INTRODUCTION

  1.  The British Bankers' Association is the leading association for the UK banking and financial services sector, speaking for 223 banking members from 60 countries on the full range of UK or international banking issues and engaging with 37 associated professional firms. Collectively providing the full range of services, our member banks make up the world's largest international banking centre, operating some 150 million accounts and contributing £50 billion annually to the UK economy.

  2.  The Treasury Select Committee has indicated that it is particularly interested in receiving written evidence on:

—  Lessons learnt by the regulators on the regulation of Northern Rock.

—  Potential reforms to banking regulation.

—  Market abuse.

  3.  While this written submission focuses exclusively on these elements of the Committee's inquiry we have enclosed, for information, the BBA's formal submission in response to the tripartite authorities' consultation document "Financial Stability and Depositor Protection: Strengthening the Framework".

LESSONS LEANT BY THE REGULATORS ON THE SUPERVISION OF NORTHERN ROCK

  4.  We believe that the critical lessons to be learnt by the regulators are that they must utilise their regulatory powers to the full and that when issues concerning potential institutional failure—or systemic threat—arise they should act decisively and with confidence. It is clear to all concerned for example that the tripartite arrangements did not work particularly well in the case of Northern Rock and that, while responsibility for its failure rests principally with management and line supervision, the subsequent dithering contributed significantly to the loss of confidence and the run on the bank.

  5.  We do not, however, believe that the tripartite system is fundamentally broken; rather we believe that it can—and must—operate more efficiently. The essential ingredients are: an approach that identifies emerging risks in a timely and robust way; a clear assignment of roles and responsibilities; improved communication between the authorities and the outside world; and a better process for crisis management. We therefore agree that the Memorandum of Understanding underpinning the tripartite arrangements needs revision, but are unsure whether this necessitates a COBR mechanism.

  6.  We support the FSA's continued role as the sole UK financial regulator. But, as recognised in the refreshingly candid internal report, in the case of Northern Rock the FSA clearly displayed shortcomings in regulatory execution and a key aspect of strengthening financial regulation must be ensuring that it is in a position to ensure that line supervisors have the resource and capability to exercise the regulatory powers in their hands. We are encouraged that steps have already been undertaken to begin the design and execution of a new supervisory enhancement programme. This will necessarily involve a review of the quantum and calibre of staff involved in line supervision and ideally should involve drawing more on private sector expertise and a more interactive approach with industry.

  7.  We also believe that conditions of market stress can be significantly calmed through a more flexible application of the Bank of England's money market operations and have observed that this requires the Bank to embrace more radical change as part of its Sterling Money Market Review. We welcome the proposals included in the recent Financial Stability Forum report on enhancing market and institutional resilience[5] particularly its comments on destigmatisation, widening the types of eligible collateral and the need for central banks to work together in an internationally coordinated way. We expect that these recommendations will flow down into a changed sterling money market regime.

  8.  Our members welcome the introduction of the £50 billion Special Liquidity Scheme by the Bank of England during April, and particularly the ability for institutions to swap mortgage-backed securities for periods of up to three years, and the Bank's confirmation that it would be willing to increase the amount of the facility should this prove necessary. We believe that such a facility could become part of a more flexible approach to the Bank's future money market operations, in tandem with concerted action by leading central banks, including a more common and interchangeable collateral pool.

POTENTIAL REFORMS TO BANKING REGULATION

  9.  The tripartite authorities published their consultation document "Financial Stability and Depositor Protection: Strengthening the Framework" on 30 January setting out a far reaching package of banking reform in response to the sustained turbulence and instability in global financial markets. The proposals for reform are aimed at five objectives summarised as follows:

—  Strengthening the stability and resilience of the financial system—in the UK and internationally.

—  Reducing the likelihood of individual banks facing difficulties—including regulatory interventions and liquidity assistance.

—  Reducing the impact if, nevertheless, a bank gets in to difficulties—including a new "special resolution regime".

—  Providing effective compensation arrangements in which customers have confidence.

—  Strengthening the Bank of England, and ensuring effective coordinated actions by authorities, both in the UK—including through reforms to the tripartite arrangements—and internationally.

  10.  The pursuit of these objectives involves a comprehensive and wide-ranging set of initiatives that collectively represent the most significant banking reform in the past 30 years. They include:

—  Plans to strengthen key aspects of regulatory arrangements placed on banks by international regulatory bodies and international cooperation by the Bank for International Settlements, the International Monetary Fund and the Financial Stability Forum.

—  Improvements in the transparency with which markets operate through the provision of better information about complex transactions and improved best practice on the part of credit reference agencies and hedge funds.

