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Transcript of Joanna GRAY
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8/6/2019 Joanna GRAY
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FINANCIAL REGULATION BEFORE AND AFTER NORTHERN ROCK
Joanna Gray, Newcastle Uniersity
Just over three years ago queues of worried and panicking bank depositors began
to form in the streets outside the branches of the UKs tenth largest bank and fifth largest
mortgage lender in one of the largest and most sophisticated financial economies in the
world.1Narratives and analyses of causes and responsibility for what was the first run on
a maor UK bank since the late 1!th"entury can be found in subsequent official
reports
#
and the academic literature in law$ economics and public policy and these will
continue to be developed and debated in years to come. %owever one thing became
crystal clear in mid&'eptember #(() and that was that the institutions and processes put
in place for the maintenance of financial stability and the prevention of bank runs and
panics by the last maor reform in UK financial regulation had not worked. *hat reform
first conceived in 1!!) on the election of a +abour ,overnment transferred responsibility
for the prudential supervision of deposit&taking institutions from the -ank of ngland/to
the newly formed 0inancial 'ervices uthority established and empowered by the
0inancial 'ervices and 2arkets ct #(((.
s the crisis in the financial system has deepened and spread into the real
economy there has been much fundamental 3back to basics4 rethinking around some of
the assumptions made about the optimal structures$ institutions$ obectives and
substantive content of financial regulation both in the UK and indeed around the world
that cannot be effected without changes to the attendant legal institutions and codes of
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financial regulation. *his chapter uses that 'eptember #(() depositor run and subsequent
nationalisation in 0ebruary #((5 of Northern 6ock as the lens through which to give an
account of how legal and regulatory reform has unfolded insofar as it affects the
regulation of financial stability and minimisation of systemic risk. *he paper concludes
with some critical comment about the practicality of some of the current and recent
proposals ostensibly designed to make the financial system 3safer4 for the future.
THE REGULATION OF NORTHERN ROCK
Northern 6ock was a mutually owned building society based in the North ast
ngland which became a public company in 1!!) at a time when a number of large
mutually owned financial institutions assumed proprietary status so that their borrower
and depositor members became shareholders in a public listed company. 7ver the ten
years since it first became a public company N6 grew to become the UKs eight largest
bank and fifth largest UK mortgage lender. 8ts business was primarily financed by
wholesale money market finance rather than by retail deposits. *he sudden loss of
liquidity that afflicted the wholesale money markets by ugust #(() meant that N6
could not raise operating finance$ and although solvent in a balance sheet sense it could
not pay debts as they fell due so it alerted its regulator$ the 0inancial 'ervices uthority
90':$ to its difficulties on 1/ ugust #((). 8n the UK formal responsibility for financial
stability and vigilance against and curtailment of risk to the financial system was shared
between the 0'$ the -ank of ngland and %2 *reasury 9the UK ,overnment
department with overall responsibility for all aspects of financial policy in the UK:.
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*hese three bodies were collectively referred to as the *ripartite uthorities 9;*ripartite
hereafter: and the terms on which that responsibility was to be e
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announced the banks nationalisation heralding a period of 3temporary public ownership4
of N6.
*hat nationalisation was achieved by the passage into law on #1 0ebruary #((5 of
the -anking 9'pecial Crovisions: ct #((5$ which effectively provided the legal basis for
this and other subsequent bank nationalisations$ and the entire share capital in N6 was
acquired by the ,overnment on ## 0ebruary #((5 pursuant to that ct. *hat ct and
secondary legislation made under it established the principle that compensation be paid
to the N6 shareholders by a scheme of independent valuation of compensation to be
conducted on the basis of the twin assumptions that that all financial assistance provided
by the -ank of ngland or the *reasury had been withdrawn 9whether by repayment
being demanded or by other means:$ and that no financial assistance would in future be
provided by the -ank of ngland or the *reasury to the deposit&taker in question.Dny
compensation due N6 shareholders was further to be computed on the basis that at the
point of its nationalisation the company was unable to continue as a going concern and
was in administration.E*hese provisions have resulted in a somewhat unholy alliance of
two very large and active hedge funds that held significant stakes in N6 at the time of its
nationalisation and$ at the other end of the scale of shareholder siFe$ passivity and
investment horiFons$ a representative group of small$ individual$ shareholders in N6.
