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Strong & Simple Rules: Keep the baby, throw out the bath water

Ahead of the 'Streamlining the regulatory framework' panel discussion at the BSA Conference next week, Ruth Doubleday, Head of Prudential Regulation at the BSA, makes the case that simple rather than complex rules are better, and that the strength of the rules is in the calibration, implementation, risk management and supervisory oversight.

By Ruth Doubleday, Head of Prudential Regulation, BSA

Much has been written about the failure of Silicon Valley Bank. Was it a failure of the regulatory framework that applied, or the firm’s poor risk management which was not adequately picked up and dealt with by supervisory oversight? Various analyses have been done to consider whether liquidity and funding ratios i.e. LCR and NSFR would have been met if they had been applied[1], including the treatment of unrealised losses on ‘available for sale’ securities. Silicon Valley Bank was subject to Pillar 3 disclosures[2] but even the rating agencies didn’t highlight problems til only days before the bank’s failure. The bigger question for me is whether rules alone are ever enough to prevent bank failure if not coupled with strong supervision, and whether those rules should be simple or complex? Here in the UK, people are now asking questions on what this means for the PRA’s post-Brexit ‘Strong and Simple’ project.

I argue that complex rules are not better. In fact I believe that simple rules are better. The strength of the rules is in the calibration, coupled with robust implementation, sound risk management and supervisory oversight. So the emphasis is on the ‘Strong’ as well as ‘Simple,’ and this project should be viewed as refining and improving the regime and not as a ‘de-regulatory Brexit bonfire.’

For context, let’s go back to 1988. A group of central bankers met in a small city in the corner of Switzerland. They set about to agree on a minimum amount of capital that international banks should hold. It was both radical and simple. It was named the Cooke ratio after the Peter Cooke, the then Governor or the Bank of England and the Chairman of what eventually became the Basel Committee.


What was radical and new about this ratio is that it introduced the concept of setting aside more capital for riskier assets and less capital for safer assets. The Cooke ratio was implemented widely and remains the fundamental basis that underpins the current Basel framework. The numerator and the denominator of the Cooke ratio have been developed and changed beyond recognition, with models driving a level of complexity to the inputs of the ratio, but the fundamental ratio has remained the same. The calibration of 8% has also endured. The components have shifted around but the 8% as a minimum requirement (before we talk about additional buffers) is still the same. Various folkloric tales involving London buses and the shape of clouds in the sky exist to explain where the 8% came from. The reality is it was more likely calibrated according to the levels of capital in banks at the time and a judgmental overlay on where they really should be. Sometimes I remind advocates of “complex rules for a complex world” that the 8% capital ratio calibration is not backed by any science.

So back in 1988, the global harmonised capital ratio was elegantly simple. Where did we all go wrong and how do we put it right? I believe the Cooke ratio was actually a victim of its own success. People loved the concept of risk weighted assets so much that they wanted more of it. Following the Mexican crisis people questioned how Mexican debt could possibly be risk-weighted at 0% having only just joined the OECD. What we needed was more granularity to achieve more accuracy and more risk discrimination. What’s more, there were these clever folk in banks that understood risk way better than regulators and could build fancy models to do the job. We should narrow the gap between the way regulators crudely capture risks and what the sophisticated banks were now doing. And so, Basel II was born. It retained the Cooke ratio but included options for modelled inputs for greater accuracy and risk sensitivity. And I’ll stop there. This isn’t an essay about the history of the Basel framework. But it can be important to understand how we got here.

Calls for simplicity are not new. Andy Haldane gave a speech about a dog and a frisbee[3] a decade ago and a growing number of people have joined him including Sam Woods the current PRA chief in his speech  ‘Bufferatti.’[4] One of the ideas often discussed is dispensing with the risk-weighted framework and replacing it with a simple leverage ratio, and this approach has been adopted in other countries. This risks throwing out the baby with the bathwater, and re-introducing some of the problems that the Cooke ratio so elegantly addressed. Incentives matter. I don’t need to spell out why requiring firms to hold the same amount of capital against UK residential mortgages as they do against a holding of Bitcoin is fundamentally a bad idea, not just for the safety and soundness of that bank but for the economy as a whole (micro and macro-prudential to use reg-speak). Naturally I’m biased, but history has shown that the actual losses on a portfolio of residential mortgages are incredibly low compared to almost all other forms of lending.

