All the studies that underlie the new UK Financial Services regulatory arrangements implemented in 2013, assumed that the problem with the previous regime was a failure of design rather than a failure of execution.
It is generally held that the relevant UK authorities could not have foreseen the 2007 crisis. But the returns (BSD3, LR) launched around the turn of the century taken together with the BT, were designed for effective macro and micro prudential analysis. It is believed that such analyses were undertaken by the FSA’s Financial Risk Analysis and Monitoring unit (FRAM); they would have shown the trends that resulted in the 2007 UK financial system problems.
For example following the RBS / Natwest merger, the reductions in bad debt provisions, would have signalled a warning; institutions over-reliant on wholesale funding should also have been apparent. Equally, those institutions over-lent on property, short on liquidity, short on excess capital or all three should have been identified also. It was generally believed that quarterly reports on potential threats to the system were prepared and circulated to the executive chairman and senior management.
It is believed that first FRAM and then the equivalent department in the Bank of England were shut down, a possible argument being the banks had PhDs looking at risk whereas what was being undertaken in FRAM was simply stress testing at a micro and macro prudential level and identification of trends in capital adequacy or liquidity that could pose threats to individual institutions, groups of institutions or the systems as a whole. The PhDs would see that there were no such threats.
But this reliance on risk modelling in individual institutions ignored a common thread running through the 2007 crisis; the 1997 financial system problems associated with LTCM about 10 years earlier; and the 1987 market correction / crash a further 10 years earlier. The common thread is the reliance on pricing models based on the normal distribution.
Although since 1987 there have been references to ‘fat tails’ and ‘black swans’, each generation of pricing and risk management specialists has relied on models based on the normal distribution1
Before the 1987 crash, Leland, O Brien and Rubenstein popularised the technique they named ‘portfolio insurance’ based on dynamic hedging of positions using derivatives priced on the basis of the normal distribution. Similarly before the 1997 problems, LTCM took on large, highly leveraged positions based on pricing models which indicated that they were fully hedged. A key contributor to the current financial systems problems is thought by some to be that the risk associated with securitised mortgage and other debt obligations was mis-valued on the basis of statistical formulae.
At the second Turner Review Conference, Shyamala Gopinath, Deputy Governor, Reserve Bank of India, said that their off-site risk analysis and monitoring arrangements enabled them to identify and manage threats to the Indian Financial System. But Neena Jain of the Reserve Bank, was trained by the FSA’s FRAM in 1999 (at the request of deputy governor Aditya Narain – now at the IMF). John Turner of APRA the Australian Prudential Regulator also had his training at the FSA’s FRAM.
The Governor of the Bank of England gave four reasons for not lending to Northern Rock, amongst these the Companies Acts and the Market Abuse Directive. It seems these obstacles prevented the Bank from fulfilling its function as lender of last resort effectively. But the tri-partite agreement made when the FSA was set-up did indeed envisage the authorities working closely to identify, assess and resolve potential UK financial system difficulties. Other institutions short on liquidity (not capital) must have had (covert) funding.
Much has been made of the way the state rode to the rescue of banks. But scrutiny of any liquidation / administration is likely to show that in these situations decision making is defensive and vast amounts of money spent on professional fees to justify / defend decisions, little effort being made to restore profitability. Public ownership of banks (UKFI) can result in the same outcomes. Whereas strengthening capital by means other than the state acquiring equity may have been more beneficial.
What should have been done? First, the results of the regulatory return analyses giving early warning of threats to individual institutions, groups of institutions or the system as whole, should have been acted on. Second, the Bank of England should have fulfilled its obligations as lender of last resort. Third where banks needed additional capital this should have been provided by means other than acquiring equity.
Some look back to the (apparently) halcyon days of supervision by the Bank of England, when, it is said, the merest twitch the ‘Governor’s eyebrows’ sent banks scurrying to put right what was wrong. But it may be worth recalling that the Bank of England was in charge of supervision when Barings Bank, BCCI, Johnson Matthey Bankers and earlier the fringe banks, collapsed. These took place during in relatively benign financial conditions compared with 2007. Care needs to be exercised in implementing the new regulatory framework to avoid a repetition of these previous problems.
Separating prudential from conduct of business regulation as is now the case, can create competing governance requirements. Regulation of conduct of business: the regulation of the selling process to ensure that suitable / appropriate products are designed and promoted, and customers treated fairly overall, best execution, etc., requires satisfactory governance arrangements. Prudential (capital adequacy and liquidity) risk management also requires governance arrangements which may be different. Moreover inadequate conduct of business controls can create operational risk which is considered a prudential risk.
It has been argued that the FSA with its ‘common platform’ approach to governance, systems and controls seemed to have recognised and handled correctly this interaction.
It could be argued also that given its stated wish to focus on all risks (including off balance sheet and operational risks) The UK had a better regulatory framework than the US with the latter’s focus on (on-balance-sheet) leverage ratio.
Will the new framework be as good? Have we designed a new framework to address a failure of execution in the old framework rather than a failure of design? Is the journey really necessary? Of course there are strong arguments for prudential regulation being with the Central Bank. Hopefully the new regime will work well and preserve London’s pre-eminence.
1Based on the work of Fischer Black and Myron Scholes, "The Pricing of Options and Corporate Liabilities", Published in the Journal of Political Economy in 1973 and Robert C Merton’s development of this, also in 1973, "Theory of Rational Option Pricing", published in the Bell Journal of Economics and Management Science
