Recent views of Financial Policy Committee (FPC) members are collected here to provide an introduction to the FPC’s role in UK financial regulation, how it will operate, and its powers and responsibilities.
How will it achieve its mandate?
How will decisions be taken by the FPC?
How will it be accountable?
How will the FPC ensure it is effective?
What are the main challenges it will face?
What changes to regulation have been made, and why were they necessary?
In the UK, responsibility for the regulation of individual firms was transferred in 1997 from the Bank to the newly formed Financial Services Authority (FSA). The Bank, for its part, concentrated on its two core purposes of setting monetary policy and maintaining a broad overview of the system as a whole. As part of this latter responsibility it published a Financial Stability Report twice a year, giving voice to its analysis in this area. Meanwhile, Her Majesty’s Treasury (HMT) was responsible for the overall structure of financial regulation, and as the controller of the public purse strings had a key role to play in crisis decisions.
This tri-partite system is widely criticised today as there was no single institution mandated with the responsibility, and powers, to monitor the system as a whole, identify potentially destabilising trends, and respond to them with concerted actions. As such there was a degree of, what Paul Tucker has called “under lap” within the system.
In response to the crisis, much progress has been achieved to redress the policy-making gap. In 2009, the Bank’s financial stability responsibility was put in statute, along with a new resolution regime to deal with failing banks in an orderly manner. In 2010, the new Government unveiled a more wide-ranging overhaul of the financial stability arrangements in the United Kingdom.
The plan involves setting up three new bodies. In 2013, the current FSA responsibilities for supervising banks (and some other financial institutions), will move to the Bank of England, and will be housed in a wholly-owned subsidiary, the Prudential Regulation Authority (PRA). The existing FSA responsibilities for business and market conduct, competition and consumer protection issues will move to a new Financial Conduct Authority (FCA). That re-arrangement will allow a clearer focus for each activity and better exploitation of synergies between the PRA and the Bank. But the third new body is truly ground-breaking. The Financial Policy Committee (FPC), housed within the Bank of England, is charged with the job of setting macro-prudential policy.
Experience around the world demonstrates that it is hard to keep supervisors focused on the stability of the system as a whole. The UK’s Financial Policy Committee is designed to achieve that. By creating a new institution within the Bank of England, the government is ensuring that stability does not fall by the wayside, into the gap between monetary policy at one end of the spectrum and the regulation of firms at the other.
At its simplest, that is why the government has established the Bank of England’s new Financial Policy Committee – to ensure that the moment when the financial system’s resilience is critically impaired does not get overlooked; that it is anticipated and appropriate action is taken.
What is the Financial Policy Committee?
A standing body, meeting regularly, transparently, and backed by powers to take decisions on regulatory measures – the FPC is the body charged with being on the case. It won’t be perfect, but it can be much better than the pre-crisis regulatory regime.
The interim FPC has 11 voting members: the Governor and Deputy Governors of the Bank, the Executives responsible for Financial Stability and Markets at the Bank, the Chairman and CEO of the FSA and four members who are called ‘externals’ (of which I am one). A representative of HMT and the head of the proposed FCA attend the meetings as well in a non-voting capacity. The FPC holds formal meetings on a quarterly basis as well as various preparatory discussions.
Speech by Donald Kohn - The Financial Policy Committee at the Bank of England 02/12/11
We greatly benefit from the range of backgrounds members bring to the task. Two members come from the FSA and are responsible for microprudential regulation and for implementing many of our recommendations; several are from the financial stability side of the Bank with their macro-financial perspective; several are macroeconomists who have dealt primarily with monetary policy issues and see the relationships between developments in the financial sector and the real economy; and importantly two of my fellow externals have quite extensive experience in the London financial markets, which they have utilized to bring issues to our attention and to inform many of the rest of us without such experience how our concerns are playing out in the “real world”.
What is the FPC’s mandate?
Article by Andrew Haldane - Our brief is simple, but critical: keep the system strong and stable 12/06/11 The FPC will aim to keep the financial system strong and stable, as its contribution to keeping the economy strong and stable. Success will mean that savers feel confident about their deposits and credit keeps flowing through the arteries of the economy in bad times as well as good.
The FPC is about filling the space between monetary policy and microregulation – in an admittedly inelegant phrase, ‘macroprudential’ policy: policy that is focused on the resilience of the system as a whole.
