Preliminary Report On UK Financial Regulation

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The Tripartite Review

A review of the UK’s Tripartite system of financial
regulation in relation to financial stability
Preliminary Report
March 2009
The Tripartite Review
Contents
Foreword .......................................................................................3
Terms of reference and review process ......................................13
Executive summary .....................................................................15
Preliminary recommendations .....................................................19
Introduction..................................................................................23
Why did the existing system fail? ................................................27
The macro-prudential regime ......................................................41
Micro-prudential regulation..........................................................54
Strengthening regulatory capabilities ..........................................62
Inter-authority and international relationships .............................74
Page 2 of 83 March 09
The Tripartite Review Foreword
Foreword
9 March, 2009
Last autumn you asked me to carry out a review of the UK's Tripartite regulatory structure for
handling matters of financial stability. I now have pleasure in enclosing my preliminary report.
I have consulted widely and, based on that consultation, I set out a programme of significant
reform of the operations of the Tripartite authorities – HM Treasury, the Bank of England and
the Financial Services Authority (“FSA”). However, I stress the preliminary nature of this report.
The crisis is ongoing and there is still uncertainty about how much of the UK’s banking industry
will end up in public ownership. As we continue to learn lessons from the unfolding events, it is
important that the question of how to improve the regulation of financial services should
continue to be debated and that we do not jump to over-hasty conclusions.
Any system of financial regulation must, of course, be focused on many issues beyond financial
stability. For the future health of the UK economy, it is important that the authorities continue to
ensure that consumers of financial services get a fairer deal; that the regime continues to
operate in a non-discriminatory way, so encouraging non-UK financial services firms to operate
in, and out of, the UK; that the regime continues to benefit from an approach focusing on
substance rather than form; that there is a real focus on driving out financial crime; and that the
relative openness of the UK authorities to appropriate innovation is not lost.
However, the focus of this report is on the adequacy of the Tripartite system in relation to
financial stability. The experience of the past 18 months has shown that, in relation to financial
stability, the UK system has failed in critical respects. The financial authorities did not have
clearly defined powers (or responsibilities) to take pre-emptive action in response to the threats
to systemic stability, as opposed to the stability of individual firms, which emerged over a
number of years leading up to the 2007 crisis; the authorities lacked appropriate instruments to
mitigate these risks; there was inadequate enforcement of existing prudential regulation; and
the authorities were poorly co-ordinated and inadequately equipped to handle the crisis when it
hit.
A major overhaul needs to take place if the UK is to have a financial stability framework that
maximises our chances of spotting emerging threats, of dealing with them appropriately and of
having authorities adequately prepared to handle the inevitable crises in a professional manner.
It is important to note, though, that the financial stability regime also covers matters of
operational disruption to the financial markets. Much work has been done in this area by the
Tripartite authorities, particularly following 11 September, 2001, and it is important that the
current focus on the financial crisis does not mean that the authorities lessen their work to guard
against the financial market consequences of threats from terrorist attacks, extreme weather
events, pandemics and other disruptive events. Indeed, efforts in these areas need, if anything,
to be redoubled, as the effects of operational disruption are likely to be even more severe at a
time of on-going fragility in markets. Important current initiatives, such as the proposed central
clearing of derivatives, should increase the resilience of the system as well as helping deal with
financial crises.
It must also be remembered that threats to the financial system take many forms and are
relatively frequent events. In the UK, for example, the falling equity markets of late 2002 and
early 2003 threatened the solvency of some of the UK’s largest life insurance companies. In that
case, the FSA, by effectively bringing forward a more flexible capital regime, acted to diffuse the
crisis. Looking forward, it is important that the Tripartite arrangements recognise the diversity of
possible financial crises, and that we do not simply construct a system that is designed to fight
the last war.
There remains much work and consultation to flesh out key areas of my recommendations but it
is my intention, at this stage, to sketch out the main areas where I believe change is required. I
am very conscious that fundamental questions, including about the nature of new capital and
liquidity regimes, accounting conventions, transparency, management incentivisation and so on
are beyond the scope of this report to resolve but I will not hesitate to inject elements into those
debates where appropriate.
It would also be foolish not to recognise up front that critical new proposals on the future
structure of European banking regulation are starting to emerge from Brussels. It is regrettable
that at a time when Jacques de Larosière has been reviewing the structure of European
financial regulation and when European Central Bank (“ECB”) board members have been
calling for the ECB to become the pan-European bank regulator, the UK authorities’ voice has
been publicly silent on the European dimension – and that the authorities have done little to co-
ordinate a clear UK public-private sector view on how the interests of the UK in terms of
financial stability and competitiveness would be best served.
The better identification of emerging systemic risks and how to ensure appropriate regulatory
responses
From at least 2005, the Bank of England, in its Financial Stability Reviews, and other private
and public sector analysts in the UK and globally, identified some of the key emerging risks.
Where the system failed was in not translating the warnings into pre-emptive action, particularly
in the years 2005-07 as banking leverage soared and asset price bubbles grew. As Mervyn
King, Governor of the Bank of England, put it in a speech on 20 January, 2009: “it is clear that
policy did not succeed in preventing the development of an unsustainable position.”
The fact that, in this very period, the Bank of England significantly downsized the resource
devoted to monitoring and analysing changes in the structure of the financial system and
assessing their implications for its stability, efficiency and effectiveness; that it lost and did not
replace critical financial market expertise among its senior executive team; and that it narrowed
the focus of its Financial Stability Reviews, meant that the Bank was actually, and mistakenly,
lessening its engagement with the markets in the immediate run-up to the financial crisis. As Sir
Andrew Large, former Deputy Governor of the Bank of England, wrote in the Financial Times on
5 January, 2009: “the systemic [scrutiny] role has been underemphasised in recent years.”
The Bank of England’s surveillance and analytical capability now needs to be enhanced in
support of its statutory financial stability objective. This requires the Bank to be explicitly and
continuously engaged with developments in the financial markets – and not just in the banking
markets. In 2004 the Bank dropped its third core purpose, relating to the efficiency and
effectiveness of the financial system. The Bank had previously regarded this as an important
underpinning for its two main objectives of maintaining monetary and financial stability, although
it was sometimes characterised, erroneously or at least anachronistically, as conducting a
lobbying role in Whitehall on behalf of the City.
For the Bank to be effective in identifying emerging systemic risks, it should in future be formally
bound, in support of its financial stability objective, to be monitoring and assessing
developments in UK and global financial markets and considering their implications for financial
stability. It will be a matter for the Governor and Court, on the recommendation of the Deputy
Governor for Financial Stability, to decide what additional quantity and quality of resource will be
needed to fulfil this remit.
The Bank should specify to the micro-prudential regulator (i.e. the supervisor of individual firms,
since 1997 the FSA) what data it requires for its system-wide analysis, whether at the sector or
firm level, and this should be provided through the micro-prudential regulator. For the avoidance
of doubt, the Bank should have a statutory right to receive such data as it deems necessary for
its macro-prudential work.
This role cannot merely be a desktop exercise but requires the Bank to be conducting a
continuous high level dialogue with market participants and with the providers of market
infrastructure such as trading, clearing and settlement facilities, if it is to be effective. The Bank's
limited dialogue with, and understanding of, markets in recent years are often unfavourably
contrasted with that of the Federal Reserve Bank of New York. While I have some sympathy
with the financial institutions that complain that they did not have a sufficiently close, open and
high level dialogue with the Bank when the markets started to unravel in the summer and
autumn of 2007, such a dialogue requires continuous effort on both sides.
The Bank’s output from this enhanced macro-prudential work should be both its biannual
Financial Stability Reports and also new formal open letters to the micro-prudential regulator
setting out its assessment of market-wide risk, including of trends in leverage. This is very much
along the lines you proposed last year. The Bank should send such letters as often as it deems
necessary but should do so at least twice a year. The micro-prudential regulator should make a
public response to these letters, setting out how it intends to reflect the Bank’s findings in its
conduct of regulation in the succeeding period. To the extent that the Bank wishes to draw the
micro-prudential regulator’s attention to issues relating to particular institutions or to other
commercially or market sensitive issues, there should be a parallel exchange of private letters.
It will be for the micro-prudential regulator to decide what regulatory consequences should flow
from the Bank’s letters and, of course, it may wish to challenge any of the Bank’s assessments.
In order to ensure the integrity of this challenge system, any private letters should normally
become publicly disclosable after a period of, say, five years.
In carrying out this macro-prudential role, the Bank of England will also be equipped to engage
more fully again in the critical European and global debates and negotiations on future
regulatory and market structures. The Bank has retreated from such engagement in recent
years – it is now time for it to re-engage on a broad front. The Bank was at the forefront of many
of the debates over the past decades that led to the current developed methodologies for the
conduct of monetary policy globally. It should play a similar role, in tandem with the micro-
prudential regulator, in what will be as important and protracted a development of truly workable
financial stability methodologies. This work should focus, in particular, on influencing the
European legislative programme which has the capacity to dictate much of the UK’s financial
stability system.
With these changes to the way the Bank operates and how it interfaces with the micro-
prudential regulator, the UK will maximise its chances of identifying threats to financial stability,
there will be greatly enhanced consideration of regulatory responses to those threats and the
UK will be more effective in influencing the global development of financial stability approaches
over time.
Appropriate instruments to mitigate emerging risks
In his Economist lecture of 21 January, 2009, Lord Turner of Ecchinswell identified macro-
economic factors, including macro-economic imbalances and low real interest rates, as being at
the core of the financial crisis. However, there has been little debate since the crisis started
about what the appropriate linkages should be between the conduct of macro-economic and
financial stability policy. This is even more striking, given that these linkages were already being
explored in a series of lectures and papers by senior officials at the Bank for International
Settlements as early as 2001.
As Professor Charles Goodhart, former member of the Bank of England Monetary Policy
Committee, put it in his evidence to the Treasury Select Committee on 13 January, 2009: “the
Bank of England ..... knew that risk was underpriced and they were worried before the event
that there would be some kind of severe reversal. They did not know where it was going to
come from, they did not know the exact trigger, but they were aware that there were problems,
but I do not think that they were prepared to take the tough actions and they did not really have
the instruments to do so.”
This is a complex issue that requires extensive debate. It is important that we should now ask,
for example, about the relationship of the Monetary Policy Committee (“MPC”) to questions of
financial stability. In response to this question, I have received a wide range of suggestions,
from the idea that the MPC should have a formal remit to consider financial stability in setting
the interest rate, through to the idea that the MPC should be asked to express publicly any
concerns it has about financial stability threats arising from its monthly meetings. Even if it is
accepted that one instrument (short-term interest rates) can deliver (at most) one target
(inflation) that does not mean the instrument affects only one target variable.
There is one straightforward way in which there could be more joined up thinking between those
directing macro-economic policy and the guardians of financial stability. At present there is no
formal channel for financial stability concerns to be transmitted to, and considered by, the
macro-economic side of HM Treasury. In future, the remit of the macro-economic side of the
Treasury should be broadened to include consideration of the financial stability consequences
of developments in the economy, and of the consequences for economic management of
financial market trends identified by the Bank and micro-prudential regulator in their work. The
Treasury already attends meetings of the MPC. In addition, the Chief Economic Adviser or
another senior official with macro-economic responsibilities, should meet regularly with the
Standing Committee of the Tripartite authorities. It is also worth considering whether the micro-
prudential regulator should write open letters to the Bank if it has concerns that macro-economic
policy is threatening financial stability.
As has been the subject of much recent debate, the macro-prudential framework described
above needs to be complemented by an appropriate counter-cyclical capital regime, so that
regulators have appropriate powers to impose a capital regime which dampens, rather than
exacerbates, the credit cycle.
This is now becoming orthodox thinking and it is beyond the scope of this report to carry the
debate much further forward. However, the other recommendations of this report are intended
to work with such a capital regime at its heart. The one country which is widely quoted as
having operated such a capital regime is Spain. In order to further the debate, we have included
in this report a short description of the Spanish regime. Other broad ideas which have been put
to us include the suggestion that firms with a dominant market position in any particular market
might be required to hold a proportionately higher level of capital than other firms, to reflect the
additional systemic risk that comes with absolute size of institution.
While it is clearly desirable that the capital and liquidity regimes are highly predictable and
certain in their impact, there are likely to be some aspects of their operation which will require
the exercise of judgement. It will be necessary to decide where responsibilities lie between the
Bank and the micro-prudential regulator for the exercise of any such discretion. The micro-
prudential regulator should exercise judgements that are institution specific (for example, by
raising the liquidity or capital requirements of a firm with an aberrant business model) but the
Bank should be responsible for any sector or market wide judgements in the operation of the
capital regime.
Some argue that a key way to address these issues is to insist on the division of activities by
complex financial groups into separate subsidiaries for different classes of business activity that
could be subject to separate capital regimes or to effect some fundamental split between ‘retail’
or ‘commercial’ banking, on the one hand, and other activities such as ‘investment banking’, on
the other. This is often referred to as the ‘Glass-Steagall’ debate. While it is something of an
over-simplification to characterise the problem as one of a “utility linked to a casino”, a number
of commentators are calling for the imposition of firewalls between different classes of business.
This means deciding which financial services should be classed as utilities and which as part of
the casino. It would seem odd to confine the former simply to the payment system, as some
have suggested, when for example the intermediation of long-term savings would normally be
regarded as a key function of the financial system.
Arguments in favour of this division include that it would provide greater security to retail
depositors in financial institutions and that it would provide an additional layer of protection to
the taxpayer against exposure to costs associated with the failure of financial institutions. Some
of those who advocate this model argue that it is only worth implementing if the ring fence is
drawn in such a way that it includes substantially all of the systemic activity, which needs to be
subject to tighter regulation, and that financial activity outside the ring fence should be in the
main not of systemic consequence and so not subject to full prudential regulation.
Much more debate is required on these issues and questions that need to be asked include
whether regulatory lines or competition and clear information to consumers will better enable a
range of retail deposit taking institutions to develop; how ‘narrow’ banking prevents a bank
getting into trouble from such traditional banking failings as concentrated lending; what the
additional funding costs for the banking system will be if deposit taking banks are not allowed to
finance or hedge their activities through a range of derivative structures; what economy of scale
and diversification benefits might be lost; what the risks and consequences of regulatory
arbitrage will be as banks look for domiciles where less restrictive regimes may exist; and
whether the new capital regime could be able to deal appropriately with a range of different
banking models without segregating activities into different legal entities.
It is also argued that ‘shadow banking’ activities, including hedge funds and other unregulated
wholesale market operators, should be fully regulated. The guiding principle should be that a
financial services entity, or a category of businesses, should be regulated either because there
is an issue of consumer protection or because the failure of the entity would have systemic
consequences. There also needs to be careful case-by-case consideration of the likely costs
and benefits, particularly against the benefits that can be gained by increased transparency,
before the scope of regulation is unthinkingly increased.
One additional instrument that is available in the USA in the event of a bank’s impending failure
is for the Federal Deposit Insurance Corporation to utilise its funds to facilitate some form of
bail-out, if it is judged that this will be a less costly outcome than having to pay out depositors if
the bank is allowed to fail. The debate about depositor protection in the UK has not explored
this issue. It would be useful if it did.
Although of only limited direct impact on financial stability, it has also been suggested to us that,
in a period of very low interest rates and with quantitative easing becoming a tool of macro-
economic management, the remit of the Debt Management Office, which has responsibility for
managing the Government’s cash and sterling debt, should either be broadened out from one
mainly concerned with least cost issuance to one that fully considers the economic implication,
including for monetary conditions, of its activities and the structure of public debt, or that it
should continue to be primarily a delivery mandate but one that is flexed to the new market
realities. These suggestions merit further investigation by HM Treasury and the Bank.
Conduct of the prudential regime
The FSA’s own report into the conduct of its supervision of Northern Rock provided a searching
and candid exposure of the very significant lapses in the conduct of its basic supervisory
regime. It is implementing a raft of reforms to bring its prudential regulatory regime up to the
expected standard.
The broader question that arises is whether the integrated regulatory model remains the best
option to ensure both that micro-prudential regulation, that is regulation at the level of the
individual firm, is properly conducted, and also that the competing demands of prudential versus
conduct of business regulation can best be reconciled. As Lord Turner said on the BBC on 15
February, 2009: "The FSA at that time was more focused on the processes, the structures, the
reporting lines, rather than simply saying 'when I look at this whole business model... it's all too
risky'."
Proper conduct of micro-prudential regulation is fundamentally about having the right sort of
people carrying out the work under the direction of senior managers who are steeped both in
the industry they are regulating and in the nature of the regulatory process. Although it would be
an over-simplification to say that prudential regulators need a completely different mindset and
training from conduct of business regulators, the focus of their work and the way it is carried out
have significant differences.
The reconciliation of the competing demands of prudential and conduct of business regulation
has to be done both in the context of regulating the individual firm and in setting the broad
direction and thrust of regulatory policy for the regulator as a whole. By its own admission, the
FSA failed the former test. In retrospect, it is easy to see that the focus of the FSA on the
development of policies to give the consumer of financial services a better deal (conduct of
business) was not matched over the past decade by a similar focus on developing the
prudential regime.
The other fundamental issue is whether, if the Bank is the macro-prudential regulator and the
FSA (or a successor body) the micro-prudential regulator, we can be certain that nothing will fall
through the crack between them. The regular exchange of letters that I have proposed, together
with better close working between the Bank and micro-prudential regulator, addresses this issue
but it is for further debate as to whether this will be enough. We need to look at whether we can
build in any safeguard to stop things falling down the crack, but without causing unnecessary
overlap in the responsibilities of the different authorities.
In deciding what regulatory structure best fits these fundamental requirements there are a
number of other factors and trade-offs to be considered:
• Creating more regulators or having overlapping responsibilities between the Bank and
FSA risks imposing additional burdens on individual regulated firms.
• The Bank has had difficulty in giving appropriate priority to its two objectives (monetary
policy and financial stability) and the FSA has not found an appropriate balance between
its prudential and its conduct of business work, so how would an authority with more
than two objectives be expected to manage its priorities?
• Whether the conflicts between the two strands of regulation (prudential and conduct of
business) are better handled by having two separate regulators or whether the situations
of conflict between the two strands of regulation are overstated and are, in any case,
better managed within one organisation.
• Combining macro- and micro-prudential regulation within the Bank would mean that the
judgement on all prudential matters was in one body, clarifying accountability and
enhancing the authority of the regulator. On the other hand, it would internalise the
proposed challenge function between the macro- and micro-prudential regulator, risking
a loss of clear focus on the distinct macro perspective and raising concerns over
whether the conduct of monetary policy might be inappropriately influenced by concerns
for the health of the financial sector.

