It’s just over a year since the Coalition came to Government and delivered its first budget. And we came to power in some rather unenviable circumstances.
The largest peace time deficit on record.
An unbalanced economy still jittering from the crisis.
And a financial sector climbing a steep path to recovery, but hindered by vast regulatory uncertainty.
The last twelve months, however, have given us cause for cautious optimism.
Output is growing as we rebalance away from debt-fuelled consumption to investment and export.
The budget deficit is falling from its record highs.
And half a million new private sector jobs have been created in the last year - and that includes an extra 25,000 jobs in the Square Mile alone.
Of course, we have always said that recovery would be choppy. After all we are recovering from the biggest financial crisis in almost a century.
A crisis that came on the back of debt-fuelled consumption, irrational banking exuberance, and chronic regulatory failings.
This is a situation that we cannot afford to repeat.
And we are pursuing an ambitious agenda of regulatory and market reforms to ensure that is the case.
But herein lies the challenge. As the Chancellor said in his Mansion House speech two weeks ago, we have to confront the “British dilemma”.
As a global financial centre that generates hundreds of thousands of jobs, a successful banking and financial services industry is clearly in our national economic interests.
But, whilst we strive for global success in financial services, it’s clear that success should not come at the cost of wider economic stability.
Against that, we can’t allow reform to put the UK at an unfair and uncompetitive disadvantage to the rest of the world. In such a fluid, open and competitive market as finance, it is vital that rules are consistent between national authorities.
We have to answer how we can create a successful, stable and competitive financial services sector.
A year on from coming into power, we are much closer to a consensus on the answer. A consensus based on three aims:
- Ensuring the right system and culture of domestic regulation
- Ensuring consistent international rules; and
- Ensuring that the taxpayer is not on the hook if a “too-big-to-fail” bank does in fact fail.
Taking the first, domestic regulation, we are fundamentally reforming the failed tripartite system.
We are putting in place an entirely new regulatory architecture consisting of the Financial Policy Committee and the Prudential Regulation Authority sitting within the Bank of England, and the Financial Consumer Authority.
Furthermore, we are ending the tick box culture that dominated the tripartite system of regulation.
In particular, the new Financial Policy Committee will have responsibility to monitor overall risks in the system, identify bubbles as they develop, spot dangerous inter-connections and deploy new tools to deal with excessive levels of leverage before it is too late.
This is an unprecedented structure of pro-active and judgement led regulation.
But this new approach to regulation recognises the importance of the financial sector to our economic recovery.
For that reason the FPC will be required to take economic growth into account when pursuing financial stability, whilst recognising of course that stability is in itself an important enabler of growth.
Only two weeks ago the Interim FPC met for the first time, and has now produced the first Financial Stability Report under the new regime - identifying potential risks to financial stability and suggested responses. Just what we needed in the run up to the crisis.
The Interim FPC highlighted the continued turbulence in the eurozone as its principal threat to financial stability. And that risk is another reminder that we are very much all in this together. The global financial crisis was triggered by problems in the American sub-prime mortgage market but quickly enveloped the rest of the world.
And whilst certain markets and institutions may have emerged relatively unscathed, so interconnected are our global financial markets, that there is no room for complacency in preparing for the next time around.
So it is only through consistent international regulation that we can effectively insulate the entire global financial system as a whole from instability.
We have to ensure that national authorities and banks work towards meeting internationally agreed and consistent frameworks, such as Basel III.
That said, there still remains a real risk of slipping into parochialism and protectionism when it comes to regulatory reform. As we drift further from the crisis, it’s all too easy to downplay or dismiss those near cataclysmic events as unique and one-off when history shows us that this is far from the case.
Instead, international cooperation and ambition is crucial to strengthening global financial markets against potential global risks.
The IMF, the G20 and the Financial Stability Board are central to taking this agenda forwards. The latter two are in many ways creatures of the crisis. They provide the vehicles through which we can ensure common standards and consistent implementation.
