The Turner Review A blueprint for prudential financial regulation.

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1 The Turner Review A blueprint for prudential financial Turner regulation. Contents at a glance 1 Introduction 1 Summary of Review Recommendations 3 Causes of the crisis and a fundamental rethink of the approach to regulation 3 Capital requirements 3 Liquidity 5 Shadow banks regulating by economic substance and not form Other changes 6 The role of the FSA and division of conduct of business and prudential regulation 6 The bank business model 7 Cross-border supervision 7 Product regulation 8 8 Changes to global banks business model and cost of compliance 8 Turner at a glance 5 No more light touch regulation. Fundamental changes to capital and liquidity. Regulation of shadow banking sector; not yet to include hedge funds. Possible regulation of credit rating agencies. Impact Support for development of clearing of credit derivatives. No return to Glass-Steagall but some restrictions on the casino-like Shrinkage of banks balance activities of commercial banks. sheets and restriction on leverage More Europe or less Europe? supports an EU-wide regulator but not in Role of the originate to place of a strong FSA in London. Introduction The long awaited Turner Review (the Review ), which sets out a blueprint for the future prudential regulation of banks and financial institutions in the UK, was published on 18 March The measures outlined in the Review seek to address the shortcomings of regulation and supervision which have been exposed by the current financial crisis. The proposals are aimed at ensuring that the factors which drove the current crisis, including excessive leverage, complexity of the securitised credit market, role of shadow banks in the maturity formation process, extensive commercial bank involvement in risky trading activities, and lack of adequate capital buffers, are fully taken distribute model and securitised credit in the banking system 9 Return on equity and quality of bank capital 10 Difficulty of allocating capital and liquidity on a global basis 10 Change to corporate governance and risk management practices 10 Preparation for shift in supervisory approach including focus on areas such as remuneration policy

2 into account in developing the new system of regulation. The Review heralds a fundamental shift from light touch and principles based regulation to a more intensive rules based regime, focussing to a far greater extent on macro-economic policy and systemic risk. While a number of proposals focussed on in the Review, such as the shadow bank system, procyclality and capital buffers, have been discussed and debated over the past few months, the Review provides a detailed analysis of the preferred policy approach in these and other areas. The Review in many ways represents a concerted step by the FSA and the UK government to lead the global agenda on structuring the future architecture of international prudential regulation. There are a few areas (such as the liquidity proposals and through the cycle IRB model changes) in which the FSA is taking rules forward, in accordance with its own timetable, before detailed agreement is reached at the European or global level. However, the Review highlights the constraints the FSA is under in terms of timing and implementation of its proposed rules, particularly in relation to capital requirements which require fundamental agreement at the European level. The FSA recognises that, if it steps too far out of line with other regulators, it risks the possibility of regulatory arbitrage and a movement of UK-based banks to other jurisdictions. The impact of the proposals on banks and their business models will be very significant. The fundamental changes to capital and liquidity requirements, particularly in the trading book, where market risk-based capital may increase threefold, could have a substantial impact on the shape of banks business models, in particular the viability of retaining their non-traditional investment bank divisions, such as proprietary trading. The cost of compliance with these proposals may well lead to a drag on the profitability of banks, as well as a lower return on equity. New financial products and financial innovation may be subject to intense scrutiny and suspicion. Global banking groups, used to dealing in the main with their home supervisor, could find their local branches and subsidiaries subject to interference by the host regulator, while the efficient intra-group allocation of capital and liquidity may become more difficult. Turner can, of course, only speak for the UK FSA and as noted above, the Review needs to be seen in the context of EU and global initiatives. The recent De Larosière report at a European level, which has been supported by the EU Commission, called for many of the powers of national regulators to be transferred to centralised European bodies. In his comments, Turner appears to reject strongly such a strongly centralised model and, while advocating a central European body, wants to see more powers at the national level to deal with situations like the Icelandic bank defaults. This note summarises the main findings and recommendations of the Review and assesses the possible overall impact of these proposals on banks and other financial institutions. 2