• The cost of institutional change. If, for example, this involved breaking up the FSA, this
could impose additional regulatory strain for a period.
There is no one model that clearly deals with all these considerations and we have received
some very divergent views on the best way forward. I believe that it would be wrong to rush to
hasty judgements on this question. However, in order to take the debate forward in a structured
way, I believe there are five options which merit particular debate:
1. The FSA should retain its present responsibilities but move to a new structure with
Prudential and Conduct of Business divisions at its heart, rather than its present
structure focused on Retail and Wholesale divisions. This would ensure that the FSA
had a better balance going forward between its prudential and conduct of business
activities; that prudential regulation was put at the heart of the organisation; that the FSA
was better placed to grow individuals with the appropriate skills and mindset to be
cutting edge prudential regulators; and that there was a head of Prudential on the FSA
board who could speak for the organisation and who could act as the key interface with
the Bank on financial stability issues.
2. The FSA should be reorganised as in 1 but, in addition, there should be new statutory
powers for the Bank to take direct regulatory action in respect of individual regulated
firms if it (or the Tripartite Authorities collectively) believed that there was a threat to
overall financial market stability which was not being adequately addressed by action
being taken by the FSA. This would create an additional safety net over what I have
already proposed for the Bank’s new macro-prudential role. If this were to be a power of
the Tripartite, rather than of the Bank, it would effectively be for the Treasury to decide in
the face of a disagreement between the Bank and FSA.
3. The FSA should be abolished and replaced by two separate regulators, one with
responsibility for prudential regulation and one for conduct of business regulation. This
would give complete clarity of purpose and focus to the two regulators but would pose
challenges in co-ordinating the regulation of individual regulated firms – and would mean
that most firms would have to deal with an additional regulator.
4. A combination of models 2 and 3, with the Bank or Tripartite having power to step in
over the head of the micro-prudential regulator in exceptional circumstances.
5. Under options 3 and 4, the micro-prudential regulator, of banks or of the whole financial
sector, could be folded into the Bank of England.
To emphasise the preliminary nature of this report, I use the term the “micro-prudential
regulator" rather than “the FSA” in many places in the report, though this is not intended to
suggest that I have reached any conclusions on the options available and what change is
required.
Under options 1 and 2, the conduct of prudential regulation will be improved to the extent that
the regulator can shed any of its present policy areas. The two policy areas that have been
identified as potentially capable of being transferred out of the FSA are Financial Crime and
Consumer Education. More consideration needs to be given to possible alternative homes for
these policy areas but I believe that the case for stripping them out of the FSA is strong.
In the case of Financial Crime, the US shows that there is a workable model in which the
Treasury takes the policy lead. The case for adopting a similar model in the UK bears further
serious investigation. As well as helping the focus of the FSA, such a transfer would give HM
Treasury a degree of delivery responsibility which could be helpful in embedding financial
services as much more of a core activity of the Treasury than it has been treated at some
periods in recent years. This could be linked to a wider review of the framework for tackling
financial crime - where many argue that the UK system is failing.
Expertise and preparation for crisis handling
No one to whom we have spoken argues that the Tripartite authorities were properly prepared
to handle the Northern Rock crisis in 2007. Those who have been close to the authorities since
then say that the handling of the unfolding crisis – if not necessarily the policy outcomes – has
improved at each succeeding stage. There remains, however, much to be done to ensure that
the authorities are adequately prepared for future crisis handling.
The first requirement is for the authorities to have suitably qualified people in the key financial
stability positions at all times. For the Bank, the critical thing is that the whole organisation
receives a clear message that the financial stability role really is an equal priority with monetary
policy. A key change will be to embed a definition of the role of the Deputy Governor for
Financial Stability post in such a way that there can be appropriate succession planning and
market confidence that suitably qualified individuals will always hold the office. The guarantee
that suitable appointments will be made in future should be the role description and forward
planning by the Governor and Court of the Bank, in close consultation with HM Treasury; the
final decision resting, of course, with the Chancellor. The formal public appointments process
should be a backstop but not the driver.
In the case of the FSA, there is a broad challenge, much discussed in recent months, to keep
and develop sufficient expertise at all levels of the organisation so that the gap in expertise
between regulator and regulated individual is kept to an acceptable level. With a much greater
focus on prudential regulation at the heart of the organisation, or by creating a separate
prudential regulator, the task should be clearer but it won’t be easy and will take a number of
years, involving a mix of growing talent internally and of hiring in people from the market, either
on a permanent or secondment basis.
In summer/autumn 2007 when the crisis was breaking, HM Treasury’s group of special advisers
and senior officials with direct responsibility for financial services lacked any significant financial
market experience. In order to avoid such a situation arising in future, the Permanent Secretary
to the Treasury should set out in the Treasury’s annual report to Parliament how Treasury
resources devoted to handling issues of financial stability have been maintained and developed
during the year.
More generally, the point has repeatedly been made that Treasury officials typically only spend
two years in a post before moving on and that this contributes to a low level of expertise to
handle complex financial market issues. Better ways need to be found to incentivise officials to
build up expertise in one area for longer periods.
Second, the authorities need to have suitable organisational arrangements to support their
individual financial stability functions. I have already commented on fundamental aspects of the
internal organisation of the FSA.
In the case of the Bank, I agree with the Treasury Select Committee (“TSC”) and others that the
new Financial Stability Committee is flawed. The management of a major financial crisis cannot
be under the direction of a board including market practitioners. If this is to be an executive
committee then it should be made up of a suitable sub-set of the Bank’s executive. If it is to
have outsiders on it, then it should become an advisory board, contributing to the Bank’s closer
liaison with market practitioners and including accountants and lawyers to capture their critical
insights into financial stability issues. I am inclined to the view that the Committee should be
advisory but that, in addition, the Bank’s existing executive structure is revisited to ensure that
collective executive input from right across the Bank is contributed to all key financial stability
decisions.
A rather more radical idea is that, instead of the present Court/MPC governance structure, the
Bank should be governed by one board looking somewhat like the present MPC but with
additional members with expertise relevant to the financial stability objective. This board, similar
to that of the Federal Reserve in the USA, would execute both the monetary policy and financial
stability remits of the Bank. Although the challenge function of independent non-executive
directors would be lost, I believe it is a model worth debating: I have never understood why
public sector bodies, which usually have very different functions and accountabilities to private
sector companies, should increasingly, and unthinkingly, have to ape the standard private
sector corporate governance model.
It is also somewhat of an anomaly that the Non-Executive Directors of the Bank report annually
on the procedures of the MPC but that there is no similar requirement to report on the conduct
of the Bank’s financial stability objective. I believe that there should be such a requirement.
Indeed, it is striking that the Bank, unlike the FSA, has produced no public assessment of its
own conduct in the period leading up to the collapse of Northern Rock. It should do so in order
to assure the public that any lessons have been learnt and to strengthen public confidence in
the Bank.
For HM Treasury, one of the issues, as I have indicated, is to ensure that the macro-economic
side of the department is linked in to the financial stability issues. For crisis handling, one of the
Treasury’s key resources should be its Corporate Finance team. This team also liaises with the
Government’s central repository of corporate advisory skills, the Shareholder Executive. The
Corporate Finance team (and the Shareholder Executive) should be properly used in future
developing crisis situations. Consideration should be given to putting the Corporate Finance
team in the same Treasury division as financial services.
Third, the Chancellor, Governor and Chairman of the FSA (or its successor body) need to have
far more frequent meetings than they had before the present crisis started if they are to have a
proper understanding of their respective positions on issues and a mutual sense of how they
would react in a crisis. As far as I am told, there was only one formal session involving all three
Principals in the ten years before the crisis - on the conference call with the US authorities in
2006 to which the Prime Minister referred in his evidence to the House of Commons Liaison
Committee on 12 February, 2009.
The three Principals should meet with the Standing Committee Deputies in formal sessions
three times a year to have a full presentation and discussion on the issues which the Deputies
and their teams have been working on in the previous trimester; the three Principals should
have equally regular informal sessions; and they should participate in regular “war games”.
While I do not think it is necessary for the Authorities to form a joint secretariat to manage
Tripartite business, I do think that an increased flow of secondments between the three parties
would enable them to develop a better shared understanding of the underlying issues and of
their respective thinking about the issues, which would lead to better crisis handling. Also, while
it will be for the Bank to form its own macro-prudential judgements, I would expect the Bank and
the micro-prudential regulator to hold regular sessions at Executive Director level, perhaps for
one day a quarter, to share their thinking on the macro-analysis.
You have asked me to look at one specific co-ordination matter, the question of which authority
should pull the trigger to make an individual firm subject to the Special Resolution Regime, or
whether there should be a dual trigger. The issues are discussed at some length in the
September 2008 Banking Reform report of the Treasury Select Committee. I agree with the
TSC’s conclusion that while the FSA should have sole responsibility for pulling the trigger, the
Bank should have a statutory power to recommend to the FSA that a financial institution be
brought within the Special Resolution Regime.
One area on which the authorities continue to be criticised is in their handling of
communications. This has two aspects. First, if critical messages on financial stability issues are
to carry clarity and authority and to have a neutral or calming effect on markets, considerably
more effort needs to be put in to the planning and co-ordination of messages that are put out.
Second, the stream of leaks to the media at every critical stage of the developing crisis has
been remarkable. I find it strange that the questions that are being asked are now mainly
around whether the journalists should have reported leaked information. The real questions that
require answers are around the level of training that members of the authorities handling
sensitive information receive about the law on disclosure of price sensitive information; and why
there is no evidence of investigations by the FSA or police into prima facie cases of leaks of
highly price sensitive information. I have no evidence to suggest that the authorities have
broken the law but without further public reassurance, I believe that the authorities are left with
very considerable reputational taint around their ability to keep confidential matters confidential.
Last, it has been suggested that there was some confusion in the handling of Northern Rock
about whether the independence of the Bank of England was intended to cover financial
stability issues or whether the Treasury could tell the Bank what to do in a crisis. This is a rather
basic issue. It arises partly because certain activities of the Bank, including the provision of
liquidity to the market, are relevant both to the implementation of monetary policy, where the
Bank does indeed have independence, but potentially also to the maintenance of financial
stability. For the avoidance of doubt, the Memorandum of Understanding governing the
relationship of the three parties needs to clarify that, except where individual responsibilities for
particular tasks are clearly defined, such as the Bank’s responsibility for handling the Special
Resolution Regime or its operations in the money markets, the Treasury takes the final
decisions on financial stability matters, having taken the appropriate advice of the Bank and of
the micro-prudential regulator.
Other matters
While I believe that the recommendations I have sketched out in this report, and on which I will
continue to consult, represent a substantial package of measures which will materially improve
the future handling of financial stability issues in the UK, there also need to be appropriate
accountability structures in place to ensure the overall good working of the system. The
Tripartite Authorities report to Parliament, their principal interlocutor being the Treasury Select
Committee of the House of Commons. While the TSC has pursued its enquiries into the
financial crisis since Northern Rock with considerable vigour, prior to that event it held no
regular sessions on financial stability. I am well aware that it is not for me to tell Parliament how
to go about its business so I merely observe that accountability of the Tripartite Authorities
might be significantly improved if they had to face sessions with the TSC two or three times a
year.
I should end with some health warnings and acknowledgements.
For the avoidance of doubt, I should point out that although I was the senior official directly
responsible for financial services policy in HM Treasury from November 2002 until the end of
2005, and that until mid-2008 I carried out some specific advisory assignments for the Treasury,
I was not involved as an insider in any matters relating to the handling of the financial crisis. The
Treasury have not felt able to speak to me in connection with this report nor have I had access
to any official papers.
The opinions expressed in this report are entirely my own but I should like to thank the team
from PricewaterhouseCoopers for the great support they have given me in the research and
writing of the report. I am also grateful to all those in the Bank, FSA, academic institutions and
the private sector who have taken the time to speak to me or who have contributed to the
research that underpins the report.
The Tripartite Review Terms of reference and review process
Terms of reference and

review process
Terms of reference
1. George Osborne, Shadow Chancellor of the Exchequer, has commissioned me to conduct an
independent review into the UK’s Tripartite system of financial regulation so far as it relates to
financial stability. The purpose of the Review is to inform Conservative Party policy on reforming
the Tripartite system, particularly with a view to implementing reforms should the Conservatives
enter Government following the next General Election.
2. The trigger for this reappraisal of the UK’s Tripartite system was the systemic failure exposed in
the period preceding and subsequent to the nationalisation of Northern Rock in February 2008,
combined with questions around the Tripartite Authorities’ handling of the crisis. Following these
events, a range of stakeholders have stated that the Tripartite arrangement should be reformed
to mitigate the weaknesses of the existing system in minimising the risk of financial crises and in
dealing with them when they occur.
3. I was asked to look broadly at the Tripartite system and make appropriate recommendations.
These recommendations take into account the various changes already made, or proposed to
be made, by the Tripartite Authorities; and of other review work already conducted, notably that
of the Treasury Select Committee of the House of Commons. PricewaterhouseCoopers
recognise the importance of this issue and have provided support to help me deliver the
Review.
The Review process

4. Much of the content of this report have been based on the formal and informal meetings held
between members of the Review team and a range of contributors. These contributors have
included current and former officials of the Bank of England and FSA, former officials of HM
Treasury, academic experts in financial markets and regulation, board members and senior
executives of financial institutions and professional advisers on regulatory issues. All of these
meetings were held on a confidential basis, although we have used many of the ideas raised by
our contributors in this report. We were not able to meet with current officials of HM Treasury to
discuss their views.
5. This primary research was complemented by a desk-top research exercise, focusing on

analysing the causes of regulatory failure in the UK, examining the various proposals for reform
of the existing UK system and evaluating overseas models to learn from international
experience. All of the evidence presented in this report was compiled from this desk-top
research exercise, on the basis of publicly available information.
The Tripartite Review Terms of reference and review process
6. In addition, we carried out an online consultation exercise which was open to any interested
party during January 2009, where respondents were provided with an opportunity to give us
their views on a range of issues relating to the current Tripartite system and potential reforms to
the system. Respondents were provided with the option of replying on a confidential basis or
allowing the Review team to quote their responses in this report.
7. This preliminary report of the Tripartite Review can be accessed on our website
(www.tripartitereview.co.uk). Interested parties are invited to comment on this preliminary report
(on a confidential basis, if requested) until 30 April, 2009. Full details of how to submit
comments can be found on the website.
The Tripartite Review Executive summary
Executive summary
Key findings
Why did the existing system fail?
8. The financial crisis that began in mid-2007 exposed a number of weaknesses in the UK’s
system of regulation in relation to financial stability, some of which were latent in the existing
regulatory framework while others were related to the lack of expertise and preparation by the
Tripartite Authorities for crisis handling. These weaknesses may be summarised under the
following four broad headings:
• Evaluation of and response to emerging threats to financial stability: The Tripartite

Authorities recognised that certain of the economic and financial trends that underlay the
crisis were unsustainable, but they did not fully anticipate the threat they posed to financial
stability and did not take sufficient action to redress the observed imbalances.
• Lack of appropriate instruments to mitigate emerging risks: Regulators did not have
appropriate instruments that would have allowed them to dampen the unsustainable growth
in leverage and liquidity preceding the crisis, or more adequately to ensure that financial
institutions were able to withstand losses resulting from the subsequent deleveraging when
liquidity contracted. There was no adequate work-out regime for failing financial institutions.
• Inadequate prudential regulation: The FSA did not adequately pursue its existing prudential
mandate, partly due to an excess focus on conduct of business regulation at the expense of
prudential regulation.
• Expertise and preparation for crisis handling: The Tripartite Authorities had not devoted
sufficient resources to crisis preparation and did not have appropriate mechanisms in 2007
to resolve an institutional failure. The Authorities’ weak handling of the Northern Rock crisis
contributed to the threat to financial stability during this period.
The macro-prudential regime

9. To address the weaknesses identified above in relation to evaluating and responding to
emerging systemic threats, and the lack of appropriate instruments to mitigate emerging risks,
the regulatory system must significantly strengthen its macro-prudential remit.
10. The Bank of England is the Authority best placed to evaluate emerging systemic threats to
financial stability, due to its existing analytical capability, its remit in monetary stability and its
role in the money markets and payment systems. The Bank should have primary responsibility
for the evaluation of systemic threats and should also have a statutory right to access any data
regarding individual financial institutions that is necessary for this analysis. The Bank must also
deepen, across the institution, its engagement with financial markets in order to develop a
closer understanding of financial institutions’ business models and risk exposures.
11. In order to translate this analysis into regulatory action, the Bank should write public letters to
the micro-prudential regulator setting out the Bank’s views on systemic risk, including leverage,
to which the micro-prudential regulator should be required to make a public response. The
letters should also include a confidential annex raising any concerns regarding specific
institutions. This formal exchange must be supplemented by a strong day-to-day working
relationship between the individuals responsible for Financial Stability at the Bank and those
engaged in micro-prudential regulation.
12. The Tripartite Authorities should also consider enhancing the toolkit of instruments at their
disposal in relation to financial stability. At the macro-economic level, more consideration should
be given to the role of interest rate policy in financial stability, whilst other tools such as the
Government’s macro-economic and fiscal policies and the use of counter cyclical capital
requirements should be developed or enhanced. At the institutional level, more consideration
should be given to the advantages and disadvantages of moving to a narrow/utility banking
model and the regulation of ‘shadow banking’. Other tools that should be reviewed include the
potential to use funds from the Financial Services Compensation Scheme to secure the sale of
a failed institution and broadening the remit of the Debt Management Office to take account of
its wider economic implications.
Micro-prudential regulation
13. The FSA’s conduct of the micro-prudential regime was weak in the period prior to 2007.
Commentators have set out a wide range of proposals to address this, focusing on ways to
strengthen the focus on micro-prudential regulation, including by moving to an FSA internal
structure with Prudential and Conduct of Business divisions at its heart, or by splitting the FSA
into separate regulatory agencies responsible for each activity. It has also been suggested that
the Bank should have a greater role in micro-prudential regulation, either by being granted
direct regulatory powers under exceptional circumstances, or by folding micro-prudential
regulation into the Bank in the event that the FSA is split into separate agencies.
14. These questions merit further debate. Having decided that fundamental reform to the regulatory
structure is necessary, consideration would have to be given to the most appropriate time to
implement these reforms and the most effective way in which to implement them, in order to
minimise disruption to the ongoing efforts to deal with the financial crisis.
Regulatory capabilities
15. The Tripartite Authorities will need to strengthen significantly their current capabilities, to
address the observed weaknesses that contributed to the regulatory failures outlined above.
16. The Bank of England will need to strengthen the resource base, expertise and governance of its
Financial Stability team. Critically, this will require the Bank to be explicitly and continuously
engaged with developments in the financial markets and to broaden its engagement with the
most senior market practitioners. The Financial Stability Committee may help the Bank in
accessing sources of market expertise, although it should not have the executive functions
currently envisaged.
17. The Financial Services Authority, or its successor, will be able to increase its focus on its core
regulatory remit to the extent that it can shed any of its additional responsibilities, and to this
end it should consider, with the Government, whether some or all of its responsibilities for
reducing financial crime and improving consumer awareness can be transferred to alternative
public agencies. The FSA should also increase further its ability to recruit and incentivise highly
experienced supervisory and policy makers from the private sector.
18. HM Treasury should broaden the remit of the macro-economic side of the Treasury to include
consideration of the relationship between financial stability issues and wider macro-economic
management. In order to ensure no repetition of the lack of financial market experience of its
senior officials which was evident in mid-2007, the Permanent Secretary to the Treasury should
report annually on how HM Treasury resources devoted to handling issues of financial stability
have been maintained and developed during the year. HM Treasury should also strengthen its
crisis handling capability. This could be done by putting its Corporate Finance and broader
private sector facing expertise back into the same division as Financial Services.
Inter-authority and international relationships

19. Decision-making on the Special Resolution Regime involves all three Tripartite Authorities. The
quality of decision-making will be improved if the Bank draws up a list of systemic institutions,
although this should not be made public. The Bank, as the macro-prudential regulator, should
also have the statutory right to recommend that an institution be placed into the regime,
although the final recommendation should continue to rest with the micro-prudential regulator.
20. Each of the Tripartite Authorities will also play a role in communicating with the markets and
general public during a financial crisis and should strengthen their capabilities in this regard.
However the lead role should be taken by HM Treasury, since this will serve to emphasise the
level of engagement by the political leadership to prevent systemic collapse.
21. Relationships between the Tripartite Authorities need to be significantly strengthened at all
levels. We have been told that there was only one meeting of the Tripartite Principals – the
Chancellor of the Exchequer, the Governor of the Bank of England and the Chairman of the
Financial Services Authority – in the ten years preceding the financial crisis. This situation
should not be allowed to occur again. To strengthen the relationship between the Authorities,
the Principals should meet formally with the Tripartite Deputies (at least) three times per year
and informally (at least) an additional three times per year. At more junior levels, programmes
should be put in place to encourage greater interaction, for example through secondments, joint
training sessions, joint briefings and informal meetings.
22. For the avoidance of doubt, the Memorandum of Understanding should state that except where
individual responsibilities for particular tasks are clearly defined, HM Treasury should take the
final decision on the use of public resources to address financial stability matters, having taken
the appropriate advice of the Bank and FSA.
23. Given the global dimensions of the current financial crisis, it will be critical for the UK’s
regulatory system to work with international counterparts at the national and supranational level
to identify any emerging threats to financial stability. The Bank’s role in monitoring systemic
risks to financial stability means that it should lead the UK’s international working relationships
in relation to this monitoring activity.
24. The Tripartite Authorities must also contribute to the full in the European and global dimensions,
which will take many years, for truly workable financial stability methodologies to be developed.
It will be important for the Authorities to work together to prepare join contributions to
international bodies, although the lead role should be played by the Bank of England in macro-
prudential matters and by the micro-prudential regulator on micro-prudential issues.
Areas for further consultation

25. This Review has not attempted to make detailed recommendations in every area of financial
stability regulation, and in several areas we have raised questions that should be resolved only
after a more detailed analysis and consultation process. Several of these questions are
summarised below:
26. Macro-prudential instruments: Consideration should be given to the link between the Monetary
Policy Committee, interest rate setting and the maintenance of financial stability.
27. Utility/narrow banking: A full analysis and debate is needed on whether some form of separation
is required between different classes of banking business.
28. Shadow banking: A clear, principle-based rationale needs to be established for determining
what additional ‘shadow banking’ or other unregulated activities should be brought within the
scope of financial regulation.
29. Governance of the Bank of England: The Governance structure of the Bank of England needs
further consideration. The proposed Financial Stability Committee is flawed. Having clarified
what the Committee was intended to achieve, it will be possible to define a more workable
solution.
30. The Financial Services Compensation Scheme (FSCS): The Authorities should clarify the
constraints on the Financial Services Compensation Scheme funds being used to secure the
resolution of failed institutions instead of liquidation and payout under the scheme.
31. FSA responsibilities: Further consideration should be given as to whether the FSA should move
to an internal structure in which the main division is between its prudential and conduct of
business responsibilities or whether these two regulatory mandates should be handled by
separate regulatory bodies. If these mandates are to be handled separately, consideration
should be given to folding micro-prudential regulation into the Bank. The focus on micro-
prudential regulation may also be strengthened to the extent that that the FSA, or its successor,
is not required to retain the FSA’s current roles in financial crime policy and in improving
consumer awareness. The Authorities should review whether these responsibilities, in part or in
full, could be transferred to other public agencies.
32. Bank of England/Tripartite reserve powers: Consideration should be given to granting the
Bank/Tripartite statutory powers to take direct regulatory action in respect of individual firms if
it/they believed that there was a threat to overall financial market stability which was not being
adequately addressed by action being taken by the micro-prudential regulator.
The Tripartite Review Preliminary recommendations
Preliminary
recommendations
Recommendation (1): The Bank of England should have the primary responsibility for
evaluating systemic threats to financial stability.
Recommendation (2): The Bank of England should have a statutory right to receive such
data as it deems necessary for its macro-prudential work; this data
should be provided by the micro-prudential regulator.
Recommendation (3): The Bank should have a formal duty in the Memorandum of
Understanding to be continuously engaged with broad financial
markets developments.
Recommendation (4): The Bank should write a public letter at least twice a year to the
micro-prudential regulator setting out its views on systemic risk. The
micro-prudential regulator should submit a public response to the
letter stating what actions it intends to take to address the risks
identified.
Recommendation (5): The letter should include a confidential annex raising any concerns
in the Bank regarding specific financial institutions.
Recommendation (6): The Bank of England should engage fully in international debates
and negotiations on financial stability regulation.
Recommendation (7): HM Treasury should consider what, if any, change should be made
to the remit of the Monetary Policy Committee to reflect the fact that
interest rate policy may impact financial stability.
Recommendation (8): The macro-economic side of the Treasury should consider the
impact on macro-economic policy development of financial stability
concerns.
Recommendation (9): Consideration should be given to the micro-prudential regulator
writing a public letter to the Bank should it develop concerns that its
conduct of macro-economic policy may threaten financial stability.
Recommendation (10): In the conduct of a counter-cyclical capital regime, judgements at
the market level will be for the Bank and at the firm level for the
micro-prudential regulator.
Recommendation (11): The Authorities should conduct a full study of the pros and cons of
moving to a ‘narrow’ or ‘utility’ banking model.
The macro-prudential regime (continued)