United in their view of what they saw as confiscatory and unfair terms of compensation
imposed by ,overnment as part of the N6 nationalisation these somewhat odd
bedfellows have combined forces to bring a most interesting legal challenge to this
legislation which$ although unsuccessful to date in the %igh "ourt and "ourt of ppeal$ )
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is being taken to the uropean "ourt of %uman 6ights now that the new 'upreme "ourt
had declined to hear the shareholder appeal.5*his litigation has resulted in the
development of udicial narratives on responsibility for systemic stability and who should
bear the losses and responsibility for value destruction that materialise as a result of
failures in a financial system that appear to have comple< and multi&factor causes that has
been the subect of comment elsewhere.! *his chapter e
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the defining feature of the UK 0inancial 'ervices uthoritys modus operandiand whole
philosophy of regulation I namely risk related regulation and supervision. @uring its
early stage development as a financial regulator$ shortly after it assumed from the -ank
of ngland direct responsibility for bank regulation and supervision$ 0' identified
;6isk$ specifically risk to its four legislative obectives1D$ as the organising concept
around which all future regulatory activity$ including supervision$ enforcement$
intervention and overall strategy and policy development would be built. *wo e
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environmental regulation15and the idea is that a standard should be e
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funding mechanisms, including the repo market. I have to say, I do not think any
reasonable professional would have anticipated that set of circumstances, but I
think as a regulator we should have engaged with that in an etreme stress
test...!#(
nd yet the "7 of N6 itself saw the risk of the sources of N6s wholesale
financing effectively all simultaneously closing for such a long period to be an
unforeseeable$ unprecedented and entirely unpredicted event and pointed out in his
evidence to the *reasury 'elect "ommittee that no maor authority had in fact foreseen
it.#1%ence$ viewed from the perspective of the individual organisation what happened
cannot properly be described as a ;risk and is more in the nature of genuine uncertainty.
%owever this was not the view of events e
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*he second of the key techniques through with 0's risk&related regulatory
philosophy hitherto found e
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*he run on and subsequent nationalisation of N6 and subsequent events have
revealed many other shortcomings within the practical processes and capabilities of UK
financial regulation as well as problems in the 667G supervisory framework and
perceived problems with 0's less intrusive style of 3principles based4 regulation.
*hese include the lack of a bespoke statutory insolvency regime for dealing with failing
banks$ the lack of public understanding and confidence in the UKs deposit protection
scheme for retail depositors$ the inability of the -ank of ngland and N6 to keep
confidential the fact that it had sought and received emergency financial support in
'eptember #(() 9both of these being factors that contributed to the bank run: and the lack
of a clear financial stability obective for the -ank of ngland. #=8n the meantime whilst
consultation relating to longer term legislation was ongoing the -anking 9'pecial
Crovisions: ct #((5$ provided the *reasury with emergency powers to facilitate an
orderly resolution to maintain financial stability or protect the public interest and this
temporary measure was used not only to nationalise N6$ but later in #((5 also -radford
L -ingley 9one of the largest mortgage lenders on residential property bought by way of
investment:#Dand to intervene in order to protect retail deposits held in the UK
subsidiaries of 8celandic banks. s the banking crisis deepened throughout #((5 the
subsequent UK ,overnment acquisitions of shareholdings in the 6oyal -ank of 'cotland
and in +loyds *'- 9following the liabilities it took on when it had earlier ;rescued
%-7' plc: to forestall funding crises in those much larger institutions all but dwarfs the
scale of the Northern 6ock nationalisation.#E*hat ct has now been replaced by the
-anking ct #((! which 91: reforms insolvency and administration procedures giving
0' new powers for use specifically with banks only$ a range of legal tools such as
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transfer to temporary public ownership$ or a private sector purchaser or a ;bridge bank
are all now options for dealing with banks in or likely to encounter distress. *hese powers
are to be e
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RETHINKING REGULATOR! TA#K# AND FOCU# IN THE UK
fter publishing its criticisms of the handling of Northern 6ock the *reasury
'elect "ommittee went on to make broader criticisms of the way in which all three of the
*ripartite bodies responsible for financial stability in the UK performed in the failure to
follow through the implications for the stability of UK financial institutions of the
growing threat to the supply of wholesale liquidity posed by the very mispricing of risk
about which 0' had long been warning in the credit markets and the emerging problems
in the U' housing market.
/#
s has been the case here too in the U'$ #((5 was largely
taken up with responding to a rapidly deepening crisis and preventing total catastrophe in
the financial system so that the 'eptember #(() run on Northern 6ock and its
nationalisation began to look relatively small scale compared to some of the action the
UK government was the forced to take in terms of supporting and rescuing much larger
and more systemically significant banks. Nonetheless the run on Northern 6ock still was$
in the words of the *reasury 'elect "ommittee$ 3a catalyst for change4 in regulatory
practice and marked the beginning of the re&thinking of the intellectual foundations of
regulation of financial markets that is still ongoing.//
8n 2arch #((!$ +ord *urner$ the current "hairman of the 0inancial 'ervices
uthority produced a ;root and branch questioning of some of the assumptions that have
governed how we should best regulate financial markets and discussed$ among many
other issues$ the shortcomings of risk measurement models employed within regulated
firms and embedded in standards and processes used in risk&based regulation./=%is main
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conclusion$ which echoes those now being drawn in other urisdictions and at
supranational level$ was that a ;lack of [a system"wide macro"prudential] perspective,
and the failure to specify and to use macro"prudential levers to offset system risks, were
of far more importance to the origins of the crisis than any specific failure in supervisory
process relating to individual firms/D%ow best to achieve this more forward looking and
holistic macro&prudential management of the financial system$ and indeed whether or not
it is truly a realistic and achievable aspiration$ is now perhaps thekey theme to debate on
financial regulation.
