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BofE’s Breeden: ‘A banking licence is a privilege — banks must remember that’

Sarah Breeden is head of the Market Sectors and Interlinkages Division in the Financial Stability Directorate at the Bank of England. The division is responsible for assessing and identifying ways of reducing risks to the stability of the UK financial system that arise in financial markets and the real economy. Having led the Bank’s work to support the transition of prudential regulation of banks and insurance companies from the Financial Services Authority (FSA) to the Bank of England, Breeden is well positioned to discuss the impact of regulatory change on the UK financial services sector. In this interview, she shares her thoughts with Philip Moore.

EUROWEEK: It’s five years — almost to the day — since the Lehman collapse. What has been done since then to make the banking industry systemically safer?

Breeden: It’s been a busy five years, and I would highlight four international developments in that time that have played a key role. 

The first is too-big-to-fail and resolution frameworks. Compared to where we were five years ago, there has been a step-change in the authorities’ willingness and commitment to ensuring that institutions that operate in the financial system are able to fail in a way that doesn’t bring the system down with them.

That’s a big change. If you go back to 2008, when we were dealing with Bradford & Bingley in the UK, we had no resolution regime for banks. Now we do, and plenty of work is still being done to ensure that our most systemically important institutions are able to fail in a safe manner. 

The second theme is re-regulating banks based on international standards established by the Basel III capital regime to ensure that they are better capitalised, with better measured risk on their balance sheets, that are therefore less likely to fail. There are many dimensions to that. These include changing the definition of capital and focusing on going-concern capital that is there to absorb losses while firms are still operating. But as well as changing the composition of capital, and increasing the quantity that is available, we are also trying to make sure that we are smarter in the way we think about the risks that are on banks’ balance sheets.

We’ve had some good news in this area recently with the Capital Requirements Regulation (CRR) coming in at the end of this year in Europe and in the US. So not only do we have a framework, we are also well on the way to making that framework an implemented reality.

The third theme I’d highlight is the significant inroads that have been made in regulating the OTC derivatives market. We’ve mandated that there should be central clearing for some derivatives products. This means that margins will be determined by the central clearing house and that there will be effective oversight of the risks embedded in those products. 

In addition, we’ve started to introduce minimum standards for those bilaterally-undertaken transactions that will remain in the OTC derivatives space. The working group on margin requirements has set out minimum standards that will apply to all derivatives transactions.

Since derivatives can be a source of leverage and a potential means of propagating shocks throughout the system, when these reforms have been implemented over the next couple of years the market will be a much safer place. Some aspects of this reform programme will come in sooner than others, with the implementation of mandated central clearing in the US now imminent. But even on a two year horizon, the market will be much safer.

The final theme to highlight internationally is shadow banking. It is likely or perhaps even inevitable that as we re-regulate banks, activities that had previously taken place on banks’ balance sheets will migrate to other parts of the financial system. That’s not necessarily a bad thing. But as authorities, we need to ensure that the regulation of those entities is appropriate to their risk profile. 

A lot of work is being undertaken under the banner of the Financial Stability Board (FSB) setting out a variety of measures for dealing with things that we currently know to be shadow banking, defined as credit intermediation outside the banking system with leverage and maturity transformation. Money market funds is one example of where this happens. Securitisation vehicles and structured finance conduits is another. So we’re making sure that regulation deals with these known issues appropriately. 

But we also need to make sure there are regimes in place to ensure that we remain vigilant to the emergence of new sources of risk. We may be able to point to money market funds as a potential source of risk now. But what will be the issue in two years’ time? Will it be real estate investment trusts in the US, for example? We need to keep an eye on any area where we see credit being intermediated outside the banking system with leverage and maturity transformation. 

A lot has been done to design frameworks to ensure that authorities such as the Financial Policy Committee (FPC) in the UK and other systemic risk regulators look at all activities within the financial system to identify where systemic risk might arise.

These are the international areas where I think we’ve made very considerable progress. But we’d be fooling ourselves if we didn’t recognise that there was still plenty more to do. 

EUROWEEK: All those areas are predicated on a degree of international co-operation. What are the main UK-specific measures that have been taken?

Breeden: The main measures specific to the UK are the legislative changes that were introduced in April 2013, when we did two things.

First, we created the Financial Policy Committee (FPC) as our macro-prudential authority, which is charged with identifying, monitoring and taking action to remove or reduce systemic risks to enhance the stability of the financial system. 

The new legislation also took the old Financial Services Authority (FSA) and chopped it in two, with the introduction of a Twin Peaks regulatory regime. The Financial Conduct Authority (FCA) is responsible for ensuring the integrity of financial services, while the Prudential Regulation Authority (PRA) is responsible for prudential regulation and supervision of all deposit-takers and insurance companies in the UK.

Both these institutional changes are very important in ensuring that the international framework that I described earlier is applied rigorously in a domestic context. It is clear, for example, that the PRA together with the Special Resolutions Unit at the Bank will be absolutely focused on ensuring that systemically important financial institutions in the UK are able to fail in a way that is safe for the rest of the system. 

And following on from what we were saying about the importance of being vigilant to risks from outside the banking system, the FPC will be charged with monitoring the regulatory perimeter in the UK so that those risks are monitored and identified, and that regulation is capable of addressing those risks. 