Recommendation (12): The Authorities should give further consideration to the need for
increased regulation of previously unregulated activities. Clear
principles should be applied in each specific case; the relative
benefits of transparency and of indirect regulation versus direct
regulation should be considered.
Recommendation (13): The Authorities should clarify the constraints on the Financial
Services Compensation Scheme funds being used to secure the
resolution of failed institutions instead of liquidation and payout
under the scheme.
Recommendation (14): The Tripartite Authorities should give further consideration to
financial institutions, in the future, pre-funding the Financial Services
Compensation Scheme on a risk-weighted basis.
Recommendation (15): The Debt Management Office’s mandate should be reviewed by the
Treasury and the Bank of England.
Recommendation (16): Consideration should be given to the structure of the micro-

prudential regime, with five options meriting particular debate:
1. Restructuring the internal organisation of the FSA to put
prudential regulation at its centre
2. Restructuring the FSA as in 1 but giving the Bank/Tripartite
additional statutory powers to take direct regulatory action in
exceptional circumstances
3. Abolishing the FSA and replacing it with two separate regulators,
one for prudential and one for conduct of business regulation
4. A combination of 2 and 3, with the Bank/Tripartite able to step in
over the head of the micro-prudential regulator in exceptional
circumstances
5. Under options 3 and 4, the micro-prudential regulator, of banks
or of the whole financial sector, being folded into the Bank of
England.
Strengthening regulatory capabilities
Recommendation (17): The Bank’s executive should consider whether it requires more
resources to deliver its enhanced Financial Stability mandate.
Recommendation (18): The Bank should strengthen its governance in relation to Financial
Stability.
Recommendation (19): The Bank of England should produce a public assessment of its
own conduct in the period leading up to the collapse of Northern
Rock.
Recommendation (20): The remit of the Bank’s Financial Stability Committee established
under the Banking Act, 2009 should be amended to remove any
executive function and to make it an advisory group of market
experts.
Strengthening regulatory capabilities (continued)
Recommendation (21): The Bank should clarify the role and qualifications required for the
Deputy Governor for Financial Stability and take steps to plan for
the succession of future Deputy Governors.
Recommendation (22): The Authorities should consider transferring responsibility for
financial crime policy out of the FSA to HM Treasury. This could be
linked to a wider review of the framework for tackling financial crime.
Recommendation (23): The Government and FSA should review the latter’s role in relation
to consumer awareness.
Recommendation (24): The FSA should increase further its ability to recruit and incentivise
highly experienced supervisors and policymakers from the private
sector.
Recommendation (25): HM Treasury should maintain a sufficient financial markets
expertise at all times.
Recommendation (26): The Permanent Secretary to the Treasury should report annually to
Parliament on the appropriateness of HM Treasury’s expertise and
resources in relation to financial stability.
Recommendation (27): HM Treasury should report every three years on the
appropriateness of the legislative and regulatory framework for
financial stability.
Recommendation (28): HM Treasury’s Corporate Finance team should be put into the same
HM Treasury division as financial services policy.
Inter-Authority and international relationships
Recommendation (29): The Bank of England, in consultation with the micro-prudential

regulator, should maintain a confidential list of systemically
important financial institutions.
Recommendation (30): The Bank of England should have a statutory right to recommend to
the micro-prudential regulator that an institution be placed into the
Special Resolution Regime.
Recommendation (31): The Tripartite Authorities’ Principals should play an active role in
communicating with markets and the general public in the event of
institutional stress or failure, but the lead role should be played by
the Chancellor of the Exchequer.
Recommendation (32): Members of the Tripartite Authorities should be given regular
training in the rules concerning the handling of price sensitive
information.
Recommendation (33): The Authorities should consider whether sufficient investigation has
been carried out into the leaks of price sensitive information to the
media since September 2007.
Recommendation (34): The Tripartite Principals should meet formally at least three times a
year and have an additional three informal meetings a year.
Recommendation (35): The Authorities should strengthen links at more junior levels through
a programme of secondments, training, joint briefings and informal
meetings.
Inter-Authority and international relationships (continued)
Recommendation (36): The secretariat to the Standing Committee should continue to be

provided by HM Treasury.
Recommendation (37): The Memorandum of Understanding should reflect all the proposals
in this report, making clear which Authority is responsible for each
regulatory function.
Recommendation (38): The Bank of England should strengthen its working links with
international bodies, including contributing to the development of
improved collaborative tools.
Recommendation (39): The Bank of England should lead the UK’s contribution to
international policymaking of a macro-prudential nature, with the
micro-prudential regulator continuing to lead the UK’s contribution
on micro-prudential matters, while HM Treasury should lead
international political negotiations.
Recommendation (40): The Tripartite Authorities should work closely with financial
institutions to develop a consensus position to contribute to
international regulatory developments.
The Tripartite Review Introduction
Introduction
Overview
33. This chapter sets out the context of this Review in terms of the importance of the regulatory
structure and the reasonable expectations of the regulatory structure in relation to financial
stability.
34. The chapter also presents a summary of the regulatory structure as it was in mid-2007 when the
ongoing financial crisis began and sets out the changes to that structure under the Banking Act
2009.
Why does the regulatory structure matter?

The objectives of financial regulation
35. The institutional framework of financial regulation has a significant impact on whether regulatory
regimes succeed or fail in achieving their objectives. The objectives of financial regulation have
been defined as:
“Safeguarding the system against systemic risk; protecting consumers against

opportunistic behaviour by suppliers of financial services; enhancing the
efficiency of the financial system; and achieving a range of social objectives
[using the financial system to achieve social/political objectives such as
supporting the housing market]”
Herring and Santomero, ‘What is optimal financial regulation’, May 1999

(as quoted in Jeffrey Carmichael, The Development and Regulation of Non-Bank
Financial Institutions, 2002)
36. This Review is centred on the first objective, of safeguarding the system against systemic risk,
and does not directly consider issues related to the other objectives of financial regulation, for
example the most effective ways of protecting consumers of financial services through the use
of conduct of business regulation, or of promoting the efficiency of the provision of financial
services through competition policy.
37. Specific objectives in relation to maintaining systemic stability are to maintain systemically
important financial system infrastructure (especially payments and settlements systems); to
protect the financial system from destabilising developments in domestic and international
markets; and to limit the impact of financial shocks from causing contagion in other parts of the
financial system or the wider economy.
The importance of the regulatory structure

38. The regulatory framework influences the effectiveness of regulation in terms of the success of
regulators in achieving the above objectives. David Llewellyn set out a number of reasons why
the institutional structure is important in a 2006 paper to the World Bank (‘Institutional structure
of financial regulation and supervision: the basic issues’, June 2006). These can be
summarised as:
• Regulatory culture: The regulatory structure will have an impact upon the development of
expertise, experience and culture of the regulatory staff who work in it.
• Clarity of responsibility: The regulatory structure will influence the clarity of responsibility for
given regulatory functions or roles. This is important for the regulators themselves and for
members of the public or oversight bodies (such as the House of Commons) in seeking to
hold regulatory agencies to account.
• Conflicts between objectives: There may be scenarios where conflicts arise between
regulatory objectives, for example between the need to maintain the safety of financial
institutions and the need to protect consumers. The regulatory structure will determine
whether these conflicts are handled internally within a single agency or externally between
agencies, which either alternative presenting certain costs and benefits.
• Regulatory costs: The regulatory structure will influence the cost of regulation, both in terms
of providing resources to regulatory agencies and the burden of regulation on financial
institutions.
• Coverage: Some structures may create the potential for overlap or underlap, leading to
overregulation of financial institutions or a lack of regulation, respectively.
• Regulatory arbitrage: Multi-agency regulatory regimes provide incentives for financial

institutions to construct their business in order to minimise their compliance costs, which may
reduce the overall quality of financial regulation.
Limits to a structural approach

39. Creating an effective regulatory structure is a necessary but not sufficient condition for a
successful regulatory regime. Critically, the regulatory agencies within the structure must be
adequately resourced with talented and experienced staff, enjoy an appropriate range of powers
under the legislative framework and have a good working relationship with the financial
institutions they oversee.
“New structures do not guarantee better regulation. More appropriate structures

may help but, fundamentally, better regulation comes from stronger laws, better-
trained staff and better enforcement.”
Prof. Jeffrey Carmichael, Australia’s Approach to Regulatory Reform, December 2003
Implications for the UK’s system of financial regulation

40. The analysis of the reasons for the failure of the UK’s system of financial regulation highlights
that the existing UK system failed due to structural and non-structural factors. The
recommendations set out in this report therefore include ways in which the UK’s regulatory
framework can be made more effective as well as ways to improve the functioning of regulation
within that framework. It is particularly important that regulators, policymakers and financial
market participants do not work to deliver an improved regulatory structure in response to the
current financial crisis, but then fail to deliver the more day-to-day requirement to ensure that
the resultant regulatory structure operates in an efficient and effective way to minimise the risk
of another financial crisis in the future.
What are the reasonable expectations of the regulatory system?

41. The objective of this Review should not be to create a “no failure” regime, as this would be likely
to stifle positive financial innovation and lead to excessive costs to financial institutions and
financial services consumers.
42. The regulatory framework should, however, be expected to enable regulators to maximise their
chances of anticipating emerging threats to financial stability, of dealing with those threats
appropriately and of ensuring that the regulatory authorities are adequately prepared to deal
with any crises that do emerge in a professional and effective manner.
The existing regulatory structure

Basis of the current framework
43. The division of responsibilities for financial regulation in relation to financial stability is set out in
statute as well as in the Memorandum of Understanding between the Tripartite Authorities. The
following overview sets out the division of responsibilities in mid-2007 when the current financial
crisis started.
44. The key pieces of legislation are:
• The Financial Services and Markets Act (2000): The Act gave the FSA regulatory
responsibility for insurance, securities and banking in the United Kingdom. The Act
established the four statutory objectives of the FSA as: maintaining market confidence;
promoting public awareness; the protection of consumers; and the reduction of financial
crime.
• The Bank of England Act (1998): The Bank of England was established by the original Bank
of England Act in 1694. The Act of 1998 allocated responsibility for banking supervision to
the Financial Services Authority and granted operational independence to the Monetary
Policy Committee for achieving the inflation target.
45. The original Memorandum of Understanding between the Treasury, FSA and Bank of England
was published in October 1997 and was amended in 2006. The Memorandum outlines the
responsibilities of each authority in relation to financial stability and is the key source for the
current Tripartite framework.
The Bank of England

46. The Bank is responsible for contributing to the maintenance of the stability of the financial
system as a whole. This is one of the Bank’s two core purposes, the other being to maintain
monetary stability.
47. The Bank’s specific duties are to:
• Act in the money markets to limit fluctuations in liquidity
• To oversee the payments system and financial markets infrastructure
• To maintain a broad overview of the state of the financial system
• To undertake operations to minimise the threat posed by an institutional failure
The Financial Services Authority

48. The FSA’s responsibilities are based on the Financial Services and Markets Act and cover the
four statutory objectives of the FSA for the financial services sector.
49. The FSA is also responsible for promoting the resilience of regulated institutions to operational
disruption and for working with regulated institutions to resolve any problems that may prevent
them from operating normally.
HM Treasury
50. HM Treasury is responsible for overseeing the legislative basis of the Tripartite regulatory
structure and for authorising any support operation in the event of a financial crisis.
Changes since mid-2007

51. The most important change to the overall regulatory structure since mid-2007 is the increase in
the role of the Bank of England under the Banking Act 2009, which gives the Bank a statutory
objective to maintain Financial Stability. The Bill also introduces a permanent special resolution
regime to address situations of bank failure, strengthens the Financial Services Compensation
Scheme to facilitate faster pay-outs, formalises the Bank of England’s role in the oversight of
inter-bank payment systems, and establishes the Financial Stability Committee (see Box 11).
The Tripartite Review Why did the existing system fail?
Why did the existing system

fail?
Overview
52. The following chapter describes the global and domestic background to the financial crisis and
examines its key causes.
53. Having discussed the origins of the crisis, the chapter goes on to evaluate the causes of
regulatory failure in the UK, focusing on the evaluation of and response to emerging threats to
financial stability; the lack of appropriate instruments to mitigate emerging risks; inadequate
prudential regulation; and the lack of expertise and preparation for a financial crisis.
Background to the financial crisis

54. The following paragraphs set out a high level view of the causes of the financial crisis, based
upon commentary by leading economists and market practitioners. We have not set out all the
underlying analysis in detail, as this has been done elsewhere, however we have highlighted
some important trends insofar as they help to illustrate key issues. For a more detailed review of
the underlying causes of the financial crisis, see the recent speeches by the Chairman of the
FSA, Lord Turner of Ecchinswell1, and the Deputy Governor for Financial Stability of the Bank of
England, Sir John Gieve2.
55. First, we must recognise that, while the current financial crisis has been a global financial crisis,
the UK contributed to the imbalances in the global economy and exhibited a number of the
same unsustainable characteristics as the US. Furthermore, the actions of British financial
institutions meant that the UK was heavily exposed to the sharp correction in the global financial
system that began in early 2007. Responsibility for the global financial crisis cannot be pinned
at the door of the UK regulatory system, but understanding the extent to which developments in
the British economy contributed to global imbalances and the reasons for the vulnerability of
British banks to the financial crisis will have important implications for the UK’s system of
financial regulation.
1
Adair Turner, The Economist's Inaugural City Lecture, 21 January, 2009
2
John Gieve, 2008 Europe in the World Lecture Panel Discussion, 19 November, 2008
56. An important enabling factor for the global financial crisis was the historically low real risk free
rate of interest in Western economies, driven by the purchase of Western government bonds by
oil and manufactured goods exporting economies (such as the Gulf states and China) to finance
large current account deficits in some Western economies. Low real risk free interest rates had
two consequences: a rapid increase in credit and an increasing search for yield among
investors in high grade securities. These factors drove an asset price boom in Western
economies, with a mutually reinforcing process of rising asset prices enabling individuals and
corporations to take on more leverage to invest in assets.
57. The macro-economic imbalances that were emerging in the period to mid-2007 were
compounded by innovation in financial markets and products. A key element exacerbating the
credit cycle and increasing risks in the financial system was the increasing use of the ‘originate-
to-distribute’ model, where financial institutions making loan decisions were shielded from the
risks associated with those decisions by securitising their loans. In an environment of high asset
price growth and low interest rates, increasing numbers of high risk borrowers (such as ‘sub
prime’ borrowers) were offered loans, since lenders could limit their risk exposure through
securitisation and investors in sub-prime mortgage-backed securities perceived them to offer
attractive risk-weighted returns due to the limited risk of default when asset prices were rising.
However, when house prices peaked in the US in early 2007, default rates rose and the value of
mortgage-backed securities declined sharply.
58. The decline in the value of mortgage-backed securities led to a significant contraction in credit.
This was driven initially by a sharp decline in interbank lending, as the opacity of the mortgage-
backed securities made it difficult for banks to evaluate exposure to losses and therefore the
potential risk that a financial institution would fail. The weakness of the wholesale market, driven
by a lack of interbank confidence, was clearly exacerbated by the failure of Lehman Brothers in
September 2008. Furthermore, the securitisation markets shut down from August 2007 and
have not recovered to date, removing an additional source of bank finance.
59. International Financial Reporting Standards related to fair value accounting and international
capital adequacy requirements have also contributed to pro-cyclical behaviour. While the move
to increased use of fair value accounting has introduced greater realism and transparency in the
reporting of banks’ results and the presentation of their balance sheets, in an environment
where market prices in illiquid markets have been driven to unrealistically low levels, this move
has caused significantly higher write downs of these assets than if alternative accounting
treatments had been used. This has put pressure on banks’ core capital ratios, with the result
that to conserve or repair their regulatory capital ratios banks have been forced to behave pro-
cyclically by further reducing their lending.
60. A further source of systemic risk resulting from financial innovation has been the threat posed
by ‘shadow banking’ institutions, which conduct similar activities to banks but are unregulated
(e.g. hedge funds, structured investment vehicles and other unregulated wholesale market
operators). These unregulated financial institutions have taken advantage of the unsustainable
macro-economic and financial environment, in particular the search for yield among investors in
high grade securities, to fuel much of the innovation in complex financial products that has
contributed to the current crisis. Many of these institutions have reached a sufficient scale or
degree of interconnectedness in the financial system that they may pose a threat to financial
stability. Recent moves in many countries have increased the transparency of their operations,
but arguably the opaque nature of these operations in earlier years helped the impending crisis
to be less visible to governments and regulators.
61. The systemic risks to financial stability resulting from these developments are two-fold. First,
financial institutions that rely heavily on external sources of finance may be unable to secure
sufficient liquidity to fund their obligations, as occurred with Northern Rock. Second, the very
large write-downs in the value of mortgage-backed securities held by other financial institutions,
particularly investment banks (and the investment banking arms of retail banks), has generated
fears regarding their balance sheet solvency, although government-led recapitalisation schemes
have avoided large scale bank failures due to insolvency.
62. Developments in the UK economy and financial system during this period contributed to the
emerging threats to global financial stability, as the UK exhibited many of the same trends as
the US. For example, the supply of credit to UK consumers increased at 11.1% p.a. from 2000
to 2007, fuelling an asset price boom exemplified by the 12.2% p.a. growth in property prices
over the same period (see Box 1). Consumer debt as a percentage of GDP was higher in the
UK than in the US throughout the last ten years. Furthermore, UK banks were heavily exposed
to the impact of the financial crisis as it developed, both in terms of their reliance on external
sources of liquidity (the cause of the failure of Northern Rock) and their exposure to losses on
the value of securitised assets in their trading books and outstanding assets in their loan books.
The IMF estimated in April 2008 that total losses by British banks on sub-prime investments
would amount to $40bn. UK banks also increased their leverage ratios significantly from 2002-
08 (see Box 1); exposing them to greater risk during the subsequent downturn.
63. We consider the extent to which the UK’s regulatory regime should be held responsible for the
UK’s financial crisis in the following sections.
Evaluation of and response to emerging threats to financial stability

64. The regulatory system was not able to anticipate effectively how macro-economic
developments, together with innovation in financial markets and products, could pose a threat to
financial stability. Although many of the symptoms of the emerging financial crisis (particularly
asset bubbles such as in the US and UK housing markets) were recognised, regulators were
not able to anticipate how these risks would impact financial stability and so did not translate
them into regulatory action. For example, in its evidence to the Treasury Select Committee’s
report “The MPC, ten years on” and in its Financial Stability Reviews from 2004 onwards, the
Bank of England identified the emerging risks associated with macro-economic imbalances and
their impact on credit availability:
“The questions are whether risk is being priced properly, and to what extent the
search for yield is leading to excessive leverage”
Bank of England’s Financial Stability Review, December 2004
“The growth of UK-owned banks’ lending to households and firms continues to

outpace the growth of funding from these sources.... liquidity management could
become more challenging should any individual bank come under financial
pressure”
Bank of England’s Financial Stability Review, December 2004
“[Some] aspects of the global economy look unsustainable, particularly the

pattern of global current account imbalances and the low level of real interest
rates and risk premia. So the macroeconomic context is likely to be somewhat
less benign [in the next ten years]”
Bank of England’s written evidence to Treasury Select Committee, February 2007
“Strong and stable macroeconomic and financial conditions have encouraged

financial institutions to expand further their business activities and to extend their
risk-taking, including through leveraged corporate lending, and the compensation
for bearing credit risk is at very low levels”
Bank of England’s Financial Stability Report, April 2007
65. A key weakness in regulators’ anticipation of the systemic risks to financial stability lay in their
analysis of how these developments might pose threats to individual institutions. For example,
the Bank and FSA did not take into account the potentially sudden impact of changes in asset
prices and mortgage default rates on banks’ lending behaviour, due to a limited awareness of
the issues surrounding mortgage-backed securities. Despite recognising that asset prices rises
and low risk pricing were unsustainable, the Bank and FSA did not predict how declining asset
prices and higher risk pricing might impact banks’ confidence in other banks. In recent
interviews, the Bank of England’s Deputy Governor for Financial Stability, Sir John Gieve, has
argued that the Bank failed to appreciate the impact of the trends it was observing in credit
markets and asset prices:
“[We] did see something coming. We did spot the global imbalances, we worried
about them. We did spot some crazy borrowing going on, asset prices looking
unsustainable and we said actually for a couple of years before the crash that a
correction was coming. [But] we didn’t think it was going to be anything like as
severe as it’s turned out to be ... I think that’s because we hadn’t kept pace with
the extent of globalisation ...We saw the credit, we saw the house prices but we
did see a fairly stable pattern of earnings prices and output.”
Sir John Gieve, BBC interview, December 2008
66. One factor that may have contributed to the Bank’s failure to “keep pace with the extent of
globalisation” was the change in the structure and content of its biannual Financial Stability
Review, then renamed as the Financial Stability Report, in 2006, when the Bank stopped
including a section focused on international financial stability risks and shifted to a
predominantly UK market focus. The Bank’s reduced research and analysis of global financial
stability risks signals a narrowing of the Bank’s focus on international issues which may have
contributed to its failure to anticipate the potential financial market consequences of the growing
imbalances.
Lack of appropriate instruments to mitigate emerging risks

