Considered in Grand Committee
That the Grand Committee do report to the House that it has considered the Bank of England Act 1998 (Macro-prudential Measures) Order 2013.
Relevant documents: 18th Report from the Joint Committee on Statutory Instruments, 26th Report from the Secondary Legislation Scrutiny Committee.
My Lords, the background to these regulations is the failure of the previous system for regulating financial services to provide clear responsibility for financial stability, which was shared in an opaque way between the Treasury, the Bank of England and the FSA. This meant that it has been all too easy for the identification and management of risks to financial stability to fall between the cracks in what those organisations believed were their respective roles in protecting and promoting stability in the financial sector. That confusion was a key contributing factor to the emergence of the financial crisis in 2007. None of those three institutions was effectively horizon-scanning to identify macroprudential risks to stability across the system as a whole.
In the light of those failings, the Financial Services Act gives the Bank of England clear responsibility for financial stability. The Bank will no longer,
“contribute to protecting and enhancing”
financial stability; it will “protect and enhance” it. To support this objective, the Act creates a new committee of the Bank, the Financial Policy Committee, with a role of identifying, monitoring and managing systemic risks to the UK financial system. In order to carry out this role, the FPC will need macroprudential measures to mitigate the risks to stability that it identifies.
The FPC will act through the regulators that work directly with financial institutions. The FPC will do this in two ways: primarily through recommendations, which can be made to the regulators, to industry, to the Treasury, within the Bank and to other persons—and, where appropriate, through directions to the PRA and FCA. The FPC’s direction power will be limited to the measures set out in this order. The regulators must comply with a direction but they will have discretion over the timing and implementation method of the direction.
Before discussing the measures that will be granted to the FPC, it is worth noting that there is international consensus on the need for macroprudential regulation. International regulations such as Basel III and CRD4 go some way towards establishing minimum standards while retaining room for national discretion, although areas such as the leverage ratio remain under discussion. The UK strongly supports the ability of national supervisors to exercise discretion where appropriate.
In February 2011, the Government and the Bank established an interim FPC to undertake, as far as possible, the work of the statutory FPC ahead of the passing of the relevant legislation. One of the tasks set for the interim FPC was to analyse and recommend macroprudential measures for which the statutory FPC should have direction-making powers. Following the interim FPC’s recommendations in March 2012 on the tools that the committee should have, the Government consulted on these tools, seeking comments on our intention to: make the FPC responsible for setting the level of the UK’s countercyclical capital buffer; provide the FPC with a direction-making power to impose sectoral capital requirements; and provide the FPC with a time-varying leverage ratio direction-making tool, but no earlier than 2018 and subject to a review in 2017 to assess progress on international standards.
The statutory instrument relates to the ability to set the sectoral capital requirements, or SCRs. I will deal with this tool first, then briefly cover the others. The interim FPC recommended that the statutory FPC should have a power of direction to vary financial institutions’ capital requirements against exposures to specific sectors over time, arguing that often the overexuberance that precedes crises begins in specific sectors before spreading further. The Government agree that this targeted approach would allow these risks to be managed in a more effective and proportionate manner than raising capital requirements more generally.
There are, of course, risks associated with the use of these tools. Although the majority of respondents to the Government’s consultation supported the introduction of SCRs, some noted that the FPC risked being perceived as applying an industrial policy via the application of sectoral capital requirements. The FPC has stated that it would wish to avoid an “overly activist, fine-tuning approach”, which should limit this risk. However, there may be times when using the tools in a granular way would be necessary. The Government will keep the use of this tool under review to ensure that it is being used in an effective, proportionate way. There is also a risk that imposing sectorally specific requirements would merely displace excessive risk-taking in other sectors. The FPC will need to monitor carefully the impact of any policy interventions using this tool and may need to consider adjusting more general capital requirements if displacement is a significant problem. I should take the opportunity to highlight one change that the Government have made to the order since the version that was published for consultation. The current order excludes investment firms that are not regulated by the PRA from the FPC’s SCR power. This will ensure that systemically important firms are captured, while smaller firms are not subject to additional requirements.
I now move on to discuss briefly the other macroprudential tools that the Government intend to give the FPC: the role of setting the UK’s countercyclical capital buffer—the CCB—and from 2018, the power to intervene to limit leverage ratios. These are not covered by the draft order, but give useful context to the debate. The CCB is part of the Basel III agreement and will be implemented in Europe by the capital requirements directive, known as CRD4. It aims to ensure that banking sector capital requirements take account of the macrofinancial environment in which banks operate. It will be deployed by national jurisdictions when excess aggregate credit growth is judged to be associated with a build up of system-wide risk to ensure that the banking system has a buffer of capital to protect it against future potential losses. Requiring banks, building societies and larger investment firms to build up capital during periods of overexuberance should help to increase the resilience of the financial system and might also dampen the credit cycle. Unwinding these requirements in the downturn once the particular threat has passed might help to mitigate contractions in the supply of lending. It is clear that with its macroprudential focus, the FPC will be the body best placed to determine the level of the CCB. This was supported by the results of the Government’s consultation.