Unsurprisingly$ as 0' "hairman$ *urner saw no need to radically reorder the
institutional responsibilities for financial regulation in the UK and would retain the model
introduced over a decade ago of a single$ unitary financial regulator responsible with
prudential$ conduct of business and systemic risk responsibilities for the entire financial
sector. s for ;principles&based or ;lighter touch regulation$ the *urner 6eport
acknowledged that this less intrusive regulatory philosophy was based on 3the then
dominant philosophy of confidence in self correcting markets .and was not with
hindsight aggressive enough in demanding adustments to business models which even at
level of the individual institution were e
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increasingly clear before the election that ;light&touch and risk based financial regulation
was effectively dead. *he run on Northern 6ock marked the start of a progressive
abandonment by 0' of an approach to its 0'2 #((( responsibilities that respected the
autonomy of regulated firms in working out how best to minimise risk to regulatory
obectives through their interpretation and application of general phrased regulatory
principles. Just one e
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financial regulation is planned by the new ,overnment. Gith its emphasis on#udgment,
$ocus and %tability the language in the very title of the July #(1( consultation that
introduces these proposed reforms signals that change is to come$ not ust at the formal
and institutional level of financial regulation$ but at every layer and process of regulation$
in the inner meanings and psychology of regulation and regulatory actors$ as well as in
their e
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uthorityH Mes$ insofar as institution&specific regulation goes but certainly not insofar as
system&wide risk is concerned. 8nstead there is a new form of risk based regulation in
town I but the risk it seeks to signal for and act as a buffer to is a risk that cannot be
diversified away or reduced by the actions of any single institution$ sector or even
country I for it is the risk that is endogenous to the whole game itself and thus requires a
holistic and panoramic lens and a fle
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e
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members of N6 on the one hand$ and the "7 of the 0' on the other hand$ as to
whether the closure of the sources of wholesale finance of #(() was foreseeable on the
part of anyone.==*he 0' took the view that they should have foreseen it but failed to do
so$ due to shortcomings in the application of the 667G model Ghether it is fair or
wise to have such e
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stumbles the ne
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17ne typical headline on 1D 'eptember #(() ran 3&olice called to break"up Northern Rock panic 'ueues as customers
withdraw millions4 in the @aily 2ail.
#Dth6eport from %ouse of "ommons *reasury 'elect "ommittee (he Run on the Rock %" DE&8 9January #((5:
/-ank of ngland ct 1!!5
=+astra$ 6. 9#((E:)egal $oundations of International *onetary %tability7
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1/$%A Internal Audit 2epartment In'uiry into supervision of NR9pril #((5 0':.
1=@alker Review of 5orporate overnance in B 0anks and other financial institutions9 "onsultation @ocument July
#((!? 0inal 6eport November #((! :
1D'ection # 0inancial 'ervices and 2arkets ct #((( defines these as market confidence? public awareness? protection of
consumers? and the reduction of financial crime.
1E-lack$ J. 9#((D: S*he mergence of 6isk -ased 6egulation and the New Cublic 2anagement in the UKS&ublic )awD1#&
D=!? ,ray$ J. and %amilton$ J. 9#((E:Implementing $inancial Regulation$ Giley 0inance$ "h #
1)&rinciples"based Regulation9 $ocusing on the 4utcomes that *atter90' pril #(():? -lack$ J.? %opper$ 2. and -and$
". 9#((): S2aking a 'uccess of Crinciples -ased 6egulationS 91:)aw and $inancial *arkets Review1!1(E? 0lueprint
for a *odernised $inancial Regulatory %tructure 9U' *reasury 2arch #((5: at 11D and at 1!1
157gus$ .$ 91!!=:Regulation9 )egal $orm and 7conomic (heory$ "larendon$ "h 5.
1!*he 0ifth report from *'" in #(()#((5
#(vidence given by %ector 'ants$ "7 of 0' to *reasury 'elect "ommittee$ ! 7ctober #(()
#1vidence given by the former "hairman and "hief
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