Response

FSA Discussion Paper "A Regulatory Response to the Global Banking Crisis" (DP 09/2)

Response by the Building Societies Association

Contact: Jeremy Palmer Date: 19 Jun 2009

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Background

The Building Societies Association represents all 53 building societies in the United Kingdom. Building societies have total assets of £385 billion and, together with their subsidiaries, hold residential mortgages of almost £250 billion, more than 20% of the total outstanding in the UK. Societies hold over £240 billion of retail deposits, accounting for more than 20% of all such deposits in the UK. Building societies also account for about 37% of all cash ISA balances. Building societies employ over 51,500 full and part-time staff and operate through more than 2,000 branches.

Introduction

We are pleased to contribute a detailed response from the building society sector on the majority of the questions and issues set out in the discussion paper, following on from our initial response to Lord Turner’s review. Where topics are of no, or marginal, relevance to building societies we have generally not addressed them in this response.

We welcome the FSA’s readiness to question previous policies, to base future policies on sound intellectual analysis rather than simplistic slogans, and to move away from its previous over-reliance on market mechanisms.  In the same way, we welcome the recognition that

(i)  the FSA’s balance between conduct of business type issues and prudential regulation was, at least in deposit-taking, biased towards the former; and

(ii)  the risks in deposit-taking are different from those in other financial services; with the FSA consequently having to lower its own risk appetite for bank failure.

We agree that the recent problems in the financial markets call for macro- as well as micro-prudential measures.  While we support a role for counter-cyclical buffers of some kind to reduce the instability attendant on the collapse of macro-economic bubbles, there is need for a debate about the extent to which monetary policy and /or fiscal tools can also be used to support financial stability objectives and to prevent or burst bubbles – it is not clear that deposit-takers’ capital should carry the sole burden of such macro-economic management.

The role of inadequate capital and liquidity in causing instability

Q1: Are there shortcomings in the international prudential framework not already identified in the DP that are relevant to the analysis?

The FSA has identified almost all the major policy shortcomings in the international prudential framework: insufficient minimum levels and quality of capital; dilution in the quality of capital resources banks hold; over-reliance on model-based approaches to capital requirements; insufficient mitigants to procyclicality; excessive balance sheet leverage; inadequate risk capture by the capital framework for market risk; rapid accumulation of funding liquidity risk; and issues bridging capital and liquidity, such as asset encumbrance.  To this long list, we would add that more recently the international prudential framework – largely through its move towards complexity(1) under Basel 2/CRD – has tended to disadvantage smaller firms such as the majority of building societies. Indeed, we see such complexity , beyond a certain point, as inherently counter-productive – as it causes both firms and regulators to fail to see the wood for the trees. Perhaps it also creates or re-inforces an unhealthy co-dependency between the purveyors of complex policy at the regulator and the interpreters of the same complex policy at firms or consultancies, which may not be in the wider interests of either firms or the regulator as a whole(2) . For that reason we note with interest the re-emergence of much simpler but possibly highly effective measures such as gross leverage and core funding ratios.

However, many of the listed shortcomings apply only, or to a significantly greater extent, to the bigger universal or internationally active banks. Given the concerns about the massively increased concentration in the UK deposit-taking sector (and the explicit challenges in favour of increased competition in the Budget Report) we think FSA needs to redress more vigorously the inherent big bank-centricity of its policy making.

Finally, although this is identified elsewhere in the Turner review and DP, the practical application of the “international prudential framework” clearly failed in relation to passporting banks, which have been shown to pose a major threat to domestic financial systems in host countries such as the UK. Arising from the Icelandic disaster, we could see a legacy of distrust of foreign banks, as UK depositors question whether in practice domestic depositor preferences will operate, to their detriment, in the relevant foreign state.

Q2: What are the measures supervisors should take to mitigate the risks to depositors and other unsecured senior creditors of secured funding, taking account of the benefits of such funding where used to an appropriate degree?

We agree with much of the analysis on this topic at paragraphs 3.70 to 3.72. and fully support the development of a comprehensive and thought-through policy on asset encumbrance, though this needs to involve a consistent approach across the Tripartite Authorities  - given that the conditions of central bank liquidity provision appear to have been a major driver towards asset encumbrance. Seeking an internationally agreed approach is also desirable, though may prove ambitious – especially as there may be historical and cultural reasons why some foreign jurisdictions view asset encumbrance (e.g. through covered bonds) more benignly – in contrast to the UK regulatory tradition which we understand has tended to disfavour banks or building societies giving security at all apart from repos and similar market collateral arrangements.

Section 4: Solutions through micro-prudential measures

Q3: Do you agree with the proposals to redefine what counts as capital with a stronger emphasis on going concern loss absorbency?