So that then leads me to the question of how to simplify the existing framework. If we keep the baby, what’s in the bath water that we need to throw out? There are some obvious components that can simply be removed such as pillar 3 disclosures. I hear from finance directors of most UK building societies, that based on website hits, the number of people reading such disclosures are in single digits, and they are more likely to be academics, job applicants or internal staff than any of the so-called ‘market disciplinarians’ as per the original policy intent.

Buffers are another obvious area. Going back to Basel I, all capital is essentially a buffer. Contrary to popular belief, the PRA’s ‘threshold conditions’ are not hard-wired to any magic number.  So why do we now need buffers on buffers and even a buffer on the leverage ratio? The leverage ratio was designed to be a non-cyclical backstop and yet we apparently need a buffer (designed to absorb cyclical shocks) on top of it. Then firms set their own risk appetite to avoid going close to breaching buffers so you have a management buffer on top of the regulatory ones.

Pillar 3 and buffers are just two examples. My general observation of the development of regulation is that new rules are made but rarely are old rules reviewed to ensure they remain relevant and fit for purpose. So the rulebook grows and grows. In the BSA’s response to the PRA’s recent discussion paper on policy development DP4/22[5] we argued that for every new rule there should be consideration of existing rules and these should be streamlined and reduced where there is overlap and duplication. We also called for the rulebook to be written in Plain English[6] to make it easier to understand and to implement consistently.  

I would challenge the myth that if rules are more detailed and more numerous that they are somehow better and more robust. I would argue the opposite. A small number of easy to understand and easy to implement rules that capture the biggest risks and are sensibly calibrated are surely better than pages and pages of complex regulations that no bank can ever attest to fully complying with. Let’s not forget that compliance departments take a risk-based approach to assessing compliance, as do auditors and supervisors.

My final point is on accountability. The Senior Manager’s Regime requires clear ownership of all the risks in the business, and for those senior managers to demonstrate that they have taken ‘reasonable steps’ in discharging those duties. This is a great demonstration of how simple rules can be very effective. A simple rule is one that is easy to understand and clear to assess. It does not mean that it is easy. Demonstrating ‘reasonable steps’ can be far from easy but it focusses the mind. If there is one regulation that I would argue could have prevented the Silicon Valley Bank collapse more than others it would have been the Senior Manager’s Regime which would not allow a bank of that size to go without a Chief Risk Officer for so long. Furthermore, interest rate risk management would likely be owned by the CFO, so her or his head would be on the block too.

So what does this all mean for the PRA’s Strong and Simple project? I would again like to emphasise the word ‘strong.’ Taking away, for example, pillar 3 reporting, is about the removal of superfluous requirements that have failed to deliver the outcome they were designed to achieve. This should not be seen as a de-regulatory measure that weakens the regime. To the contrary, staff currently tied up preparing these disclosures can be re-deployed to better use, such as providing insightful tailored analysis for a firm’s own Board. The same can be said of a number of regulatory returns that are neither useful for firms and nor is it clear how they are actually used by regulators. My view is that we keep the Basel capital ratio but simplify the inputs and reduce or streamline many of the peripheral requirements such as pillar 2, pillar 3 and buffers.

So, let’s not throw out the Cooke ratio, but rather let’s go back to basics. Keep the baby, but throw out the bath water.  

Find out more:

Join the debate at the BSA Conference next week. We have two prudential panels – one on Regulatory Reporting - Achieving a future state on Thursday 4th May at 11.40am, and a second on Strong and Simple – Streamlining the regulatory framework on Thursday at 2pm. Both sessions will be under the Chatham House Rule.

 


[1] Yale analysis of LCR and NSFR


[3] The Dog and the Frisbee, speech by Andy Haldane, Jackson Hole, August 2012

[4] Bufferati, speech by Sam Woods, Mansion House, April 2022

[5] BSA Response to DP4/22, December 2022

 

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