67. Regulators lacked instruments that would have enabled them to address emerging systemic
risks, even if they had fully anticipated the potential threat to financial stability. In particular,
regulators lacked an instrument that would have allowed them to dampen the growth in liquidity
from 2000 to 2007. Since the Bank of England is currently only allowed to use interest rates to
achieve its objectives in relation to monetary stability, interest rates cannot be used to promote
financial stability when it is threatened by growth in credit during periods of low inflation. The
difficulties associated with using interest rates as an instrument for financial stability have been
highlighted by Sir John Gieve:
“[If] we’d used interest rates to try and address this asset price/credit growth, we
would have been holding down the level of activity elsewhere in the economy ...
at a time when consumer price inflation and earnings were stable and reasonably
low, and people would have said this is a wilful reduction in the prosperity of the
country.”
Sir John Gieve, BBC interview, December 2008
68. Regulators do not have appropriate alternative instruments to control the liquidity cycle by
constraining growth in bank lending during periods of low inflationary economic growth.
Currently the only instrument at the disposal of regulators (excluding interest rates) is micro-
prudential regulation of individual institutions, based on Basel II and the Capital Requirements
Directive. This stipulates that lenders must maintain a level of capital appropriate to the size and
risk of their liabilities, including a minimum capital requirement for credit, market and operational
risk. However, since regulators are not able to vary capital requirements to reduce the supply of
credit during periods of low inflationary growth (this is prevented by the Directive), regulators
cannot currently use capital requirements to impact the liquidity cycle.
Inadequate prudential regulation

69. Although the Tripartite regulators lacked the necessary instruments to mitigate the systemic
risks associated with the growth in credit, the FSA also failed to deliver effectively its existing
mandate in micro-prudential regulation. This can be attributed to the FSA’s lack of focus on
prudential regulation, as opposed to conduct of business regulation, and its lack of attention to
liquidity issues when it did address prudential regulation.
70. The FSA was excessively focused on conduct of business regulation and did not give sufficient
priority to the prudential regulation of major UK deposit taking institutions prior to mid-2007. This
stemmed from the wide range of responsibilities allocated to the FSA, and from FSA Board and
management decisions, which meant that during periods of apparent financial stability
resources and management time were focused on factors other than prudential regulation (see
Box 2 for an overview of the FSA’s organisational structure at the time the Northern Rock crisis
emerged). The FSA implicitly accepted this view in its internal report into its handling of
Northern Rock:
"Our concern is that some of the fundamentals of work on assessing risks in firms
(notably some of the core elements related to prudential supervision, such as
liquidity) have been squeezed out as a result of prioritisation decisions and
resourcing capacity issues"
FSA, ‘The supervision of Northern Rock: a lessons learned review’, March 2008
“The FSA [is] to increase its focus on prudential supervision, including liquidity
and stress testing”
FSA, ‘The supervision of Northern Rock: a lessons learned review’, March 2008
71. Where the FSA was conducting prudential regulation, it devoted more time and resources to
capital than to liquidity risks. While this was rooted partly in the failure of the Basel Committee to
develop liquidity standards to complement its capital requirements standards, the FSA must be
held accountable for its lack of focus on liquidity. This view has been set out in testimony to the
Treasury Select Committee’s investigation into the failure of Northern Rock:
“The FSA is an institution that cares more about capital adequacy and solvency
issues than about liquidity issues”
Professor William Buiter, Evidence to Treasury Select Committee, November 2007
In the period prior to 2007, the ease with which banks could access a range of sources of
funding meant that little attention was paid to the significant reliance of some banks on external
funding. This meant that the risks associated with business models reliant on external funding
were not taken into account by the FSA, allowing banks such as Northern Rock to take on more
risk. However, had the FSA devoted more time and resource to liquidity regulation, it is likely
that Northern Rock’s outlying business model would have been identified as a significant risk:
“If we had a system of proper liquidity regulation, although Northern Rock would
have shown up as doing very well on the capital side, it would have looked very
flawed on the liquidity side, and that would have been picked up”
Mervyn King, Governor of the Bank of England, Evidence to Treasury Select Committee,
December 2007
72. The FSA also failed to ensure that financial institutions had conducted sufficiently rigorous
exercises to prepare for a financial crisis, particularly by working with institutions to stress test
their models against various potential threats. Although the duty to design and run stress testing
scenarios lay with the institutions themselves rather than with the FSA, it remained the
responsibility of the FSA to monitor firms’ activities in this area. Stress testing for liquidity risk
was particularly weak. Despite frequent liquidity risk testing having been made compulsory for
all deposit-taking institutions by the FSA in 2004, Northern Rock did not satisfactorily carry them
out.
“Although the Board of Northern Rock undertook some stress testing of its own
business model, it proved to have been thoroughly inadequate. It was the
responsibility of the Financial Services Authority to ensure that the work of the
Board of Northern Rock was sufficient to the task. The Financial Services
Authority failed in its duty to do this”
Treasury Select Committee, The Run on the Rock, January 2008
73. The most compelling evidence that the FSA failed to enforce adequately micro-prudential
regulation is in its failure to recognise that Northern Rock’s outlying business model (see Box 3)
left it dangerously exposed to the contraction in wholesale funding and securitisation markets
that occurred in mid-2007. While the simultaneous closure of these sources of bank finance
may not have appeared likely in early 2007, the FSA should have given greater consideration to
the potential impact of weaker securitisation and wholesale funding markets on financial
institutions, particularly in the light of its warnings regarding liquidity risk:
“The problem of NR was a business model that exposed it to a Low Probability

High Impact risk. What emerges is that the supervisors of the bank did not
address this feature of the bank’s strategy with sufficient rigour, though both the
FSA and the Bank of England (and other central banks) had for several months
been making general warnings about liquidity risk.”
Prof. David Llewellyn, ‘The Northern Rock crisis: A multidimensional

problem waiting to happen’, July 2008
The FSA’s organisational Box 2
structure in mid-2007
FSA Responsibilities
• The FSA’s four statutory objectives consist of: maintaining confidence in the financial system; promoting public
understanding of the financial system; securing the appropriate degree of protection for consumers; and reducing the
extent to which it is possible for a business to be used for a purpose connected with financial crime
• In July 2007, the FSA was delivering this mandate by dividing its internal organisation between three core divisions: an
operational division (Regulatory Services); a division focused on retail banking (Retail Markets); and a division
focussing on wholesale banking (Wholesale and Institutional Markets)
• In practice, this meant that the Senior Supervisors responsible for the FSA’s regulation of each firm made decisions
regarding the relative prioritisation of prudential versus conduct of business regulation, and in many cases prudential
regulation was not sufficiently prioritised
FSA Organisational Chart – August 2007 (simplified)
Chairman
Chief Executive Officer
Wholesale &
Regulatory Services Retail Markets
Institutional Markets
Cross – FSA sector

Auditing and Accounting | Asset Management | Banking | Capital Markets | Consumers
Financial Crime | Financial Stability | Insurance | Retail Intermediaries
Wholesale &
Regulatory Services
Retail Markets Divisions Institutional Markets
Divisions
Divisions
Source: FSA website, FSA Annual Reports, FSA ‘The supervision of Northern Rock: a lessons learned review’
Northern Rock’s Box 3
business model
How it worked Risks

• A key feature of Northern Rock’s business model was • Northern Rock’s reliance on wholesale funding meant
its reliance on securitisation and short-term wholesale that it was exposed to a low probability, high impact
funding, which enabled it to pursue a strategy of risk in the event of a contraction in inter-bank lending.
aggressively growing its share of UK mortgage lending Whilst this scenario appeared unlikely prior to mid-
without needing to increase its depositor base, since it 2007, Northern Rock’s business model left it
could finance its lending externally particularly vulnerable to this risk when it materialised
• Northern Rock was the only major bank to base its • Following the closure of securitisation markets in
business model on securitisation August 2007, Northern Rock was unable to securitise
its existing mortgages. This had two negative impacts:
“Northern Rock has been the only major 1. Northern Rock faced unexpected additional funding
requirements due to the need to finance mortgages
bank to have securitisation as the centre- it had intended to securitise
piece of its business strategy”
2. Northern Rock was forced to retain its existing
portfolio of mortgage loans on its balance sheet,
David Llewellyn, The Northern Rock Crisis, July 2008 exposing itself to downside risk in the event of an
increase in the default rate
• Northern Rock was also unusual in the extent of its
reliance on wholesale funding (see below)
Northern Rock's reliance on wholesale funding
70%
62%
Percentage of funding
60%
52%
50%
50% 48%
42%
38% 39%
40%
30%
RBS Lloyds TSB Barclays Alliance&Leicester HBOS Bradford&BingleyNorthern Rock
Bank
Source: David Llewellyn, ‘The Northern Rock Crisis: A Multi-

Dimensional Problem Waiting to Happen’, Press reports
Expertise and preparation for crisis

74. The Tripartite Authorities were poorly prepared for a crisis, and, in particular had spent
insufficient time conducting joint planning for a financial crisis. There was very little interaction
between the Tripartite Authorities at the most senior level prior to mid-2007 – in the absence of
documented records of meetings, we have been informed that the Authorities met at the
Principal level only once in the ten years preceding the financial crisis. This was when the
Chancellor of the Exchequer, the Governor of the Bank and the Chairman of the FSA
participated in a conference call with the US authorities in 2006. This was referred to by the
Prime Minister in his evidence to the House of Commons Liaison Committee in February 2009.
Basic crisis management tools that are used elsewhere in the Government and private sector,
such as developing ‘war games’ to understand potential weaknesses in crisis management
capabilities, were used only rarely by the Tripartite Authorities. The Treasury was particularly
short of relevant financial market and crisis handling expertise in mid-2007.
75. The mechanisms to deal with financial institutions in the event of failure were also clearly
inadequate, as the lack of a resolution regime for financial institutions meant that the Authorities
had to utilise the corporate insolvency regime. This meant that, in the case of systemically
important institutions, the Authorities had little option other than to provide ongoing liquidity
support from the Bank of England or nationalising the institution.
“[Out of an exercise in 2005] came the very clear understanding that we had no
adequate tools for dealing with a failing bank ... all three Tripartite Authorities felt
that an urgent work programme on how to resolve the problems of a failing bank
was necessary”
Mervyn King, Evidence to the Treasury Select Committee, December 2007
When overseas regulators/governments allowed an institution to fail, as with Lehman Brothers

in September 2008, the inadequacy of the UK’s wider insolvency regime was exposed. Given
that this weakness in the UK’s legislation was recognised in 2005, the failure of HM Treasury to
have drafted an alternative legislative framework for a resolution regime should be
acknowledged.
76. The arrangements for depositor protection in the event of an institutional failure were also
inadequate and contributed significantly to the damage done to the UK’s financial system
following the run on Northern Rock’s retail deposits in September 2007. Specifically, the lack of
a 100% guarantee on retail deposits and the long delays in recovering deposits via the Financial
Services Compensation Scheme meant that there was a rational incentive for deposit holders to
join a bank run, factors recognised by the Governor of the Bank of England in the aftermath of
the crisis:
“The system of administration for banks which means that retail depositors find
their deposits frozen for months on end and they cannot access them is a system
which is a direct inducement for retail depositors to take their money out at any
sign of trouble”
Mervyn King, Evidence to the Treasury Select Committee, September 2007
“In the absence of a government guarantee, it was actually rational to queue up

and take your money and it would have been dishonest for us to have pretended
otherwise"
Mervyn King, Interview with the BBC, November 2007
77. In addition to the challenges associated with the lack of a resolution regime and weak depositor
protection, the Tripartite Authorities failed to communicate effectively with the markets and
general public to try to reduce the impact of the emerging crisis. The delays in making a public
announcement regarding the liquidity support operation for Northern Rock left the bank in a
precarious position with its depositors when news of the support operation was leaked in the
media prior to the official announcement (see Box 4). The leaking of Government support
operations prior to their announcement was not confined to the Northern Rock operation, as the
market-sensitive news regarding the bank recapitalisation scheme in October 2008 was also
leaked to the media before being officially announced.
78. Furthermore, the Authorities failed to use communication to reassure financial markets and
depositors, as it was not clear who was taking the lead in communicating with the public and
official announcements used language that failed to reassure financial services consumers.
“There was no sign of a communications strategy of the Tripartite authorities

during the crisis of September 2007. We believe that this was a contributory
cause of the run on the bank”
The Run on the Rock, January 2008
“Calling [the Bank of England liquidity support operation] emergency lending was
I suppose asking for trouble”
Geoffrey Wood, CASS Business School, Evidence to the Treasury Select Committee,
November 2007
“[Regulators] failed to speak plain English: assurances from the FSA that
Northern Rock was, for example, ‘solvent’ cut no ice with the bank's retail
customers because it is not a term that is widely understood by non technicians”
Building Society Association, Evidence to the Treasury Select Committee, December

2007
79. One of the specific reasons for the failure of the Tripartite Authorities adequately to resolve the
Northern Rock crisis was the perception among key decision-makers within the Tripartite
Authorities that a covert liquidity support operation for Northern Rock would constitute market
abuse.
“I found it hard to believe that a public policy intervention that was in the interests
of everyone in Northern Rock [a covert operation] could not go ahead because of
a legal responsibility to disclose. There is wording in that [European Union]
Market Abuse Directive which would give you the impression that in a case of
financial distress it would be possible not to disclose but we had to take legal
advice ... and we were advised finally that it could not be covert”
Mervyn King, Evidence to Treasury Select Committee, September 2007
The FSA has subsequently clarified its interpretation of the Market Abuse Directive to allow for
covert liquidity support operations so long as delays in disclosing such an operation do not
mislead the public and confidentiality can be maintained, however the failure to determine this
question prior to mid-2007 was very costly to the UK’s financial system. Even if this issue had
not been adequately addressed when the Market Abuse Directive was transposed into UK law
and regulation, it is difficult to understand, without a clearer public account of the events leading
up to the run on Northern Rock, how a simple defect in the FSA disclosure rules was allowed to
prevent a covert support operation, when there was in fact no obstacle in the Directive.
80. The weakness in the Authorities’ communications may have reflected a deeper problem
regarding leadership of the regulatory and Government response to the emerging crisis.
Although formally the Treasury retained final responsibility for resolving a financial crisis under
the Memorandum of Understanding, uncertainty regarding the implications of the Bank of
England’s monetary policy independence may have limited HM Treasury’s perceived authority
to take decisions regarding support operations.
“[There was] insufficient clarity in the allocation of roles, responsibilities and

authority of the parties to the Tripartite authorities”
British Bankers Association, Memorandum to the Treasury Select Committee, November

2007
81. People involved in successive stages of the crisis report that the Tripartite Authorities’ crisis
handling has markedly improved in the period since the collapse of Northern Rock, with a
swifter and more effective handling of Bradford & Bingley’s nationalisation and the
recapitalisation of HBOS, Lloyds TSB and the Royal Bank of Scotland – although the same
people may also question whether the right policy outcomes were achieved. . The challenge for
the Tripartite Authorities will be to ensure that the current level of preparedness does not
dissipate once the ongoing financial crisis has concluded.
The Tripartite Review The macro-prudential regime
Overview
82. The previous chapter identified the weakness of the Tripartite regime prior to 2007 in identifying
and acting on systemic threats to financial stability. In this chapter a proposed macro-prudential
framework is outlined that would address many of the weaknesses identified.
83. The chapter sets out the core issues in relation to the macro-prudential regime, considering in
turn the most effective way to improve the evaluation of and response to emerging threats to
financial stability; and the appropriate instruments to mitigate these risks.
Evaluation of and response to emerging threats to financial stability

What functions will the regulatory system be required to perform?
84. The regulatory system needs to develop a much more effective capability in monitoring
emerging threats to financial stability and translating this into regulatory action.
85. First, regulators must be able to collect and analyse economic and financial data at the systemic
level. This will include analysing macro-economic and financial data for both the UK and the
global financial system, in order to identify any imbalances that might lead to financial instability.
86. Second, regulators must be able to anticipate how macro-economic and financial developments
may impact upon the UK’s financial stability, in particular by addressing the vulnerability of
British financial institutions to emerging systemic risks. This will require regulators both to have
access to institutional financial data, in order to quantitatively evaluate risk exposure and
vulnerability at the institutional level, and to engage with senior market practitioners in order to
understand how financial institutions’ business models may expose them to systemic risks.
87. Third, this analysis must be translated into regulatory action. This will require regulators to
develop mechanisms to effectively communicate internally within the regulatory community and
externally with financial institutions, to ensure that financial institutions are adequately informed
about and prepared for emerging systemic threats to financial stability.
Responsibility for identification and analysis of systemic risks

88. Each of the Tripartite Authorities should play a role in evaluating emerging threats to financial
stability, however the nature of this role will differ depending on the specific position, resources
and existing capabilities of each Authority. The most significant change is that the Bank of
England should in future be formally bound, in support of its financial stability objective, to be
monitoring and assessing developments in UK and global financial markets and considering
their implications for financial stability. Also, the macro-economic side of the Treasury should
have a new role in considering the impact of financial stability issues on the conduct of macro-
economic policy, and, vice versa. The micro-prudential supervisor should continue to input into
this analysis, given its detailed knowledge of financial institutions’ risk exposures.
89. The Bank of England should be primarily responsible for evaluating systemic threats to financial
stability for the following reasons:
• Capability: The Bank has an existing capability in monitoring and analysing macro-prudential
threats to financial stability, with many of the systemic threats to financial stability that
caused the financial crisis identified by the Bank in its Financial Stability Reports and other
public statements. There is room, though, to strengthen this capability by building upon the
analytical strength and access to macro-economic data that the Bank has developed to fulfil
its monetary stability mandate.
• Access to markets: The Bank is actively involved in the money markets as part of its
monetary stability and payment system functions. This enables it to have access to real time
financial data and to build contacts and working relationships with market practitioners,
allowing the Bank to gain an insight into developments in financial markets that the other
regulatory bodies will find challenging to replicate.
• Creative tension: Giving the Bank an unequivocal mandate in macro-prudential analysis will
enable there to be both a private and a public dialogue between the Bank and the micro-
prudential regulator regarding the key systemic risks and their implications. This should
engender a degree of creative tension between the Bank and the micro-prudential regulator
on the nature of the systemic risks; it will ensure that the regulatory implications of systemic
concerns are properly followed up; and it will add a new dimension of transparency to the
Tripartite process.
90. The strength of the Bank’s position with regard to financial stability was highlighted by Paul
Tucker, who becomes Deputy Governor for Financial Stability in March 2009, in his recent
written response to the Treasury Select Committee’s appointment hearing:
“[The Bank] can draw on a strong endowment, rooted in our being the UK’s
monetary authority. [This includes] analytical strengths, especially given the
Bank’s position in the labour market for Masters and PhD economists; financial
market/banking operational expertise, stemming from our role at the heart of the
monetary and payment system; a wide range of contacts in, and so breadth of
intelligence from, capital markets given our operational roles; goodwill towards
the Bank across the international financial system; [and] the high standing of the
six-monthly Financial Stability Report.”
Paul Tucker, Written response to Treasury Select Committee, January 2009
91. The increase in the role of the Bank in relation to macro-prudential regulation will require the
Bank to have greater access to institutional financial data to complement its existing sources of
macro-economic and financial data. The most important source of institutional data will be the
micro-prudential regulator (the FSA under the current Tripartite framework), as its institutional
regulatory role gives it access to a range of detailed information on institutions’ financial
positions and risk exposures. It will therefore be critical that the Bank and micro-prudential
regulator agree on what data is required to perform their roles in macro and micro-prudential
regulation, with consideration given to avoiding additional new regulatory burdens on financial
services institutions (including taking into account institutions’ existing management information
systems and the costs associated with providing data in a different form). The Bank should
specify what data is required for its analysis and the micro-prudential regulator should provide
this data. The operating protocol between the Bank and FSA includes a commitment by the
FSA to provide data on request. However, for the avoidance of doubt, the Bank should have a
statutory right to receive such data as it deems necessary for its macro-prudential work.
92. Most importantly, the success of the Bank in fulfilling its macro-prudential role will be heavily
dependent on the development of an ongoing, high level engagement with senior market
practitioners, to enable Bank officials to gain a greater insight into different institutions’ business
models and the risks to which these institutions are exposed. A number of people we have
spoken to during the course of this Review have highlighted the Bank’s less market-focused
outlook in the period preceding the financial crisis versus earlier periods. One factor that may
have contributed to this shift is the Bank’s decision to drop its third core purpose relating to the
efficiency and effectiveness of the financial system. The Bank had previously regarded this as
an important underpinning for its two main objectives of maintaining monetary and financial
stability, although it was sometimes characterised, erroneously or at least anachronistically, as
conducting a lobbying role in Whitehall on behalf of the City. For the Bank to be effective in
identifying emerging systemic risks, it should in future be formally bound, in support of its
financial stability objective, to be monitoring and assessing developments in UK and global
financial markets and considering their implications for financial stability.
93. Having analysed the potential systemic risks to financial stability, it will be critical to ensure that
the outputs of its macro-prudential analysis are translated into regulatory action. The key
channel to achieve this will be via the micro-prudential regulator, with whom the Bank should be
in constant informal dialogue on the relevant issues. The formal way in which the Bank should
communicate its views on macro-prudential regulation to the micro-prudential regulator should
be via a public letter from the Bank to the micro-prudential regulator, to be published in addition
to the Bank’s Financial Stability Report and setting out the Bank’s views on the overall level of
systemic risk in the UK, together with the source and nature of specific risks identified. The
Bank should send such letters as often as it deems necessary but should do so at least twice a
year, potentially in conjunction with its biannual Financial Stability Reports. The micro-prudential
regulator would have a duty to submit a public response to the letter, setting out any areas of
disagreement with the Bank regarding systemic risk and stating what actions the micro-
prudential regulator will take in the following months to address them. This would enable
Parliament (via the Treasury Select Committee) to hold the micro-prudential regulator to
account regarding its response to systemic risks identified by the Bank.
94. In addition to the public letter from the Bank to the micro-prudential regulator setting out
systemic risks, the Bank should also include a confidential annex raising any concerns
regarding specific institutions that it has developed during its macro-prudential work. This annex
must remain confidential due to the need to preserve market confidence and prevent market
abuse. In order to ensure the integrity of this exchange, confidential annexes should be publicly
disclosed after five years. The micro-prudential regulator should also be required to respond to
this letter, stating any disagreements and actions to be taken, and should be accountable to
Parliament for carrying out these actions.
95. In carrying out its macro-prudential role, the Bank will also be equipped to engage more fully in
the critical European and global debates and negotiations on the future regulatory structures
that will underpin much of the UK’s financial stability regime. We have been told that the Bank is
not as engaged in these debates as it was in previous years. It is important that this trend is
reversed and that the Bank re-engages with the key international bodies. The Bank was at the
forefront of many of the debates over the past decades that led to the current developed
methodologies for the conduct of monetary policy globally. It should play a similar role, in
tandem with the micro-prudential regulator, in what will be as important and protracted a
development of truly workable financial stability methodologies. This work should focus, in
particular, on influencing the European legislative programme which has the capacity to dictate
much of the UK’s financial stability system.
Recommendation (1): The Bank of England should have the primary responsibility for
evaluating systemic threats to financial stability.
Recommendation (2): The Bank of England should have a statutory right to receive such
data as it deems necessary for its macro-prudential work; this data
should be provided by the micro-prudential regulator.
Recommendation (3): The Bank should have a formal duty in the Memorandum of
Understanding to be continuously engaged with broad financial
markets developments.
Recommendation (4): The Bank should write a public letter at least twice a year to the
micro-prudential regulator setting out its views on systemic risk.
The micro-prudential regulator should submit a public response to
the letter stating what actions it intends to take to address the risks
identified.
Recommendation (5): The letter should include a confidential annex raising any concerns
in the Bank regarding specific financial institutions.
Recommendation (6): The Bank of England should engage fully in international debates
and negotiations on financial stability regulation.
Use of macro-prudential instruments

