UK banking system, as is the case with the entire global banking industry, is progressively recovering from the global economic turmoil which started in 2007. The economic crisis affected UK banks in varying degrees depending on a myriad of their internal and external business factors. Even though only two banks recorded full year losses in 2008 and 2009, the losses were so huge that it the government was forced to bail the banks out using public funds. Since these bailouts, authorities in the United Kingdom have set out to comprehensively restructure banking laws. This paper critically analyses the various regulation changes which have so far been made in respect to the banking system. The paper further assesses the likelihood of these changes succeeding in achieving their set objectives.
Recent regulation changes for UK banking system
Most of the changes in UK banking regulation revolve around lending practices as well as capital structure of banks. Beginning in August 2007, a global meltdown of the financial markets caused extremely insufficient liquidity in the lending market for banks. In reaction to the severe economic recession, the Bank of England quickly slashed the official lending rate to an unprecedented 0.5% in March 2009 (Guardian 2009). This overemphasized the scale of monetary easing since the transmission mechanism was weakened by the economic crisis. Also, considerable reductions in inter-bank borrowing rates failed to adequately trickle down the borrowers (Monaghan 2010).
Major amendments are being carefully considered with respect to management of liquidity, contrary to earlier practice where regulation entailed enforcement of very minute details of limitations placed on banks’ activities (Parliament 2009). For them to be successful, extensive changes call for reconsideration of the current regulations, and authorities will have to rebalance an approach that has in the past depended profoundly on market information and principles. This would be possible with extra quantitative restrictions and a better formulation of rules. Furthermore, an expansive issue of concern is how to connect macro-prudential and micro-prudential regulation more successfully (Barrel & Davis 2008) with the design of a countercyclical regulatory structure.
Since December 2008, the Financial Services Authority (FSA) has been mulling over introducing a new liquidity system which would be closely associated with the funding requirements of each bank , and it is founded on more severe nature of liquidity shortages (FSA 2007 & 2008). There are six proposed aspects to the planned changes: First, all regulated entities must have sufficient liquidity and must not rely on additional funding from members of their groups to survive liquidity stresses, unless authorized by the FSA (Nehmias 2011:8).
Second, there will be a new systems and controls framework founded on the latest work by the Committee of European Banking Supervisors and Basel committee on Banking Supervision. Third, there will be a structure of quantitative individual liquidity sufficiency standards for each institution founded on a firm being able to endure liquidity pressures of varying degree. Fourth, a new group-wide as well as cross-border liquidity management framework commenced and is geared towards facilitating divergence of the “self-sufficiency” philosophy common among banking institutions firms to diverge from self-sufficiency (Practical Law Company 2011:8).
Fifth, a new reporting framework for liquidity will be formulated with the FSA assembling detailed and regulated liquidity data at a suitable frequency. Lastly, the FSA will make it mandatory for banks to hold assets worth six to ten percent of their equity in government bonds, compared to five percent which is the standard for the ten largest UK banks. This would lead to a significant increase in banks’ buffer of liquid assets.
The above measures would be successful and would also aid to tackle moral hazard issues ensuing from the provision of liquidity under an economic meltdown. The buffer is highly essential in that and assist banks in their endeavour to increase the quantity of liquid assets they hold. It will also be vital to ensure that regulatory arbitrage is looked into if UK regulations are to be at least moderately tight (OECD Paris & OECD Staff 2009:111).
The economic crisis peaked in quarter 4 of 2008 subsequent to the collapse of Lehman Brothers. This affected U.K. banking regulatory system as banks had to partly reintegrate their balance sheet obligations which had swollen unswervingly through 2007, particularly in regard to securitization (Nahmias 2011: 3). In April 2000, commissions set up to look into areas of banking regulations that required reforms recommended modification of existing regulations by obliging banks to keep 5% of their underlying loans on their balance sheets in order to defend the quality of risk monitoring. The Capital Requirement Directive II tackles this issue comprehensively and was implemented by the European Parliament in September 2009. It has been successful and was applicable to EU member countries from 31 December 2010.
In order to build up the banking regulatory system, the government opted to enlarge a lending scheme from the Bank of England, and permit financial institutions to swap an extensive range of hard-to-sell assets for government debt (MollenKamp & MacDonald 2009).
