This was published under the 2010 to 2015 Conservative and Liberal Democrat coalition government
Speech by the Financial Secretary to the Treasury.
The topic that we’re discussing today is one that’s going to dominate European and indeed global negotiations for months, if not years, to come.
Can we have stable and sustainable growth and tougher regulation of financial services?
Well the right answer is yes… We need both if the recovery is to be sustainable.
The financial crisis has shown us all the risks associated with a light-touch approach to financial regulation, and the economic costs of going down this road.
The real issue, from my perspective, is how can we strike the right balance between ensuring stability, and supporting the global economy.
Now that’s a much more difficult question to answer.
In fact, with the wealth of new financial regulation being agreed internationally, this is a topic we could discuss for hours.
So instead, what I’d like to focus on this morning are the new rules on capital and liquidity that were agreed through the G20.
I know that many people are concerned about the impact of these reforms on profitability and the returns investors can make from investing in bank and equity.
There are concerns that banks may generate less profit for shareholders as they absorb the costs associated with the new structures.
This could make them less attractive as an opportunity to investors seeking a higher return in the short term.
And in the medium term, a better capitalised banking system will have a different risk and return profile, both for equity and debt investors
There are also concerns that a greater emphasis on stable funding and long-term investment to improve liquidity may possibly limit the role of short-term money markets.
And the instruments required to establish bank bail-ins may be more difficult to price in the short term, until the market becomes established.
I think that one of the factors determining the impact of Basel II on banks, investors and the wider economy will be implementation. We must ensure the following:
- First of all, that when the new capital and liquidity rules are implemented, they’re done so in an internationally consistent way
- Secondly, that this is a transparent process, where it’s easy to see that firms operating in financial services are adhering to these new regulations.
- And finally, that we take every action possible to ensure that bank leverage standards maintains, not fragments global financial markets.
So that as we strengthen regulation across the world, we don’t undermine the many benefits that openness can bring to financial centres.
Turning to competition first.
In this area, there’s been a lot progress over the last decade.
The most obvious example being the developments made in Europe as we’ve moved towards the Single Market. With Europe, directives such as MIFID have strengthened the single market in financial services.
But competition has also flourished outside the European Union.
Firms headquartered in the UK are having an ever increasing presence in developing markets such as India, China, and across South America.
And it’s this competition that has helped bring down trading costs; improve liquidity standards; and has led to better protection for investors worldwide.
Which is why, as we take forward the agreements made at Basel, it’s important we remember that our financial sector doesn’t work in isolation to the rest of the world.
That the finance industry is a vastly complex web of trades, liabilities, shares, and holdings….
…and capital and liquidity standards need to reflect that fact…
…Otherwise we would only weaken - not strengthen - the system as a whole.
Which is why we must ensure that these new rules are implemented consistently across the world.
So that on the one hand, we are all able to benefit from growth that is stronger, more resilient to future shocks, and more sustainable in the longer term.
And on the other, that firms are able to compete on a level playing field and are not unfairly priced out of financial markets.
Failure to do this would risk undermining the progress the G20 has already made, question the credibility of the reforms we’re trying to take forward, and risk the stability of the global recovery…
…Something we’re all keen to avoid.
The financial crisis has also shown that we need more transparent markets to help safeguard the interests of consumers; ensure growth is sustainable; and enable regulators to fulfil their duties.
On transparency, the G20 has shown real leadership at a global level.
Working with the Financial Stability Board and other standard setters, the G20 has driven forward an agenda that has improved disclosure requirements for complex financial products and increased transparency around pay and wider remuneration.
This progress is certainly welcome, but I feel there’s still more that can be done.
In the case of bank leverage, this is of the upmost importance as there is no use in having rules in place if it’s difficult to monitor their effectiveness.
And we need to be clear about how we approach this problem.
Take last year’s EU stress tests for instance.
This was certainly a step in the right direction, yet the tests were nowhere near demanding enough.
For instance, they failed to show us to the magnitude of the problems Ireland faced… where the bailouts 6 months later dwarfed the initial CEBs figures on capital deficiencies.
So in my opinion, just as we need higher capital requirements to ensure stability, we also need better tools for ensuring they’re adhered to… So that risks can be identified sooner and steps taken to ensure compliance.
With stress tests that are more timely.
And more comparable across the many institutions they’re meant to assess.
The obligations of investors and market participant also have a role to play here.
With more data available on the strength of institutions, investors should be using this to exercise their judgement of the risks involved- rather than blindly relying on external credit ratings.
An effective crisis management structure- which I will touch on later- is essential in incentivising investors to do this- by ensuring that the costs of failure, as well as the rewards for success, are borne by the decision-makers and investors.
I also want to discuss is the importance of preserving open markets when implementing the Basel agreements.