3 Summary of Review Recommendations Causes of the crisis and a fundamental rethink of the approach to regulation The Review begins by outlining the key reasons for the current crisis. In recent years, issues such as increasing macro-economic imbalances and a growth in market size and financial innovation have combined to increase overall systemic risk. The crisis has necessitated a fundamental re-evaluation of the assumptions that underpin current regulatory practice. In particular, the theory that markets operate in a rational and efficient manner is in need of challenge. Consequently, the Review urges, by way of response, a fundamental change in global regulatory policy. The key proposal is for a shift towards a more systemic approach to regulation. This idea forms the basis of many of the proposals outlined below. Capital requirements Quantity and quality of capital The Review recognises two different approaches to the formation of capital adequacy rules. First, rules can be designed to protect creditors in the event of a single bank failure. Alternatively, they can be used to influence the behaviour of banks for the benefit of the wider economy, by reducing the incentives for excessive risk taking. The FSA favours the latter approach for systemically important banks. The Review proposes an increase in the quality of capital held by banks, so that there is a greater focus on Core Tier 1 and Tier 1 capital. As regards the optimum level of capital in the system, it is suggested that the current ratio of 2 per cent of Core Tier 1 and 4 per cent Tier 1 and 8 per cent of total capital could be replaced with a new structure of through the cycle (see paragraph headed Pro-cyclicality and countercyclical buffers below) 4 per cent Core Tier 1 and 8 per cent Tier 1 or alternatively by increasing the risk-weightings applied to assets. It is less clear what the role for Tier 2 capital (broadly subordinated debt) will be in the future, but there are strong indications that it may be excluded entirely from capital calculations. The Review notes that this is an area that requires international co-ordination and agreement and that capital requirements should not increase at this vulnerable stage of the economic cycle. The trading book The Review highlights the inadequacy of the rules used to define the riskiness of certain assets held in the trading book, particularly the 3

4 application of the value-at-risk ( VAR ) methodology to structured illiquid products. These rules have allowed banks to hold a surprisingly small percentage of their total capital against market risk. While the FSA support the recent Basel proposals, including the incremental credit risk charge and stressed VAR, they propose a more radical review of risk measurement in the trading book. This should cover (i) the definition of assets appropriately booked in the trading/banking books; (ii) the use of VAR rules; and (iii) whether approaches should vary according to trading book activity. It anticipates that market risk requirements in the trading book may increase by up to 300 per cent as a result. Pro-cyclicality and counter-cyclical buffers The approaches to banking book risk weightings under Basel II have the effect of lowering capital requirements in good economic times, and increasing them in bad times, especially if a point in time estimate of losses is used. The result is higher leverage and increased risk taking in good times, and reduced lending in bad times a clear and unfortunate accentuation of the economic cycle. While the FSA is currently addressing pro-cyclicality by through the cycle rather than point in time measures of probability of default, the Review also recommends that counter-cyclical capital buffers should be introduced, whereby capital is increased in an upswing. This should both keep a check on excessive lending, and mitigate the impact of the economic cycle, as the buffer is used to absorb losses in the downswing. A formula driven calculation (rather than a discretionary one) is preferred by the FSA, although it is not clear whether the buffer will consist of increased capital ratios, or a reserve deducted from profits, to be released in a downturn. The Review suggests that buffers of 2-3 per cent of risk weighted assets may be appropriate at the peak of the market. The Review makes clear that the counter-cyclical approach should be reflected in published accounts, which should include buffers which anticipate potential future losses, through, for instance, the creation of an Economic Cycle Reserve. This change requires a fundamental shift in accounting rules and the FSA acknowledges that the appropriate way forward needs careful debate between regulators and accounting boards. The Review does not address in detail the issue of who determines when an upswing or an downswing is in progress, or how. Gross leverage ratio The Review notes that if the system for determining capital requirements in relation to specific assets is robust enough, a gross leverage ratio (i.e. of total assets to capital) is in theory not necessary. However, the FSA supports the idea of a gross leverage ratio of some sort as a further 4

