Bank of England – Page 19 – Digital Finance Analytics (DFA) Blog

UK PRA Releases Consultation Paper On Pillar 2 Capital Requirements

The UK Prudential Regulation Authority (PRA) today released a consultation paper which sets out proposed changes to the PRA’s Pillar 2 framework for the UK banking sector, including changes to rules and supervisory statements. Under the Pillar 2 framework, the PRA assesses those risks either not adequately covered, or not covered at all, under Pillar 1 capital requirements, as well as seeking to ensure that firms can continue to meet their minimum capital requirements throughout a stress. It also introduces the content of a proposed new statement of policy: The PRA’s methodologies to setting Pillar 2 capital. This sets out the methodologies that the PRA proposes to inform its setting of firms’ Pillar 2A capital requirements.

The proposed policy is intended to ensure that firms have adequate capital to support the relevant risks in their business and that they have appropriate processes to ensure compliance with the Capital Requirements Regulation (CRR) and Capital Requirements Directive (CRD). It is also intended to encourage firms to develop and use better risk management techniques in monitoring and managing their risks. Pillar 2 therefore acts to further the safety and soundness of firms, in line with the PRA’s objectives. The PRA intends that the publication of its proposed methodologies to set Pillar 2 capital will help firms to understand the rationale for the PRA’s decisions and plan capital accordingly.

This consultation is relevant to banks, building societies and PRA-designated investment firms (‘firms’). The paper includes:

Overview and background on the proposed Pillar 2 framework.
Pillar 2A methodologies, including the proposed new approaches the PRA will use for assessing Pillar 2A capital for credit risk, operational risk, credit concentration risk and pension obligation risk, alongside the existing approaches for market risk, counterparty credit risk and interest rate risk in the non-trading book (usually referred to as interest rate risk in the banking book (IRRBB)). It also details the proposed associated data requirements.
The PRA buffer and how the PRA proposes to operate this new buffer regime.
Governance and risk management, including proposals to tackle significantly weak governance and risk management under Pillar 2.
Disclosure, including the impact of the proposed Pillar 2 reforms on capital disclosure and proposals for a more transparent regime.
Analysis on the impact of the proposed reforms.

The paper provides an excellent summary of the current thinking in terms of pillar 2 regulation, and it will further increase the capital required to be held by UK banks. There are implications for financial services companies and regulators in other jurisdictions. We discussed the implications of these capital changes recently.

The UK consultation closes on Friday 17 April 2015.

Shadow Banking And Monetary Policy

The Bank of England just published a research paper “Do contractionary monetary policy shocks expand shadow banking?”

We previously discussed the role and importance of shadow banking, making the point that up to the 1980s, traditional banks were the dominant institutions in intermediating funds between savers and borrowers. However, since then, the role of market-based intermediaries has steadily increased. Whilst shadow banking cannot be defined as a homogenous, well-defined category, it embrances at least three types of intermediaries: asset-backed (ABS) issuers, finance companies, and funding corporations. In addition, shadow banking sector involves a web of financial institutions and a range of securitisation and funding techniques, and these activities are often closely intertwined with the traditional banking and insurance institutions. These interlinkages can involve back-up lines of credit, implicit guarantees to special purpose vehicles and asset management subsidiaries. So, given the focus on greater banking system regulation, and the role of monetary policy in this, the question is, does tighter monetary policy flow on to impact shadow banking. Is so, how?

Using detailed modelling, they find that monetary policy shocks do seem to affect the balance sheets of both commercial banks and their unregulated counterparts in the shadow banking sector. However, a monetary contraction aimed at reducing the asset growth of commercial banks would tend to cause a migration of activity beyond the regulatory perimeter to the shadow banking sector. In fact the monetary response needed to lean against shadow bank asset growth is of opposite to that needed to lean against commercial bank asset growth.

This means that monetary policy designed to control commercial banking may, as an unintended consequence, increase shadow banking activity (and so work against the policy intent). Therefore, they suggest that authorities should continue to develop a set of regulatory tools, complementary to monetary policy, that (a) seek to moderate excessive swings in risk-taking by commercial banks, as embodied in recent macroprudential frameworks, and (b) seek to strengthen oversight and regulation of the shadow banking sector. Monetary policy alone is not enough.