96. The earlier analysis of the causes of financial instability and systemic risk centred on the
problems associated with financial innovation and unsustainable macro-economic
developments. Proposals to respond to these challenges have fallen into two broad categories,
including those that seek to reduce the potential for unsustainable macro-economic imbalances
to develop and those that address problems at the financial institution level.
Instruments to address macro-economic imbalances

97. The linkages between macro-economic policy and financial stability have been explored in a
series of speeches and papers by officials at the Bank for International Settlement since 2001.
In a UK context the first question to be asked is about the relationship of the Bank’s Monetary
Policy Committee (“MPC”) to questions of financial stability. The range of views that should be
considered includes:
• Dual mandate for the MPC: This approach would see the MPC being given an explicit
objective of maintaining financial stability as well as hitting the inflation target.
• MPC consideration of financial stability implications: The MPC might be required to give
consideration to the financial stability implications of its interest rate decisions. This covers a
range of options in practice, from requiring the MPC to ‘lean against the wind’ during periods
of high liquidity growth by raising interest rates (this might be justified by asking the MPC to
take a longer term view of the inflation target time horizon), to requiring the MPC under
exceptional circumstances to prioritise issues relating to financial stability over its monetary
stability objective.
• Including asset prices in the inflation basket: This would enable the MPC to take into account
increases in asset prices whilst preserving its single mandate in relation to inflation targeting.
Work on including owner-occupied housing costs (a metric for house price asset inflation) is
currently being conducted by Eurostat, although in evidence to the House of Lords Economic
Affairs Committee in 2006 the Governor of the Bank of England stated that he did not expect
this to be completed during his lifetime. Sir John Gieve, in his speech of 19 February, 2009,
argued that house prices are of such importance to UK households’ budgets and wealth that
the UK should consider incorporating this measure into the inflation basket, even if action is
not taken at the European level.
• MPC comments on financial stability implications of decisions: Requiring the MPC to

comment on the implications for financial stability of its decisions in setting interest rates will
not enable the MPC to explicitly use interest rates to promote financial stability, but will
increase the level of focus on particular financial stability issues discussed by the MPC.
98. Among the commentators putting forward the view that the role of the MPC in relation to
financial stability need to be reconsidered are Sir John Gieve:
“We must be willing to “lean against the wind” of asset price booms and credit
expansion and to tolerate somewhat weaker growth and lower employment in
doing so”
Sir John Gieve, Speech to the London School of Economics and Political Science,
February 2009
99. A more straightforward way in which the Authorities can use levers to influence financial stability
would be to make greater use of wider Government policy options to promote financial stability.
In particular, strengthening the links between the Government’s wider economic management
toolkit and its consideration of financial stability issues should be a high priority, not least in
relation to fiscal policy. At present there is no formal channel for financial stability concerns to
be transmitted to, and considered by, the macro-economic side of HM Treasury. To strengthen
HM Treasury’s role in relation to financial stability, the remit of the macro-economic side of the
Treasury should be broadened to include consideration of the financial stability consequences
of developments in the economy and the consequences for economic management of financial
market trends identified by the Bank and micro-prudential regulator. In addition it is worth
considering whether the micro-prudential regulator should write an open letter to the Bank
should there be concerns that its conduct of macro-economic policy may threaten financial
stability.
100. The third lever that might be used by the Authorities as a part of their macro-prudential toolkit is
an appropriate counter-cyclical capital regime that would allow regulators to dampen the
liquidity cycle and to minimise the threat to financial institutions during periods of deleveraging.
The need for such a counter-cyclical regime has been highlighted by Paul Tucker:
“My provisional view, which may prove wrong, is that it will be insufficient to rely
on the design of micro rules. I therefore think it will be worthwhile exploring
whether a ‘macro’ instrument could be devised. Candidates include varying
across-the-board capital ratios for banks during the upswing part of the credit
cycle”
Paul Tucker, Written response to Treasury Select Committee, January 2009
101. The only country which is widely quoted as operating such a capital regime is Spain, with its
dynamic provisioning approach (see Box 5), although there have been a number of criticisms of
its effectiveness. It is clear that the dynamic provisioning did not prevent a strong cyclical
expansion of credit in Spain, with corresponding problems in housing and other markets.
However, it has been argued that it left Spanish banks better prepared for the financial crisis,
enabling them to call on provisions amounting to 1% of total assets during the downturn3.
102. It is beyond the scope of this report to determine the exact nature of this regime, including
whether it should be applied separately to individual institutions or across the system as a
whole. In the absence of a clearly defined counter-cyclical capital regime, it is not possible to
say which Authority should be responsible for operating it. However it is possible to set out
which Authority will be best suited to operating different a regime that operates at the systemic
level versus one that operates at the institutional level.
103. Given the Bank’s role and capabilities in relation to the analysis of systemic threats to financial
stability, the Bank is the Authority that is best placed to exercise judgements over the counter-
cyclical capital regime at the sector or market wide level. As the institution primarily responsible
for conducting the analysis of systemic risks to financial stability, the Bank should also be
required to act on those risks using a counter-cyclical capital regime. If, on the other hand, the
counter-cyclical capital regime is designed to operate at the level of individual financial
institutions, the micro-prudential regulator is best placed to operate the regime.
104. Other broad ideas that have been suggested to us include the concept that firms with a
dominant share in any particular market might be required to hold a proportionately higher level
of capital than other firms, to reflect the additional systemic risk that comes with absolute size of
institution; that firms with an aberrant business model might be required to hold more liquidity or
capital; that financial institutions should be required to hold more liquid assets during cyclical
upturns; or that constraints on lending, such as loan to income and loan to value ratios, should
be introduced.
3
Speech by Sir John Gieve to the London School of Economics and Political Science, ‘Seven lessons from seven years’, 19
February 2009
Dynamic Provisioning Box 5
in Spain
Background
• Spain is currently the only country utilising the dynamic provisioning instrument. The Bank of Spain introduced
dynamic provisioning requirements in mid-2000 due to concerns regarding the cyclicality of banks’ lending and risk
pricing
• Banks’ provisions for loan defaults tend to be inversely correlated to economic growth, as default rates are typically low
during periods of economic growth and high during recessions. This leads to pro-cyclical behaviour as banks make
more loans when the economy is growing and limit lending during recessions
• Dynamic provisioning requires banks to take a more conservative view during periods of economic growth, setting
aside provisions to mitigate losses from rising defaults during downturns. The dynamic provision requires banks to
recognise credit risk in their balance sheets and to set aside reserves to cover it
• This prevents banks gearing up during a period of economic upturn on a capital base that has been inflated by ignoring
the longer run losses associated with their lending, and provides a buffer which will cover the exceptionally high losses
incurred in the subsequent cyclical downturn
How it Works Criticisms of dynamic provisioning

• The ‘Dynamic Provision’ is a balancing number, and • The first criticism of dynamic provisioning is that it is
equals the difference between the expected default costly and complex to administer. For example, it
risk for loans throughout the economic cycle and the requires regulators to develop an expertise in
actual default risk in any given year (this is assessing the default risk for loans across a number of
summarised below) asset classes and hold detailed historical data on
default rates across these each of these classes (this is
• Relatively low annual default rates during periods of
particularly problematic where banks operate
economic growth will result in a positive dynamic
internationally). On the other hand, there are similar
provision being charged to the income statement and
concerns regarding the Internal Ratings-Based
added to reserves, whereas relatively high default
approach set out under Basel II
rates during recessions will lead to a release of
dynamic provision reserves from the balance • Dynamic provisioning in Spain does not take into
statement to the income statement to offset losses account the losses that may be realised on marked-to-
market assets, which have been the primary sources of
• However, there is a limit on the total level of dynamic
bank write-downs in the UK
provision reserves required to be held by any
individual bank, set at 1.5% of total assets • Dynamic provisioning is also inconsistent with
International Accounting Standard 39 on the
impairment of assets
Dynamic Provision = Average annual provision (Loans x Default risk across the cycle) –
Provisions in a given year (Loans x Default risk for year)
Impact in Spain
• Dynamic provisioning did not prevent a significant • However, Banco de Espana emphasise that dynamic
increase in credit and a resultant asset price boom in provisioning was not intended to ‘dampen down’ the
Spain. Lending to households grew at 19% p.a. liquidity cycle, but to ensure banks were better
between 2000 and 2007, whilst house prices grew at prepared for a downturn by recognising credit risk and
13% p.a. during the same period setting aside reserves during economic upturns. In this
respect dynamic provisioning may have been
• Total dynamic provisions are believed to have equalled
successful in ensuring Spanish banks were better
1% of total banking assets at the starts of the down-
placed to withstand losses in the current financial crisis
turn
Sources: Banco de Espana, Thomson Datastream, Press reports
Addressing threats to financial stability at the institutional level

105. One proposal set out by a number of commentators to address issues at the institutional level
would be to enforce a division of activities by complex financial groups into separate
subsidiaries for different classes of business activity that could be subject to separate capital
regimes, with the traditional deposit taking and lending activities of financial institutions (‘retail’
or ‘commercial’ banking) separated from their trading operations (‘investment’ banking). This
means deciding which financial services should be classed as utilities and which as part of the
casino. The imposition of fire-walls between different classes of business has some intuitive
appeal in the light of the very substantial losses by the trading arms of large deposit-taking
institutions, however much more debate is required regarding the implications of such a change.
Some commentators have suggested confining the ‘utility’ to the payment system, however this
may be problematic given that for example the intermediation of long-term savings would
normally be regarded as a key function of the financial system.
106. Arguments in favour of a division include that it would provide greater security to retail
depositors in financial institutions and that it would provide an additional layer of protection to
the taxpayer against exposure to costs associated with the failure of financial institutions. Some
of those who advocate this model argue that it is only worth implementing if the ring fence is
drawn in such a way that it includes substantially all of the systemic activity, which needs to be
subject to tighter regulation, and that financial activity outside the ring fence should be in the
main not of systemic consequence and so not subject to full prudential regulation.
107. Among the wide range of issues associated with a separation of financial activities are concerns
regarding whether regulatory lines or competition and clear information to consumers will better
enable a range of retail deposit taking institutions to develop; how ‘narrow’ banking protects a
bank from traditional prudential risks such as concentrated lending; what the additional funding
costs for the banking system will be if deposit taking banks are not allowed to finance or hedge
their activities through the repo market, and a range of derivative structures; what economy of
scale and diversification benefits might be lost; what the risks and consequences of regulatory
arbitrage will be as banks look for domiciles where less restrictive regimes may exist; and
whether the capital regime could be able to deal appropriately with a range of different banking
models without segregating activities into different legal entities.
108. A second proposal at the institutional level that merits more consideration than it has to date is
the recommendation that ‘shadow banking’ institutions should be fully regulated. The guiding
principle should be that a financial services entity, or category of businesses, should be
regulated either because there is an issue of consumer protection or that the failure of the
institution(s) would have systemic consequences. This merits careful case-by-case
consideration of the potential costs and benefits associated with such a development,
particularly against the benefit that can be gained by increased transparency. However, it will be
challenging to regulate these institutions directly, as their limited size (in terms of staff and
operational footprint) and ready access to global financial markets means that they are highly
geographically mobile. The approach that has been adopted in recent years, for example, with
hedge funds, is for regulators to focus on the prime brokerage activities of the regulated
investment banks which provide the brokerage service to the unregulated hedge funds. It is
perhaps too early to conclude that this approach has proved wholly effective but it provides a
reminder that direct regulation may not always be the right answer and that we need to find a
clear rationale for determining which institutions are subject to prudential regulation. It will be
important to bear in mind the lessons of the Sarbanes-Oxley legislation in the USA following the
collapse of Enron: that additional regulation can impose a cost on business running into
hundreds of millions of pounds without achieving much except the growth of the box ticking
industry.
Additional instruments
109. One further instrument available to authorities in the US is the use by the Federal Deposit
Insurance Corporation of its funds to facilitate the transfer of parts of an ailing institution to
another financial institution, where it judges that the ultimate cost to the scheme will be lower
than compensating the depositors in the insolvent institution through a liquidation (see Box 6),
with a different set of criteria in systemic situations. This represents a practical additional tool for
dealing with bank insolvencies. The UK Authorities should clarify the constraints on the
Financial Services Compensation Scheme funds being used to secure the resolution of failed
institutions instead of liquidation and payout under the scheme.
110. There will remain a number of practical issues associated with such an instrument in the UK,
where compensation of depositors in the event of a bank failure is currently managed by the
Financial Services Compensation Scheme (FSCS), an independent body funded by the
financial services industry and accountable to the FSA (see Box 7). The Banking Act 2009
allows for the FSCS to move to a pre-funded model, whereby financial institutions would fund a
build up of the FSCS to pay for any potential claims, rather than the current post-funded model.
More consideration should be given to financial institutions pre-funding the compensation
scheme in the future, and in particular there should be more work done to evaluate the various
options for a risk-based contributions framework (where financial institutions whose depositors
are most at risk must pay higher premiums to the FSCS). In this context the existing cross-
subsidy arrangements between financial industry sub-sectors should be revisited.
The Federal Deposit Box 6
Insurance Corporation
Background
• The Federal Deposit Insurance Corporation (FDIC) was created in 1933 by the Glass-Steagall Act. It is a government
corporation, devoted to maintaining confidence in the banking system through insuring deposits at American banks.
These deposits are then guaranteed by the government
• The FDIC is funded by premiums from banks, and insures approximately 5,160 banks in the United States,
representing over half of the institutions in the US banking system
The FDIC’s powers and remit Purchase and Assumption Agreements

• FDIC insurance covers savings, checking and other • A purchase and assumption agreement is an
deposit accounts agreement entered into by the FDIC, the failed bank
and an institution which wishes to acquire the failed
• Normally, FDIC insured depositors are guaranteed up
bank. The acquiring institution would then be allowed to
to $100,000 per bank; however this was temporarily
purchase the bank subject to it assuming some or all of
increased on 3 October, 2008 to $250,000 per
the failed bank’s liabilities. Purchase and assumption
depositor per bank
transactions are the most common resolution method
• The FDIC finances its operations by charging a risk- for the FDIC
based premium to the institutions it insures, with higher
• The FDIC can draw upon the funds paid to it from
risk banks required to pay a higher premium. The
insured institutions to reduce the cost of a takeover to
FDIC is pre-funded, mitigating the problem of low risk
acquiring institutions, where the overall cost to the
institutions having to pay for high risk institutions failing
FDIC will be lower than if it pays out insurance to an
in a crisis
insolvent institution’s depositors
• FDIC assesses the riskiness of an institution by a two-
• Recent purchase and assumption transactions with the
step process looking first at capital ratios and secondly
FDIC includes the acquisition of 1st Centennial Bank by
at other relevant information gathered during
First California Bank in January 2009, where First
supervision
California agreed to acquire the deposits and $293m of
• The FDIC is the agency responsible for handling bank 1st Centennial’s assets. The estimated overall cost to
insolvencies in the United States the FDIC of this transaction is $227m, but it did not
disclose the projected alternative cost of allowing the
institution to fail
Dealing with insolvency
• Other recent purchase and assumption agreements
• The FDIC uses three resolution methods to deal with with the FDIC include the acquisition of Downey
bank insolvency: purchase and assumption Savings and Loan Association and PFF Bank and Trust
transactions (see below), where the bank’s operations in California by US Bank, as well as Branch and
are sold to another institution; deposit payoffs, where Banking and Trust’s assumption of Haven Trusts’
the FDIC pays insured depositors the value of their deposits in November and December 2008 respectively
deposits and liquidates the institution; and open bank
assistance transactions, where the FDIC provides an
institution with financial assistance to keep it from
failing
Source: The Federal Deposit Insurance Corporation
The Financial Services Box 7
Compensation Scheme
Overview Funding
• The Financial Services Compensation Scheme • The Scheme is post-funded in the form of levies. The
(FSCS) compensates consumers of failed authorised two costs covered through the levies relate to
financial institutions for financial loss management expenses and compensation payments
• It was created under the Financial Services and • For purposes of compensation payments, firms are
Markets Act in 2000. The scheme covers deposit- divided into five classes: deposits, life and pensions,
taking institutions, investment business, general general insurance, investments and home finance.
insurance and insurance mediation, as well as With the exception of deposits, each class is then
mortgages divided into two sub-classes of provider/intermediation
activities
Accountability
• Different classes have different levy tariffs.
• The FSCS is an independent body, but accountable to
Compensation is paid from a sub-class up to the
the Financial Services Authority (FSA) and the
threshold, after which other sub-classes within the
Treasury
broader class contribute. For deposits, compensation
is paid up to the threshold of £1,840m, which
• The Financial Services Authority appoints the Directors
represents the amount the FSA has judged that the
for the Scheme, and appointment and removal of the
deposits class can afford
FSCS’s Chairman is subject to Treasury approval
• Should the broader class reach its annual threshold,
• The levy rules for the FSCS are written by the FSA
funds will be used from a general retail pool of funds
which sits above the five broad classes
• Should even this not be sufficient, funds are borrowed

from HM Treasury and the interest from those funds is
then paid by class
Source: The Financial Services Compensation Scheme
111. It has been suggested that, in a period of very low interest rates and with the prospect of
quantitative easing becoming a tool of macro-economic management, the Debt Management
Office (DMO) (see Box 8 for a brief description), which has responsibility for managing the
Government’s cash and sterling debt, should have its mandate reviewed by the Bank and HM
Treasury. The DMO’s mandate is to “carry out the Government's debt management policy of
minimising financing costs over the long term, taking account of risk, and to minimise the cost of
offsetting the Government's net cash flows over time, while operating in a risk appetite approved
by Ministers in both cases” (DMO web-site). Suggestions for changing this mandate include the
thoughts that either it should be broadened to one that fully considers the wider economic
implications, including for monetary conditions, of its activities and of the structure of public
debt; or that it should or that it should continue to be primarily a delivery mandate but one that is
flexed to the new market realities. The DMO’s mandate should be reviewed by HM Treasury
and the Bank of England.
The UK Debt Management Box 8
Office
Overview Structure and Accountability
• The Debt Management Office (DMO) was created on
• Although the DMO is legally part of HM Treasury,
the 1st of April 1998 to carry out the Government’s
as an executive body it operates at arms’ length.
debt policy with the aim of minimising financing costs
The policy and framework of the DMO is
over time
determined by the Chancellor of the Exchequer,
• Until 1998 debt management had been the but operational decisions are delegated to the
responsibility of the Bank of England. However, with Chief Executive of the DMO
the decision to grant the Bank of England operational
independence for monetary policy the DMO was made • The DMO reports to the Debt and Reserve
a subsidiary of HM Treasury Management team at HM Treasury. The Debt and
Reserve Management team also provides the
Responsibilities
DMO with policy advice
• The DMO’s responsibilities include debt and cash
management for the UK government, lending to local • As an agency of the Treasury the DMO produces
authorities and managing certain public sector funds. It an annual business plan detailing its objectives for
has also been appointed by the Department of Energy the coming year
and Climate Change to conduct the auction of EU
allowances in the UK for Phase II of the EU Emissions • The DMO is operational rather than policy-making,
Trading Scheme and as such does not interact on a day-to-day
basis with the rest of the Treasury, but may offer
• The DMO conducts its cash management operations advice channelled through the Debt and Reserves
through a combination of trades in the sterling money Management team. The affiliated minister for DMO
markets and the issuance of Treasury bills is the Economic Secretary to the Treasury
• Before the end of each financial year, the DMO is given

its financial remit for the following year by the Treasury,
specifying the annual total gilt sales planned for the
financial year and the break-down between index-
linked and conventional gilts. The remit is usually
revised in November/December with the publication of
the pre-Budget report
Source: The Debt Management Office
Recommendation (7): HM Treasury should consider what, if any, change should be made
to the remit of the Monetary Policy Committee to reflect the fact that
interest rate policy may impact financial stability.
Recommendation (8): The macro-economic side of the Treasury should consider the
impact on macro-economic policy development of financial stability
concerns.
Recommendation (9): Consideration should be given to the micro-prudential regulator
writing a public letter to the Bank should it develop concerns that its
conduct of macro-economic policy may threaten financial stability.
Recommendation (10): In the conduct of a counter-cyclical capital regime, judgements at
the market level will be for the Bank and at the firm level for the
micro-prudential regulator.
Recommendation (11): The Authorities should conduct a full study of the pros and cons of
moving to a ‘narrow’ or ‘utility’ banking model.
Recommendation (12): The Authorities should give further consideration to the need for
increased regulation of previously unregulated activities. Clear
principles should be applied in each specific case; the relative
benefits of transparency and of indirect regulation versus direct
regulation should be considered.
Recommendation (13): The Authorities should clarify the constraints on the Financial
Services Compensation Scheme funds being used to secure the
resolution of failed institutions instead of liquidation and payout
under the scheme.
Recommendation (14): The Tripartite Authorities should give further consideration to
financial institutions, in the future, pre-funding the Financial Services
Compensation Scheme on a risk-weighted basis.
Recommendation (15): The Debt Management Office’s mandate should be reviewed by the
Treasury and the Bank of England.
The Tripartite Review Micro-prudential regulation
Overview
112. The previous chapter outlined the macro-prudential issues and the potential instruments to
mitigate these under the regulatory regime. However, there remains a challenge in determining
how to ensure that regulation is delivered effectively at the institutional level.
113. This chapter sets out the key challenges in determining the appropriate framework for micro-
prudential regulation and discusses the advantages and disadvantages of alternative responses
to these challenges, setting out five potential options to be considered during further
consultation.
Key challenges in micro-prudential regulation