Our comments relate to the particular situation of building societies, where we consider that what counts as capital, within the constraints of their mutual form of ownership, is currently clear. Building societies’ principal (and in some instances sole) form of capital is reserves, and their only other source of tier 1 capital is through the issue of deferred shares (whether conventional permanent interest bearing shares, or the latest variant of profit participating deferred shares) which have always qualified as core capital under the CRD and its predecessor the Own Funds Directive (notwithstanding FSA’s periodic attempts at gold-plating) and, according to the BSA’s legal advice, continue to do so following the latest amendments. Building societies therefore have no need of hybrids, and since PIBS already meet  the requirements for loss absorbency, these are not in need of redefinition as regards building societies. Recent circumstances have indeed conclusively demonstrated that PIBS do in reality absorb losses on a going concern basis.

 Our more general concern is that that any framework for capital must not be limited to the joint stock company-based model but must equitably cater for the structural differences inherent in building societies – as for other mutuals - for whom “ordinary shares” do not exist. While DP09/2 praises certain (unspecified) cases where company dividend payments were, it is claimed, cancelled on ordinary shares, it remains silent on perhaps the most egregious example of the opposite, widely reported at the time – the refusal of Northern Rock’s board, even after being bailed out at public expense, to cancel the 2007 interim dividend until compelled to do so at the very last minute by the FSA and the Treasury. Indeed, the “ordinary shareholders” of Northern Rock (abetted by the Rock’s then chairman) seemed to have considerable difficulty in understanding that their role was to absorb losses. And it was the speculation in the “ordinary shares” of some of the major banks, through short selling etc, which nearly led to their collapse – demonstrating that “ordinary shares” can be a source of serious instability too. Nor, given the relative ease with which all PLCs, including banks, can now buy back some of their own shares, are “ordinary shares” necessarily all that permanent, and PLC banks will have inbuilt incentives to do so whenever  the combination of dividends and share price appreciation required by investors cannot be sustained. As we have explained to FSA before, this adds up to an implicit American call option on at least a portion of the “ordinary shares”, whose exercise of course weakens the bank’s capital base. The FSA could profitably reflect further on these aspects before promoting “ordinary shares” as the paragon of core tier 1 capital. Why, under its public awareness statutory objective, has FSA not from time to time reminded bank shareholders that the regulatory function of bank ordinary shares is to absorb losses on a going concern basis?  It seems the shareholders in the failed banks feel they were not let in on this secret.

The EU Directives seem to have less difficulty in catering for mutuals, perhaps reflecting the very strong role of mutual and cooperative banks in many other member states, so it is to be hoped that the UK can in this instance learn from Europe. 

The Association will resist in the strongest terms any attempt by FSA at superequivalent implementation of the plain provisions of article 57a of the amended CRD that disadvantage building societies. This is a matter which we are continuing to discuss with the relevant policy team at FSA.

Q4: Should IRB banks be required to use a system such as variable scalars, or equivalent, whose effect is to limit the potential for procyclicality in capital requirements to a level that would be produced by a TTC ratings system?

It is clear that the pro-cyclicality of Basel II needs to be addressed because of the impact it is having on building societies and banks in this recession.  In such circumstances, pro-cyclicality acts to reduce the amount of lending building societies and banks can do. The revised guidance on variable scalars is welcomed and outlines an approach consistent with those originally developed by a number of lenders. Whilst supportive of rating systems that limit the potential for procyclicality, we do not support a move towards a single prescribed approach for capital assessment. There may be other approaches that reduce procyclicality and firms should perhaps be allowed to choose – with supervisory agreement - the one most suitable for them.

Furthermore, we need to recognise that it was the FSA that induced a number of lenders to move away from variable scalars in favour of procyclical models.  Therefore, whilst supportive of the revised guidance, the timescales against which firms redevelop their models and the detail of the methodology should remain at the discretion of the firm.

While variable scalars are a starting point for combating procyclicality, the door should be kept open for the development of other methods which may be more appropriate for individual institutions or sectors. A further consideration, also relevant to other questions below, is the need to avoid opening up inconsistencies between IAS accounting treatment and any calculations of provisions / reserves which are developed and required by the regulatory authorities.

Q5: Are there any other key issues that the review of trading book capital should cover?

We agree broadly with the approach outlined in the discussion paper.   Building societies do not have trading books: they are already narrow - or utility – deposit-takers.  If “casino banking” is not to be segregated from retail utility banking, and therefore continues to be conducted by banks whose retail deposits are insured by the FSCS, then it is all the more important that the considerable risks it introduces are mitigated by much higher capital, to reduce the propensity for these risks to be transmitted to other deposit-takers via the FSCS(3) .

