[Please check against delivery]
Good morning, and thank you for inviting me to speak here today, and thank you to Chatham House for hosting today’s events.
Quite often when we discuss financial regulation it’s easy to become lost in the technical detail, the minutiae of complex reform and the alphabet soup of European directives, from CRD through MIFID to EMIR.
And I’ve had to make plenty of speeches over the past couple of years which have been pretty detailed and technical.
Today I’d like to use this opportunity to take a step back and look at what we are trying to achieve through regulatory reform.
And in explaining our reform objectives I’d like to focus in particular on one of the key lessons from financial crisis, the need for a macroprudential approach to complement high firm by firm prudential standards.
Let me start by explaining our objectives for regulatory reform.
We are committed to reform that secures a stable and successful financial sector with a global outlook … a sector that provides sustainable lending, supports sustainable growth, but one that doesn’t put our wider economic stability in jeopardy.
And yes, it’s an objective that contains an inherent dilemma … how can we reform the sector without undermining the competitiveness, and stifling the innovation that continues to be critical to its growth and success?
And given the strength and importance of financial services in the UK, and the global leadership of the City of London, it’s a particularly British Dilemma.
A successful financial sector is vital to the UK economy, channelling the funds of savers to investment opportunities, transforming our bank deposits into loans to our businesses and helping businesses and individuals manage risk.
But of course London is home to a financial centre that serves not just the UK but the wider world. Year after year the City of London ranks as the world’s most competitive financial sector, with the UK home to the largest insurance industry in Europe, and the second largest fund management industry in the world.
The financial sector accounts for around 10% of UK GDP, employs over 2 million people in financial and professional services, and provides indispensable services to millions of people and businesses across the country, and indeed across Europe and the world.
So a successful financial sector is in our critical economic interest.
But that does not mean going soft on regulation. Events of the last few years provide stark evidence of the lasting damage that can be wrought by an inadequately regulated financial sector.
It is only by reforming regulation to ensure the stability of the financial sector, that we can secure a foundation of sustainable lending to households and businesses across the economy.
But disproportionate regulation brings with it significant costs, undermining growth by limiting the capacity of the sector to lend to the wider economy.
The financial crisis revealed many regulatory failings, but perhaps the two most important were:
- inadequate microprudential regulation and supervision of banks; and
- the mistaken belief that the soundness of individual banks implied the system itself was sound; meaning regulators failed to monitor and address the build up of systemic risks in financial markets.
Touching first on firm-by-firm bank regulation, there is an international consensus, reflected in the G20-endorsed Basel agreement, that banks need to be subject to significantly tougher minimum capital, liquidity and leverage standards.
2008 wasn’t just an Anglo-Saxon crisis, it was a universal crisis that has come at great cost to us all through rescuing failed banks and providing in excess of three trillion Euros in guarantees and other support across Europe.
So we need full and consistent implementation of Basel III by all G20 countries and we will resist any attempts at EU level to unpick this crucial agreement to:
- fragment markets through opt-outs from minimum standards; and
- undermine our efforts to tackle the perceived implicit guarantee in banking, one of the biggest distortions to the single market.
That is why the Prime Minister wrote a letter with eleven other Heads of Government before the last European Council calling for no dilution of the Basel 3 agreement in Europe. And why we support the amendments proposed by the European Central Bank to the Commission’s CRD4 proposals currently on the table to bring them fully into line with the Basel 3 agreement for globally active banks.
But high minimum prudential standards is but one piece of the jigsaw, the UK is also leading international efforts to tackle the too big to fail problem posed by the largest, most interconnected banks.
Through reforms based on the recommendations of the Independent Commission on Banking we will ringfence retail banking activities supported by insured deposits, and place investment banking activities in a separate entity held at arm’s lengths.
And those ring fenced retail banks will also be subject to additional loss absorbency requirements over and above the Basel minimum.
Furthermore, both the ringfenced and non-ringfenced entities will be subject to other robust prudential requirements and rigorous supervisory intensity.
Placing both on a sustainable footing, and making it easier to resolve a failing bank in an orderly manner without taxpayer support
These are vital reforms that will support and strengthen the universal banking model and will strengthen the European single market by reducing the implicit guarantee.
We are concerned that there may be dwindling political will in Europe to tackle the implicit guarantee with the same vigour that we are.
So we welcome the establishment by Commissioner Barnier of the Expert Group under Governor Liikanen and we hope that this will place this issue at the front and centre of their debate.
And hand in hand with that, we also look forward to the Commission’s proposal on a comprehensive banking resolution framework and bail-in measures to ensure losses in the future are borne by creditors and not taxpayers.
Higher capital standards and tackling too big to fail need to be complemented by a step change in firm by firm supervision.
That is why this Government is abandoning the failed and discredited “Tripartite” system of regulation, abolishing the Financial Services Authority and creating a new Prudential Regulation Authority with a focus on micro-prudential regulation and supervision.
Instead of mere box ticking, it will bring judgement and foresight to the task of supervision.
But the financial crisis also demonstrated starkly that a micro-prudential approach to prudential regulation, which focused entirely on ensuring that banks individually can survive an exogenous shock, is insufficient.
We had all…firms, regulators, central banks and Governments… been dangerously naive about the systemic risks that were building up in the financial system.
Financial markets have frequently proved prone to periods of excessive expansion in good times, where the self-reinforcing interactions between credit growth, asset prices and economic performance result in excessive risk taking and leverage.
