Report on banking regulation and supervision

31 July 2009

The Treasury Committee today releases its final report following its evidence sessions this year on the banking crisis. The report considers how regulation and supervision have changed, and can be further improved, in order to return to and maintain more stable banking

Reforms to the Tripartite structure

The Committee considers the reforms to the institutional structure of the Tripartite Committee announced in the Treasury’s recent White Paper to be largely cosmetic. Merely re-branding the Tripartite Standing Committee will do little in itself, the report says. There is still a lack of clarity regarding who is responsible for systemic oversight, and who has executive authority in a crisis, a problem the Committee first highlighted in the aftermath of Northern Rock’s demise. Where before no-one had a formal responsibility for financial stability, now many do - the Bank of England, the FSA, the Treasury, the Council for Financial Stability and the Bank’s Financial Stability Committee. Where responsibility lies for strategic decisions and executive action was, and remains, a muddle, the report says.

However, in the Committee’s view no new macroprudential responsibilities should be allocated until a decision has been made about the precise tools needed. For this reason, the report does not advocate substantial change to the Tripartite framework. When that decision is made however, responsibilities need to be crystal clear, and aligned with powers, it urges.

The Committee was also extremely perturbed by the evidence from the Governor of the Bank of England that he was kept in the dark over the contents of the White Paper to the extent that he had "no idea" what it would contain, or even when it would be published, only a fortnight before publication. The report looks to the Chancellor to address why consultation papers on financial reform are now no longer jointly published, or even shared, with his Tripartite colleagues.

John McFall, Chairman of the Committee said:

"The Tripartite structure of regulation is in a state of flux at the moment: change and coordination are clearly needed to clarify responsibilities, but the picture is constantly moving. Institutional reforms should wait until the macroprudential tools themselves have been designed. When the dust settles though, we cannot afford to have any ambiguity over who is in charge, and who is responsible if something goes wrong."

The FSA’s response to the financial crisis

The report recognises that the regulatory philosophy of the FSA has changed. It is now far less trusting of banks’ ability to make the right decisions left to their own devices. It has less faith in market forces than before; it is more willing to challenge firms’ business decisions; it now considers the competence of new bank directors and appears more willing to remove ‘the punchbowl from the party’. However, the report also emphasises that the real test for the FSA will be when the boom years return. By then, the organisation must have developed the confidence to take unpopular decisions in the face of potential resistance both from industry and politicians.

John McFall, Chairman of the Committee said:

"By any measure the FSA has failed spectacularly in its supervision of the banking sector, but it has acknowledged this and already begun to rectify its mistakes. The change of philosophy since Lord Turner’s arrival and the launch of the Supervisory Enhancement Programme show that the organisation is moving in the right direction. However, all this is very fashionable now; the FSA must develop sufficient teeth in order to be able to go against the tide in the future and take unpopular decisions."

Systemically significant banks

Many banks are systemically significant because they are too big, they conduct many types of business, or they are too complex and interconnected. The report addresses each of these issues in turn, concluding that though it is unlikely that all banks could be shrunk to a size where they posed no systemic risk, the Government can and should still act. First, it should ensure that there are no banks which are ‘too big to save’. It should also review the wisdom of allowing a banking market to be dominated by firms whose balance sheets are larger than the national economy. Second, banks must not operate under any incentive to grow large just in order to benefit from the status of being ‘too big to fail’. The report suggests that this market failure be addressed through a ‘tax on size.’

On the question of a return to ‘traditional banking’ along the lines of the US Glass-Steagall legislation, the report concludes that it would be intolerable if banks took advantage of the implicit Government guarantee for deposits to take risky bets on proprietary trading. It calls on the FSA to not rule out a prohibition on proprietary trading by deposit-taking banks at this early stage in the debate. The more complex and interconnected a bank is, the higher its capital requirements should be, reflecting the greater potential impact on the wider financial markets and real economy if failure were to ensue.

John McFall, Chairman of the Committee said:

"Major banks have managed to establish themselves in a powerful position in the economy. By becoming too large and complex, they can hold the taxpayer to ransom, because no government could allow them to fail. Some banks have been able to take advantage of this implicit guarantee to make risky bets. This has to stop. Tweaking the capital requirements to prevent this happening may work, but we should not rule out more drastic action, such as forcibly shrinking the banks or separating out the riskier functions."

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