As the CCB is expected to be provided for in the CRD4, the simplest way to incorporate it into UK law is via regulations made under Section 2(2) of the European Communities Act 1972 to transpose into UK law the provisions of the CRD4 which relate to the CCB. It is vital that the FPC’s decisions in relation to the CCB should be subject to comparable procedural and reporting requirements to the FPC’s other tools. Therefore, in addition to the requirements imposed by the EU legislation, the Government intend to ensure that the CCB will be subject to the same transparency requirements as other FPC decisions, with a summary of the FPC’s discussions when taking decisions on the CCB set out in the FPC’s meeting record and the FPC’s use of the CCB covered in the biannual FSR. The Government will make any necessary changes to achieve this in the regulations which incorporate CRD4 into UK law.
As with the SCRs, small investment firms will be excluded from CCB requirements, although the exact terms of the exclusion have yet to be determined. The interim FPC also recommended that the statutory FPC should have a power of direction to set and vary a minimum leverage ratio. A leverage ratio could indeed potentially be a useful macroprudential tool for the FPC. The unweighted nature of this measure would guard against risk weights underestimating the true riskiness of assets in firms and provide a directly comparable figure across firms. The leverage ratios of firms were a useful indicator of failure during the last crisis, and the period immediately preceding the crisis was characterised by sharp increases in leverage.
The Government strongly support the inclusion of a backstop leverage ratio in the EU prudential toolkit and consider it an essential measure to ensure that leverage remains at sustainable levels. It is also important to maintain consistency with international and European standards, and it is clear that a leverage ratio will not be implemented across the EU until 2018. The Government intend to provide the FPC with a time-varying leverage ratio direction-making tool, but no earlier than 2018 and subject to a review in 2017 to assess progress on international standards. The precise design of the tool will depend on the provisions of the relevant European legislation and will be set out in secondary legislation at the time.
Finally, the Government will, of course, be able to add to this suite of macroprudential tools in future by further orders subject to the approval of this House and the other place. At the moment, however, we believe that the measures I have just described are an appropriate and sufficient starting point for the FPC. The Government expect the FPC’s toolkit to adapt and evolve as the international debate and academic literature on this subject develops and empirical experience becomes more widely available. We expect the FPC to make recommendations to the Treasury if its macroprudential measures require amendment or new measures are required. I hope that that explanation has been helpful. I beg to move.
My Lords, that was interesting introduction to this order as it spent most of its time discussing measures that are not included. It also began with a preamble that was an extraordinary rewrite of history, referring to a failure to identify macroprudential risks prior to 2008. Will the Minister specify any Government or regulatory document that includes a reference to macroprudential risk before 2008 and before publication of the Turner review? He will be hard put to find it. There are some academic articles on systemic risk but the whole issue of macroprudential risk was simply not on the horizon at that time.
I was also somewhat distressed to find that the Government still believe that following the Basel III approach of using capital related to risk-weighted assets is still at the centre of the approach to the determination of stability, particularly in the banking sector. This is using weapons with which we fought the last war to try to deal with the new war. It is an excessive emphasis on the asset side of the balance sheet to the detriment of the liability side, and indeed has been criticised very strongly recently by the IMF. I hope that the Government will rethink their approach and not continue to rely on this outdated measure.
I want to talk about some of the measures before us rather than some that might appear in the future, although the Minister has tempted me to ask what is happening with the leverage ratio. Leverage collars, which after all apply to the liability side of the balance sheet, have been demonstrated to be far more effective than risk-weighted capital requirements. Do the Government still plan to weaken the Vickers proposal of a leverage ratio of 25:1 and to fix the requirements simply on the Basel minimum of 33:1? When thinking about the leverage ratio, is the FPC planning any distinction between deposits and wholesale funding in the specification of a leverage cap?
In its earlier consideration of these measures, the FPC rejected the adoption of a loan-to-value ratio in mortgage finance, arguing that this was a political decision. In this instrument, though, we find the requirement on financial institutions to maintain additional own funds with respect to exposure to residential property. Will that not have the same effect? Is it not a back-door method of introducing loan-to-value restrictions by the requirement to hold additional capital against residential exposures?
Turning to the sectors specified in this instrument, it is striking that the measures are confined to financial instruments issued by financial sector firms. Why is that? If there were a bubble in the stock market, it could involve predominantly financial instruments issued by non-financial firms. Why is this legislation restricted only to instruments issued by financial institutions?
Another peculiarity of the drafting of this instrument is that it refers only to an increase in requirements of holding of own funds. It refers to “additional funds required” and that the PRA may require additional own funds both by banks and by other financial institutions. How will the PRA reduce the amount of funds required since the instrument only allows it to require additional funds? How will that happen?