On top of buying a number of securities from non-financial corporate sector, the central bank, using funds from public coffers, set out to buy government debt floating in the secondary securities markets (PricewaterhouseCoopers 2009).This facilitated expansion of money supply, in the process assisting to stabilize inflation and increase output as well as enhanced nominal demand (OECD 2009: 4). In addition, the practice of banks to purchase gilts from the government and then selling them to the Bank of England paved way for stability in the banking regulatory system (Sadler 2011).
In view of U.K. Central Bank’s role, the question about unwinding its ‘exit strategy’ is when to begin withdrawing quantitative easing and increase interest rates. The Bank of England’s responsibility is to promote price stability and control inflation (ideally at 2%). For fiscal policy makers, the question of approach is extremely complex. A tax cut may boost consumer demand and in the short run contribute significantly to economic recovery, but might be harmful to the economy in the long run.
Restoration of reliable supply of credit in adverse economic environment calls for improved willingness and ability of financial institutions to lend in such an environment. In spite of the fact that every financial crisis tends to be significantly unique in regards to the specific issues that brings it around, evidence from cases from around the world indicate that government intervention that permits deeply weakened banking institutions to continue with operations is bound to enhance the economic and fiscal costs of crises. Certainly, there is a need for weakened banks having inadequate capital to mitigate losses from past operations not to sit on the path of credit supply.
Asset protection and recapitalization measures remain suitable where a bank can operate normally with some public help. Where institutions are not likely to be feasible, even with considerable help, other steps to reinvigorate the banking system need be considered. These measures should, however, come with minimal financial burden to the taxpayer. The latest regulation offers numerous alternatives for banking institutions that find themselves under a financial crisis, including but not limited to transfer of ownership, and short-term public ownership.
Effective banking regulation of banking system also needs to track the full range of markets, firms and sectors that fall under the financial services industry. Additionally, effective banking regulation may assist to greatly reduce the chances of recurrence of similar problems witnessed in the 2008 global economic crisis. Attempts to realize this objective will call for assignment of enough resources to the necessary institutions as well as to the process gathering of enough information for effective supervision.
The senior leadership of the FSA (Financial Services Authority) should play a lead role in matter by providing strategic direction to regulation objectives. In this regard, the elaborate mechanisms to monitor the operations of key players in the banking system set up by the FSA are commendable. In this strategy, the senior management of key banking institutions is actively engaged by the FSA to determine the suitable level of capital ratios in the light of examination of macro-prudential matters and macroeconomic cycle (Sants 2010).
This should serve to improve the quality of financial analysis, which is already doing being done. Macro-prudential considerations also ought to be integrated into supervisory assessments comprehensively. As such, the merging of prudential supervision of banks with central banks’ functions has facilitated macro-prudential examination of the banking sector and guaranteed a combined approach to liquidity risk management (FSA 2009).
The 2008 economic crisis, epitomised by near total collapse of Northern Rock Bank, highlighted several flaws in the framework of regulation of the banking system, more so regarding crisis management (Shin 2009). The Special Resolution Regime has initiated a new pre-insolvency monitoring system to help identify banks headed for potential collapse. It clearly describes steps to be taken to help alleviate such adverse outcomes.
This is helpful in mitigating failure risk for banks since it makes it inexpensive to track and contain failures of banking institutions. Nevertheless, for this new measure of regulation to be successful, the central should find and set aside adequate financial resources which would help cope with the likelihood of several bank failures. In particular, the monetary authority should give both qualitative judgments and numerical targeting first priority in formulating regulatory policies.
Moreover, current efforts to cut back on debt by use of both budget reform and nonfinancial agents are highly likely to make even worse the existing uncertainty over sustained profitability of banks and economic expansion as well. Nonetheless, recurrence of another severe and widespread crisis in the banking system is highly unlikely since stringent regulatory measures are in place (Nahmias 2011:9).
Positive Advances in Banking brought about by the new Regulation
Increased but measured recapitalisation of banks
A sustained economic recovery calls for restoration of reliable supply of credit as well as reinstatement of a strong financial services system. In order to supply and sustain liquidity, regulatory authorities have rightly and timely embarked on setting up extensive measures that would touch on every aspect of banking. These measures are essentially important in that they are aimed at restoring the capacity of the banking industry to supply credit to the economy, besides offering a guarantee for securities supplied by banks.
A scheme in which insurance of banks against operation losses as a result of holding selected bad assets was also developed, in addition the establishment of a fund to recapitalise banks. Following this, major banks agreed to recapitalizing funds from the government with some of them consequently merging (OECD 2009: 4).