Q6: How should the leverage ratio capture (i) off-balance sheet exposures and (ii) derivatives?

We understand the rationale behind the proposal to apply a backstop measure such as a leverage ratio – of total assets to capital - and therefore we are open to the concept of such a ratio, though it is open to the twin objections that it adds little further value if run in parallel with the existing risk-weighted asset methodology, and it is too crude to be an alternative ( nor is that proposed).  However, any reasonable measure that limits unsustainable growth, and could avoid repeating the current contraction of liquidity and consequent financial crisis, deserves sympathetic consideration. We agree with the FSA’s suggestion that off balance sheet assets should generally be re-consolidated. Building societies do not create derivatives, so while we agree that derivative activity needs to be captured, we do not offer a methodology for doing so, though we would point out that derivatives subject to effective netting arrangements should be included on a net, rather than a gross basis. We would also want to see further consultation on the possible distinction in any leverage calculation between the treatments of derivatives as part of a trading book, and derivatives used (as building societies use them) only for hedging purposes to manage and reduce risk.

Q7: Should the numerator of the leverage ratio be Core Tier 1 capital or should a broader measure of capital be used?

We could accept the numerator being core tier 1 only if, in accordance with the correct interpretation of the amended CRD, for the building society sector, core tier 1 capital includes all PIBS, stepped and unstepped.  Any superequivalent adjustment to exclude PIBS would, as previously stated, be unacceptable. 

Section 5: Macro-prudential policy

Q8: Should these reforms be applied to smaller and domestic banks, building societies and investment firms? If so, how can this be achieved in a proportionate manner?

We believe these reforms can, and should, be applied to institutions other than high street and/or international banks.  However, the key is proportionality.   Measures designed to stop failures such as Northern Rock and the Icelandic bank defaults should not have a disproportionate effect on sound, mutually-owned, customer-focused institutions such as building societies.  Applied too broadly they will only limit societies’ ability to lend and will skew competition.  One way to ensure the proposed reforms do not damage smaller and domestic firms is to relate the intensity of application to the proportion of wholesale funding (as FSA has already proposed for liquidity).

Q9: Do you agree with the FSA’s reasons for favouring a range of policy measures to deal with macro-prudential policy issues rather than adjusting the Basel II risk-based capital requirement?

In a perfect world, building societies and banks would be preparing for Basel III, a new set of prudential policies that applied lessons learned from the current crisis and ensured businesses had appropriate levels of capital and liquidity at all times.  It would not be as  complex as Basel II, which disadvantaged smaller firms, led to excessive reliance on models, and risked both firms and supervisors not seeing the wood for the trees (including the failure to give due attention to liquidity risk ). But we are not in a perfect world– and we do not have time for the upheaval needed to get to a Basel III. In view of this, and the fact building societies and banks are already coping with unprecedented levels of regulatory involvement in a time of acute recession, we consider that the FSA has made the right choice in favouring a range of supplementary policy measures. The time is not right to embark on Basel III. Rather, attention should be focused on ensuring that the supplementary policy measures are rational, evidence-based, and proportionate, with particular care needed to avoid sudden changes that can undermine planning assumptions and business models.
Q10: What should be the focus of the FSA’s initiatives on valuation and disclosure in UK banks’ accounts so as to maximise their impact on market confidence?

FSA has already identified the key ingredient – the understanding clearly but elegantly explained in the main Turner review  as follows:

“The essential challenge is therefore that the accounting regime which makes sense from the point of view of idiosyncratic risk and of the shareholders of banks operating in stable conditions is quite different from that which may be optimal when viewed from a regulatory, systemic and macro-prudential viewpoint. These different perspectives have in the past been the cause of some disagreements between accounting bodies and regulators on the appropriate way forward.”

So we suggest an important focus for FSA initiatives should be firmness in pressing the regulatory, systemic and macro-prudential viewpoint against a narrow and idiosyncratic accounting viewpoint. Valuation and disclosure should be sufficiently transparent to ensure that market confidence and the reduction of systemic risk are paramount.

A further issue on which the FSA should focus is that of simplification. Current rules and disclosure – particularly for IFRS societies – are complex and arguably produce too much information of little value: rather than making things more transparent, the volume of information can make accounts more difficult to interpret and use. Another instance of not seeing the wood for the trees.

The IASB is currently in the process of revising its standards in response to the issues emerging and we look forward to seeing the proposals. We agree with the proposed three-way dialogue between the FSA, banks and auditors in order to reduce complexity and increase market confidence.

Clearly, reporting by banks can extend further than their general purpose financial statements (e.g. Pillar 3 reports) and every attempt should be made to align the total reporting package in such a way as to avoid any unnecessary duplication.  The Tripartite Authorities should also work together to align their prudential and other reporting
requirements to ensure common data definitions etc.