—  Plans to strengthen regulatory execution on the part of the FSA, including the introduction of a clearer path to heightened supervision on the part of the FSA in the event of the financial position of an institution giving serious cause for concern.

—  Plans to develop the money market tools at the disposal of the Bank of England, within an approach that seeks greater convergence internationally in the money market operations of key central banks.

—  The introduction of a special resolution regime (SRR) and bank-specific insolvency arrangements that would help resolve an ailing institution in the rare event that heightened supervision had not succeeded.

—  Measures aimed at enhancing the terms of the Financial Services Compensation Scheme and the confidence in which consumers hold the scheme and the prospect of efficient and orderly payout in the event of bank failure.

—  Improvements to the basis on which the tripartite arrangements work and further measures aimed at strengthening the Bank of England's role in overseeing financial stability.

  11.  In responding formally to the tripartite consultation document, the BBA, on behalf of the banking industry, expressed support for the reform package in concept and committed to working with the tripartite authorities and other interested parties to ensure that each of the measures is developed with the full engagement of the industry.

  12.  We nevertheless found it appropriate to explain that the industry has significant concerns about various aspects of the proposals. While we remain optimistic that constructive dialogue can resolve our concerns satisfactorily, they are summarised below for the committee's information.

Use of the FSA's existing powers

  13.  We are not convinced that sufficient weight has been placed on the benefit of improving the FSA's execution of its existing regulatory powers. The FSA's internal audit report on the supervision of Northern Rock and the supervisory enhancement programme outlined in the high level recommendations illustrate the extent to which the poor execution of existing regulatory powers was a factor in to the downfall of Northern Rock. The high level recommendations and the proposed supervisory enhancement programme will contribute significantly to the execution of the FSA's extensive regulatory powers and in themselves will greatly strengthen banking supervision in the UK. Any proposals to introduce additional regulatory powers should be scrutinised critically in light of what can be achieved by exercising existing powers.

  14.  We believe that heightened supervision can play a significant part in the turning around of an ailing institution and would propose to engage constructively in discussion with the FSA on this. We support such arrangements resting on banks or building societies breaching threshold conditions based on key regulatory ratios but would underline the need for there to be sufficient scope within the heightened supervision arrangements to find the best means of working with management to secure the future of the institution in question.

  15.  The aim of heightened supervision should be to return the bank or building society to a state of normality, with varying degrees of strategic refocusing, depending on need. This should be the primary objective of heightened supervision and the triggering of the SRR arrangements should only be undertaken when it becomes clear that there really is no viable alternative. Entering heightened supervision should be based on quantitative and qualitative factors and should involve threshold criteria based on key regulatory ratios. We should ensure however that heightened supervision in itself does not become self-fulfilling as a result of a loss of market confidence following institutions being made subject to such arrangements.

  16.  A decision that heightened supervision will not work, and that there is no alternative to utilising the SRR arrangements, should be taken by the Chancellor of the Exchequer on the advice of the tripartite authorities and should involve responsibility passing from the FSA to the Bank of England; any engagement on the part of the Bank in advance of this should be limited in scope to the Bank assessing which of the SRR tools is likely to be most appropriate. Should this not prove possible then we would wish to think again about the best process for ensuring appropriate oversight for the introduction of SRR arrangements and may wish to reconsider whether or not transfer of responsibility to the Bank is necessarily the right way to proceed.

  17.  We further noted that the Treasury Committee report "Financial Stability and Transparency" recommends the establishment of a mechanism whereby warning of deteriorating market conditions from the Bank of England or the FSA would need to be formally acknowledged by financial institutions and discussed at Board level. This strikes us as being a highly practical suggestion in keeping with the UK principles-based regime.

Special resolution regime and bank-specific insolvency arrangements

  18.  The BBA can see the reasons why the tripartite authorities would want a special resolution regime and possibly bank-specific insolvency arrangements as part of the "toolkit" for dealing with the consequences of an ailing institution in extreme circumstances. While we would hope that the answer lies in the better execution of the FSA's regulatory powers, including through a process of heightened supervision, and better liquidity support to the market by the Bank of England, we cannot rule out the need for a more extreme approach and these measures are aimed at providing the statutory powers to enable a more efficient and orderly resolution of a failed bank's affairs.

  19.  In common with many other commentators, however, we are extremely concerned about the aggressive legislative timetable that the Government is proposing to follow in respect of these reforms since the changes in question impact on property rights central to the principles of English law. As matters stand, we are unclear, for example, about how a partial transfer to a bridge bank would work: would this sub-divide creditors into "haves" and "have nots" depending on whether their interests were transferred to the surrogate institution or left behind in the residual company? We are also concerned about the potential effect on commercial practices that form the backbone of the UK's financial markets. What will the effect be on set-off and netting arrangements; how will the arrangements affect the ability to close out contracts against a defaulting counterparty in derivative and securities trades? What will be the effect on the ability of counterparties to realise collateral held by way of title transfer against the bank or to enforce security interests? There are then issues concerning the impact on the rights of employees.