In plain language, that means detecting and reducing threats to the financial system as a whole, and ensuring that the flow of financial services to the wider economy is maintained ... The job of policy makers is to recognise and assess such developments, and subsequently take actions to mitigate their impact.
The FPC is also tasked with responsibility for advising the Government on the so-called ‘regulatory perimeter’ – i.e. what parts of the financial system should (and should not) be subject to regulation. This will essentially mean that the FPC needs to keep a close eye on the ‘shadow banking sector’ – comprising firms engaging in banking-like activities but not regulated as banks (for example, hedge funds, money market funds etc). Given that the financial system constantly evolves, and that some financial activity might migrate from the regulated banking system to the shadow banking system, advising on the location of the perimeter will be very important.
How will it achieve its mandate?
Record of FPC meeting on 16/03/12
In its February 2011 Consultation Document and June 2011 White Paper, HM Treasury had asked the interim FPC to provide advice on the macroprudential tools over which the statutory FPC would need powers of Direction in order to meet its proposed objective...the Committee welcomed the Government’s inclusion of a clause in the Financial Services Bill setting out a clear and expeditious parliamentary process for altering this set of tools, as and when the need arose.
Where it has statutory powers, the FPC will be able to direct the PRA or FCA to implement its decisions. To be considered appropriate for inclusion in these directive powers, beyond being helpful in meeting the FPC’s financial stability objectives, tools will need to be effective at addressing systemic risk, efficient in not generating unwanted spillovers, specific and transparent. They will also need to form an appropriately diverse set. In addition to directive powers, the FPC will be able to recommend anything to anyone. Within that, where it doesn’t have directive powers, the FPC will be able to make recommendations to the PRA and FCA on a ‘comply or explain’ basis.
The FPC will need some tools – so-called macro-prudential regulation. That means applying the brakes when credit is running out of control to reduce the risk of a financial pile-up. For example, it might increase the amount of capital or liquidity banks are required to hold...The aim would be to take the heat out of credit markets.
But, as importantly, it may also mean the FPC releasing the brakes when credit is stalled at the roadside. That might call for a loosening of the regulatory reins to inject some life into credit markets. If the FPC does its job, future credit feasts may be less raucous, but financial famines will stunt growth less often.
At our March meeting we discussed which instruments should be included in the toolkit of specific legal, directive powers. We have asked for a short list, although there may be a case for adding more as we learn about how the tools can be used in practice.
What has the FPC asked for? The first is the directive power to require banks to hold extra capital – essentially shareholders’ money – over and above the internationally agreed minimum standards, if risks are building up in the system. That extra capital would act as a cushion if risks crystallised and the banks faced losses. And the FPC will be able to allow those extra buffers to be run down if conditions are stressed, so as not to jeopardise lending to the economy.
In addition, the FPC would like to be able to require firms to hold more capital against particularly risky types of lending. In the past, there have often been bouts of excessive lending to the commercial property sector for example. Being able to adjust sector-specific capital requirements to reflect such risks may help promote more stable lending.
Finally, the FPC has asked for directive control of a simple leverage ratio – the ratio of total capital to total lending as defined by international standards – that provides a clear, comparable and simple way to limit the most excessive build up of risks on the balance sheets of our banks.
Generally we have chosen to recommend a small tool kit that contains those tools with which there is more familiarity within the regulatory community. As I have outlined, the need for transparency and accountability in the final allocation of such powers is clear. However, the need for suitable tools is also clear if the Bank is to do something meaningful when it next determines that there is systemic risk building dangerously within the financial system or indeed if it wants to allow financial institutions in bad times to utilise a countercyclical capital buffer built up in good times.
I cannot emphasise enough that the FPC will not indulge in attempts to micromanage the banking system or the allocation of credit. Nor will we be excessively activist, trying to fine-tune credit policy. This is about stability, which is an absolute precondition for steady improvements in economic activity and employment. The goal is to make the financial system resilient, to contain destructive ‘busts’, and to do so without impairing the contribution that the financial sector makes to the economy’s medium-term growth.