Q11: Do you agree with the FSA’s analysis of the implications of accounting standards for procyclicality?

Broadly, yes –especially the analysis in paragraph 5.27 - and we note that the FSA acknowledge that the current mixed attribute accounting model may still be valid and "telling things as they are" from a general purpose financial statements perspective. The issue is then how to manage the impact of this procyclicality on bank capital through prudential filters, additional capital buffers or accounting requirements.

While no approach is free of undesirable side effects, and it may be too early to opt definitively for one single approach, we tend to the view that it must be desirable for financial stability for credit institutions to make “rainy day” provisions in the good times to protect themselves and others against future economic shocks.  This “economic cycle capital buffer” could be included either as a reserve in an institution’s balance sheet or as a provision charge in the profit and loss account, leading to a liability on the balance sheet, and could address procyclicality in fair values in the trading book and the “cost less impairment” category. There would need to be a consensus both on how the actual stage of the economic cycle is diagnosed at the time ( and who definitively does so ) and how  firms should respond if the localised conditions affecting their individual business manifestly either lead or lag the more general economic cycle.

We are aware that including a provision for the buffer in their profit and loss accounts would mean a fundamental change to international accounting standards, which currently require institutions to disclose only incurred losses.  But we consider the resulting smoothing of profits over the economic cycle would on balance be beneficial, especially for predominantly retail funded institutions such as building societies. So the issue should be approached in an outcome-focused way. This is another instance of the general point captured in the quotation from the Turner Review above. The regulatory, systemic and macro-prudential viewpoint may need to trump some instances of narrow, idiosyncratic doctrinaire accounting.

Q12: How best should prudential regulators address the problem of procyclicality through counter-cyclical reserves/buffers?

We support the idea, already practised by some international regulators, of credit institutions making “rainy day” provisions in some form during the good times to protect themselves against future economic shocks.  And the FSA proposes that this capital buffer should be in the range of 2% to 3% of risk weighted assets at the top of the cycle in order to allow institutions to sustain significant losses without breaching the regulatory minimum.

Two sets of options for the buffer are proposed:

• as an economic cycle reserve that would be treated as an appropriation of earnings or an accounting provision under international accounting standards in the P&L.
• as a form of additional capital on top of the regulatory minimum or a separately constituted reserve.

We take it as read that any buffer will (for PLCs) be incapable of distribution to shareholders, however presented. We think it is highly desirable that the buffer should not only absorb losses in the downturn, but also mitigate the effect of those losses on stated profits – at the expense of slightly depressing stated profits while the buffer is being built up during the upturn. Otherwise the full benefits for financial stability and depositor confidence will not be realised. So we consider that the “economic cycle provisioning” method, illustrated in example 2 on page 110, by smoothing profits, probably gives a better overall outcome in terms of retail depositor confidence and financial stability ( than the economic cycle reserving method in example 1 ). As to the choice between additional capital on top of the regulatory minimum or a separate reserve, we agree with the analysis in paragraph 5.32 and for those reasons, on balance favour the separate reserve. As to how such provisioning should be calculated, consistency is important – while management judgment is not excluded, there has to be confidence that PLC banks, which are otherwise strongly incentivised to minimise the hit on profits, have done it properly – so some element of a formula-driven approach may have to be considered.

There is another, more general, but very important issue which we think needs to be highlighted: the risk of, in effect, “double counting” through the accumulation of buffers, and other add-ons driven by extreme stress testing, on top of existing Pillar 1 and 2 capital requirements. It is all too easy in the current climate to say “both/ and“ when perhaps the logical answer might include more  “either/or “. For instance, where Pillar 2 is based on a TTC ratings system already designed to absorb 1 in 25 year credit losses, how do we ensure that any buffers or capital add-ons take account of this, and are truly incremental, rather than to some extent duplicating or overlapping with the job that Pillar 2 is supposed to do.

A leading society has also contributed the following helpful insights. If prudential regulators are to require through the cycle or dynamic loan provisioning that differs from the current incurred IFRS model then this could be reflected through general purpose financial statements in a number of ways including 1) an accounting provision in the income
statement; 2) recognition in other comprehensive income; 3) an appropriation of equity outside of comprehensive income or 4) by additional note disclosure.

Given that the form and calculation of any required provision / reserve is not yet clear we currently have an open mind.  However, we note that accounting standards are designed to support the preparation of general purpose financial statements and we can see that if too much influence in respect of financial stability  as mentioned in our response to Q10) is brought to bear in the design of accounting standards then one side-effect could be that comparability of reporting between banks and with other non bank reporters is prejudiced. So it is not yet clear where the optimal balance lies.It would also be necessary to ensure that there was an appropriate alignment of prudential capital requirements and the measure of accounting / prudential capital.