  20.  We believe that the complexities involved are such that changes of this nature could usually be expected to be the subject of an extended and multi-stage process of consultation and research. We understand however that the Government has placed absolute priority on the primary legislation at least being in place before the temporary powers provided by the Banking (Special Provisions) Act 2008 run out. In recognising the severe constraint that this places on the timetable we have recommended that as a minimum the Government:

—  Ensures that the legislation is drawn up in such a way that the broad legal framework provides scope for time to be taken to get the detailed arrangements right.

—  Engages openly with interested parties in the development of the Bill so as to ensure that there is an opportunity to take on board concerns; this should involve a further consultation on the draft legislation before it is introduced into Parliament.

—  Commits in clear and unambiguous terms to a full consultative process in respect of the secondary legislation that will subsequently be brought forward; and ensures that Parliamentary debate on this also takes place.

  21.  We should further add that we believe that one of the arguments in favour of pre-funding arrangements for the FSCS is that it would create a pot to pay for SRR arrangements. If this is the case, then we would negate this by saying that we believe that the cost of invoking the SRR arrangements should fall to the estate of the failed institution. Other than within the confines of the deposit protection scheme, we can see no case for the banking industry generally bearing the cost of failure.

Deposit protection and consumer confidence

  22.  Perhaps the first point that we should make is that the deposit protection scheme is only necessary as a last resort when the regulatory system has not prevented the failure of a deposit-taking institution. Thus the best protection for depositors will come from well run, appropriately capitalised and profitable banks, operating in effectively regulated and stable markets.

  23.  Within this context, we fully support the objective of providing effective compensation arrangements in which consumers have confidence. We supported the removal of the co-insurance element of the depositor compensation scheme within the £35,000 limit and regard this as a highly significant improvement in the terms of the scheme; the industry has also agreed to a revised funding structure for the FSCS involving ex-post levy contributions of up to £4 billion per year. We further believe that there may be a case for moving to gross payments.

  24.  But in the highly concentrated UK market we cannot see a role for pre-funding as such arrangements would be either punitive or tokenistic and neither is advisable. It would take several years to build up an adequate fund and in the interim we fail to see how the admittance of a partial fund could enhance consumer confidence. Pre-funding would also constitute a drag on bank liquidity and would tie up capital that could otherwise be better utilised. We regard the key to consumer confidence as being a guarantee of payment and in this regard see no substitute for a guarantee from the Bank of England.

  25.  We also believe that the Government has massively underestimated the consequences of permitting an institution to fail operationally and that as a result its expectation of 7 day payout by the FSCS is unrealistic other than in the case of a very small institution. While this is an area on which the BBA is undertaking further work, we believe the only possible outcome is that all concerned agree that it is imperative that all be done to ensure that business can continue to be conducted using the existing infrastructure of the failed institution.

  26.  In the case of using one of the pre-insolvency arrangements, this would enable a continuum in the provision of banking services precluding the need for resort to the compensation arrangements. Customers would in essence have access to their account monies and banking services with only minimal disruption. While no doubt there may be a process of account normalisation that would necessarily follow to all intents and purposes they would experience a seamless—or near seamless—service delivery. This by far is the optimal outcome in terms of how to deal operationally with the consequence of an institution failing financially.

  27.  Even in the case of the FSCS being called upon, it remains the case that utilisation of the infrastructure of the failed institution provides the most efficient means of dealing with the consequence of failure. What is at issue here is not only the payment of compensation, but the recreation of banking services that enable customers to re-establish their full range of banking facilities, including money deposit, the payment of direct debits and standing orders and the receipt of regular and ad hoc payments.

  28.  Only in extreme cases—circumstances that we believe are highly unlikely to arise in the case of a large or medium-sized financial institution—would the FSCS need to proceed without being able to rely on the use of the existing infrastructure. Financial failure need not be synonymous with operational failure, though we naturally accept that the two can go hand-in-hand and the maintenance of operational capacity in the event of financial failure requires careful planning. In view of this, we consider the consultation document to fall short in terms of setting out a realistic plan in terms of how payout could work in the event of the complete failure of anything other than the smallest of institutions.

  29.  We are concerned in particular that there is a lack of appreciation of the scale of the IT changes that would be involved in delivering the single customer view as proposed in the consultation document and an unreal expectation of what could be achieved in terms of delivery through the FSCS. Paragraphs A.206 to A.213 relate to the proposal for a single customer view enabling the FSCS to obtain information from banks and building societies at an earlier stage. Paragraph A.210 states: "There are no significant ongoing or one-off direct costs associated with this measure. This is because the amount of information being required is the same; its just the timing that is different". The cost quantification is given as negligible.