The lessons of the past were forgotten as we found new paradigms that explained why this time credit could grow rapidly without triggering the crashes that have regularly punctuated, and indeed punctured, economic growth. As the financial crisis showed, history has a habit of repeating itself.
Of course increasingly interconnected firms mean that a shock affecting one firm can be quickly transmitted across financial markets and on to the wider economy.
So a key objective of regulatory reform, the final piece of the jigsaw, must be to increase our capacity to monitor and mitigate systemic risk.
In an economic upswing we need to be alert to the tendencies to excessive risk taking and credit over-expansion.
In the downturns, we need to be alive to cushioning the fall by allowing banks to draw on capital and liquidity buffers built up in better times.
Today there is a clear consensus that monetary policy is not enough to manage systemic risks in financial markets - we need macro-prudential tools as well.
As the G20 agreed in 2009, we have to “reshape our regulatory systems so that our authorities are able to identify and take account of macro-prudential risks.”
And taking it even further, the De Larosiere Group argued that “central banks have a key role to play” in that task.
The UK is at the forefront of international efforts to turn that ambition into a reality.
In the Financial Policy Committee, we are establishing a strong and expert macro-prudential authority sitting within the Bank of England.
Its task will be to monitor overall risks in the financial system, spot dangerous inter-connections, and stop excessive levels of leverage before it’s too late.
To echo the words of Former Federal Reserve Chairman William McChesney Martin, it is the FPC that will take the punch bowl away.
Just as the independence of the MPC gives UK monetary policy credibility, just as the Office of Budget Responsibility through its independence polices the Government’s adherence to its fiscal mandate, the independence of the FPC is critical to its effectiveness as a macro-prudential regulator.
So how will the FPC work in practice?
The interim FPC met again last Friday, and we look forward to its report later this week setting out recommendations on tools that it believes should be included in the statutory FPC’s macro-prudential toolkit.
We, like many of our international peers, are in the early stages of understanding how these tools will work, and our knowledge will only increase through shared experience.
That’s why we have committed to public consultation on the FPC’s initial set of policy tools before presenting our proposals to Parliament.
At the same time, as financial markets innovate and change, and as new risks emerge, the judgement and foresight of the FPC and the Bank of England will be critical to responding to those risks, for example by recommending changes to the macro-prudential tool kit or the perimeter of regulation.
These are substantial responsibilities, and substantial powers.
By exercising these macro-prudential tools, the FPC will be taking decisions that can have significant economic implications.
That’s why it is essential not only to embed the FPC’s independence in statute but also to put in place strong mechanisms to promote transparency and ensure accountability.
First and foremost, we have been clear that as the FPC pursues its objective to protect and enhance the financial system, it cannot be over-zealous in its pursuit of stability to the point where the financial sector can no longer support the real economy - “The stability of the graveyard”
That’s why the legislation explicitly prohibits the FPC from taking any actions that would be likely have a significant adverse effect on the financial sector’s ability to contribute to sustainable growth in the medium or long term.
This represents a strong growth element in the FPC’s objective… stronger even than that of the Monetary Policy Committee.
Let’s not forget that by taking effective and timely action to ensure stability, for instance to lean against unsustainable credit growth, the FPC will at the same time be protecting long term economic growth. Targeted and effective action by the FPC can therefore prevent the damage to growth that would be caused by a bubble building and then bursting.
Growth is and will continue to be an overriding priority for this Government. But we - and the FPC - need to focus on the right kind of growth… sustainable growth based on strong fundamentals …and not growth built on the unsustainable mountains of debt that preceded the recent crisis.
Of course, compared to inflation rate targeting through the interest rates, targeting financial stability with what are still embryonic tools, is an altogether different task.
That’s why it is essential that Bank of England and the FPC must continue
- to develop, and report against, robust indicators of financial stability;
- to set out their analysis of risks to the system and effectiveness of their policy actions; and
- to demonstrate to the Parliament and the public how they achieve the right balance between financial stability and sustainable economic growth.
So the FPC is the final piece in the jigsaw of domestic reform - it fits together with higher capital standards, the Vickers reforms and strengthened supervision.
But we also believe that macro-prudential supervision needs to be mirrored in Europe. It is vital that all national regulators develop macro-prudential and resolution tools to address emerging risks.
The European Systemic Risk Board has already issued recommendations on macro-prudential policy to all Heads of Government …and alongside the European Central Bank they have also sought changes to CRD4 to ensure necessary flexibility to implement macro-prudential policy at national and European levels.
We believe that Commission’s current proposals do not provide the proper basis for the transparent use of macro-prudential tools across the whole sector.
Nearly five years since the financial crisis started, Europe needs to put in place the means to prevent or deal with the next one at both Member State and European levels.
So let me conclude. The UK is committed to fundamental reform of the financial sector, remedying the gross failures of the past decade.
But as we reform, we all have to be mindful of the inherent dilemma between stability and growth.
We are committed to reform that secures a stable financial sector that doesn’t jeopardise the wider economy…
- …a sector that provides sustainable lending and supports sustainable growth…
- …a sector that thrives on an open, competitive and un-fragmented market.
But if we are to achieve those objectives then regulatory reform has to adhere to three core principles.
We must underpin global markets with high, non-discriminatory and consistent standards of regulation…
At home, we have to embed judgement and foresight at the heart of a supervisory approach led by the Bank of England.
And across the entire breadth of regulatory reform, domestically, in the EU and internationally, we need to ensure that reform is proportionate and evidence based, providing the right balance between growth and stability.