5 backstop measure, and they are pushing for an international consensus on this. Liquidity The Review acknowledges that managing liquidity risk is as important as managing solvency risk, given the systemic implications of a breakdown in liquidity. In many respects, the current financial crisis is one of liquidity not solvency, caused in part by the lack of a comprehensive set of liquidity rules. The FSA has already proposed changes to the UK liquidity regime, which are due to come into force in October 2009, and which amount to a major change and intensification of its approach to the measurement and management of liquidity risk. These proposals include a requirement for large complex firms to retain a robust buffer of highly liquid assets (broadly government securities) on a stress tested basis, a much greater degree of regulatory intervention in the process of settling liquidity models and less reliance on group liquidity. These measures are largely designed to improve the micro-prudential supervision of individual banks. To address systemic risk, a core funding ratio is proposed. This would essentially be a loans to deposits ratio, and could be implemented as a rule in itself, or merely as an indicator of concerns, to be addressed in guidance given to individual banks. Shadow banks regulating by economic substance and not form The Review notes that one of the origins of the crisis is the increase over the past decade of institutions that have been performing bank-like functions which have not been subject to a bank regulatory regime. Off-balance sheet SIVs and other shadow banks have been highly leveraged and performed extensive maturity formation with liabilities far shorter than the maturity of assets, thereby posing real systemic risk, but falling outside the regulatory net. According to the Review, future regulation should focus on economic substance, not legal form. Regulators should have the power to identify shadow banks and if necessary extend prudential regulation to them or restrict their impact on regulated entities. Bank s off-balance sheet vehicles may be brought back on-balance sheet if they pose a substantive economic risk to the bank. The Review suggests that, to achieve this, domestic regulators will need to become more integrated and co-ordinated to reduce the risk of arbitrage between regimes. As regulation becomes tougher globally, there will also be an incentive to seek a consensus on bringing offshore jurisdictions within the regulatory net. While the Review considers 5

6 that hedge funds are not currently playing a bank-like maturity transformation role and should not therefore fall within the scope of the shadow bank rules, it does note that regulators need to gather far more information on hedge funds and evaluate and monitor whether they do indeed pose a systemic risk. Other changes Credit Rating Agencies ( CRAs ) The Review states that CRAs have contributed to the crisis, by for example increasing pro-cyclicality. Whilst proposing some changes in this area, the Review is cautious about the impact of regulation, noting that ratings-based investment remains rational for many firms. Remuneration The Review acknowledges that the structure of remuneration in many banks can create incentives for inappropriate risk taking. The FSA has already issued a draft Code addressing this issue, but the Review suggests that further measures are necessary. The overarching principle of the draft Code (that firms must ensure that their remuneration policies are consistent with effective risk management) is to be made into an FSA rule. The assessment of remuneration policies will also be integrated into the ARROW process, with increased Pillar 2 requirements deployed to compensate for nonadherence to the Code. Netting, clearing and a central counterparty in derivatives trading The Review addresses concerns about the size and complexity of the vast OTC derivatives market. Whilst the gross value of the CDS market was around $60 trillion in 2007, net exposures amounted to only $3.7 trillion in There are thus many redundant gross positions, with a risk that the failure of a single counterparty could have disastrous systemic consequences. The FSA supports the development of central counterparty clearing systems to aid the reduction of unnecessary gross exposures. The role of the FSA and division of conduct of business and prudential regulation Regulatory approach The Review acknowledges the shortcomings of the FSA s light touch approach to regulation, which was founded in the belief that markets are self 6