We note that in the future there is also the possibility of accounting standards moving towards an expected rather than an incurred impairment model.  Whilst this may tend to smooth profits during a "normal" economic cycle it has the capacity to exacerbate accounting volatility in more extreme economic conditions.

Q13: Do you agree that serious consideration needs to be given to establishing some form of global supervisory architecture for international audit firms?

As the paper says, global supervision of international audit firms will be hard as they are primarily networks of nationally-based partnerships and do not have a unified global management and financial structure.  A strengthening of the role of the International Forum of Independent Audit Regulators may help, but will probably take too long to deliver. Would it not be more focused and more immediately effective for there to be  a structured dialogue – say twice yearly bilaterals – between  each Big 4 firm and a college of financial regulators from the main jurisdictions ?

Q14: What macro-prudential policy tools should be considered other than those mentioned in this DP?

The FSA is already proposing new measures to enhance capital and liquidity, and a leverage ratio, as well as the principal tool of counter-cyclical buffers – which, prima facie, would seem to meet the bill.  Building societies and banks should be given time to embed these (and the FSA time to assess how well they work) before seeking ever more measures.  Too many measures run the risk of not being able to “see the wood for the trees”, nor will it necessarily be clear - once introduced- which ones  work and which ones are otiose or even counterproductive. There is also the risk – highlighted in the answer to Q12 above – that measures inadvertently overlap and duplicate, thereby constraining lending to an even greater degree than the Authorities intended. So we prefer an incremental approach as regards regulatory measures. But we  re-iterate the point made at the beginning of this response: there is need for a debate about the extent to which monetary policy and /or fiscal tools can also be used to support financial stability objectives and to prevent or burst bubbles – it is not clear that deposit-takers’ capital should carry the sole burden of such macro-economic management.

Q15: What are your views on the effectiveness of a core-funding ratio as a measure to constrain excessive asset growth?

Criticism of Northern Rock, Bradford & Bingley, the Icelandic banks which collapsed, and of the other major UK banks which were saved from collapse by the Government , has frequently focused on the obvious unsustainability (once this was fully exposed) of their funding. So a core funding ratio could well be a useful tool to prevent recurrence of those problems, though it may come at a cost: potential consequences could be further consolidation, with a rise in concentration risk, a lack of competition, and scarcity of credit which in turn may slow economic growth and development. And we have already drawn to FSA’s attention that – if the effect of a core funding ratio applied to broad banks that include “casino” banking activities is to encourage them to draw more funding through insured retail deposits- a core funding ratio may increase, not reduce, risk to the rest of the banking system through the FSCS.

Under section 7 of the Building Societies Act 1986, building societies are subject to a form of core funding ratio – they are required to keep at least 50% of their funding from member retail deposits.  We feel this model (although its original purpose was different, and it  gives no credit for stable medium-term funding such as  MTNs or covered bonds) has worked well and protected societies from the worst of the current financial crisis.  Furthermore, we see no case currently for modification(5) .

Given this, application of a separate core funding ratio (calculated slightly differently) as well might be problematic as well as unnecessary – though a CFR that required a minimum slightly above 50%  that included both retail funds and term wholesale funding might  be acceptable to societies (if not to most banks) – provided it came with a commitment from the Tripartite Authorities to promote long-term funding solutions for societies at reasonable cost.

We see two further difficulties with a CFR. First, using the same limit for all firms could encourage some to move towards that limit without properly considering the appropriate funding structure and ratios for their particular circumstances and risk profiles ; that is, what was intended to be a limit turns out (due to pushing out of the envelope and herd behaviour) to set a norm. More seriously, if the CFR were set too high, and applied across all banking sub-sectors, it could prolong and worsen the current shortage of credit in the economy. Given that the total supply of retail deposits is in the short term relatively inelastic, so unlikely to expand quickly in response, the aggregate, macro-effect of a high CFR, through limiting the use of wholesale funding, does risk shrinking the availability of credit to businesses and households.

Q16: What types of institutions should be exempt from such a core funding ratio? How would any exemptions limit the effectiveness of the measure?

As mentioned above, building societies are already subject to a strict funding limit(6).  As indicated above, and depending on the level at which a CFR is to be set, it may be that building societies – because of their strict statutory controls – should formally be exempt, as the same outcome is achieved by an existing tool – the funding limit

Extending the principle of a core funding ratio to retail banks would constrain the risky gearing up with wholesale funds that characterised Northern Rock and several of the other converted building societies. But we have explained our reluctance to see  “casino” banking activities financed predominantly from (protected) retail deposits (which is one probable result of applying a core funding ratio to “broad” banks). Moreover, there is also a risk that a bidding war for retail deposits itself changes the hitherto stable character of such deposit bases as banks may encourage high value deposits from individuals that are both extremely rate- sensitive and, increasingly, credit-sensitive as well.