Restoration of banks’ access to short-term financing
New legislations which were meant to ease monetary controls were quickly passed in order to permit the banks to easily re-access liquidity which would in turn facilitate refinancing of their short-term obligations. Before the economic crisis, the banking system was faced with the risk of overheating. The decision to slash the base rate, from 5.5 percent in December 2007 to just five percent in April 2008, and then more actively after the disintegration of Lehman Brothers from 5 percent in September 2008 to 0.5 percent in March 2009 (The Telegraph 2009), was not only timely but highly effective.
On top of the producing the desired effects on the real economy, the Bank of England’s successive slashes on the interest rates assisted boost intermediation margins, which had washed away nearly four consecutive years of a reversed yield curve in the year 2004 to 2008 (Nahmias 2011: 5).
Reinforcement of existing customer deposits guarantee mechanism
In October 2008, the FSA raised the cap on deposit assurances to 50,000 pounds from the previous 35,000 pounds in order to curtail the danger of bank runs. The cap was further adjusted upward to one hundred thousand pounds on December 2010 so as to comply with the new legislation across Europe. This way, rather than rolling out a full ex nihilo refinancing structure, the government instituted a simpler mechanism pertaining to guarantees by government on debts from new banks (Nahmias 2011: 6). This mechanism also proved to be successful in developing the bank regulatory system.
Increasing solvency through nationalisations of firms
To prevent the collapse of major banks which was then almost imminent, the government targeted to reinforce such banks’ equity capital (Nehmias 2011: 6). The effect of capital injections on the proportion of equity/total assets had previously been eliminated effectively by the general expansion of banks’ asset base in 2008 (Saleh 2010: 55). On the contrary, after consideration of the devaluation of the assets held by the rescued banks, the government decided to hold its stakes mostly in form of ordinary shares.
Thus, the bailout that saw a thirty-seven-billion capital injection into three of the country’s leading banks; Lloyds TSCB Group PLC, HBOSPLC, and RBS proved to be successful in solving the economic crisis (MollenKamp & MacDonald 2009).
The establishment of criteria for categorising banks as “Bad Banks”
In December 2009, the government established a structure of guarantees aimed at encouraging independent management of those banks facing financial crises, as well as to control assets highly impaired by such crises. The responsibility of this system was placed under APA (Asset Protection Agency). The jurisdiction of APA covers credit institutions resident in the UK and, to a lesser extend, their foreign subsidiaries (Nahmias 2011: 6).
Notably, toxic assets continue to exist on the balance sheets of each of the guaranteed banks, in place of compensation of commissions. These are similar to an insurance premium (House of Commons Treasury Committee 2009: 113). Nonetheless, under the new strategy, the government took the right steps by insuring banks losses accruing from their toxic assets. This is an improved choice for banks because it evades the tricky question of how to set a value on assets valued below market price (MollenKamp & MacDonald 2009). Effective management of toxic assets is a virtue if confidence in the regulatory banking sector is to be developed.
By the end of the first quarter of 2010, the Asset Protection Authority had covered £230.9 billion of Royal Bank of Scotland’s toxic assets in return for a sixty billion pounds franchise. In addition to the franchise, the government would absorb nine tenths of any losses while RBS would cover the rest. This strategy of acquisition of stakes in banks by government agencies is ideal for restoring the solvency of banks, thus permitting them to direct much of their focus to their core business.
Losses from operations would also be minimised under this strategy (Economics Online n.d.). This mechanism, because under it issues pertaining to valuation of toxic assets are not taken into consideration, has an additional advantage in that it can be rolled out with considerably swiftness, not to mention it presents a more flexible approach in asset management (Nahmias 2011: 8).
Strengthened by support measures of the government, banks as a whole returned back into positive territory of profitability in 2009. Ultimately-though quite sooner – the government steadily withdrawal as an equity holder of the huge banks, along with the rising significance of non-banking players, should result to a sizeable and effective restructuring of the banking sector (Orol 2009).
Many new and widely encompassing banking regulations have been put in place by the FSA since the onset of the global financial crisis in 2007. Prudent supervision as well as equal management of banks is critical, for it not only ensures reliable supply of credit in the economy, but it also immensely aids smooth operation of the financial services industry. In this regard, most of the new legislations have proven to be fruitful. The FSA and other UK monetary authorities have pursued a unique approach to the development of the regulatory system for banks. As such, more and effective banking supervision ought to be considered by monetary authorities in attempts to prevent the recurrence of another severe and widespread financial crisis.
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