The UK has a long history of working within Europe’s borders, as well as looking beyond them - a tradition reflected in the global reach of our banks.
Our largest banks get the lion´s share of their income from activities abroad. And this is something we must preserve.
We need to ensure that our financial institutions can continue to operate in a global marketplace, attracting business and investment from overseas.
Equally, we need high common standards applied across all the major financial centres of the world.
In this respect, the G20 remains the ideal forum for taking this work forward.
Already this collection of the world’s leading economies has reached agreements in areas as diverse as the clearing of derivatives; crisis management; and accounting standards.
The G20 also provided the political impetus which led to the agreement of the new Basel capital and liquidity standards.
This is a good example of where global action can deliver a strengthening of global standards whilst protecting the industry from the distortions that inevitably arise when countries act alone.
But implementation remains key.
Going forward, the G20 has an important role to play in ensuring the full and timely implementation of the Basel agreements.
Because having reached this international agreement, we now need to see it through and avoid attempts that would weaken the overall ambition of these reforms.
There are those who will say that tightening prudential controls will harm the financial sector and the wider economy.
However, the truth is that the Basel agreements will improve the resilience of our financial institutions - reducing the risk of contagion to the wider economy.
But they’ll also help make sure that it’s shareholders and creditors - not the taxpayer - who pick up the bill for bank failures in the future, which is why the global debate on financial management is vital.
Higher capital and liquidity standards will, without doubt, go some way towards helping prevent a repeat performance of the events that unfolded in 2008. Indeed, as the G20 communique said, banks should hold enough capital to absorb losses from a crisis of similar magnitude to the one we have just experienced.
But another key part of the international reform agenda is developing the tools to resolve failing financial institutions.
The ability of Europe, and indeed the world, to manage future crises is of huge significance.
We need to develop a way of allowing banks to fail, without risking customer deposits or undermining financial stability.
And we need to address perceptions of the existence of implicit taxpayer guarantees where these exist.
Whilst we need to ensure that there are proper cross-border arrangements to co-ordinate the resolution of global banks, national resolution authorities need to take the lead given that national taxpayers are still at risk.
Another avenue that the FSB and Commission are exploring is “bail-in”.
This is an interesting idea, and potentially a powerful tool to provide a better incentive for bank shareholders, creditors and company boards to collectively manage risks effectively.
Before deciding whether to proceed we of course need to consider carefully how we could make bail-in work for the investor community so that bank debt remains and attractive asset for investors.
So there is still work to be done on this, but we welcome the initiative taken by the FSB and the European Commission to consider bail-in and seek an internationally workable policy option for us to consider.
For our part, given the scale of the banking sector, we have taken the proactive step of setting up the Independent Commission on Banking to look at - amongst other things - the complicated issue of banks that are deemed ‘too big to fail’…
…and to do so in a way that ensures that there’s an open, public dialogue on banking reform.
Given the scale and importance of the financial sector in the UK, the ICB are examining how to:
- promote financial stability by reducing systemic risk in the banking sector
- mitigate moral hazard
- reduce the likelihood and impact of firm failure; and
- Promote competition in both retail and investment banking
Now I’m sure many of you looked through the ICB’s Interim Report published last month, outlining a number of proposals for consideration as they approach the second round of consultation.
- UK headquartered banks’ retail banking activities to be established in ringfenced retail subsidiaries;
- Proposing a 3 per cent equity surcharge for the ringfenced Systemically Important Financial Institutions
- A statutory bail in power which would require that creditors would have the value of their debt written down or converted to equity at the point a firm fails;
- The introduction of depositor preference which would give ordinary deposits super senior status over other bank creditors; and
- A series of possible measures to increase competition in the UK retail banking market.
I would encourage the investor community to engage with the ICB in this work as it prepares its final recommendations.
These are issues that we have to get right if we want to guarantee financial stability and sustainable growth in the future.
Beyond the ICB, for the ‘too big to fail’ agenda to be effective, a rigorous international policy for systemically important institutions needs to be agreed.
The Financial Stability Board’s work to identify Global Systemically important Banks and to recommend measures to the G20 for increasing their resilience to loss making is therefore vitally important.
We are engaging actively on this project and working closely with the FSA, Bank and international partners as the debate intensifies in the run up to the Cannes G20 summit in November.
I have focused on the reforms to capital and liquidity proposed by Basel III today, because I think these highlight some of these broader issues that we need to confront when we consider the reform of financial services in the aftermath of the financial crisis.
Whilst we want stronger, more resilient financial markets, we need to strike the right balance so that these reforms do not stifle economic growth, drive down investment opportunities and restrict capital flows unnecessarily.
That is the challenge that industry and regulators face- and one on which I’d be interested in hearing your questions and comments.