  30.  Our initial assessment shows that it would take a large bank with significant legacy systems to cope with at least three years to design and implement the necessary changes and cost in the region of £25 million to £50 million per institution. The cost of this measure across the industry would therefore be in the region of several hundred million pounds. It would involve further ongoing cost and add significantly to the scale of any future IT projects involving customer-facing systems since any change to the IT platform would need to be tested across the SCV data capability.

  31.  We are therefore undertaking further work on understanding the practical impediments to seven day payout in order that we can better understand the issues involved and whether there are shortcuts that would enable these to be overcome; we are also looking at whether we can establish a better process overall through a better understanding of the difficulties involved. In addressing this we are taking the view that the issue is not only one of compensation payout, but account maintenance or opening.

Effective coordination

  32.  As explained above, we support the proposed strengthening of the tripartite arrangements but in the UK context see the answer as lying more in the assignment of clear roles and responsibilities for each of the three parties and view this as being the key to improving coordination.

  33.  As observed in the Treasury Committee report "Financial Stability and Transparency", the international nature of the recent instability in the global financial markets and the instantaneous nature of world communications "make national borders largely irrelevant to the transmission of some shocks". The strengthening of cross-border cooperation under the aegis of the Financial Stability Forum and the International Monetary Fund is therefore of central importance given the global marketplace and international transfer of risk. The contribution that these bodies have to make has been amply illustrated by the report published by the Financial Stability Forum on 12th April and the action plan that it sets out for improvements to international regulatory requirements and market transparency. The measures set out in the report are comprehensive and their combined effect should be to strengthen regulation and market transparency in areas where existing arrangements are deficient.

  34.  In a global banking market practical cross-border supervisory cooperation is also critical in terms of more effective supervision. This is arguably where the greatest systemic risks lie. While we are highly dubious of proposals for a unified European regulator, we are firm advocates of the use of supervisory colleges and believe that these can significantly strengthen cross-border cooperation in support of home country regulation. This keeps the regulatory function closer to the principal marketplace and is preferable to an approach that would distance the regulator from the regulated institution in geographical and possibly cultural terms.

Market abuse

  35.  Our members are the FSA's strongest partners in tackling market abuse and engendering clean markets in the UK. This, we believe, is evidenced in the strong self reporting and early resolution culture of financial services firms in the UK. Both the industry and FSA's goal are clean markets.

  36.  In regard to Halifax Bank of Scotland (HBoS) share price movements the committee should bear in mind that in extreme circumstances markets can react very quickly and severely. Especially with automated trading, stoploss trades and the general level of concern. In a highly automated and integrated market as exists in the UK it is not surprising to see extensive volatility in times of stress. However volatility does not mean there has been market manipulation.

  37.  Following the FSA's failure on Northern Rock, the ensuing run on the bank, the collapse of Bear Stearns, the several days of turmoil on world stock markets it is unsurprising that the market reacted very sharply to any suggestion of weakness at HBoS.

  38.  The BBA and its members are supportive of the FSA's use of plea bargaining in market abuse cases. Judicious use of plea bargaining will allow the FSA to tackle more effectively insider trading rings. However it should not be seen as a panacea and excessive use of these powers will likely be unhelpful. For plea bargaining to be fully effective a change to the current legislation to provide full legal immunity is required. Specifically, protection from: third party civil suits; other European Regulators; and the SEC.

  39.  The Treasury is currently reviewing FSA keeping super-equivalent powers to the Market Abuse Directive (2005).[6] These powers exist very much at the fringes of the regime and firms find them both confusing and costly. These extra rules undermine the European Single Market and encourage other EU regulators to bring in their own super-equivalent rules. The FSA has wide powers in the FSA handbook under principles (PRIN) to address market abuse cases. These extra powers are therefore unnecessary.

  40.  The FSA is concentrating excessively on these marginal and confusing powers when the real issues are in the transaction reporting of derivatives. This information feeds into their database, "Sabre II". It is this that puts a spotlight on individual actions and it is in derivatives where large amounts of leverage can be obtained. Over the past 18 months the BBA and its members have been working closely with the FSA on complex derivatives and how they should be reported so that the FSA can see the true economic position of trades in the market. We therefore believe that in response to the current consultation the Treasury should conclude that it need NOT renew these superequivalent powers. We are in the process of finalizing our response to the consultation paper and will forward on completion.

May 2008

6   HMT consultation paper "FSMA Market Abuse Regime: A Review of the Sunset Clauses". Back