Bank of England Releases GFC Court Minutes

The Bank of England today published, in a special release, the minutes of Court and related meetings from the crisis period of 2007-09, in appropriately redacted form. This follows the Bank’s 11 December 2014 announcement of a series of proposals to enhance the transparency and accountability of the Bank. As part of this announcement, the Governor committed to publishing the 2007-2009 Court minutes, as requested by the Treasury Committee.

In the period covered by these minutes the Bank was operating within the statutory framework established in 1998. Court was much larger than the present Court, a number of members had standing conflicts of interest, and there was no provision for a non-executive chairman (to compensate for that, the Governor established the practice of having all Court business discussed first in the non-executive directors’ committee). At the time, the Bank had no powers to take actions to manage macro-prudential risks. It was not responsible for banking supervision and there was no bank resolution authority. The roles, in a crisis, of the Bank, the Treasury and the FSA were ill-defined. These deficiencies were rapidly identified during the period covered by the minutes, and were addressed both by the 2009 Banking Act and subsequently by the 2012 Financial Services Act, which radically changed both the role of the Bank and the structure of its governance.

Governor, Mark Carney said:

“The financial crisis was a turning point in the Bank’s history. The minutes provide further insight into the Bank’s actions during this exceptional period – the policies implemented to mitigate the crisis, the lessons that were learned, and how the Bank changed as a result.

The Bank is committed to increased openness and transparency and these minutes, in combination with the other recent reviews, provide a complete record of the Bank’s activities during the crisis.”

UK’s Financial System Not “Entirely Safe”

The UK’s financial system is not “entirely safe” according to former Bank of England governor Lord Mervyn King, speaking on BBC Radio 4’s Today programme. He questioned the banking system’s ability to withstand another crisis and argued the core problems that led to the meltdown have not yet been dealt with.

“I don’t think we’re yet at the point where we can be confident that the banking system would be entirely safe. I don’t think we’ve really yet got to the heart of what went wrong.”

The warning comes despite banks and other financial institutions being forced to hold more capital to prevent the risk of failure in the event of another downturn.

King, went on to say that imbalances between global economies have not yet been resolved. He added keeping base rate at the low of 0.5 per cent cannot go on .

“The idea that we can go on indefinitely with very low interest rates doesn’t make much sense.” However raising interest rates now “would probably lead to another downturn”.

He was at the helm of the Bank of England during the GFC.

His comments mirror some of the concerns highlighted in the recent Murray report.

Long-Term Unemployment Will Impact Wage Growth

In economic circles, the relationship between wage growth and unemployment is an important factor. Many will focus on the relationship between short-term unemployment and wage growth, but a paper released by the Bank of England highlights that long-term unemployment is also an important factor in the equation. Given the fact that wage growth is slowing in Australia, and long-term unemployment is rising, these findings are important.

The relationship between wage growth and unemployment is a key trade-off concerning monetary policy makers, as labour costs form a critical part of the inflationary transmission mechanism. One important question is how the composition of the unemployment pool, and specifically the share of long-term unemployment, affects that tradeoff. Detachment from the labour force is likely to increase with unemployment duration, so that the long-term unemployed search less actively for jobs and therefore exert less downward pressure on wages. If so, short-term unemployment may pull down on wage inflation more than long-term unemployment does. In this situation, policymakers might anticipate a period of high wage growth if short-term unemployment starts to fall to low levels even if the long-term unemployment rate remains elevated.

But there may be complications arising from the integral dynamics of unemployment. In this paper it emerges that the estimated disinflationary effects of long-term unemployment hinge on whether or not wage growth becomes less sensitive to unemployment as the latter rises – a form of non-linearity. One reason why the negative relationship between wages and unemployment might become flatter at high levels of unemployment is that workers may tend to resist cuts in their nominal wages. When unemployment is low, wage growth tends to be high as firms compete for a scarce pool of resources. But due to worker resistance to wage cuts the reverse might not hold to the same extent, with a relatively large increase in unemployment needed to reduce wage growth during a recession.