114. Proper conduct of micro-prudential regulation is fundamentally about having the right sort of
people carrying out the work under the direction of senior managers who are steeped both in
the industry they are regulating and in the nature of the regulatory process. Although it would be
an over-simplification to say that prudential regulators need a completely different mindset and
training from conduct of business regulators, the focus of their work and the way it is carried out
have significant differences.
115. This reconciliation of the competing demands of prudential and conduct of business regulation
has to be done both in the context of regulating the individual firm and in setting the broad
direction and thrust of regulatory policy for the regulator as a whole. By its own admission, the
FSA failed the former test. In retrospect, it is easy to see that the focus of the FSA on the
development of policies to give the consumer of financial services a better deal (conduct of
business) was not matched over the past decade by a similar focus on developing the
prudential regime.
116. The other fundamental issue is whether, if the Bank is the macro-prudential regulator and the
FSA (or a successor body) the micro-prudential regulator, we can be certain that nothing will fall
through the crack between them. The regular exchange of letters proposed in the previous
chapter, together with better close working between the Bank and FSA, addresses this issue
but it is for further debate as to whether this will be enough. Considerations should also be
given to the development of safeguards to stop things falling down the crack, but without
causing unnecessary overlap in the responsibilities of the different authorities.
Improving the efficacy of micro-prudential regulation

117. The key criticism levelled at the FSA regarding its regulation of financial institutions in the period
prior to the crisis was that it was insufficiently focused on prudential regulation. One structural
change that has been debated to address this issue is to divide responsibility for prudential and
conduct of business regulation between separate regulatory agencies (the ‘twin peaks’ model
commonly associated with Australia and the Netherlands (see Box 9). The most compelling
justification for this structure is that it reduces the risk that one element of financial regulation
will be prioritised at the expense of the other. This has been highlighted by a range of sources,
including the US Treasury, with specific reference to the FSA, and leading academic
commentators:
“[Housing] all regulatory functions related to financial and consumer regulation in

one entity may lead to varying degrees of focus on these key functions. Limited
synergies in terms of regulation associated with financial and consumer
protection may lead the regulator to focus more on one over the other. There
may also be difficulties in allocating resources to these functions”
US Treasury, ‘Blueprint for a modernised regulatory structure’, March 2008
“[There] is a potential conflict of interest between prudential and conduct-of-

business regulation and supervision because of the different nature of their
objectives. The former is focused on solvency while the focus of the latter is on
consumer interests. The unified agency might give priority to one over the other.
It might be judged that separate agencies responsible for dedicated types of
regulation and supervision (i.e. prudential and conduct-of-business) might be
more effective at focussing on their respective objectives and mandates.”
Prof. David Llewellyn, ‘Institutional structure of financial regulation

and supervision: the basic issues’, June 2006
118. There are several further arguments in favour of a ‘twin peaks’ model, which are set out below:
• Conflicts between prudential and conduct of business regulation: There may be instances
where the mandates in relation to prudential and conduct of business regulation lead to a
conflict. For example, a conduct of business regulator might argue for early and full
disclosure of a firm’s problems while a prudential regulator might put greater weight on the
potential threat to market confidence in the institution of an early announcement. It may be
argued that any decision which involves a trade-off between these two objectives is a
political decision that must be taken openly and in the public interest, rather than being
determined behind closed doors within a single regulator.
• Clear mandates and accountability: Under the ‘twin peaks’ model each agency has
dedicated objectives and a clear mandate, enabling them to be held to account more easily.
• Reputational risk: It may be argued that dividing prudential and conduct of business
regulation limits the potential for contagion, where problems in one area of regulation
contaminate the reputation of the regulator in the other area.
Twin Peaks Box 9
Background
The ‘twin peaks’ model divides regulation on functional rather than sectoral lines. Regulation is divided between prudential
regulation, which focuses on institutions’ financial viability, and conduct of business regulation, which centres on customer
protection. The twin peaks approach assigns each of these areas to separate regulatory agencies.
Conduct of Business Prudential Central Bank
Function • Responsible for • To prevent banks and • Lender of last resort in a

promoting transparency other financial crisis
and for consumer institutions from failing
protection • This includes
• It designs and enforces monitoring capital
standards for behaviour reserves, enforcing
in the financial market legislation, and
place developing prudential
standards and
guidance
Australia Australian Australian Reserve Bank of
Securities and Prudential Australia
Investments Regulation
Commission Authority
The Netherlands Autoriteit
Financiele De Nederlandsche Bank
Markten
Relationship with Central Bank Information Collection/Sharing

• Both the Dutch and Australian central banks are • In Australia, the prudential regulator is also responsible
responsible for safeguarding systemic stability and for data collection for the financial sector. Other
exercising lender of last resort functions agencies may request the APRA to collect financial
sector data for them, and the APRA estimates that
• In Australia, the prudential regulator is separate from
approximately 80% of the data it collects is for other
the Reserve Bank, whereas in the Netherlands
agencies
prudential regulation is managed by the
Nederlandsche Bank. Certain writers therefore classify • APRA and ASIC maintain regular meeting and contacts
the Australian system as not two but ‘three-peaked’ at senior executive and operational levels. The AMF
and the Dutch Central Bank are statutorily obliged to
• The Australian decision not to give the Reserve Bank
maintain regular contact
prudential responsibilities was based on the belief that
the Reserve Bank was ill-equipped to deal with Relative Sizes/Capabilities
institutions other than banks; that it voided the
• The budget for APRA in the 2007-2008 budget was
expectation that the central bank would automatically
AUS $ 144.4 million, whilst the budget for ASIC for
provide liquidity support in the event of a crisis; and
2007-2008 was AUS $ 274 million
that separation of the central banking and prudential
functions would enable each institution to become International Links
more focused and efficient
• The Dutch central bank represents the Netherlands in
• The Dutch decision to keep prudential regulation within the Basel Committee and in the European Central Bank
the central bank was based on the view that there is a
• Australia is not a member of the Basel Committee,
strong connection between prudential regulation and
however APRA represents Australia on the
systemic stability, and that the information gathered
International Liaison Group, which is the main channel
through prudential regulation is important for effective
of communication between the Committee and non-
systemic supervision
members
Source: ‘The integration of financial regulatory authorities – the Australian experience’,
APRA, De Nederlandsche Bank, AMF, Global Financial Regulation: the Essential Guide
119. However, there are also a number of costs associated with a shift to a ‘twin peaks’ regulatory
structure. The most important of these costs are highlighted below:
• Managing conflicts: The advantages of publicly managing conflicts between conduct of

business and prudential regulation may be outweighed by the disadvantages of this
approach, including the potential for delays in resolving conflicts; the desirability of covert
regulatory activity in some instances where an optimal response (from both a prudential and
consumer interest perspective) depends on non disclosure; and the potential for separate
agencies to blame each other for any mistakes made.
• Regulatory burden: Dividing micro-prudential and conduct of business regulation may lead to
a duplication of regulatory oversight, for example by requiring banks to have multiple visits
from separate regulators rather than a single visit from an integrated regulator. This
duplication is likely to lead to an increased cost of regulation in terms of the regulatory
burden on financial institutions and a need for greater resources within regulators. Splitting
regulation across two agencies may also lead to the loss of economies of scale associated
with costs such as IT systems, staffing and knowledge sharing.
• Quality of regulatory staff: It may be more difficult to recruit and retain the most talented and
motivated staff to either institution under a ‘twin peaks’ model. The possible impact on the
quality of regulation would need careful consideration.
120. An alternative option to splitting the FSA into separate regulatory agencies along the lines of the
‘twin peaks’ model would be to reform its internal structure, with the main organisational division
becoming the split between prudential and conduct of business streams in terms of
management and oversight, resources, and links to the market and other Tripartite Authorities.
This would broadly reflect the structure that was in place at the FSA from its creation until April
2004 (see Box 10) and would have the following benefits:
• Management/executive oversight: The FSA does not currently have representation at the
Board level for the individuals responsible for prudential policy and standards or conduct of
business. Instead, the FSA Board reflects its organisational structure, with a split between
Operations, Retail Markets and Wholesale/Institutional Markets. This shift would ensure any
conflicts between prudential and conduct of business regulation, whether in terms of policy
or resourcing, would be considered at FSA board level.
• Balance of resources: By internalising the ‘twin peaks’ model within the FSA, it would be
possible to allocate an appropriate balance of staff resources between the two strands of
regulation, thus reducing the possibility that one strand will be more heavily resourced than
another. By encouraging supervisory staff to become more specialised in a given area, this
might have additional benefits of increasing the level of staff expertise in the FSA. The FSA’s
recruitment of specialist prudential and conduct of business senior advisers is a positive step
in this regard. However, senior advisers are not intended to provide a day-to-day supervisory
resource and therefore this will not be sufficient to address the wider resourcing issue within
the FSA.
• Links to the market, general public, and other Authorities: A further benefit of this approach
would be that the FSA’s contacts within financial markets, the general public and the other
Tripartite Authorities would have a greater degree of visibility regarding the individual
responsible for prudential versus conduct of business regulation within the FSA. At the Board
level, the head of prudential policy and standards could liaise with the management of the
largest financial institutions, act as an FSA spokesman, and liaise with his/her counterparts
in the Bank and HM Treasury on prudential issues. At lower levels, there could be greater
visibility for financial institutions regarding the relevant individual within the FSA addressing
prudential versus conduct of business issues for their firm.
121. While, under this model, separate pools of supervisory staff within the FSA would be necessary
if the advantages of a new internal structure are to be achieved, lead supervisory teams should
be established for each financial services firm or group, to coordinate supervisory interaction
and manage relationships. There should be a far stronger degree of co-operation than exists or
is proposed for international supervisory colleges, but it should nevertheless be on similar
principles. The lead team would then be the principal contributor to international supervisory
colleges, strengthening appropriate specialisation and skills among supervisors. Transfers of
staff between teams, together with common training and quality control processes, would assist.
both in ensuring that the regulatory burden on firms was minimised and that supervision of the
highest quality was maintained.
122. Notwithstanding the relationship between the macro- and micro-prudential regulators, there
remains a potential risk of “underlap” between them. One response to this risk could be to give
the Bank, or the Tripartite Authorities collectively, statutory powers to take corrective action in
the event that the micro-prudential regulator was not adequately addressing a threat to financial
stability. For example, if, in the course of its analysis of market, sector and institutional data the
Bank identified a threat to financial stability from certain risk exposures, then it might have the
power to require that financial institutions limit or more carefully monitor risk exposures to
certain asset classes or counterparties. If this were to be a collective power of the Tripartite
Authorities, then in the event of a disagreement between the Bank and micro-prudential
regulator, HM Treasury would effectively make the final decision.
123. The potential advantages and disadvantages of combining macro- and micro-prudential
regulation within the Bank should also be considered. On one hand, this would mean that the
judgement on all prudential matters was in one body, clarifying accountability and enhancing the
authority of the regulator. On the other hand, it would internalise the proposed challenge
function between the macro- and micro-prudential regulator, risking a loss of clear focus on the
distinct macro perspective and raising concerns over whether the conduct of monetary policy
might be inappropriately influenced by concerns for the health of the financial sector.
124. The main practical question with this model is how, in a world of integrated financial services
firms which, for example, combine banking and insurance groups, the micro-prudential
regulatory function could be split either along old-style bank, insurance, asset management etc.
lines, or between systemic and non-systemic institutions. In addition to this concern, there
would be a risk that making the Bank responsible for micro-prudential regulation would lead to
challenges associated with prioritisation and management focus in relation to the Bank’s other
responsibilities of maintaining monetary stability and maintaining financial stability from a
macro-prudential standpoint.
FSA organisational charts Box 10
February 2009 and June 1998

FSA Organisational Chart – February 2009 (simplified)
Chairman
Chief Executive Officer
Wholesale &
Operations Retail Markets
Institutional Markets
Cross – FSA sector teams

Industry Sectors: Banking Sector | Insurance | Retail Intermediaries & Mortgage | Asset Management
Thematic Sectors: Auditing and Accounting | Capital Markets | Financial Stability
Wholesale &
Operations Divisions Retail Markets Divisions Institutional Markets
Divisions
FSA Organisational Chart – June 1998 (simplified)
Chairman
Chairman
Chief Executive Officer Managing Director & Head
Managing Director & ManagingChairman
Director & Head Managing Director & Head
of Authorisation,
Managing
Chief Director
Operating &
Officer Managing Director
of Financial & Head
Supervision of Authorisation,
Enforcement & Consumer
Managing Director & Head
Chief Operating Officer of Financial Supervision Enforcement
Managing & Consumer
Relations
Director & Head
Managing Director & Managing Director & Head of Authorisation,
Managing
Chief Director
Operating &
of Financial & Head
Supervision ManagingRelations
Director & Head
of Authorisation,
Managing
Chief Director
Operating &
of Financial & Head
Supervision of Authorisation,
Relations
Managing Director & Head
Chief Operating Officer of Financial Supervision Enforcement & Consumer
Relations
Managing Director & Managing Director & Head of Authorisation,
Chief Operating Officer of Financial Supervision Relations
Authorisation,
Human Resources & Relations
Financial Supervision Authorisation,
Enforcement and
Human Resources
Business Planning&
Financial Supervision
Divisions Enforcement
Consumer and
Relations
Business Planning
Divisions
Divisions Consumer Relations
Divisions
Authorisation,
Human Divisions
Resources &
Financial Supervision Divisions and
Authorisation,
Enforcement
Human Resources
Business Planning&
Financial Supervision
Divisions Enforcement
Consumer and
Relations
Business Planning
Divisions
Divisions Consumer Relations
Divisions
Divisions
Divisions
Source: FSA website, FSA Annual Reports, FSA ‘The supervision of

Northern Rock: a lessons learned review’
125. The decision on restructuring the UK’s system of financial regulation must be based on an
analysis of costs and benefits of such a change. Under ordinary circumstances, structural
reform is likely to lead to a number of costs and uncertainties, with particular risks including the
loss of key personnel and the risk of unexpected problems during the change management
process.
“[Change may introduce a] “Pandora’s Box” effect: a bargaining process is

opened between different interest groups; the legislative process might be
captured by vested interests; loss of key personnel; [and] managerial diversion
from the core activity of regulation and supervision”
Prof. David Llewellyn, ‘Institutional structure of financial regulation and supervision: the
basic issues’, June 2006
Having decided that fundamental reform to the regulatory structure is necessary, consideration
would have to be given to the most appropriate time to implement these reforms and the most
effective way in which to implement them, in order to minimise disruption to the ongoing efforts
to deal with the financial crisis.
126. There is a very wide range of views regarding the ideal structure of prudential and conduct of
business regulation in the UK and as the analysis above indicates there are arguments in favour
of each proposal. However, in order to take the debate forward in a structured way, the
following five options have been set out as meriting particular debate during the further
consultation phase of this work:
1 The FSA should retain its present responsibilities but move to a new structure with
Prudential and Conduct of Business divisions at its heart, rather than its present structure
focused on Retail and Wholesale divisions. This would ensure that the FSA had a better
balance going forward between its prudential and conduct of business activities; that
prudential regulation was put at the heart of the organisation; that the FSA was better placed
to grow individuals with the appropriate skills and mindset to be cutting edge prudential
regulators; and that there was a head of Prudential on the FSA board who could speak for
the organisation and who could act as the key interface with the Bank on financial stability
issues.
2 The FSA should be reorganised as in 1 but, in addition, there should be new statutory
powers for the Bank to take direct regulatory action in respect of individual regulated firms if
it (or the Tripartite Authorities collectively) believed that there was a threat to overall financial
market stability which was not being adequately addressed by action being taken by the
FSA. This would create an additional safety net over what I have already proposed for the
Bank’s new macro-prudential role. If this were to be a power of the Tripartite, rather than of
the Bank, it would effectively be for the Treasury to decide in the face of a disagreement
between the Bank and FSA.
3 The FSA should be abolished and replaced with two separate regulators, one with
responsibility for prudential regulation and one for conduct of business regulation. This would
give complete clarity of purpose and focus to the two regulators but would pose challenges
in co-ordinating the regulation of individual regulated firms – and would mean that most firms
would have to deal with an additional regulator.
4 A combination of models 2 and 3, with the Bank or Tripartite having power to step in over the
head of the prudential regulator in exceptional circumstances.
5 Under options 3 and 4, the micro-prudential regulator, of banks or of the whole financial
sector, could be folded into the Bank of England.
Recommendation (16): Consideration should be given to the structure of the micro-

prudential regime, with five options meriting particular debate:
1. Restructuring the internal organisation of the FSA to put
prudential regulation at its centre
2. Restructuring the FSA as in 1 but giving the Bank/Tripartite
additional statutory powers to take direct regulatory action in
exceptional circumstances
3. Abolishing the FSA and replacing it with two separate
regulators, one for prudential and one for conduct of business
regulation
4. A combination of 2 and 3, with the Bank/Tripartite able to step in
over the head of the micro-prudential regulator in exceptional
circumstances
5. Under options 3 and 4, the micro-prudential regulator, of banks
or of the whole financial sector, being folded into the Bank of
England.
The Tripartite Review Strengthening regulatory capabilities
Strengthening regulatory
capabilities
Overview
127. This chapter discusses each Authority in turn and sets out the key areas in which they may
strengthen their capabilities in delivering their proposed regulatory roles.
128. The discussion emphasises areas where changes to the role of the Authority or previous
observed weaknesses in their handling of regulation imply a need for improved capabilities.
Bank of England
Strengthening the Bank’s Financial Stability capability
129. The proposed regulatory framework will require the Bank of England’s Financial Stability
function to play a greater role because of its responsibility for macro-prudential regulation.
However, the resources available within the Financial Stability Directorate have declined
significantly in recent years, with staff numbers reduced from approximately 180 in June 2003 to
120 in April 2008. This has been highlighted by Sir John Gieve in his recent speech to the
London School of Economics and Political Science:
“[Financial Stability] was not mentioned in the 1998 Act and appeared something
of an orphan in the Bank when supervision moved to the FSA”
Sir John Gieve, Speech to the London School of Economics and Political Science,
February 2009
130. While we recognise that the quality of oversight depends primarily on the effectiveness of
people involved rather than on the level of resource available, staff numbers in the Bank’s
Financial Stability team may need to be increased in light of the proposed extension of the
Bank’s role. It will be a matter for the Governor and Court, on the recommendation of the
Deputy Governor for Financial Stability, to decide what additional quantity and quality of
resource will be needed to fulfil this remit.
Strengthening the Bank’s governance and access to external advice in relation to Financial
Stability
131. The Bank’s delivery of its financial stability remit – including its macro-prudential responsibility
and its role in relation to the resolution regime – will be supported to the extent that the Bank
can strengthen its governance in relation to Financial Stability and improve its access to advice
from expert outsiders.
132. The Financial Stability work of the Bank is not currently subject to the same level of oversight
and accountability as for Monetary Stability. There remains a discrepancy in the governance
responsibilities of the Bank’s Non-Executive Directors in relation to Financial Stability and
Monetary Stability. According to the Bank of England’s 2007 annual report, the Non-Executive
Directors are responsible for:
“Reviewing the performance of the Bank in relation to its objectives and strategy,
monitoring its financial management, and reviewing the procedures of the MPC”
Bank of England’s 2007 Annual Report
133. The problems associated with the absence of a stated role for the Non-Executive Directors in
relation to the Bank’s Financial Stability work were recognised by a formal Board evaluation in
2006.
“During 2006/07, [the Committee of non-executive Directors] considered how it

could increase its engagement and familiarity with the Bank’s financial stability
work ... Greater engagement is desirable so that non-executive Directors can
assess the approach, processes and resources employed more effectively,
consistent with their responsibilities to review performance against objectives.”
Bank of England’s 2007 Annual Report
134. Progress was subsequently made, with the introduction of quarterly financial stability reports to
the Court of Directors and the introduction of regular attendance of the Risk Policy sub-
Committee of the Court at Financial Stability Board meetings. However, the Risk Policy
Committee was dissolved in 2007 and the Bank’s 2007 Annual Report contains relatively little
reference to financial stability oversight.
135. The apparent weakness of the Bank’s internal oversight of its financial stability is also reflected
in the lack of a public assessment of its own conduct in the period leading up to the collapse of
Northern Rock, which is striking given the FSA’s internal review of its performance. The Bank
should produce such a report in order to assure the public that any lessons have been learnt
and to strengthen public confidence in the Bank.
136. Given the proposed increase in the Bank’s financial stability role, it is desirable to strengthen the
Bank’s governance in relation to financial stability to ensure that a transparent process is
followed when making financial stability decisions, with clear lines of accountability between
executive decision-makers and the non-executive Directors responsible for overseeing the work
of the Bank. There will also be an increased need to ensure that decisions on financial stability
are taken with input from across the Bank’s executive, in order to ensure that insight from the
Monetary Stability, Financial Stability, Markets and Banking directorates at the Bank are taken
into account.
137. The Bank would benefit from an advisory board that would provide its executives responsible for
financial stability with a formal channel to access independent sources of expert advice. The
Financial Stability Committee (FSC) – to be established under the Banking Act, 2009 (see Box
11) – has been developed with the intention of increasing the Bank’s access to sources of
expert advice. However, there has been a significant degree of confusion regarding its potential
executive powers. For example, references by the Chancellor to the similarity between the FSC
and the Monetary Policy Committee, as well as the FSC’s structural position as a subcommittee
to the Court of the Bank, suggest that it will have executive functions:
“[We] will build on the very positive experience of the Bank's Monetary Policy
Committee”
Alastair Darling, Mansion House speech, June 2008
Submissions by HM Treasury to the Treasury Select Committee have not clarified whether the
FSC will be advisory or executive in nature:
“The primary function of the committee will be advisory, providing an effective

source of expertise and guidance to the Bank’s executives and staff on the
execution of the policy levers it has, relating to financial stability such as the
SRR... It will also advise Court on the overall strategy for developing and
implementing the Bank’s financial stability objective. The legislation is
appropriately flexible, allowing for the role of the Committee to evolve, and for
Court to delegate further responsibilities to it, for the purpose of pursuing the
Financial Stability Objective”
HM Treasury, Written response to Treasury Select Committee, October 2008
138. The FSC in its proposed form will conflate the objectives of strengthening the workings of the
Bank’s executive in relation to financial stability and providing it with access to independent
expert advice. These issues should be dealt with separately and we have discussed potential
reforms to the Bank’s executive above. The Bank’s Board of Banking Supervision was used in
the past as a means of ensuring that senior officials within the Bank were able to call upon
expert advice from market practitioners (see Box 12).
Board of Banking Supervision Box 12
Background
• The Board was created following the 1987 the Banking Act. It comprised the Governor of the Bank of England, the
Deputy Governor, the executive director of the Bank responsible for banking supervision, and six independent
members, who were primarily bankers active in the market place and jointly appointed by the Governor and the Bank
of the Exchequer
• It was set up with the objective of bringing in external expertise to inform the Bank’s decisions on financial stability
• The responsibilities of the Board included giving advice to the Bank in matters relating to financial sector supervision,
justifying the advice it has given to the Bank to the Chancellor, and producing an annual report explaining any
disagreements between the Board and Bank of England that were reported to the Chancellor
Composition of the Board
Chair (Governor of the Bank

of England)
Other ex- Independent

officio Members
members of
the Board
Deputy Executive Six independent members

Governor Director
(BoE) (BoE)
Source: Bank of England, Banking Supervision: Regulation of the