Where institutions pose no systemic risks and take no retail deposits we see no need for a core funding ratio requirement. 

Q17: To what extent would market discipline and the convergence of supervisory practices be improved by the disclosure of information relating to Pillar 2
assessment? What information would be most useful?

We agree with the reservations expressed in paragraph 5.70 on greater public disclosure of information relating to Pillar II assessments, for banks as well as building societies. We see this as another instance of the conflict – so well identified in the Turner review itself - between  what is desirable for idiosyncratic and for systemic purposes. And the incisive questioning of market mechanisms in the Turner review should caution against expecting too much from so-called “market discipline”. For the larger building societies especially, the risk is that commentators will seize on the figures and make ill-founded comparisons, not just between sectors, but also between individual institutions.  Particularly on their own, increased Pillar II disclosures may only lead to misunderstandings and instability ; without any benefits materialising from either “market discipline” or the convergence of supervisory practices.

Section 6: Scope of regulation

Q18: Are there other considerations that are relevant to the assessment of the issues and risks posed by the boundary question?

Although some (but not all) of the causes of the current crisis lay within the regulated sector, the crisis also exposed risks that parts of the unregulated financial sector posed to financial stability.   We agree that this is because of their connections, financial and reputational, to regulated firms and the impact on market pricing of asset sales and other activity by the unregulated. 

We also applaud the aim of the FSA’s strengthened regulatory framework to reduce the incentives to move activities outside the new regulatory boundary.   Whether “strong surveillance at global level” of unregulated sectors. and information sharing about the sector with other supervisors, will work better  remains to be seen. The experience with passporting banks is not encouraging. The FSA’s proposal to regulate on the basis of economic substance rather than legal form will, however, give the regulator the authority and means to tackle sources of instability.  

Q19: Is the escalating response set out here the right way to deal with the threats to financial stability and consumer protection posed by unregulated financial
activities and institutions? Or should the FSA, along with other regulators, develop an alternative approach?

The series of rapidly escalating steps as set out in chapter 6 is essentially the right way to deal with the threats to financial stability and consumer protection posed by unregulated financial activities and institutions. The escalating response must be flexible though to limit damage to the regulated sector from fall-out, financial and reputational, and deal with any unforeseen consequences.  The response must also be proportionate.

Q20: What are the implications of subjecting parent holding companies for financial services groups to direct powers to comply with the requirements of the
prudential framework?

A building society is always itself at the head of its group, and cannot be owned by a “parent”, so the possibility of   parent holding company not subject to regulation does not arise for societies. We think making parent holding companies of banks subject to compliance with the prudential framework will promote financial stability and discourage attempts at regulatory arbitrage by banks.

Section 7: Systemically important firms

Q21: Are there other issues which regulators should take into account when assessing their response to the evidence from the current crisis that some financial institutions have been deemed too big to fail fully? If so, what are they?

We have considered carefully the proposal that tougher prudential requirements should be applied to a top tier of systemically important banks, based on an acceptance that they are “too big to fail”.  We note the reservations about the too big to fail concept expressed recently by the Governor of the Bank of England(7). Such an approach also presents dangers for the many building societies that are not in this systemic category: they may end up wrongly being  perceived as less safe than those in the top tier.

But we recognise that the UK banking system has become extremely concentrated, and failure of a systemically important bank would be catastrophic for all building societies, both in terms of the immense burden of FSCS levies and in terms of the overall drop in depositor confidence.   At the same time, systemically important banks may be so big that some resolution tools (such as directed transfer to a private sector purchaser) cannot realistically be used.  On balance, therefore, we are inclined to agree that the top tier of banks will have to meet tougher prudential requirements designed to drive down their propensity to fail to an extremely low level.

One word of caution. The creation of this top tier has to be executed in a way that does not create a flight to perceived quality, in either the retail savings or wholesale money markets. These systemically important banks may be able, purely as a result of their “protected” status, to raise funds more easily, and do so at finer rates, than non-systemic banks – so we need some mechanism to ensure that an unfair competitive advantage does not result. It would be ironic if, as part of the design of a post-crisis banking system, the Authorities replicated one of the most unsatisfactory aspects of the current recovery phase – the unfair perceived safety advantage enjoyed by nationalised banks which distorts competition in the deposit market – with that advantage merely handed on from the currently nationalised or part-nationalised banks to the “too big to fail” banks (noting moreover the significant overlap between the two categories). Here, too, the Governor’s comments are relevant(8).

