Bank of England Act 1998 (Macro-prudential Measures) Order 2013

Lord Eatwell Excerpts

Tuesday 26th February 2013 Grand Committee

Finally, the Government will, of course, be able to add to this suite of macroprudential tools in future by further orders subject to the approval of this House and the other place. At the moment, however, we believe that the measures I have just described are an appropriate and sufficient starting point for the FPC. The Government expect the FPC’s toolkit to adapt and evolve as the international debate and academic literature on this subject develops and empirical experience becomes more widely available. We expect the FPC to make recommendations to the Treasury if its macroprudential measures require amendment or new measures are required. I hope that that explanation has been helpful. I beg to move.

[Lord Eatwell]

My Lords, that was interesting introduction to this order as it spent most of its time discussing measures that are not included. It also began with a preamble that was an extraordinary rewrite of history, referring to a failure to identify macroprudential risks prior to 2008. Will the Minister specify any Government or regulatory document that includes a reference to macroprudential risk before 2008 and before publication of the Turner review? He will be hard put to find it. There are some academic articles on systemic risk but the whole issue of macroprudential risk was simply not on the horizon at that time.

I was also somewhat distressed to find that the Government still believe that following the Basel III approach of using capital related to risk-weighted assets is still at the centre of the approach to the determination of stability, particularly in the banking sector. This is using weapons with which we fought the last war to try to deal with the new war. It is an excessive emphasis on the asset side of the balance sheet to the detriment of the liability side, and indeed has been criticised very strongly recently by the IMF. I hope that the Government will rethink their approach and not continue to rely on this outdated measure.

I want to talk about some of the measures before us rather than some that might appear in the future, although the Minister has tempted me to ask what is happening with the leverage ratio. Leverage collars, which after all apply to the liability side of the balance sheet, have been demonstrated to be far more effective than risk-weighted capital requirements. Do the Government still plan to weaken the Vickers proposal of a leverage ratio of 25:1 and to fix the requirements simply on the Basel minimum of 33:1? When thinking about the leverage ratio, is the FPC planning any distinction between deposits and wholesale funding in the specification of a leverage cap?

In its earlier consideration of these measures, the FPC rejected the adoption of a loan-to-value ratio in mortgage finance, arguing that this was a political decision. In this instrument, though, we find the requirement on financial institutions to maintain additional own funds with respect to exposure to residential property. Will that not have the same effect? Is it not a back-door method of introducing loan-to-value restrictions by the requirement to hold additional capital against residential exposures?

Turning to the sectors specified in this instrument, it is striking that the measures are confined to financial instruments issued by financial sector firms. Why is that? If there were a bubble in the stock market, it could involve predominantly financial instruments issued by non-financial firms. Why is this legislation restricted only to instruments issued by financial institutions?

Another peculiarity of the drafting of this instrument is that it refers only to an increase in requirements of holding of own funds. It refers to “additional funds required” and that the PRA may require additional own funds both by banks and by other financial institutions. How will the PRA reduce the amount of funds required since the instrument only allows it to require additional funds? How will that happen?

I also regret the exclusion of smaller firms, to which the noble Lord referred in his introductory remarks. The Treasury seems to have totally failed to understand that a significant amount of the financial crisis was due to the aggregation of a large number of small firms doing the same thing at the same time, which had the same consequence as a large firm doing the similar thing in terms of the development of systemic risk.

The measures also refer to the requirement to ask or require that banks treat particular exposures as if they give rise to an increased level of risk, which is true not just of banks but also of investment firms. How is this level of risk to be specified by the FPC? Is it as a risk weight or as a modification of the stochastic distribution model used in the calculation of the firm’s value at risk? How is it to be done? If it is with respect to the modelling, does that now mean that the ability of firms to use their own risk models is to be modified and that there is to be a standardisation of risk models used by firms in the calculation of capital requirements?

The noble Lord referred to the use of these measures in what he called a granular way and what in the instrument is referred to as a solo basis. What will the relationship be between the FPC’s requirements of measures and competition policy, in the sense that imposing measures on a single firm would have competition implications? Will the views of the competition authorities be taken into account?

I assume that this is the first of a series of instruments that will implement the various proposals aired in the consultation papers issued by the interim FPC. Perhaps it would be helpful if the Minister gave us some timetable as to when those other instruments will be laid before the House.