Why does this non-linearity matter for the measured effect of long-term unemployment on wage growth? It is because long-term unemployment inevitably lags behind movements in short-term unemployment as it takes time for the new unemployed to move into the long-term category. So high levels of long-term unemployed are only associated with lengthy periods of high unemployment. A flattening off of the relationship between wages and unemployment at high levels of unemployment would then imply that long-term unemployment does little to reduce wage inflation further. The apparently different effects of short and long-term unemployment on wage inflation could therefore be merely as a result of timing rather than labour market detachment among the long-term unemployed.

By modifying statistical models of labour market dynamics to incorporate this insight, this paper finds that there appears to be much less difference between the short and long-term unemployed in terms of their marginal influence on wage behaviour than is suggested by the recent literature. When the non-linearity described above is not taken into account, estimation results corroborate the finding already established in the literature that it is predominantly the short-term unemployed that matter for wage inflation. Long-term unemployment in this specification tends to have no statistically significant effect on wage inflation. When the non-linearity is taken into account, long-term unemployment has a much larger effect on wage inflation. For some of the specifications considered, the data fail to reject the hypothesis that short and long-term unemployment rates have equal effects on inflation. In some instances, the models even suggest that long-term unemployment creates more of a drag on wage growth than short-term unemployment does, all else equal. Statistical uncertainty makes it difficult to draw a very precise conclusion, but the results in this paper caution against excluding long-term unemployment from estimates of aggregate labour market slack as is suggested by much of the recent literature. Both the short-term unemployment rate and the long-term unemployment rate are likely to contain useful information for judging the degree of wage pressure in the economy.

UK Macroprudential Update

The Bank of England just released their latest Financial Stability report. Within the document there is a section on the implementation of macroprudential measures relating to mortgage lending. This makes an interesting contrast with the Australian Regulatory framework.

Mortgage affordability test – Implemented: When assessing affordability, mortgage lenders should apply an interest rate stress test that assesses whether borrowers could still afford their mortgages if, at any point over the first five years of the loan, Bank Rate were to be 3 percentage
points higher than the prevailing rate at origination.

Loan to income limit – Implemented: The PRA and the FCA should ensure that mortgage lenders do not extend more than 15% of their total number of new residential mortgages at loan to income ratios at or greater than 4.5. This Recommendation applies to all lenders which
extend residential mortgage lending in excess of £100 million per annum.

Powers of Direction over leverage ratio – Action under way: The FPC recommends that HM Treasury exercise its statutory power to enable the FPC to direct, if necessary to protect and enhance financial stability, the PRA to set leverage ratio requirements and buffers for PRA-regulated banks, building societies and investment firms, including:

a minimum leverage ratio requirement to remove or reduce systemic risks attributable to unsustainable leverage in the financial system;
a supplementary leverage ratio buffer that will apply to G-SIBs and other major domestic UK banks and building societies, including ring-fenced banks to remove or reduce systemic risks attributable to the distribution of risk within the financial sector;
a countercyclical leverage ratio buffer to remove or reduce systemic risks attributable to credit booms — periods of unsustainable credit growth in the economy.

The Government intends to lay the final legislation before Parliament in early 2015, alongside publishing a consultation response document and impact assessment. As with the housing instruments, the FPC intends to issue a draft Policy Statement in early 2015 to inform the Parliamentary debate.

HM Treasury intends to consult separately on LTV/interest coverage ratio powers for the buy-to-let sector in 2015, with a view to building further evidence on how the UK buy-to-let housing market may pose risks to financial stability.

Results of UK Bank’s Stress Tests

The Bank of England announced the results of the first concurrent stress testing exercise of the UK banking system. Alongside the stress test publication, the Bank of England also published its Financial Stability Report, which sets out the Financial Policy Committee’s (FPC) assessment of the outlook for the stability and resilience of the financial sector, and the Systemic Risk Survey, which quantifies and tracks market participants’ perceptions of systemic risks.

Following on from the EU-wide stress test, the 2014 UK stress test of the eight major UK banks and building societies was designed specifically to assess their resilience to a very severe housing market shock and to a sharp rise or snap back in interest rates. This was not a forecast or expectation by the Bank of England regarding the likelihood of a set of events materialising, but a coherent, severe ‘tail risk’ scenario.

The eight banks and building societies tested as part of this exercise were Barclays Bank, Co-operative Bank, HSBC Bank, Lloyds Banking Group, Nationwide Building Society, Royal Bank of Scotland, Santander UK and Standard Chartered.