EUROWEEK: April 1 was only just over five months ago. Is it too early to assess what the impact of Twin Peaks has been in that short time?

Breeden: In that period, we have already had some examples of occasions on which these new bodies have worked together very effectively. When you look at the public recommendations that the FPC has made to the PRA about banks’ capital and liquidity, and to the PRA and the FCA about the risks that might arise in the event of interest rates normalising, you’ll see evidence of the three working effectively together. 

The very first weekend after the PRA and the FCA came into existence, we had the Cyprus crisis. Both institutions had to work together to ensure a satisfactory resolution of those Cypriot banks that operate in the UK.

Within days we had a true test of how effectively the two organisations could work together in an important, high profile case. So the experience we’ve had to date has been encouraging.

EUROWEEK: Do we now have absolute clarity on UK banks’ capital and leverage requirements going forward?

Breeden: The Basel framework has set the international standards. So the international benchmarks to which banks are being held are clear, and have been supported by the FPC’s own recommendations that were published in March.

There is of course still some international debate on the details of the leverage ratio, with the Basel Committee’s recently circulated consultative document looking at the detail of how to calculate it. 

EUROWEEK: In the UK is there a specific timetable on observance of the 3% leverage ratio? 

Breeden: The FPC recommended in March that the PRA should have regard to high levels of leverage as well as to risk-adjusted measures of capital adequacy. And the PRA has said that six of the eight banks and building societies will already meet the 3% leverage ratio as part of meeting the broader 7% capital adequacy ratio by the end of this year.

For Barclays and Nationwide, a time frame has been agreed within which they will reach 3%. In each case the time line is different and that reflects the individual nature of their business. Barclays expects to reach 3% by the middle of next year while Nationwide has until the end of 2015. I think that underlines that we are implementing these targets in a reasonable manner. 

EUROWEEK: How do you respond to the stability of the graveyard argument, which says that too much regulation may stifle growth?

Breeden: I think we’d all agree that well capitalised banks are in a better position to lend to the economy. It’s common sense that if you have confidence in your own solvency you’ll be more comfortable with taking more risk on to your balance sheet. 

Our aim is to ensure that our banks are well capitalised and so able to lend to the economy, which is the best way to make certain that we don’t create the stability of the graveyard. More generally, the objective to achieve financial stability while supporting the government’s growth and employment objectives is recognised in the remit that the FPC has been given by the Treasury and in the statutory framework under which the PRA operates. 

But the important point is that the right conditions for growth could not possibly be created with an unstable financial system — as any company and any household that has lived through the last five years would recognise. 

EUROWEEK: Where does a regulator draw the line between regulating banks and seeking to influence their commercial strategy?

Breeden: The PRA has a clear objective, which is to promote the safety and the soundness of the firms it regulates. That necessarily requires it to understand the business of those firms and to make a judgement on the risks that those businesses entail. It needs to do this not by looking at what’s happening today or what happened in the past, but by taking a forward-looking approach to assessing what risks might arise and by ensuring that a firm is well prepared to deal with those risks.

As soon as we’re in a judgement-based, forward-looking world, reasonable people will differ in their views of risk. I think it is inevitable that the banks will sometimes disagree with the judgements that their prudential regulator makes. In that context, the prudential regulator’s responsibility is to its statutory objective. This is to promote the safety and soundness of the banks it authorises to take deposits from members of the public. Having a banking licence and the ability to take deposits should be regarded as a privilege, not as a right. I think it’s important for banks to remember that. 

EUROWEEK: What tools does the FPC and the PRA have at its disposal to address some of the broader concerns about financial stability? For example, would the FPC and the PRA be able to act early to head off an unsustainable housing boom?

Breeden: This comes back to the statutory objectives of the PRA and the FPC. Understanding and monitoring the risks that are on banks’ balance sheet is an integral part of those objectives.

If the FPC were to be concerned about the risks to financial stability that were arising in the housing market, it would respond in just the same way as it would if it were concerned about risks to stability arising from the commercial property market or from dealings with hedge funds or Reits. We begin by thinking about banks’ underwriting standards, and the terms on which they do business, to try to ensure that they are appropriate. We also communicate our views of the risks, as we already have in the Financial Stability Report and in the record of the FPC meetings. 

The FPC has wide-ranging powers to make recommendations to the PRA in respect of the prudential regime for the housing market, and to the FCA in respect of conduct rules for mortgage lenders. The FCA is in the process of implementing a new code of conduct for mortgage lenders.

Finally, the FPC has a power of direction over sectoral capital requirements which might mean that if all the other tools have failed to reduce the risks in the system arising from the housing market, higher capital requirements can if necessary be imposed on residential mortgage lending. So there is a very broad range of tools available to the FPC. 

EUROWEEK: Finally, do you have the impression that public confidence in banks is now being restored?

Breeden: The financial crisis highlighted the importance of having a safe and well-functioning banking system to maintain the flow of credit to the economy. Banks themselves have gone a long way to address the misdeeds of the past. However, there is still much to be done, and the main objective of the new regulatory framework will be to ensure that the financial system as a whole is safer and more resilient to any future shocks.

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