Q22: What are your views on the balance between varying the intensity of supervision according to the impact and risk that an individual firm poses, and having policy frameworks and approaches that differentiate across-the-board according to a firm’s systemic significance?

In an ideal world, policy frameworks would be a level playing field for all deposit-takers. But we recognize, in responding to the previous question, that tougher prudential requirements for those banks too big to fail may be a reluctant necessity, given the concentration in the UK banking system. For the remainder, we think the general approach, in line with much of FSA’s own thinking, is that policy frameworks should not be different in kind but rather their application should be sensible and proportionate, and related to the risks the firm is running. We see the move to sharply increase capital requirements for the trading book as an instance of this, assuming for the moment that we do not see firmer measures to separate the contagion of casino banking from insured retail deposits. We also see this broad approach reflected in the new specialist sourcebook for building societies, which  are prudent, conservatively run institutions that are inherently risk-averse. And we support some policy guidance to promote transparency and to constrain what might otherwise be arbitrary and inconsistent action by individual supervisors. Supervision of most societies clearly needs to be different to that of a high street bank or international, wholesale funding-dependent bank.

We recognise a possible danger that policy frameworks that explicitly differentiate between institutions according to their systemic significance could raise boundary issues which in turn distort banks’ commercial decisions, 

Section 8: Groups and intra-group exposures

Q23: Are there other aspects of group structures that the FSA should be taking into account?

As explained above, a building society is always at the head of its own group, and given the statutory principal purpose, nature limits and restrictions on financial trading in the Building Societies Act 1986, building society groups are in general fairly straightforward and do not introduce the complexities and risks rightly catalogued in chapter 8. Nor have building societies been significant users of SPVs, SIVs and other conduits. Nevertheless, we agree that the FSA has identified the main risk issues in relation to group structure and intra-group exposures and their impact on the way financial groups should be regulated.

Q24: Is the increased focus on group structures and intra-group relationships and increased supervisory cooperation the right way to deal with the threats to financial stability and consumer protection posed by large, international group structures? In what circumstances would a greater focus on individual legal entities be warranted?

We agree that an increased focus on group structures and intra-group relationships accompanied by increased supervisory cooperation is the right way to deal with the threats posed by large, international group structures.  But we welcome the FSA’s understanding that, in a crisis, it is legal entities rather than “business lines” that fail, and threaten consumers. So we support the stricter approach on legal entities being taken, for instance, in liquidity policy. The collapse of the Icelandic banks, and confidence issues around banking groups from certain other EU states and non EU countries confirms that international groups pose different threats to financial stability, although purely domestic entities such as Northern Rock and Bradford & Bingley can clearly cause as much damage.

Section 9: Responding to events – international architecture

Q25: How can the international architecture be arranged to provide the most effective early warning of threats to financial stability and challenge to national authorities and in an apolitical way?

We broadly agree with the analysis in chapter 9, the overview in the purple text box on pages 145-146 and in paragraphs 9.1 to 9.3. We strongly support the FSA’s call for a radical review of EU passporting rules and powers for host regulators to restrict or halt the business of EU bank branches where the home supervisor’s regime or compensation scheme is flaky. This essential lesson of the costly Icelandic disaster must not be missed. We also support the FSA’s view that day to day supervision of firms should remain with national supervisors, which echoes the same point, against erosion of national supervisors, that this Association made in its own response to the de Larosiere report. We agree with the analysis in paragraph 9.20 of the unavoidable linkages between supervisory authority, fiscal responsibility and political accountability as a major reason why supervision must rest with national supervisors.

Q26: Is this the most effective way of organising colleges on the one hand and crisis management groups on the other?

While this matter is not directly relevant to building societies, we are broadly content with the FSA approach. Effective colleges / crisis management for global banks do matter to societies because of their indirect exposure, via the FSCS, to bailing out the UK depositors when one or more such bank fails - as with Iceland.

Q27: Do these options represent the right approach to the problems posed by EEA branching?

As stated above, and in earlier BSA responses to various other consultations, we welcome, post-Iceland, a very tough line on passporting foreign banks, and we think the FSA has rightly recognized (paragraph 9.17) that the dogmas of the “single market” have to be challenged. The Icelandic bank situation caused uncertainty and distress to UK households, impoverished UK charities, heaped yet more onerous levies on UK building societies and banks, burdened UK local authorities and council tax payers with losses, and left the UK general taxpayer contingently picking up the residual bill. This cannot be allowed to happen again.

Q28: Are the functions of rule-making capability and supervisory oversight the right ones to be given to a European institution that has the characteristics
described here?