Because whilst we can create a consensus on objectives, we’re well aware that a consensus on implementation is often harder to come by.
Nowhere is that clearer than on Basel III.
Indeed, it’s unsurprising that Basel III steals most of the headlines when it comes to the international regulatory debate. It has proved a striking example of the kind of ambitious reform that international cooperation can achieve.
Through committed European leadership and intense collective negotiations we have come to an international consensus on some of the biggest changes to bank capital and liquidity requirements that we have ever seen. G20 Leaders described it as a “landmark” agreement precisely because for the first time there was agreement on the details as well as principles.
Consensus on such big changes is no mean feat and of course, negotiation entailed necessary tradeoffs on the original proposal.
The final Basel agreement embedded lengthy transition times to allow banks to adapt and so as not to endanger the economic recovery.
It accommodated European banking models including bancassurance, by providing significant allowances for less loss absorbent forms of capital to make up to 15% of Core Tier 1.
And the final capital thresholds themselves were only agreed after painstaking discussion and compromise to ensure that we reached a consensus that all countries could agree to in full.
So the right balance was struck on transition, on allowances for particular capital structures and on the overall level of capital. It was a carefully calibrated equilibrium demonstrating that we had learnt the lessons from the financial crisis.
We, and the other G20 countries, all agreed… and I quote, “We are committed to adopt and implement fully these standards”.
As you know, the Capital Requirements Directive will implement Basel in the EU. We must resist attempts to unpick Basel at this stage.
It’s incredibly disappointing to hear mutterings of discontent and resistance on the implementation of Basel, including from some G20 signatories.
Yes, we are still suffering from the aftershocks of the crisis, and the sovereign crisis across the Euro area is the most obvious example.
But that is no reason to shy away from fundamental reform. The lengthy transition timetable already caters for these economic uncertainties.
The Basel reforms that we have collectively arrived at will help secure a more stable financial system. It is vital that we implement them in way that protects and supports the single market.
What does that mean in practice?
Firstly, we know that banks need to be better capitalised - in both quality and quantity - to be able to absorb the losses which taxpayers picked up the bill for during the crisis. The crisis demonstrated that ordinary shares are the capital instruments that are best able to absorb losses.
That’s why we should adhere strictly to the Basel definition of Core Tier 1 capital. The market trusts these instruments to absorb losses, expects Core Tier 1 to be defined as ordinary shares and expects all banks to be capitalised on the same basis.
Nor should banks be able to double count capital held in insurance subsidiaries, beyond the very generous concession already provided. So in Europe we should stop the alternative approaches to counting of insurance capital that are allowed under the Financial Conglomerates Directive.
And weak capital instruments should not be grandfathered as equivalent to the new Core Tier 1 standard.
So we would be failing taxpayers if we retreated from strong capital standards.
Of course, it is well understood that there needs to be a special regime for mutuals, which are not able to issue ordinary shares.
Secondly, we must recognise that the lack of liquidity was one of the fundamental faultlines of the crisis. So as part of the Basel package, we must entrench rigorous and internationally consistent liquidity standards.
The crisis demonstrated vividly how a narrow liquidity shock can feed back into a system wide seizure. Banks were all too often over-reliant on short-term wholesale funding and lacked liquidity cushions to reassure markets. The lack of internationally agreed liquidity standards exacerbated that feedback loop.
That is why Basel has committed to two Pillar 1 liquidity measures - the Liquidity Coverage Ratio, and the Net Stable Funding Ratio. Of course, a diverse and balanced range of funding is essential for financial stability and sustaining lending to the real economy, but core liquidity must be sustainable and proven to be liquid in stressed markets.
Thirdly, it means that we commit to implementing a leverage ratio on a Pillar 1 basis and that we require banks to disclose what their ratio is. A leverage ratio is a vital backstop against any deficiencies in a future risk based regime. And disclosure is essential to improve transparency and therefore market discipline on potentially reckless firms.