UK Banking Sector under the Banking Act 1987
139. The Board of Banking Supervision, which operated in the period prior to the creation of the FSA,
provides a model for creating a new advisory board. The Bank should consider developing an
analogous solution to its ongoing requirement for expert advice or reconstituting the Financial
Stability Committee to be a truly advisory panel. The advisory board should be chaired by the
Deputy Governor for Financial Stability and should meet quarterly. In order to ensure that the
advisory board has an appropriate mix of skills and experience, and to reduce the potential for
conflicts of interests to prevent particular members from participation, consideration should be
given to the appropriate mix of current and retired market practitioners, as well as the range of
skills between those members with financial, legal and accountancy backgrounds.
140. A rather more radical idea is that, instead of the present Court/MPC governance structure, the
Bank should be governed by one board looking somewhat like the present MPC but with
additional members with expertise relevant to the financial stability objective. This board, similar
to that of the Federal Reserve in the USA, would execute both the monetary policy and financial
stability remits of the Bank. Although the challenge function of independent non-executive
directors would be lost, this is a model worth debating: it is difficult to understand why public
sector bodies, which usually have very different functions and accountabilities to private sector
companies, should increasingly, and unthinkingly, have to ape the standard private sector
corporate governance model.
141. There is also a need to clarify the role of the Deputy Governor for Financial Stability, and the
qualifications required of applicants to the position. This role is central to the Bank’s
engagement with financial markets, as well as its overall financial stability work, and therefore it
may be desirable for the Deputy Governor to have had previous experience outside the Bank.
On the other hand, we recognise the value of creating opportunities for internal promotion within
the Bank, in order to ensure it can recruit and retain the most talented staff, and therefore the
Bank should take steps to ensure that its own staff have opportunities to gain this direct market
experience via a programme of secondments. There should be a published definition of the role
and the skill set required of a prospective Deputy Governor for Financial Stability. This will then
allow for proper succession planning – which should start soon after the appointment of the
Deputy Governor.
Recommendation (17): The Bank’s executive should consider whether it requires more
resources to deliver its enhanced Financial Stability mandate.
Recommendation (18): The Bank should strengthen its governance in relation to
Financial Stability.
Recommendation (19): The Bank of England should produce a public assessment of its
own conduct in the period leading up to the collapse of Northern
Rock.
Recommendation (20): The remit of the Bank’s Financial Stability Committee established
under the Banking Act, 2009 should be amended to remove any
executive function and to make it an advisory group of market
experts.
Recommendation (21): The Bank should clarify the role and qualifications required for the
Deputy Governor for Financial Stability and take steps to plan for
the succession of future Deputy Governors.
Financial Services Authority

Financial crime and consumer education
142. The potential changes to the FSA’s role, responsibilities and internal structure were outlined in
the previous chapter. With a much greater focus on prudential regulation at the heart of the
organisation, or by creating a separate prudential regulator, the task should be clearer but it will
not be easy and will take a number of years, involving a mix of growing talent internally as well
as hiring in people from the market, either on a permanent or secondment basis. Should the
FSA retain its role in prudential regulation, its focus will be improved to the extent that it can
shed any of its present policy areas.
143. The FSA currently has two further statutory objectives in addition to its micro-prudential and
conduct of business responsibilities: reducing financial crime; and promoting public
understanding of the financial system. Allocating these responsibilities to other regulatory or
public bodies would allow the FSA to focus more resources and management time on its core
regulatory responsibilities. Further analysis is required before making a definitive commitment to
reallocate these responsibilities, however we have included a brief overview of the FSA’s role in
both of these areas below, along with commentary on the issues associated with allocating
these roles to another body. Such an analysis could be linked to a wider review of the
framework for tackling financial crime which many argue is currently failing.
144. The FSA’s role with respect to reducing financial crime is complex, as there is a wide range of
public authorities engaged in reducing financial crime in the UK and there is also a greater
degree of overlap with some areas of the FSA’s regulatory responsibilities. However, the FSA,
in consultation with other public authorities involved in reducing financial crime, should consider
ways in which it can limit its role in order to increase the focus on prudential regulation without
undermining the UK’s response to the threat of financial crime.
145. The FSA’s responsibility for monitoring financial institutions’ systems and controls to prevent
financial crime (primarily money laundering) is one area where the FSA may be able to reduce
its responsibilities without materially undermining the UK’s capabilities in reducing financial
crime. In the US, the Treasury is responsible for working with financial institutions to reduce
money laundering (see Box 13), and it would be possible to build up the existing HM Treasury
Financial Crime team in the UK to take on this role.
146. The FSA also has a role in working to prevent criminal fraud from ‘boiler room’ schemes, where
groups of professional criminals seek to defraud consumers, although this role has been
challenged in the High Court. There are very limited synergies between this work and the FSA’s
regulatory role, while transferring responsibility to law enforcement agencies such as the
Serious Organised Crime Agency might be expected to yield benefits by pooling expertise in
combating organised financial crime.
147. The FSA’s responsibilities as market supervisor mean that it would continue to have clear
responsibilities in relation to market related financial crime, with a statutory duty to prosecute
insider dealing and the offence of making “misleading statements” about the price or value of
investments with a view to inducing others to trade. Other prosecutors appear to accept that the
FSA has the lead responsibility in this area, and have not initiated any new proceedings relating
to these crimes committed after 2002. The FSA is able to apply a range of financial, civil and
criminal sanctions in this area that other agencies cannot and therefore may be better
resourced to retain its role in reducing market related financial crime.
148. This issue was the subject of an article by Sir Ken Macdonald, QC, former Director of Public
Prosecutions, in The Times on 23 February, 2009, in which he wrote:
“In Britain, no one has any confidence that fraud in the banks will be prosecuted
as crime. But it is absolutely critical to public confidence that it should be ... So
we need a single powerful authority to take the place of the failed Financial
Services Authority and the embattled Serious Fraud Office. Independent and
strong, it should have responsibility for both regulation and prosecution”
Sir Ken Macdonald, Article in The Times, February 2009
Financial Crime Box 13
US Model
Securities and Financial Crime Office of Terrorism Asset Forfeiture and Federal Bureau of
Exchange Enforcement and Financial Money Laundering Investigation
Commission Network Intelligence Section
Location Independent agency Operates under the Operates under the Department of Law enforcement
of the government US Treasury US Treasury Justice, Criminal agency
Division
Main functions in Holds primary Collects and analyses Consists of Office of Focuses on legislative Promotes the
relation to financial responsibility for information on Terrorist Financing and policy proposals investigation and
crime regulating and financial transactions and Financial Crime affecting asset prosecution of money
enforcing laws related in order to combat and the Office of forfeiture laundering across the
to the securities financial crimes Intelligence and US
industry Analysis. Focuses on
combating money
laundering and
terrorist financing
domestically and
internationally
Further/other Has the power to bring Also responsible for Coordinates

responsibilities civil enforcement developing and investigations and
actions against firms enforcing regulation prosecutions and
or individuals in relating to the Bank manages the
breach of federal law Secrecy Act centralized asset
forfeiture programme
UK Model
City of London The Serious Fraud HM Revenue and Department of Financial Services
Police Fraud Office Prosecution Customs’ Business, Authority
(SFO) Service Prosecution Enterprise &
Office Regulatory Reform
Location Law Enforcement Government Part of the Crown Government Government Independent
Agency Department Prosecution Department Department Regulator
Service
Main functions in The lead force for Has as its Has as its Prosecutes cases Investigates cases of Investigates insider
relation to investigating mandate to mandate to of financial crime suspected fraud that dealing, money
financial crime economic crime pursue and pursue and investigated by arise from its general laundering, forgery
across the UK prosecute those prosecute those HM Revenue and work. Investigations and more specific
and especially in involved in involved in Customs and the into suspected crime offenses under the
the City. Is serious and serious and Serious are conducted by its strategy of ‘credible
involved in complex fraud. complex frauds. Organised Crime companies deterrence’. It may
investigating and Primarily focuses Cooperates Agency (SOCA). investigation branch. apply three penalties:
prosecuting cases on frauds where closely with the Handles cases Leads on action to financial, civil
involving fraud the amount in SFO, but involving tax fraud close firms which penalties or criminal
and money issue is larger generally deals and money persistently fail to prosecution.
laundering than £1m with cases laundering meet the Although its market-
involving lower requirements of the related duties are
monetary values Companies Acts clear under the 2000
(starting from Act, recently it has
£750k) also been reviewing
its status in
prosecuting non-
market crimes
In addition, the National Fraud Strategic Authority was created on the 1st of October, 2008. However, this agency is still very much
in its infancy, and its role and responsibilities vis-à-vis the existing financial crime agencies remain unclear.
Sources: Securities and Exchange Commission, Financial Crime Enforcement Network, US Treasury, Financial Action Task Force,
Financial Services Authority, HM Revenue and Customs, The Serious Fraud Office, Fraud Prosecution Service, Department of Business,
Enterprise and Regulatory Reform, City of London Police
149. The FSA is currently the only UK body with a statutory objective to promote public
understanding of the financial system. The FSA’s role in this respect has been enhanced
following the Thoresen Review of generic financial advice, which recommended that the FSA
should be made responsible for the provision of Money Guidance, in addition to its ongoing role
in promoting public understanding of the financial system. The FSA’s capability and
effectiveness in consumer financial education is widely recognised and there are no other public
bodies in the UK with a significant existing capability in this area, so carving out the FSA’s
consumer education team represents a risk in terms of costs of change and potential impact on
the quality of provision. However there are limited synergies with the remainder of the
organisation and there are successful alternative models for the provision of financial education
internationally (see Box 14). As a short to medium term recommendation, we believe that the
FSA should continue to take steps to ensure that the consumer education team, including FSA’s
responsibility for Money Guidance, is managed and resourced separately from its regulatory
teams, with a view to minimising the potential for the FSA’s consumer education role to reduce
the FSA’s focus on prudential regulation and to reduce the potential costs of a future carve out
of consumer education from the FSA.
Financial Education Box 14
Background
Under the New Zealand system, consumer financial education is separate from the financial regulator, and is primarily the
responsibility of the Retirement Commission. The Ministry of Consumer Affairs supplements the education provided by the
Retirement Commission by providing further educational resources for school children
The Retirement Commission The Ministry of Consumer Affairs

• The Retirement Commission is an autonomous entity • The Ministry of Consumer Affairs, which is a part of the
funded by the government and delivering financial Ministry of Economic Development, also has the
education to New Zealanders is one of its key ‘provision of appropriate, accurate and accessible
functions information, education and advice for consumers and
businesses’ as part of its remit
• The Commission has been involved in developing
personal financial education programmes since the • This primarily involves advice on consumer
mid-1990s.The Commission’s status as an representation, administration of consumer legislation,
autonomous entity means that it has a degree of and development of consumer policy
independence from the government, although it is
• In terms of financial education, the Ministry focuses on
required to ‘have regard to’ government policy
supplementing the Retirement Commission’s work with
• The Commission focuses on financial literacy, which it school children by providing further educational
defines as ‘the ability to make informed judgments and resources for teachers
take effective decisions regarding the use of and
management of money’
Comparison with the UK
• The Commission runs a web-site called ‘sorted.org.nz’
for the purpose of assisting adults in managing their • In the UK financial education is the responsibility of the
finances. The web-site targets all demographic groups financial regulator, the FSA. The FSA is currently the
only agency responsible for consumer education
• In addition, the Commission also runs surveys to
assess financial literacy among adults, evaluates its • The FSA’s Financial Capability team (in charge of
impact on consumer awareness, and designs consumer awareness) is part of Retail Markets
strategies for reaching the most vulnerable groups
• The FSA similarly runs a financial education web-site:
‘moneymadeclear.fsa.gov.uk’
• The FSA has also been made responsible for the
government’s scheme to provide generic financial
advice following the Thoresen Review
Source: New Zealand Ministry of Consumer Affairs, New Zealand
Retirement Commission, Financial Services Authority, OECD
Resources and expertise

150. There appears to be confusion among many regulated institutions and market participants
regarding the steps being taken by the FSA to strengthen its regulatory capabilities; the FSA
has not yet convinced financial institutions that its ongoing work to build its capability is
delivering results. We have been heard concerns expressed regarding the level of
remuneration, expertise and market experience of FSA supervisory staff, with the head of one
major UK financial group expressing a willingness to incur greater costs through the regulatory
levy to help the FSA build its capability.
151. The FSA should increase further its ability to recruit and incentivise highly experienced
supervisors and policymakers from the private sector and maintain the attractiveness of a
career in regulation for its most talented junior staff by offering clear avenues for rewarding
career progression. The recommendations set out within ‘Reconstruction: Plan for a Strong
Economy’ in September 2008 – to increase the levy on financial services firms to fund an
increase in FSA remuneration and to require financial institutions to participate in a secondment
scheme – will help in this regard. The FSA’s business plan for 2009/10 also clearly recognises
these issues:
“In response [to the Internal Audit report], the FSA designed and launched a
Supervisory Enhancement Programme which entails important changes in our
internal processes, a significant intensification of our supervision of large
systemically important firms, and major investment in the number and skills of our
staff devoted to that supervision. In total, about 280 additional staff will be
recruited… We will have appointed around 280 staff involved in the supervisory
process in the first half of 2009/10, through external recruitment and staff
deployment. External recruitment will be used to fill specific skills or knowledge
requirements and ensure the right mix of regulatory and market experience”
FSA Business Plan 2009/10
Recommendation (22): The Authorities should consider transferring responsibility for

financial crime policy out of the FSA. This could be linked to a wider
review of the framework for tackling financial crime.
Recommendation (23): The Government and FSA should review the latter’s role in relation
to consumer awareness.
Recommendation (24): The FSA should increase further its ability to recruit and incentivise
highly experienced supervisors and policymakers from the private
sector.
HM Treasury
152. HM Treasury will continue to play a pivotal role in maintaining the UK’s financial stability, due to
its role in developing the Government’s fiscal policy and its decision-making role as part of the
Tripartite Authorities, particularly where the Authorities are required to make decisions involving
public finances in the event of an institutional failure. It has been suggested by a number of
parties that HM Treasury lacked the resources and expertise to fulfil these roles in the period
preceding and immediately following the start of the financial crisis in mid-2007. While we
recognise that HM Treasury has strengthened its capabilities since that time, there remains
scope for further improvement, particularly in the quality of HM Treasury’s financial markets
expertise.
153. There remains a risk that HM Treasury’s capabilities with regard to the financial stability are
downgraded when the current crisis subsides, as other issues take greater priority. The
evidence from the current crisis demonstrates that financial stability is of such centrality to the
UK economy that HM Treasury must retain sufficient resources and capabilities to participate as
an equal in the decision-making process with the other Tripartite Authorities in the event of a
future financial crisis. To preserve this capability, the Permanent Secretary should set out in HM
Treasury’s annual report to Parliament how HM Treasury resources devoted to handling issues
of financial stability have been developed and maintained during the year. Related to this point
is the short duration of many HM Treasury postings, where it is desirable to incentivise officials
to spend a greater amount of time in a post in order to build up their expertise in financial
stability issues.
154. In addition to reporting to Parliament on the appropriateness of its capabilities, HM Treasury

should also evaluate the overall financial stability legislative and regulatory framework every
three years.
155. The Treasury’s internal organisation may need to be strengthened in order to support this
financial stability role. One of HM Treasury’s key resources for crisis handling should be its
Corporate Finance team, which also has a working relationship with the Government’s central
repository of corporate advisory skills, the Shareholder Executive. These resources need to be
used effectively to manage the Government’s response to future financial crises, and as such
consideration should be given to putting at least the Corporate Finance team into the same
Treasury division as Financial Services. The Government should also consider placing all the
private sector facing policy areas of the Treasury, including financial services, corporate finance
and enterprise, into a single directorate in order to more effectively coordinate the Government
response to future financial crises.
Recommendation (25): HM Treasury should maintain a sufficient financial markets

expertise at all times.
Recommendation (26): The Permanent Secretary to the Treasury should report annually
to Parliament on the appropriateness of HM Treasury’s expertise
and resources in relation to financial stability.
Recommendation (27): HM Treasury should report every three years on the
appropriateness of the legislative and regulatory framework for
financial stability.
Recommendation (28): HM Treasury’s Corporate Finance team should be put into the
same HM Treasury division as financial services policy.
The Tripartite Review Inter-authority and international relationships
Inter-authority and
international relationships
Overview
156. This chapter discusses the links between the Authorities that will be required to operate
successfully under the proposed new framework and considers the respective responsibilities of
the Authorities for international negotiations and relationships.
Placing an institution into the Special Resolution Regime

Determining whether an institution is systemic
157. One of the key areas of overlap under the Tripartite system concerns decision-making when a
financial institution fails or is at risk of failing. This requires the Tripartite Authorities to make a
decision regarding whether an institution is systemic and whether/when to put an institution into
the Special Resolution Regime (SRR).
158. An assessment of whether an institution should be provided with liquidity support or placed into
the SRR in the event of its failure depends upon a judgement regarding whether a disorderly
failure could have systemic effects. There is currently a lack of transparency around the criteria
used to determine whether an institution is systemic, leading to the risk that decision-making
may become politicised in the event of an institutional failure. In order to limit this risk, the
Authorities should maintain a list of systemically important institutions at all times, based on
clear published criteria (see Box 15 below for an overview of the US CAMELS criteria for
determining the ongoing viability of a bank). To avoid concerns around moral hazard, this list
should not be made public but should be subject to Parliamentary scrutiny in the event of a
decision to support an institution or to allow it to fail.
159. While it is recognised that the question of which institution is or is not systemic will, to some
extent, be situation specific, the existence of a standing list will form a useful starting point for
discussions by the Authorities. It should go some way to heading off, for example, the perhaps
understandable assumption of some politicians for whom financial stability is not an every day
concern that if a financial institution has, say, a concentration of customers in a particular
geographic region of the UK that, in itself, makes the institution systemic.
160. The creation and maintenance of a list of systemic institutions should be the responsibility of the
Bank of England, because of its responsibility for systemic stability and its additional roles in
relation to the payments system. The Bank should compile and maintain this list in consultation
with the micro-prudential regulator, as the micro-prudential regulator will have a greater level of
familiarity with individual institutions’ management and financial data.
US CAMELS ratings Box 15
Background
• The United States does not keep a general list of criteria to draw on in deciding which institutions to recapitalise in the
event of financial crises – however, in dealing with the most recent downturn, the US Treasury has made use of
CAMELS ratings to form an impression of which institutions may be financially viable in the longer term
• CAMELS ratings are a number from one to five which reflects an assessment by regulators of the institution, and
provides a ‘snapshot’ view of a bank’s financial condition
• The United States does not keep a list of systemically important institutions
CAMELS ratings Use of ratings

• CAMEL ratings were introduced by the Federal • CAMELS ratings are used by the three federal banking
Reserve in 1979, with the ‘S’ for ‘Sensitivity’ added in supervisors (the Federal Reserve, the Federal Deposit
1996 Insurance Corporation and the Office of the Comptroller
of the Currency) and other financial supervisory
• CAMELS ratings are based on financial statements
agencies to provide an overview of a bank’s financial
provided by the bank as well as inspections by the
condition. CAMELS ratings may be used to assess a
Federal Reserve, the Office of the Comptroller of the
bank’s current condition as well as to help assess the
Currency and the Federal Deposit Insurance
probability of bank failure
Corporation. CAMELS stands for Capital adequacy,
Asset quality, Management, Earnings, Liquidity and • In order to prevent bank runs, an institution’s CAMELS
Sensitivity to market risk score is not made public but made available only to top
management of the institution and the appropriate
• Each one of the criteria under CAMELS is assessed
supervisory staff. Institutions receive a number from
following a number of evaluation factors outlined under
one to five, with 1 being the most favourable
the revised Uniform Financial Institutions Rating
System (UFIRS) • An institution’s CAMELS score also determines the
risk-based premium it pays to the Federal Deposit
Insurance Corporation and deposits in institutions with
a score less than 3 will not be insured
• In the case of the recent US bank support operations,
which were approved through the Emergency
Economic Stabilization Act, CAMELS ratings were
among the criteria used to decide which institutions
should qualify for support
Sources: Federal Reserve Bank of San Francisco, US Treasury,

Federal Deposit Insurance Corporation
The ‘trigger mechanism’

161. There has been considerable debate regarding which Authority should be responsible for the
‘trigger mechanism’, the decision to put an institution into the SRR. Under the Banking Act
2009, the FSA will be the sole institution with the right to pull the trigger, although it must consult
the Bank and HM Treasury before doing so:
“[Initiation] of the regime would be subject to an assessment by the FSA ...

