Lords publish banking supervision and regulation report

• Report: Banking Regulation and Supervision
• House of Lords Economic Affairs Committee

The Committee criticises the inadequate definition of roles and responsibilities of the Bank of England, The Treasury and the Financial Services Authority (FSA) in the current Memorandum of Understanding on regulation of the financial sector.

The report particularly identifies a failure of macro-prudential supervision – surveillance of the stability of the financial system as a whole - as a contributory cause of the crisis. The Committee believes the FSA focussed on its consumer protection role and failed to take sufficient steps to alleviate risks to the financial system caused by excessive debt and banks’ ventures into complex and opaque financial instruments. They also point out that the Bank of England had reduced the number of its staff working on financial stability.

The Committee believes that, although there is no need for a rush to all-embracing new legislation, some changes to the regulatory system should be made soon and the authorities should move rapidly to develop policies on a range of issues highlighted by the crisis.

The Lords’ Committee recommends the Government should revisit the tripartite supervisory system in the UK as a matter of priority with the aim of ensuring a sharper focus on financial stability. In particular, the Committee recommends that the Government should return responsibility for macro-prudential supervision from the FSA to the Bank of England. To achieve this, the Committee recommends the Bank of England Financial Stability Committee, created by The Banking Act 2009, be given executive responsibility for macro-prudential supervision; it should have direct access to the information required and a suitable policy instrument to counter pro-cyclicality in the banking sector. As envisaged by the Government, the FSC is not to have executive powers and the Lords’ Committee expresses concern that this would leave it ineffective. The Committee recommends that the FSC should be chaired by the Governor of the Bank of England and include senior representatives from the FSA and the Treasury.

The Committee also recommends that in future regulators should focus more closely on the risk models used by banks. The Committee concludes that prior to the financial crisis banks were using short term risk models which relied too heavily on recent financial data. With limited data, towards the end of any period of economic boom risk models paint a rosy picture which can lead to speculative bubbles. The report recommends that regulators should rigorously question the assumptions in banks’ risk assessment models, insist that they calibrate their models over long periods and submit risk models to regular stress tests.

Other recommendations in the report include:

• Increases in regulatory capital requirements for assets on banks’ trading books
• Central reporting and clearing of Credit Default Swaps (CDSs)
• Greater oversight by the British authorities of UK branches of multinational banks

The Committee also recommends the development of policies to:

• Counter pro-cyclicality in existing regulations
• Regulate and supervise liquidity
• Improve bank governance
• Remove agency ratings from capital regulations.

Commenting Lord Vallance, Chairman of the House of Lords Economic Affairs Committee, said:

"This has been the most severe banking crisis since the 1930s. Its impact on the wider economy is still unfolding. But it is already clear that there is a strong case for reforming many aspects of the supervision and regulation of banking and financial services in the UK and internationally.

"We need to acknowledge that the regulations and their application contributed to the crisis, and made it worse when it came, because among other things, they had a pro-cyclical bias, did not pay enough attention to liquidity, and were wide open to regulatory arbitrage.

"It is also clear that in the UK the tripartite authorities of the Bank of England, FSA, and the Treasury failed to maintain financial stability, in part because it was not clear who was in charge in a crisis and because not enough attention was paid to macro-prudential supervision – oversight of the aggregate effect of the actions of individual banks - in the period when “boom and bust” was mistakenly assigned to history.

"We recommend early action to improve focus on financial stability in future. One way to help achieve this would be to return responsibility for macro-economic supervision from the FSA to the Bank.

"We make a range of other recommendations for early action and for the development of policies on other issues. The aim should be to restore confidence in the stability of the financial system and the international competitive position of the British financial services industry and so pave the way for renewed growth in the sector and the wider economy."