And finally, it means that we should implement Basel as the minimum standard across the EU, not the maximum. Jurisdictions should retain the right to apply higher levels of regulation to ensure financial stability.
As Stefan Walter, the Secretary General of the Basel Committee, has said “This has always been an option under Basel I and II, and it will remain the case under Basel III”.
In its recent Article IV report on the UK economy, the IMF strongly supported the case for full implementation of the Basel agreements while retaining discretion for national authorities to go beyond agreed minimum standards.
As a cursory glance around Europe demonstrates, no one financial market is the same as another. So a one size fits all approach to capital, liquidity and leverage needs to reflect the fact that to safeguard the stability and resilience of financial markets and national economies, supervisors need the flexibility to go further.
Maximum harmonisation would limit the ability of national regulators to impose requirements to reflect the unique risks and characteristics of their home markets.
Maximum harmonisation would also severely undermine the ability of national regulators to tackle macro risks unique to their markets.
Indeed, pre-crisis we were naive of the risks that can materialise at the system level, not just the firm level.
The crisis has shown that we need new tools to lean against the credit cycle. We have learnt that national regulators need the discretion to use macro-prudential tools to adequately react to systemic risk through targeted interventions.
This does not undermine our commitment to a Single Rule Book, which explicitly allows for higher standards where appropriate. Rather, it reflects the inescapable fact that one size fits all cannot prevent the build up of unacceptable fiscal and systemic risk in individual countries.
Nor can we rely on ‘soft’ implementation, Pillar 2 type measures. The regulator’s macroprudential response must be clear, justifiable and transparent, and typically system-wide. The European Systemic Risk Board can play an important role here to help share national macroprudential authorities’ experiences.
These are the critical criteria for uniform implementation of Basel. They are essential to ensuring that reform is credible, effective, and ensures greater financial stability.
We must also appreciate that Basel alone may not be enough to ensure the stability of the largest, global, systemically important financial firms.
In particular, how do we ensure that regulatory requirements reflect the higher systemic risk that such firms pose?
And where they do fail, how do we ensure we have the tools to resolve such firms without recourse to taxpayers’ money?
We are already tackling the issue through the Independent Commission on Banking, and I am grateful for your engagement with the Commission as it undertakes this vital work. Indeed, the Commission’s interim report provided a valuable contribution to the domestic and international debate, and it put forward two particularly important proposals.
Firstly, bail-in instead of bail-out so that private investors, not taxpayers, bear the losses if things go wrong.
Secondly, a ring fence around better capitalised high street banks to protect them and make them safer.
As the Chancellor said at Mansion House, the Government endorses both these proposals in principle, and we look forward to the Commission’s final report in September.
The Financial Stability Board will also be considering proposals from the Basel Committee for systemically important banks to be subject to a capital surcharge above the Basel III minimum, reflecting the unique risk that they pose to the wider economy. Later this year the G20 will be considering these issues.
As the Chancellor has made clear, we agree with the need for further capital requirements on systemically important banks, and we agree with the Commission that, outside the ring-fence, this is best done internationally.
But even with these changes, we cannot reduce risk to zero. There is still the risk that a global, systemically important firm fails.
Internationally consistent Recovery & Resolution plans play a central role in addressing these risks, as do internationally consistent and credible tools to implement a resolution. The development of an EU framework for Crisis Management is critical to realising these goals, and it will be essential to replicate these measures globally, in a consistent manner.
I’m sure you’ll agree that we have come a long way to achieving a new settlement for our financial system.
A settlement that will preserve the competitive strengths of our financial system.
A settlement that ensures the stability of the financial system
A settlement that protects the taxpayer from financial failures.
There is still further to go to resolving the “British dilemma” but we are working tirelessly on domestic and international reform to reach an answer.
It is in everyone’s interest that we get these reforms right. And it is vital that we continue to work with the industry, including the BBA, to do so. I look forward to working with you in the years to come.