In its report on Banking Regulation and Supervision published today, theUK House of Lords Economic Affairs Committee criticizes the banking and financial services tripartite regulatory regime and concludes that failures of regulation and supervision contributed to the financial crisis in the UK.
The Committee criticizes the inadequate definition of roles andresponsibilities of the Bank of England, The Treasury and the FinancialServices Authority (FSA) in the current Memorandum of Understanding onregulation of the financial sector.
The report particularly identifies a failure of macro-prudentialsupervision – surveillance of the stability of the financial system as awhole – as a contributory cause of the crisis. The Committee believesthe FSA focused on its consumer protection role and failed to takesufficient steps to alleviate risks to the financial system caused byexcessive debt and banks’ ventures into complex and opaque financialinstruments. They also point out that the Bank of England had reducedthe number of its staff working on financial stability.
The Committee believes that, although there is no need for a rush toall-embracing new legislation, some changes to the regulatory systemshould be made soon and the authorities should move rapidly to developpolicies on a range of issues highlighted by the crisis.
The Lords’ Committee recommends the Government should revisit thetripartite supervisory system in the UK as a matter of priority with theaim of ensuring a sharper focus on financial stability. In particular,the Committee recommends that the Government should returnresponsibility for macro-prudential supervision from the FSA to the Bankof England. To achieve this, the Committee recommends the Bank ofEngland Financial Stability Committee, created by The Banking Act 2009,be given executive responsibility for macro-prudential supervision; itshould have direct access to the information required and a suitablepolicy instrument to counter pro-cyclicality in the banking sector. Asenvisaged by the Government, the FSC is not to have executive powers andthe Lords’ Committee expresses concern that this would leave itineffective. The Committee recommends that the FSC should be chaired bythe Governor of the Bank of England and include senior representativesfrom the FSA and the Treasury.
The Committee also recommends that in future regulators should focusmore closely on the risk models used by banks. The Committee concludesthat prior to the financial crisis banks were using short term riskmodels which relied too heavily on recent financial data. With limiteddata, towards the end of any period of economic boom risk models paint arosy picture which can lead to speculative bubbles. The reportrecommends that regulators should rigorously question the assumptions inbanks’ risk assessment models, insist that they calibrate their modelsover long periods and submit risk models to regular stress tests.
Other recommendations in the report include:
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Increases in regulatory capital requirements for assets onbanks’ trading books;
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Central reporting and clearing of Credit Default Swaps (CDSs);
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Greater oversight by the British authorities of UK branches ofmultinational banks;
The Committee also recommends the development of policies to: .
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Counter pro-cyclicality in existing regulations;
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Regulate and supervise liquidity;
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Improve bank governance;
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Remove agency ratings from capital regulations.
Commenting Lord Vallance, Chairman of the House of Lords EconomicAffairs Committee, said:
“This has been the most severe banking crisis since the 1930s. Itsimpact on the wider economy is still unfolding. But it is already clearthat there is a strong case for reforming many aspects of thesupervision and regulation of banking and financial services in the UKand internationally.
“We need to acknowledge that the regulations and their applicationcontributed to the crisis, and made it worse when it came, because amongother things, they had a pro-cyclical bias, did not pay enough attentionto liquidity, and were wide open to regulatory arbitrage.
“It is also clear that in the UK the tripartite authorities of the Bankof England, FSA, and the Treasury failed to maintain financialstability, in part because it was not clear who was in charge in acrisis and because not enough attention was paid to macro-prudentialsupervision – oversight of the aggregate effect of the actions ofindividual banks – in the period when “boom and bust” was mistakenlyassigned to history.
“We recommend early action to improve focus on financial stability infuture. One way to help achieve this would be to return responsibilityfor macro-economic supervision from the FSA to the Bank.
“We make a range of other recommendations for early action and for thedevelopment of policies on other issues. The aim should be to restoreconfidence in the stability of the financial system and theinternational competitive position of the British financial servicesindustry and so pave the way for renewed growth in the sector and thewider economy.”