Building a Dam
SOURCE: SCOTTISH BANKER, AUGUST /SEPTEMBER 08
In January 2008, responding to the continuing instability in global financial markets, HM Treasury, the Bank of England and the Financial Services Authority ("FSA") together published a discussion paper headed "Financial stability and depositor protection: strengthening the framework" as part of a consultation process. It is expected that, subject to final exchanges with the industry on preliminary drafting, legislation will be introduced during the early part of 2009.
The stated aim of the proposals is “to improve the resilience of the financial system and support financial stability by strengthening depositor protection and dealing with banks in difficulties.” In other words, the triumvirate is trying to ensure that if financial stability in the UK is threatened, there is a range of tools at their disposal to mitigate risk while protecting consumers and minimising the impact on the wider economy.
In terms of preventative measures, the proposals are geared towards strengthening risk management by banks through improved stress testing and liquidity management. This would enable the Bank of England to lend in a more effective manner by improving the framework for the provision of liquidity, including allowing short-term non-disclosure of liquidity assistance to avoid depositor panic of the kind we saw with Northern Rock. Allied to this, the proposals would allow the FSA to collect information from banks in difficulty and remove any impediments to them sharing it with the Financial Services Compensation Scheme ("FSCS") and the Bank of England or HM Treasury where relevant to maintaining financial stability.
The Governor of the Bank of England has made it clear that new access to liquidity through the proposed reforms will of course have to have a reasonable, but strict, pricing structure so as to encourage banks to manage liquidity risk in a sensible way as “without the correct pricing structure, the incentives to encourage future risk taking are obvious and potentially large.”
If a bank is in real difficulty, then arguably the current insolvency laws do not provide an adequate solution and in fact create a risk for other banks in terms of financial stability and for customers who cannot get access to deposits or savings. This is to be addressed by the introduction of a 'special resolution regime' to allow the authorities to intervene when a bank gets into severe difficulties and which includes the introduction of an effective ‘insolvency’ regime for banks.
The special resolution will provide a ‘toolbox’ to the FSA on bank crisis including the ability to seize a bank’s assets to secure depositors’ savings. There is a proposed power to transfer the banking business to a third party to facilitate a private sector solution, to appoint a suitable person/body to carry out a resolution and, if a pre-insolvency procedure is not capable of saving the bank, to work alongside the FSCS to facilitate faster and efficient pay-outs of customers claims.
So, the special resolution regime will allow the FSA to essentially seize a failing bank’s assets in order to secure the savings of the depositors, avoiding a "Northern Rock" and hopefully providing a positive alternative for the governing bodies when a bank does face difficulties. In the past, the only way to deal with a bank in crisis would have been via traditional insolvency, which is not desirable for the bank at hand and further erodes public confidence in the banking industry.
However, there is a note of caution from investment banks and the British Bankers Association have warned that the proposed regime could unintentionally assign preferred creditor status to depositors, with the knock-on effect of increasing the cost of banking transactions.
Another issue is that the “trigger” for the regime becoming active in terms of a bank in crisis needs to be clearly set out. This is where the detail produced to date is relatively unclear and this is one of a number of points which require to be expanded upon and carefully considered in the final consultation and drafting process. The point is acknowledged by Mervyn King in a recent statement where he observed that “a clear framework for accountability should be established to give confidence that decisions relating to the resolution regime are exercised in line with the objectives for the regime set out in legislation.”
There is a view however that banks themselves will benefit from strengthening of the FSCS which is primarily aimed at making the financial system safer for consumers. By doing so, depositors will not feel as concerned at investing savings with a bank and thus, liquidity within any bank will have less chance of “running dry”.
The Northern Rock crisis and the resulting flood of customers removing their savings to a great extent resulted from the FSCS guaranteeing only a maximum compensation pay out of £31,700, which in October 2007 was increased to £35,000. This could be increased again on expansion of the scheme with the Chancellor considering a raise of up to £100,000. However, these increases are only suggestions which will not be confirmed until after the draft Bill is released to the public.
On this front, the Governor has suggested that an element of pre-funding would be beneficial to the compensation scheme. He said recently that “a degree of pre-funding is one of those ideas that is bound to be unpopular before the fund is called upon, but seems decidedly wise after the event as it lessens the burden on the banking system in a time of stress.”
So, in stark contrast to recent events, the intention of the new legislation is that in future the authorities will be able to take decisive action, allowing people to have continued access to banking functions or rapid and orderly depositor payment. As ever with proposals of this nature however, there is a danger that legislation is rushed through without full consideration of the potential consequences and so the general view within the banking sector has been that the Government should take time to consider the opinions of the regime and furthermore the consequences that it may carry.
AUTHOR: ALEX INNES