7 correcting, and that the responsibility for managing risk lies with the management of individual firms. This resulted in a focus on individual institutions and a failure to challenge business models and strategies. The FSA has proposed more intensive supervision, as outlined in the Supervisory Enhancement Program ( SEP ) introduced in April The SEP will be supplemented by other measures. For example, the FSA intend to have far more contact with management and auditors in relation to published accounts and accounting judgements. Supervisory structure The Review notes no correlation between any particular supervisory structure and national success in dealing with the financial crisis. It also considers that the arguments for combining responsibility for the prudential regulation and supervision of all market sectors (as the FSA does) are strong, and does not consider that the prudential supervision of banks should fall within the remit of the central bank. It does not look likely therefore that there will be any major changes to the UK supervisory structure as a result of the Review, although clearly the Bank of England will have a greater role in macro-prudential analysis. The bank business model Many large commercial banks enjoy retail deposit protection, lender of last resort access and a too big to fail status. These advantages can be used to support risky proprietary trading activities, giving rise to a clear moral hazard issue. Many countries have proposed a Glass-Steagall approach to introduce a separation between these activities. The Review dismisses this idea, questioning the practicality of such a division in the complex modern economy. It also highlights some of the advantages (if properly regulated) of the modern system. It points out that Northern Rock was a narrow bank, and that it still failed. However, it notes that the impact of the regulatory capital and liquidity requirements will have a dramatic change on the type of risky or casino-like activities currently undertaken by the investment bank divisions of commercial banks. Cross-border supervision The Lehmans and Landsbanki failures, among others, illustrated the dangers of large international failures. In its previous regulatory approach, the FSA has placed considerable reliance on home country supervisors to ensure the soundness of an institution. This clearly has shortcomings. The decision by US regulators to let Lehmans fail had significant global repercussions. The need for the UK government to support deposits of 7

8 Icelandic banks, with limited say in their regulation under the passporting regime, highlighted the risks inherent in a Home/Host architecture. To deal with this problem, the FSA supports the development of cross-border colleges of supervisors to oversee and share information on large international institutions. In addition, the FSA supports in principle the concept of an EU level financial regulatory body, which would be an independent authority with regulatory powers and involved in macroprudential analysis, but primary responsibility for supervision would remain with the national regulator whose regulatory decisions could not be overridden. The FSA also indicates that it may decrease its reliance on home-state regulators, by requiring international institutions to operate as UK subsidiaries, which will then be subject to increased capital requirements and other restrictions on business operation. This should be part of a wider retreat from European single market freedoms. Product regulation Previously, individual product regulation had been avoided because it was believed that it would stifle innovation, with all of its associated benefits. However, the Review questions the beneficial value of innovation by analysing some of the dangers inherent in this practice. The result is the possibility of a policy to regulate certain individual products, in order to avoid excessive innovation. The retail mortgage market is one area where regulation is considered, with loan-to-value or loan-to-income ratios being considered as possible developments. Regulation of the wholesale product market, and in particular of CDS contracts, is not ruled out either. These issues are left open for further debate. Impact Changes to global banks business model and cost of compliance Over the past 10 years, much of the profit of large global banks has been driven by their proprietary trading and investment banking divisions, particularly in the structured credit market. The dramatic increase of capital requirements in the trading book, possibly by as much as 300 per cent, in addition to the imposition of much higher liquidity requirements, may lead to a hiving off or sale of such businesses from the core of the bank, even without a formal Glass-Steagall approach. 8