[although this decision would] only be taken following intensive discussion and
consultation between the Treasury, the Bank of England, and the FSA through
the Standing Committee”
Tripartite Authorities, ‘Financial stability and

depositor protection: special resolution regime’,
July 2008
162. However, the Governor of the Bank of England and other respondents to the Treasury Select
Committee have expressed concern that giving the FSA the exclusive right to recommend that
an institution should be placed into the resolution regime may lead to the risk of regulatory
forbearance and have argued that the Bank should also be able to recommend that an
institution be placed into the resolution regime:
“I do not think that [a recommendation to place an institution into the resolution

regime] should be left entirely with the supervisor, because, as many of my
overseas colleagues never cease to point out, the reason why they have
someone other than the supervisor with the ability to pull the trigger is because of
their concerns about regulatory forbearance, the natural reluctance of a
supervisor to announce publicly that the supervision regime has not been
successful”
Mervyn King, Evidence to the Treasury Select Committee, April 2008
163. We recommend, in line with the Treasury Select Committee, that the FSA (or its successor body
responsible for micro-prudential regulation) should retain sole responsibility for pulling the
trigger, but that the Bank should be given a formal power in statute to recommend that an
institution be placed into the resolution regime.
Recommendation (29): The Bank of England, in consultation with the micro-prudential

regulator, should maintain a confidential list of systemically
important financial institutions.
Recommendation (30): The Bank of England should have a statutory right to recommend to
the micro-prudential regulator that an institution be placed into the
Special Resolution Regime.
Strengthening public communication

164. A further critical function during periods of institutional stress or failure is to manage
communications with financial markets and consumers, to minimise the risks of contagion prior
to or following an institutional failure. The central importance of confidence in the financial
system requires that a premium is placed on maintaining confidence in systemic stability, as a
loss of confidence can lead to systemic collapse and the inability of the banking system to
perform its maturity transformation role. Regulators have a key role in maintaining confidence in
the financial system during periods of institutional stress or failure, to avoid creating the
(potentially self-fulfilling) impression that an institutional failure might cause systemic failure, and
this role requires them to communicate effectively with financial markets and consumers to
maintain confidence.
165. Each of the Tripartite Authorities will have a significant role to play in communicating with the
public and markets in the event of institutional stress or failure; by communicating in an
integrated way the Authorities can have a positive impact on maintaining confidence in the UK’s
financial system and the effectiveness of its regulatory agencies. However, the lead role in
communicating with the public in the event of an emerging threat to financial stability should be
played by HM Treasury, specifically the Chancellor of the Exchequer, since this will serve to
emphasise the level of engagement by the political leadership to prevent systemic collapse and
to protect depositors.
166. The continuous stream of leaks of market sensitive information to the press during the crisis
emphasises the need for members of the Tripartite Authorities to be given regular training in the
rules concerning the handling of price sensitive information. The Authorities should also
consider whether sufficient investigation has been carried out into the leaks of price sensitive
information to the media since September 2007, including the leaking of the liquidity support
operation for Northern Rock in September 2007 (see Box 4) and the bank recapitalisation
package in October 2008.
Recommendation (31): The Tripartite Authorities’ Principals should play an active role in
communicating with markets and the general public in the event of
institutional stress or failure, but the lead role should be played by
the Chancellor of the Exchequer.
Recommendation (32): Members of the Tripartite Authorities should be given regular
training in the rules concerning the handling of price sensitive
information.
Recommendation (33): The Authorities should consider whether sufficient investigation has
been carried out into the leaks of price sensitive information to the
media since September 2007.
Improving the co-operation between the Tripartite Authorities

Meetings between the Tripartite Principals
167. There are no publically available records or minutes of meetings between the Tripartite
Principals. However, we have been told that there was only one formal meeting of all three
Principals in the ten years prior to the collapse of Northern Rock. The lack of a personal working
relationship between the Principals may have contributed to the slowness and uncertainty of the
regulatory response to the crisis in mid-2007 and should be avoided in the future. There should
be much more frequent meetings of the Principals, consisting of:
• At least three formal meetings of the Principals and the Standing Committee Deputies per
year, at which the Principals would be fully briefed on issues discussed by the Deputies and
their teams in the previous three months
• At least three informal sessions between the Principals per year, to allow them to develop a
common understanding of each others’ perspectives regarding key issues in relation to
financial stability
168. A model for regular principal interaction can be found in the US President’s Working Group (see
Box 16). Although this particular model may not be applicable for the UK, it provides a useful
example of institutionalisation of interaction at the most senior level.
Relationships at other levels

169. In addition to the working sessions between the Tripartite Principals and Deputies, it will be
valuable for the Executive Directors of the Bank and the micro-prudential regulator to hold
regular sessions, perhaps for one day a quarter, to share their thinking on the macro-analysis.
170. Efforts should also be made to build stronger links between staff at more junior levels of the
Tripartite Authorities. The detailed operational plans to strengthen links between the Authorities
should be made by the leaderships of each Authority, however they should consider:
• Secondments: Staff should be seconded between the Authorities (as well as to financial
institutions). These secondments should typically be for a sufficiently long time to allow
secondees to build up a detailed understanding of the workings of the other Authorities and
to develop sustainable working relationships that can be maintained following the conclusion
of the secondment. The Authorities should consider making it a prerequisite for promotion to
senior executive level for candidates to have completed a secondment to another Authority
or financial institution, unless they have been hired externally.
• Training: Regulatory staff should be given training regarding the responsibilities and
functions of the other Authorities as part of their basic training programmes. Where staff are
required to develop similar skills or expertise, the Authorities should also consider running
joint training sessions to enable junior staff to develop contacts and shared patterns of
working across the Authorities.
• Briefings: In addition to the regular interaction between senior officials regarding current
financial stability issues, more junior staff should be given joint briefings on a regular basis.
• Informal meetings: The Authorities should take steps to encourage informal meetings
between staff at various levels of their organisations, by organising lunch meetings or away
days to facilitate relationship building.
President’s Working Group on Box 16
Financial Markets
Background
• The President’s Working Group on Financial Markets (PWG) was established by executive order after the 1987 stock
market crash. It was created with the purpose of making recommendations regarding "enhancing the integrity,
efficiency, orderliness, and competitiveness of [United States] financial markets and maintaining investor confidence“
(Executive Order 12631)
• The Group consists of the Secretary of the Treasury, who chairs the Group, and the Chairman of the Federal Reserve,
the Chairman of the Securities and Exchange Commission, and the Chairman of the Commodity Futures Trading
Commission. However, other federal financial supervisors such as the Office of the Comptroller of the Currency and
the Federal Reserve Bank of New York may be invited to participate in discussions as appropriate
Roles and Responsibilities
• Since 1987, the PWG has interpreted its role broadly and issued reports and recommendations on areas covering
terrorism risk insurance, hedge funds and other pools of capital, over-the counter derivates, the Commodity Exchange
Act and financial contract netting, with a view of informing policymakers and market participants
• The PWG is often called upon by Congress to provide a view on current financial events, both formally and informally.
It also serves as an informal mechanism for various regulatory agencies to discuss relevant policy initiatives
Advantages
• Frequent interaction between the heads of the four agencies through meetings, discussion groups and joint research
means there is a shared understanding of current developments in the financial market place
• Maintaining a close relationship and understanding of current thinking within the different agencies also increases the
probability of presenting a successful and swift response in the event of a financial market crisis
• The institutionalisation of a separate group of senior financial regulators with a mandate for coordination and
communication also increases certainty in the market place, as PWG issues joint statements during crises
Areas to Improve
• In the US Treasury report ‘Blueprint for a Modernized Financial Regulatory Structure’ from March 2008, the Treasury
suggests a number of measures should be taken to clarify the mission and reinforce the purpose of the group as a
mechanism for coordination and communication
• First, this includes having a new Executive Order reinforcing PWG as an ongoing financial policy coordination and
communication mechanism, and giving the PWG a mandate to focus on the financial sector more broadly rather than
just addressing financial markets
• Second, it would clarify the PWG’s objectives: mitigating systemic risk to the financial system; enhancing financial
market integrity; promoting investor and consumer protection; and promoting capital markets’ efficiency and
effectiveness
• Third, it should expand its membership to include the heads of the Office of the Comptroller of the Currency, the
Federal Deposit Insurance Corporation and the Office of Thrift Supervision
• Fourth, the Order should clarify that the PWG should have the ability to issue reports or documents to the Presidents
and others as appropriate
Source: US Treasury, ‘Blueprint for a Modernized Financial Regulatory Structure’
Creation of a secretariat to the Tripartite Authorities

171. The Treasury Select Committee has recommended that the Tripartite Authorities create a
permanent secretariat for the Standing Committee on Financial Stability:
“We believe that it is essential that, if the Tripartite Standing Committee is to function
effectively, it must have distinct staffing arrangements to ensure appropriate levels of
continuity and expertise. We recommend the establishment of a small central secretariat
for the Standing Committee on Financial Stability, including staff drawn from the Treasury,
the FSA and the Bank of England as well as from other organisations. This secretariat
would play a crucial role in ensuring the capacity of the Committee to undertake the
functions identified in this Report. We would expect all three Principals on the Standing
Committee to have a say in the appointment of the Head of the Secretariat”
Treasury Select Committee, ‘Banking Reform’, September 2008
172. In its response to the Treasury Select Committee, HM Treasury has stated its opposition to the
creation of a permanent secretariat to the Standing Committee, as the staffing resources to the
Standing Committee are already provided by HM Treasury:
“The secretariat for Standing Committee is currently provided by the Treasury.

The Treasury will consider whether additional staffing is required for this function.
The Government notes that, in the last year, the Bank of England, FSA and
Treasury have all significantly increased resources in the area of financial
stability in response to recent events. The Authorities will need to consider what
an appropriate steady state level of staffing should be.”
HM Treasury, Response to Treasury Select Committee, October 2008
173. We do not believe it is necessary for a new secretariat to the Standing Committee to be created,
as staffing support is already provided by HM Treasury. Decisions on the appropriateness of the
resources available to the Standing Committee should be taken by HM Treasury in consultation
with the Bank and FSA.
Recommendation (34): The Tripartite Principals should meet formally at least three times a
year and have an additional three informal meetings a year.
Recommendation (35): The Authorities should strengthen links at more junior levels through
a programme of secondments, training, joint briefings and informal
meetings.
Recommendation (36): The secretariat to the Standing Committee should continue to be
provided by HM Treasury.
The Memorandum of Understanding (MoU)

174. The MoU is currently unclear on a number of basic issues, not least whether the independence
of the Bank of England should include financial stability issues. The difficulty arises partly
because the same action (provision of liquidity to the market), implemented using the same or
similar operational instruments (outright purchase by or repo to the Bank of certain securities),
is relevant both to the implementation of monetary policy, where the Bank does indeed have
independence, but potentially also to the maintenance of financial stability. A partial resolution
of the problem, in the context of an amended MoU setting out a revised general framework for
dealing with financial stability issues, might lie in determining that operations which fall within
the scope of the Bank's Red Book - the public statement of its monetary operating procedures -
would be matters for decision by the Bank while operations outside that framework would be
matters for HM Treasury. But this would in turn raise a number of questions which deserve
further consideration.
Recommendation (37): The Memorandum of Understanding should reflect all the proposals
in this report, making clear which Authority is responsible for each
regulatory function.
Working relationships with international regulatory bodies

175. The global origins of the current financial crisis were highlighted in the earlier analysis of the
causes of the crisis. Given the highly globalised nature of the financial system, it is likely that
future financial crises in the UK will be triggered at least partly by international developments
and therefore the UK’s Tripartite Authorities need to develop closer working relationships with
international regulatory bodies (both supranational and national). The Authority primarily
responsible for analysing international macro-economic and financial trends and evaluating their
impact on the UK will be the Bank of England, so the Bank should be the main point of contact
regarding macro-prudential stability. To the extent that existing arrangements for data sharing
are inefficient, the Bank should be willing to take on a leadership role in developing global
platforms/functions to facilitate data sharing, where it can do so without incurring excessive
cost.
176. It is also critical that the Bank maximises its dialogue with international regulators and other
central banks, to further its own understanding of any emerging systemic risks to financial
stability. Such a dialogue may also have some impact in encouraging international action to
redress unsustainable macro-economic imbalances. While the Bank clearly has only limited
international influence, the absence of a global macro-prudential regulator means that action to
correct macro-economic imbalances will remain primarily within the remit of national central
banks and governments, and therefore the Bank should discuss any emerging threats to
financial stability with the key national bodies involved. If the proposals of Jacques de
Larosière’s High Level Group on Cross-border Financial Supervision for a European body to
monitor and issue warnings in respect of macro-prudential risk (the European Systemic Risk
Council) are adopted, the Bank should be responsible for dialogue with such a body. The Bank
is, of course, engaged in the G20, G30, Financial Stability Forum and other fora but it needs to
consider what bilateral or other discussions should complement the formal groups.
Recommendation (38): The Bank of England should strengthen its working links with
international bodies, including contributing to the development of
improved collaborative tools.
Contribution to the international regulatory response

177. There has been a significant amount of work at the international level to address international
financial regulation, notably by the G30 Working Group on Financial Reform, the Financial
Stability Forum, Jacques de Larosière’s High Level Group on Cross-border Financial
Supervision and the ongoing work by the G20 leaders. There will continue to be a strong
emphasis on an international response to the current financial crisis, as well as developing an
international framework to reduce the threat from future financial crises. It is essential that the
Tripartite Authorities should continue to contribute their expertise to the ongoing international
response, particularly at the European level, in order to avoid outcomes that may be detrimental
to the UK’s position in the financial markets and/or a regime that is inconsistent with the UK’s
preferred regulatory framework.
178. Where the international regulatory response is focused on macro-prudential issues, the Bank of
England is the Authority best placed to lead the UK’s international contribution on the basis of
the international relationships discussed above in relation to its macro-prudential role, its high
level of international prestige and credibility, and its political impartiality. On micro-prudential
issues, it remains appropriate that the micro-prudential regulator should lead the UK’s
contribution, including the development of accords by the Basel Committee of Banking
Supervisors in relation to prudential supervision, working level discussions with the European
Commission, and representation on the Committee of European Banking Supervisors, the
Committee of European Securities Regulators, and the Committee of European Insurance and
Occupational Pension Supervisors, or the successor authorities as proposed by the Jacques de
Larosière’s High Level Group on Cross-border Financial Supervision. The Bank of England
should, nevertheless, remain able to influence the UK’s contribution on such micro-prudential
issues and should work with the micro-prudential regulator and HM Treasury to form a common
position in relation to financial stability matters. The Tripartite Authorities should consider
submitting joint papers to international bodies setting out the UK’s view on issues relating to
financial regulation. In preparing these submissions, the Authorities should actively work with
financial institutions in order to develop, as far as possible, a consensus position based on the
views of all stakeholders in UK financial markets.
Recommendation (39): The Bank of England should lead the UK’s contribution to
international policymaking of a macro-prudential nature, with the
micro-prudential regulator continuing to lead the UK’s contribution
on micro-prudential matters, while HM Treasury should lead
international political negotiations.
Recommendation (40): The Tripartite Authorities should work closely with financial
institutions to develop a consensus position to contribute to
international regulatory developments.
Compatibility of UK regulation with potential international models

179. Throughout our research, a number of people have argued that the UK must be prepared for a
potential shift to an international model of financial regulation, potentially based on a single
European regulatory structure. It is not within the scope of this preliminary report to assess the
likelihood or desirability of an international regulatory structure. However, it is important to
comment briefly on the potential impact of such a structure on the UK’s system of financial
regulation.
180. The UK’s continuing position outside the Euro zone means that the international regulation of
financial stability will not be of direct relevance to UK fiscal or monetary policy. It is questionable
whether international regulation should extend to micro-prudential regulation or conduct of
business regulation, since these activities are most effectively conducted by local regulators
with a more detailed knowledge of the financial institution in question. There has been some
discussion of developing an international regulatory function for ‘systemic’ institutions at the
European level.
181. If any key regulatory function was to be transferred to an international body it would likely be
macro-prudential regulation. For example, it is possible that a body analogous to the Basel
Committee could be given control of a macro-prudential instrument such as counter-cyclical
capital ratios, leaving national micro-prudential regulators to enforce any changes. The
regulatory structure set out earlier, with the Bank responsible for macro-prudential supervision
and the micro-prudential regulator for micro-prudential regulation, would ensure that any
transition to an international macro-prudential regime could be handled with the minimum
disruption to the UK’s system of financial regulation, limiting the risk of such a change to the
UK’s financial stability and to the competitive position of the UK’s financial markets. However, it
is only within the UK that macro-prudential judgements can be made which will take full account
both of UK financial system issues and of relevant European and global market developments.
For example, the credit cycle in the UK may be at a different point to that elsewhere in Europe.
182. In the final analysis, prime responsibility for financial stability regulation must remain with the
political authority which has access to taxpayers’ money to fund any crisis resolution. This
means that for the foreseeable future, the UK authorities will have to retain prime responsibility
for UK financial stability.

Preliminary Report On UK Financial Regulation

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Preliminary Report On UK Financial Regulation

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Descriptor I (Author: service area, industry or audience)

Descriptor II (Topic: service or industry)

The Tripartite Review

Appropriate instruments to mitigate emerging risks

Conduct of the prudential regime

for the health of the financial sector.

Expertise and preparation for crisis handling

Terms of reference and

The Review process

5. This primary research was complemented by a desk-top research exercise, focusing on

• Evaluation of and response to emerging threats to financial stability: The Tripartite

The macro-prudential regime

Inter-authority and international relationships

Areas for further consultation

The macro-prudential regime

The macro-prudential regime (continued)

Recommendation (16): Consideration should be given to the structure of the micro-

Strengthening regulatory capabilities

Strengthening regulatory capabilities (continued)

Inter-Authority and international relationships

Recommendation (29): The Bank of England, in consultation with the micro-prudential

Inter-Authority and international relationships (continued)

Recommendation (36): The secretariat to the Standing Committee should continue to be

Why does the regulatory structure matter?

“Safeguarding the system against systemic risk; protecting consumers against

Herring and Santomero, ‘What is optimal financial regulation’, May 1999

The importance of the regulatory structure

• Regulatory arbitrage: Multi-agency regulatory regimes provide incentives for financial

Limits to a structural approach

“New structures do not guarantee better regulation. More appropriate structures

Prof. Jeffrey Carmichael, Australia’s Approach to Regulatory Reform, December 2003

Implications for the UK’s system of financial regulation

What are the reasonable expectations of the regulatory system?

The existing regulatory structure

44. The key pieces of legislation are:

The Bank of England

47. The Bank’s specific duties are to:

• Act in the money markets to limit fluctuations in liquidity

• To oversee the payments system and financial markets infrastructure

• To maintain a broad overview of the state of the financial system

• To undertake operations to minimise the threat posed by an institutional failure

The Financial Services Authority

Changes since mid-2007

Why did the existing system

Background to the financial crisis

Evaluation of and response to emerging threats to financial stability

Bank of England’s Financial Stability Review, December 2004

“The growth of UK-owned banks’ lending to households and firms continues to

Bank of England’s Financial Stability Review, December 2004

“[Some] aspects of the global economy look unsustainable, particularly the

Bank of England’s written evidence to Treasury Select Committee, February 2007

“Strong and stable macroeconomic and financial conditions have encouraged

Bank of England’s Financial Stability Report, April 2007

Sir John Gieve, BBC interview, December 2008

Lack of appropriate instruments to mitigate emerging risks

Sir John Gieve, BBC interview, December 2008

Inadequate prudential regulation

Professor William Buiter, Evidence to Treasury Select Committee, November 2007

Treasury Select Committee, The Run on the Rock, January 2008

“The problem of NR was a business model that exposed it to a Low Probability

Prof. David Llewellyn, ‘The Northern Rock crisis: A multidimensional

The FSA’s organisational Box 2

FSA Organisational Chart – August 2007 (simplified)