Banking regulation

One notable consequence of the recent global financial crisis is the recognition that existing regulation of financial institutions has failed. Self regulation via banking codes failed to prevent the 2008/09 banking crisis, as did national regulation. The growth in high risk trading of extremely complex financial products, including derivatives and options, and the increasing securitisation of assets, created what has widely been dubbed a shadow banking system, which increasingly operated outside of normal banking practices. Like all large businesses, banks are subject to regulation by the OFT and the Competition Commission. As early as 2001 the Competition Commission concluded that a number of the largest banks operated a complex monopoly in the supply of services to small and medium sized enterprises (SMEs) which resulted in reduced competition to the detriment of the customers. For example, customers were reluctant to switch banks because they all offered very similar benefits. The tri-partite system Current banking regulation in the UK involves three organisations, the Financial Services Authority (FSA) the Bank of England and the Treasury. Until the banking crisis, UK banking regulation could be described as light-touch - in other words, regulators do not engage in aggressive regulation, preferring to intervene only when necessary, and only in limited ways. The main problem for the regulators was that the heavy-touch regulation might force global banks to seek out countries where regulations were less strict. In other words, they would move out of London, leading to huge job losses in the City. (Source: Reuters) The role of the FSA The main UK bank regulator is the Financial Services Authority (FSA). It has two main objectives:

To promote efficient and fair financial services To help consumers of financial services achieve a fair deal

To achieve this the FSA sets standards for the activities of banks and other financial businesses, and can take action to ensure these standards are met. Rules vs Principles Some critics of the US regulatory system maintain that it is too 'rule-based' and should move towards the European model of 'principle-based' regulation.

With rule-based regulation the regulators interpret the rules as laid down in law, and there is little room left for judgement or interpretation. Under a principles-based system the general principles are contained in legislation, and this gives regulators extra powers to to assess the behaviour of financial institutions. The Banking Act 2009 In order to protect depositors and to maintain financial stabilit, the Banking Act of 2009 gave the those organisations responsible for banking regulation the collective powers to deal with the crisis in the banking system. One of these powers is the ability to put a failing bank under temporary public ownership. The Turner Review In March 2009 Lord Turner, Chairman of the FSA, published the findings of his review into the banking crisis and recommended the following: More coordinated international banking regulation, especially the creation of a pan-European regulator 1. Banks to hold more assets 2. Regulation of liquidity 3. More information to be collected from those institutions that are part of the shadow banking system, like hedge funds. 4. More regulation of overseas banks by host countries - this recommendation is largely in response to the collapse of the Iceland banks, who were unregulated by the UK regulators, but UK citizens suffered large losses. 5. Control of bank employees remuneration 6. A review of bank's accounting practices

At last, sense seems to be entering the U.K. banking reform debate. I argued here two weeks ago that Project Merlin missed an important trick not addressing the U.K. mortgage famine, which is partly due to the chronic funding challenges faced by British banks. I also argued yesterday that the high cost and scarcity of U.K. bank lending was one of the biggest risks to the recovery and the reason why the Bank of England is right to be cautious about raising interest rates. So I view reports that George Osborne is considering ways to loosen the U.K.s tough liquidity rules as very positive news not just for bank investors but for anyone with a stake in the performance of the U.K. economy. If it is a sign the tide is finally turning on the fundamentalists at the Bank of England and Financial Services Authority who, egged on by the crude bank-bashing U.K. press, have had a free rein since the start of the financial crisis, then it cannot come soon enough.

The U.K. currently has some of the most draconian bank regulation in the world, its policymakers insisting on gold-plating international rules while arguing publicly for a break-up of the banks and a return to Victorian era capital ratios. The result has been to hobble an already fragile U.K. banking system just at the point it is most needed to finance a recovery. No one doubts that inadequate liquidity was one of the primary reasons for the banking crisis and that it was essential banks in future held more liquid assets. But the FSAs liquidity regime goes well beyond other countries. Barclays now has a total liquidity pool of 154 billion more than 10% of its balance sheet almost all of it tied up in zero-yielding cash and low-yielding government bonds. The cost of maintaining this liquidity pool was 900 million in 2010. Loosening the rules on what qualifies as liquid assets and reducing the liquidity buffer would free up funds for more profitable lending to the economy. Santander also this month cited the FSAs liquidity rules as a reason why it was cautious on its U.K. outlook this year. If the message is finally beginning to dawn on the Treasury that the BOE and FSA do not have a monopoly on wisdom and that the radical experiments being conducted on the U.K. banking sector, while fine in academic theory, are potentially ruinous in practice then this is an important moment in the crisis. It may mark the point at which the pendulum finally starts to swing back from the extreme banker-bashing that has characterized the U.K. debate for the last three years. That could have important implications for the outstanding Basel 3 negotiations and above all the context in which the Independent Banking Commission delivers its recommendations. If so, it could also mark the moment at which the huge regulatory discount hanging over the U.K. banking sector starts to lift.