Liquidity & Capital Reform

The UK’s Financial Services Authority (FSA) has issued a discussion paper which focuses on policy measures aimed at addressing the problem of systemically important ‘too-big-to-fail’ banks.

There are huge dangers posed by those financial firms that are seen as too-big or too-interconnected-to-fail, or too-big-to-rescue. In the discussion paper the FSA describes the full range of policy options that are available in order to provide the basis for an informed debate, but also outlines the position which the FSA is currently proposing in various bodies. Key positions are:

• There is a strong case for applying some form of capital (and perhaps liquidity) surcharge internationally for systemically important banks; surcharges could be proportional to continuous and increasing measures of systemic importance, avoiding the dangers created by specific thresholds of systemic importance.
• A capital surcharge could be combined with an approach to global banking groups which places greater emphasis on the standalone sustainability of national subsidiaries, with overt understanding that home country authorities will not be responsible for the rescue of entire groups. The more that groups are organised on this basis, the less the required surcharge at group level might need to be.
• Action should be taken to reduce inter-connectedness in wholesale trading markets, with much over-the-counter (OTC) derivative trading moved to central counterparties (CCPs), and with effective collateral and margin call arrangements for bilateral trades which reduce the dangers of strongly pro-cyclical margin call effects.
• Reform to trading book capital should significantly increase capital requirements and differentiate more strongly between basic market making functions which support customer service and riskier trading activities, with a bias for conservatism in relation to the latter.
• Systemically important banks should be required to produce recovery and resolution plans (‘living wills’) which set out how operations would be resolved in an orderly fashion. If supervision examination of these plans reveals serious obstacles to resolution, then steps will need to be taken to reduce or remove them – this could require restructuring certain parts of the group. Restructuring could include clear separation between retail deposit taking business and businesses involved in proprietary trading activities, with the latter able to fail even if the former were supported in crisis conditions.

The discussion paper also stresses the need to assess the possible cumulative impact of multiple reforms to capital and liquidity regimes now being considered by international standard-setting bodies. It describes the case for significant increases in capital and liquidity requirements to reduce financial instability risks, while recognizing the potential implications for lending volumes and the cost of credit intermediation. It considers methodologies which can help inform judgments on the trade-offs involved.

The FSA’s plan of action includes:
• Living wills: The FSA intends to press ahead with resolution and recovery plans in the UK and work is underway to produce guidance for systemically important firms to use in developing living wills. The plans will build on requirements the FSA has already put in place that contribute to a firm’s preparedness for recovery. By the end of 2009, according to the FSA, a small number of major UK banking groups will have begun to produce living wills as part of a pilot exercise intended to help the FSA develop policy in this area.
• Cumulative impact of capital and liquidity reforms: The FSA acknowledges that given the inherent uncertainties involved in assessing optimal capital and liquidity levels, it means that models such as those described in the DP can never provide ‘the answer’. However, the FSA believes that the conceptual approach described can help inform an effective global debate on optimal capital levels. It will, therefore, encourage global regulatory bodies, industry groups and academics to conduct similar analysis.
•Conference: The issues discussed in the discussion paper will set the agenda for the second Turner Review conference which is being held on 2 November 2009.

The FSA regulates the UK’s financial services industry and has four objectives under the Financial Services and Markets Act 2000: maintaining market confidence; promoting public understanding of the financial system; securing the appropriate degree of protection for consumers; and fighting financial crime.