9 Shrinkage of banks balance sheets and restriction on leverage It is clear from the Review that the FSA considers that that one of the major causes of the crisis was the unchecked increase in total system leverage, hidden to a great extent by the opacity and complexity of the securitised credit model and the unregulated shadow banking system, such as bank sponsored SIVs and conduits. The stringent liquidity rules, in particular the liquidity buffer, together with the backstop gross leverage ratio and regulation of the shadow banking system, may cause an inevitable shrinkage in banks balance sheets and restrict the ability of banks to leverage their balance sheet in the future. Role of the originate to distribute model and securitised credit in the banking system The growth of global banks balance sheets and the overflow of available credit in the wider economy was driven over the past decade, to a large extent, by an explosion in growth of the securitised credit market. However, with that growth came opacity, the opportunity to originate to arbitrage and the misplaced reliance by banks on the liquidity of structured products. What can be drawn out from the Review is the tension regulators face between ensuring the securitisation market does not cause such systemic risk and damage to the financial system in the future, while attempting to reopen a market which is, in the view of many financial market participants, essential to the future recovery of lending and the flow of credit intermediation in the banking system. The new proposed liquidity and trading book rules, together with the Capital Requirements Directive skin in the game and intensive disclosure and due diligence requirements, may have an adverse cost effect on the decision by banks to become investors in the structured product market. Other investors, such as mutual funds and other funds may understandably be anxious about investing in such securities again. In addition, the proposal that off-balance sheets SIVs and conduits if they create substantive economic risk must be treated as on-balance sheet may impact on the ability of banks to carry on the originate to distribute model. Assuming the securitisation market reopens at some point in the not too distant future, the combination of capital and liquidity rules seem likely to ensure that that it is in a simpler, less complex and packaged form, with more diversification to end investors. 9

10 Return on equity and quality of bank capital The possible change to quality of bank capital with subordinated debt not counting for regulatory capital, in addition to an increase in the regulatory capital minimum requirements, whether by an increase in actual capital ratios or risk weighting of assets, together with the proposed capital buffers, seems likely simply to constitute an unavoidable cost, which will lead to a lower average return on equity for banks. Difficulty of allocating capital and liquidity on a global basis The increase of supervision and regulation of subsidiaries and branches of global banks by the host country regulator may affect the ability of the group parent entity to allocate capital and liquidity in the most efficient manner. As Mervyn King noted, Banks are global in life and local in death. There is an inherent tension between the home supervisor who has control over the consolidated group and the host supervisor who has a role in protecting the depositors and to a lesser extent the creditors of the local branch or subsidiary. The previous assumption of primary responsibility for prudential soundness lying with the home regulator is now very much open to debate. It is clear that, while the FSA considers that international co-operation and supervisory colleges should be strengthened, the optimum method of protecting depositors and creditors is ensuring the resilience of the local entity. The proposals of the FSA for host countries to manage liquidity on a local rather than group basis, together with the possibility of the regulator using its powers to require major international banks to operate as subsidiaries in the host country, may lead to a higher overall cost of group capital and liquidity. Change to corporate governance and risk management practices The risk management operations and corporate governance within banks will require review, and the FSA are clearly intending to embed a new risk management culture in all aspects of banks operations. While the FSA is awaiting the result of the Walker review on corporate governance, it has highlighted the issues of technical capability of non-executive directors and the integrity of the risk management function within a bank. 10

11 Preparation for shift in supervisory approach including focus on areas such as remuneration policy Banks will need to prepare for a major shift from the light touch principlesbased regime to an intensive, and interventionist, rules-based regime. One of the core messages from the Review is that the FSA no longer buys into the assumption that markets are self-regulating, with market discipline a more effective tool than regulations, and primary responsibility for managing risk with the boards of banks, not bank regulators. This assumption is replaced by the assumption that only a sophisticated and comprehensive system of prudential regulation, together with demanding, pro-active and questioning supervision, will keep banks in check and protect the stability of the prudential financial system. Instead of the previous focus on procedures and systems, the FSA will concentrate on policies, balance sheet analysis, banks models and strategies, and intervention in decision making which previously has been within the remit of the board. As regards remuneration, the FSA will enforce key principles within the Code of Practice on remuneration and include a focus on the risk consequences of remuneration, if necessary using Pillar Two capital requirements on banks where remuneration structures of an individual bank are not consistent with the Code. Banks should therefore be prepared for a continuation of the SEP process already in place and a similar level of information-gathering to that currently undertaken by banks participating in the Asset Protection Scheme

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