One practical role for macro-prudential policy...is to communicate about risks to the system to better enable ... risks to be priced. If risk is over-priced, and agents over-pessimistic, communicating that might help in correcting overshoots in risk appetite.Speech by Donald Kohn - The Financial Policy Committee at the Bank of England 02/12/11
We are also building on a risk-identification structure already in place at the Bank of England. Staff provide extensive briefings to FPC members in advance of our meetings. This includes information and analysis on the macrofinancial environment and short- and medium-term risks to financial stability – both in the UK and abroad in those markets in which UK banks are active. A key aspect of that analysis is the ability of the UK banks to withstand potential adverse developments. We review many different metrics and model outputs within this process. In addition, the Bank has an active market intelligence function that produces reports on what is going on in markets and the views of market participants about emerging risks. But of particular value is that members bring their own knowledge and understanding of the UK financial and economic system to the meetings. For myself, I make it a practice to talk to people in the financial sector on my visits to London so I can learn first-hand what stability issues are on their minds.
How will decisions be taken by the FPC?
Most of the time, the Governor, as Chairman of the Committee, seeks to form a consensus amongst FPC members on any given policy issue. However as the dynamic of the Group evolves and the debates become sharper we have needed to formally vote on some policy matters and I suspect that going forward voting will become the norm.
How will it be accountable?
Promoting greater transparency has been an important theme of the initial discussions of the FPC and the need for better transparency among financial institutions is clear. But transparency in accountability is also extremely important for the FPC itself. Building trust with the public will help the FPC to take seemingly unpopular measures further down the line while still retaining public support.
Overall, a lot of time is spent ensuring that the public understand the macro-financial context for decisions, the thinking of the FPC and its recommendations. For example, a statement and a record of the deliberations of each FPC policy meeting is made public promptly after meetings. The FPC also now publishes the Financial Stability Report (FSR) twice a year and includes a full assessment of the outlook for the financial sector and a summary of the systemic risks, vulnerabilities and potential imbalances. The FSR and FPC policy recommendations are discussed in a twice-yearly press conference. Members of the FPC give speeches, write Op-Eds and give interviews. To ensure further public accountability, members of the FPC appear in front of the TSC to answer questions on FPC matters.
How will the FPC ensure it is effective?
To make a success of financial policy the FPC must be empowered to take decisions which are enforceable and which will have a real impact. Creating a FPC that is only able to provide advice or give sermons won’t move us very far from where we were when the financial world broke apart in 2008.
To be effective in influencing the private sector, the FPC’s concerns need to be credible and focused. They will be credible if they are well reasoned – backed up by facts and cogent analysis. That in turn will require a good deal of openness about our deliberations, for example in the Records of our meetings. For the public to be able to evaluate the quality of our recommendations, we need to be clear how we reached our conclusions, including that we considered a range of issues, responses, and outcomes.
What are the main challenges it will face?
Countercyclical macroprudential policy is challenging. This is true in good times when it appears the system is strong and there will resistance to damping the upswing. But it may be even more difficult to allow or even encourage drawing down of capital and liquidity buffers in bad times to reduce the potential for tightening credit conditions to feed weakening economic trends. This problem illustrates nicely the different perspectives of macro- and micro-prudential regulation. From a micro perspective, conserving capital and liquidity by reducing lending and being tough on restructuring troubled credits under such circumstances strengthens the bank and helps to keep it from failing. From a macro perspective, however, those actions will tend to activate an adverse feedback loop between the financial sector and the real economy that will weaken both. Congruence between micro and macro considerations requires that financial institutions have high levels of capital and liquidity before trouble hits.
The FPC’s objective is to protect and enhance the resilience of the UK financial system against risks including “unsustainable levels of leverage, debt or credit growth”. Therein lies a key FPC challenge. There is evidence of unsustainably high levels of leverage in some sectors. But elsewhere, there is evidence of credit growth being unsustainably low.
In framing macro-prudential policy today, both these factors need to be weighed: on the one hand, enhancements to the risk-bearing capacity of the financial system to repair balance sheets; on the other, encouragement for the risk-taking capacity of the system to boost credit supply.
We have clearly moved into an environment where the notion of self-correcting markets and light touch regulation is a distant memory. However, care must be taken to ensure that regulators don’t go too far and stifle legitimate risk taking which creates value in the real economy.
Article by Paul Tucker - The good things in life require stability 04/04/12
We will not be able to control lending into our economy by foreign firms. But we hope the central banks and regulators of other countries will, in exercising their own macroprudential powers, place weight on our assessment of the risks.
Avoiding a repeat of the current crisis will undoubtedly be difficult and the process to get macroprudential regulation up and running will be long and complex. But the prize for succeeding will be huge. It has been estimated that the current crisis has cost the UK up to 10% in lost output or, in money terms, £130bn. And this is expected to persist over time.