I also regret the exclusion of smaller firms, to which the noble Lord referred in his introductory remarks. The Treasury seems to have totally failed to understand that a significant amount of the financial crisis was due to the aggregation of a large number of small firms doing the same thing at the same time, which had the same consequence as a large firm doing the similar thing in terms of the development of systemic risk.
The measures also refer to the requirement to ask or require that banks treat particular exposures as if they give rise to an increased level of risk, which is true not just of banks but also of investment firms. How is this level of risk to be specified by the FPC? Is it as a risk weight or as a modification of the stochastic distribution model used in the calculation of the firm’s value at risk? How is it to be done? If it is with respect to the modelling, does that now mean that the ability of firms to use their own risk models is to be modified and that there is to be a standardisation of risk models used by firms in the calculation of capital requirements?
The noble Lord referred to the use of these measures in what he called a granular way and what in the instrument is referred to as a solo basis. What will the relationship be between the FPC’s requirements of measures and competition policy, in the sense that imposing measures on a single firm would have competition implications? Will the views of the competition authorities be taken into account?
I assume that this is the first of a series of instruments that will implement the various proposals aired in the consultation papers issued by the interim FPC. Perhaps it would be helpful if the Minister gave us some timetable as to when those other instruments will be laid before the House.
I am grateful to the noble Lord for those extremely thoughtful questions, and I will do my best to answer them. He said that systemic risk was not on the horizon before the crisis. I think that the phrase was first used in academic literature in 1979. Although the phrase was not in common parlance, it was well understood, at least by some people, that a bubble was building up that was capable of creating systemic risk. The first problem was that it took a long time for the authorities and the Government to accept that there was a bubble. The second was that when they realised that there was a problem, and indeed when there was a crisis, it was far too late to forestall it. It was then necessary to deal with a crisis rather than dealing with a problem at an early stage.
The noble Lord said that we rely far too much on Basel III and that it is a weapon of the last war. We are part of an international discussion on Basel III. Although Basel III is part of the armoury that we use, it is only one part. Indeed, the measure that we are looking at today is not a Basel III measure. Even if the noble Lord was correct that Basel III does not deal with every issue that we will be grappling with, it is not the only tool that we are looking at.
The noble Lord asked me about the leverage ratio, and whether we still plan to weaken the Vickers ratio. I do not believe that the Government’s view on this has changed.
The Government said in response to Vickers that they believed he was going too far, and I do not believe that that view has changed. The noble Lord asked about the loan-to-value ratio and whether that tool would not have the same effect as introducing a loan-to-value ratio. In an aggregate sense, in many ways it does so. However, the advantage of this approach over adopting a loan-to-value limit is that it places an overall requirement on an institution in terms of its lending to the property sector, but still gives that institution the flexibility to provide loans at a high loan-to-value ratio. This might take place, for example, in a minority of cases in which the circumstances of the person to whom the loan is being given makes that loan prudent. In many ways it could have the same overall effect on the sector, but it gives institutions greater flexibility than a prescriptive loan-to-value ratio.
The noble Lord asked why the stock market was not included and why we were not including firms in that sector. The answer is that at this point the FPC believes that the definition of which firms are covered includes those firms that are most likely to cause a problem. The FPC has taken the view that firms in the stock market are not creating an equivalent risk to those elsewhere and those already covered. That is its judgement, which one can take a view on. The noble Lord disagrees, but that is the answer to the question.
The noble Lord asked about the order using the word “increase” and how it is envisaged that any increase might be unwound. When the FPC considers that any increase is no longer required, it will revoke the direction.
My Lords, I do think that that is an eventuality that the order caters for because, as the noble Lord says, it uses “increase”. If I am wrong on that, I shall let him know but, as he has said, the order is relatively straightforward. It will be for the PRA to decide whether it wants to do that, and it may do so, but obviously I will correct the record if I am wrong. It may require an amendment to the order for it to do that.
The noble Lord asked about the aggregation of a large number of small firms. This issue formed part of the consultation. The strong view came back that the effect that was being sought could be achieved by limiting the order at this point to larger firms. If any evidence built up that a large number of small firms could cause a risk beyond that currently envisaged, it would be for the FPC at that point to make appropriate provision.
The noble Lord asked how the FPC would specify risk. It will be for the PRA to determine capital models allowed by firms within the overall levels set by the FPC.
The noble Lord asked me about the timetable—whether there would be more orders and when they were going to be. There may be more orders, but none is envisaged at the moment. There is not a conveyor belt of other orders that are half-thought of. The view is that these measures are adequate for the time being. It is always open for further orders to be brought forward, but there is no perceived need for any further orders at this point.
There is one issue that I have not dealt with concerning the relationship between the FPC and the competition authorities. I hope that the noble Lord will forgive me if I write to him on that subject.
Before the Minister sits down, perhaps we could go back to how an increased level of risk is to be specified by the FPC. Is that to be specified as a change in risk weights in old-fashioned Basel I structures, or is it to be specified as a modification of the value at risk models used by the financial institutions? If it is the latter, are we moving away from the ability of institutions to use their own value at risk modelling towards a standardised model?