[Lord Newby]

I am grateful to the noble Lord for those extremely thoughtful questions, and I will do my best to answer them. He said that systemic risk was not on the horizon before the crisis. I think that the phrase was first used in academic literature in 1979. Although the phrase was not in common parlance, it was well understood, at least by some people, that a bubble was building up that was capable of creating systemic risk. The first problem was that it took a long time for the authorities and the Government to accept that there was a bubble. The second was that when they realised that there was a problem, and indeed when there was a crisis, it was far too late to forestall it. It was then necessary to deal with a crisis rather than dealing with a problem at an early stage.

The noble Lord said that we rely far too much on Basel III and that it is a weapon of the last war. We are part of an international discussion on Basel III. Although Basel III is part of the armoury that we use, it is only one part. Indeed, the measure that we are looking at today is not a Basel III measure. Even if the noble Lord was correct that Basel III does not deal with every issue that we will be grappling with, it is not the only tool that we are looking at.

The noble Lord asked me about the leverage ratio, and whether we still plan to weaken the Vickers ratio. I do not believe that the Government’s view on this has changed.

[Lord Eatwell]

Why not?

[Lord Newby]

The Government said in response to Vickers that they believed he was going too far, and I do not believe that that view has changed. The noble Lord asked about the loan-to-value ratio and whether that tool would not have the same effect as introducing a loan-to-value ratio. In an aggregate sense, in many ways it does so. However, the advantage of this approach over adopting a loan-to-value limit is that it places an overall requirement on an institution in terms of its lending to the property sector, but still gives that institution the flexibility to provide loans at a high loan-to-value ratio. This might take place, for example, in a minority of cases in which the circumstances of the person to whom the loan is being given makes that loan prudent. In many ways it could have the same overall effect on the sector, but it gives institutions greater flexibility than a prescriptive loan-to-value ratio.

The noble Lord asked why the stock market was not included and why we were not including firms in that sector. The answer is that at this point the FPC believes that the definition of which firms are covered includes those firms that are most likely to cause a problem. The FPC has taken the view that firms in the stock market are not creating an equivalent risk to those elsewhere and those already covered. That is its judgement, which one can take a view on. The noble Lord disagrees, but that is the answer to the question.

The noble Lord asked about the order using the word “increase” and how it is envisaged that any increase might be unwound. When the FPC considers that any increase is no longer required, it will revoke the direction.

[Lord Eatwell]

Let us suppose that we are in the situation that we are in today, that there is no direction in place and that we wish to reduce the own funds. How do we do that?

[Lord Newby]

My Lords, I do think that that is an eventuality that the order caters for because, as the noble Lord says, it uses “increase”. If I am wrong on that, I shall let him know but, as he has said, the order is relatively straightforward. It will be for the PRA to decide whether it wants to do that, and it may do so, but obviously I will correct the record if I am wrong. It may require an amendment to the order for it to do that.

The noble Lord asked about the aggregation of a large number of small firms. This issue formed part of the consultation. The strong view came back that the effect that was being sought could be achieved by limiting the order at this point to larger firms. If any evidence built up that a large number of small firms could cause a risk beyond that currently envisaged, it would be for the FPC at that point to make appropriate provision.

The noble Lord asked how the FPC would specify risk. It will be for the PRA to determine capital models allowed by firms within the overall levels set by the FPC.

The noble Lord asked me about the timetable—whether there would be more orders and when they were going to be. There may be more orders, but none is envisaged at the moment. There is not a conveyor belt of other orders that are half-thought of. The view is that these measures are adequate for the time being. It is always open for further orders to be brought forward, but there is no perceived need for any further orders at this point.

There is one issue that I have not dealt with concerning the relationship between the FPC and the competition authorities. I hope that the noble Lord will forgive me if I write to him on that subject.

[Lord Eatwell]

Before the Minister sits down, perhaps we could go back to how an increased level of risk is to be specified by the FPC. Is that to be specified as a change in risk weights in old-fashioned Basel I structures, or is it to be specified as a modification of the value at risk models used by the financial institutions? If it is the latter, are we moving away from the ability of institutions to use their own value at risk modelling towards a standardised model?

[Lord Newby]

My Lords, as I said earlier, the PRA will set overall levels; the capital models allowed by firms will, I believe be determined by the PRA.

[Lord Eatwell]

I am sorry, but the noble Lord contradicts the instrument before us. It states clearly,

“if they gave rise to an increased level of risk specified by the FPC”.

It is not the PRA, it is the FPC that has to specify this increased level of risk.