ shareholders. There seemed to be a clear message: curb the bonus culture and you prevent excessive risk-taking and avoid the risk of a repetition of the 2007–2008 financial crisis. This view was particularly applied to those financial firms that had had to be rescued or provided with financial support during the crisis. Excessive risk-taking and the expectation of high bonuses were not viewed as appropriate for those institutions at least partly owned by the government.

The return of several of the major financial firms to, at least reasonably, healthy profitability in 2009 and the subsequent triggering of bonuses for their staff has kept the issue very much in the media.

In 2009, the FSA produced a code of practice on remuneration for employees of financial firms. The code banned guaranteed bonuses for periods of beyond one year, stated that it expected two-thirds of bonuses for senior staff to be spread over three years and required financial firms to submit their remuneration policies for review by the FSA. The expectation was that such policies should be consistent with effective risk management practices at the institutions.

The code was criticised for being weak on the thorny issue of the bonus culture by scaling back on some of the controls on bonus payments it had considered in a Consultation Paper earlier in 2009. However, the Chief Executive of the FSA, Hector Sants, accurately pointed out at the time that the FSA had neither the responsibility nor the power to determine how much staff employed by financial firms got paid.

In July 2010 the FSA announced plans to update its remuneration code to accommodate remuneration rules required by the EU’s Capital Requirements Directive (CRD3) and the Financial Services Act 2010. The plans took effect from 2011. The proposals built on the requirements of the then existing code, which stated that firms should have remuneration policies consistent with the promotion of effective risk management. Amongst the proposals was a requirement for at least 40 per cent of bonuses to be deferred over a period of at least three years, rising to 60 per cent for bonuses above £500,000. In addition, at least 50 per cent of performance-linked remuneration must be in shares or in other non-cash form. In respect of guaranteed bonuses these may not be for periods of more than one year and may only be given in exceptional circumstances to those newly hired by firms.

The issue about bankers’ bonuses was in the headlines towards the end of 2009 as the year-end ‘bonus season’ approached. The adverse public reaction to the prospect of high bonuses being paid to bankers – particularly those working for RBS, which had been rescued by public funds in 2008 – prompted a robust response from the government. In the pre-budget statement in December 2009, the Chancellor of the Exchequer introduced a 50 per cent tax to be paid by the banks on bankers’ bonuses in excess of £25,000. This was in addition to the tax liability falling on the recipient bankers.

Bonuses were also an issue during the campaign leading up to the General Election in May 2010. The Liberal Democrats called for tight limits on bank bonuses with a cap of £2,500 per year on cash payments, with no bonuses being paid to board members and with no bonuses being paid by those financial institutions making losses. After the formation of the Coalition government it was announced that action would be taken to curb ‘unacceptable’ bonus payments. The resultant measures are unlikely to be as Draconian as suggested by the Liberal Democrats during the election campaign due to the desire not to drive London’s investment banking activities overseas.

The banks, indeed, continue to insist that material bonuses need to be offered to ensure that they can attract and retain the best banking staff – and that high-quality staff are the best guarantee of a return to profitability by the banks. Indeed, the investment bank JP Morgan was reported in December 2009 as considering abandoning its plans to build a headquarters in London as a result of concerns about the 50 per cent tax on bonuses and the tightening regulatory environment in the UK (The Times, 2009).

The fear is, therefore, that tougher regulatory reform will end up with financial firms relocating from London. This would hit both the government’s tax receipts and employment in the UK.

Activity 5

Despite the financial crisis London remains the financial capital of the world. Can you think of any reasons for this?

Answer

Partly it is historical and reflects the pre-eminent position the UK used to have in the global economy up until the 20th century and during the period of the establishment of banking and financial services.

Partly it is geographical: London sits in the middle – in terms of ‘time-zones’ – of the major global financial centres of Asia (Hong Kong and Tokyo) and America (New York). If you are based in London you can deal with Asia in the morning and America in the afternoon.

It also reflects the financial expertise based in London and the UK’s flexible labour laws, which provide, relative to some other global locations, for ease of recruitment and dismissal of staff.

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References

The Open University — Wed, 18 May 2011 12:35:56 GMT

FSA Internal Audit Division (2008) The Supervision of Northern Rock: A Lessons Learned Review, London, FSA; also available online at http://www.fsa.gov.uk/ pages/ Library/ Other_publications/ Miscellaneous/ 2008/ nr.shtml (Accessed 7 November 2009).

FSA (2009) The Turner Review: A Regulatory Response to the Global Banking Crisis, London, FSA; also available online at http://www.fsa.gov.uk/ pubs/ other/ turner_review.pdf (Accessed 15 November 2010).

Goodhart, C.A.E. (2009) The Regulatory Response to the Financial Crisis, Cheltenham, Edward Elgar.

HM Treasury (2008) Treasury Statement on Financial Support to the Banking Industry [online], http://www.hm-treasury.gov.uk/ press_105_08.htm (Accessed 15 December 2009).

The Times (2009) ‘Bonus tax may lead JP Morgan to scrap new London headquarters’, 29 December 2009, p. 36.

Turner, C. (2008) FSA Financial Regulation: The Official Learning and Reference Manual (13th edn), London, Securities and Investment Institute.

Weir, K. (2009) BoE Discloses Emergency Loans to RBS, HBOS in 2008 [online], http://uk.finance.yahoo.com/ news/ update-2-boe-discloses-emergency-loans-to-rbs-hbos in2008-targetukfocus-5d476a529395.html (Accessed 15 December 2009).

Acknowledgements

The Open University — Wed, 18 May 2011 12:35:56 GMT

Acknowledgements

Grateful acknowledgement is made to the following sources:

Figures

Figure 1: JUPITERIMAGES/BananStock/Alamy

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