While re-stating the Association’s view that day to day supervision should rest with national supervisors, we agree with much of the FSA analysis in paragraphs 9.19 to 9.25. Smaller and specialist credit institutions, such as the majority of UK building societies, will however take a lot of convincing that rule-making by an EU body instead of a national supervisor, will be sufficiently responsive to their needs. Consultation and dialogue by an EU body with societies on policy proposals will be distant and less effective, so we doubt the outcomes will be optimised.

Section 10: Market issues

Q29: Does the DP highlight the correct issues concerning the role of CRAs and the use of their ratings?

We welcome the acknowledgement of past over-reliance on credit rating agencies and we support the regulator’s aim of examining the role of credit ratings agencies in the current market collapse and preparing an appropriate response.  We also support the EU regulation on credit rating agencies, which comes into force later this year.  As a regulation, it will have direct effect in all member states (unlike a directive it does not need to be transposed into member state law).

This is not the first time we have alerted the Government and its agencies to the problems of credit ratings. We raised this in 2004 when the guidance on local authority investments was consulted on. Our January 2009 submission to the Communities and Local Government Committee on local authority investments reiterated how the current guidelines on local authority investment place too great a reliance on credit ratings, which probably contributed to recent local authority losses with Icelandic banks. 

We have said repeatedly that such reliance on credit ratings (for which most building societies otherwise have no need) operates to the competitive disadvantage of smaller and specialist institutions including most societies. We have also explained on several occasions that obtaining, and then maintaining, a credit rating involves significant management time and costs which does not make it a sensible choice for smaller societies.

While we do support the FSA’s objective of encouraging investors to undertake their own due diligence and risk assessment, this may not always be practical for smaller institutions such as local building societies.

Finally, it is clear that credit ratings were not much use in predicting the collapse of Northern Rock or Bradford & Bingley, or the need for government-funded recapitalisation of other major banks.  The failure of credit rating agencies to give sufficient early warning of the problems in structured finance vehicles have demonstrated the need to assess their practices with a view to restoring market confidence in the rating process.

Q30: Are the approaches outlined to address these issues appropriate and proportionate?  

The approaches outlined in the discussion paper are generally speaking appropriate and proportionate.   But credit rating agencies must – as the new EU regulation will anyway require -explain their methodologies better.   This would enable investors to form their own judgment of the plausibility of the ratings and the credibility of the agency.  Market discipline might also be enhanced as investors would likely request rating agencies to re-evaluate older deals on the basis of newer methodology. This would have a two-fold benefit of making ratings much more comparable and create an environment where many more regular forensic, ground-up reviews of transactions were carried out by the rating agencies. In particular, greater transparency is imperative where rating reviews are the result of changes in rating methodology, rather than changes in the circumstances of rated firms.

Q31: What options should a review of the use of structured finance ratings in the regulatory framework consider?

We note the suggestion in paragraph 10.28 that CRA structured finance ratings can no longer be relied on for capital requirements purposes, and would generalize from this – the performance of CRAs generally surely argues that no ratings – not only structured finance ratings but also institutional and senior debt ratings– should be so relied on. We also support the important insight(9) in the Turner review itself that “public policy should avoid unnecessary requirements for investing institutions to hold securities of a specific rating”.

Q32: Is this the most appropriate framework for post-trade transparency or are there other aspects we should be considering?

Q33: Are there other measures which the FSA should be considering or promoting in international fora?

Q34: What other considerations should the FSA take into account with respect to OTC derivatives infrastructure?

Q35: Are any (other) changes to clearing arrangements needed? If so, what should they be?

Q36: Are any changes to settlement arrangements needed? If so, what should they be?

We do not offer comments on QQ 32-36 as these matters are at best of marginal relevance to the majority of societies. Some individual societies may wish to address them in their own responses.

Section 11: Supervisory approach

As we said at the start of our response, we welcome the FSA’s readiness to question previous policies, and to base future policy on sound intellectual analysis, rather than simplistic slogans.  Clearly the previous reliance on the sufficiency of various market mechanisms was excessive and misplaced. In the same way, we welcome the acceptance that FSA’s balance between conduct of business type issues and prudential regulation was, at least in deposit-taking, biased towards the former. Finally, we detect, and welcome, the recognition that the risks involved in deposit-taking are qualitatively different from those arising in other financial services, and that FSA’s own risk appetite in the banking sector has to be lowered.

Section 12: Implementation and transition

Careful transitioning to the future capital (and  funding/ liquidity) regimes is imperative to avoid prolonging the credit crunch. FSA has clearly recognised this point, and we agree broadly with the analysis in section 12.2.

Section 13: Implications for other regulated sectors

Q37: Which of the issues set out for discussion in this DP are most relevant to other regulated sectors?

Q38: Are there any lessons which have been learned in other sectors which could be applied to banking

We offer no comments on QQ 37-8 

 

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