There was substantial variation across the banks and building societies in terms of the impact of the stress scenario. From an individual-institution perspective, the Prudential Regulation Authority (PRA) Board judged that this stress test did not reveal capital inadequacies for five out of the eight participating banks, given their balance sheets at end-2013 (Barclays, HSBC, Nationwide, Santander UK and Standard Chartered). The PRA Board did not require these banks to submit revised capital plans.

Following the stress testing exercise, the PRA Board judged that, as at end-2013, three of the eight participating banks (Co-operative Bank, Lloyds Banking Group and Royal Bank of Scotland) needed to strengthen their capital position further. But, given continuing improvements to banks’ resilience over the course of 2014 and concrete plans to build capital further going forward, only one of these banks (Co-operative Bank) was required to submit a revised capital plan.

The FPC considered the information provided by the stress-test results from the perspective of the resilience of the UK banking system as a whole. The FPC noted that only one bank fell below the 4.5% threshold at the trough of the stress scenario, that the capitalisation of the system had improved further over the course of 2014 and that the PRA Board had agreed plans with banks to build capital further. Overall, the FPC judged that the resilience of the system had improved significantly since the capital shortfall exercise in 2013. Moreover, the stress-test results and banks’ capital plans, taken together, indicated that the banking system would have the capacity to maintain its core functions in a stress scenario. Therefore, the FPC judged that no system-wide, macroprudential actions were needed in response to the stress test.

Projected CET1 capital ratios in the stress scenario

	Actual (end 2013)	Minimum Stressed ratio (before the impact of ‘strategic’ management actions)	Minimum Stressed ratio (after the impact of ‘strategic’ management actions)	Actual (latest, Q2 or Q3 2014)
Barclays	9.1%	7.0%	7.5%	10.0%
Co-operative Bank Plc	7.2%	-2.6%	-2.6%	11.5%
HSBC Bank Plc	10.8%	8.7%	8.7%	11.2%
Lloyds Banking Group	10.1%	5.0%	5.3%	12.0%
Nationwide Building Society	14.3%	6.1%	6.7%	17.6%
Royal Bank of Scotland	8.6%	4.6%	5.2%	10.8%
Santander UK	11.6%	7.6%	7.9%	11.8%
Standard Chartered Plc	10.5%	7.1%	8.1%	10.5%

Central Bank Psychology

Andrew Haldane, Chief Economist of the Bank of England, will be speaking at the Royal College of Medicine conference on Leadership: stress and hubris. He will discuss how psychological biases can affect policy making, and how the institutional design of policy making committees at the Bank of England have been designed to counteract those effects.

In the speech, Andrew highlights four “cognitive ticks that can affect human decision making” that may be relevant for public policy making:

Preference biases – where the decision maker might put “personal objectives over societal ones, such as personal power or wealth”

Myopia biases – “people differ materially in their capacity to defer gratification” and studies suggest that people who show greater patience “outperform their impatient counterparts in everything from school examinations, to salaries, to reported life satisfaction”.

Hubris biases – over-confident individuals are “more likely to be promoted to positions of influence” but tend to pursue “over ambitious targets” like “undertaking over-complex company takeovers. That way nemesis lies”

Groupthink biases – people tend to adapt their view to confirm to those around them and also have a “tendency to search and synthesize information in ways which confirm their prior beliefs”.

Andrew then shows how policy making at the Bank of England has been organised to try to protect from these biases.

To tackle preference bias, the Bank’s does not set its own objectives. It has three policy making committees – for monetary policy (MPC), financial policy (FPC) and prudential regulation (PRA Board). In addition, “to ensure the actions of the Bank’s policy committees are well-aligned with society’s wishes” their targets are “set ex-ante in legislation by Parliament acting on behalf of society”.

To prevent myopia, the Bank of England has been made independent from government when choosing how to set monetary and financial policy to achieve their respective objectives. These decisions have been given to an institution “whose time horizon stretches beyond the political cycle”. Andrew suggests that central bank independence has been successful at taming “the inflation tiger” but he warns that “as some countries are finding today, the tiger is capable of biting back” in the form of low and falling inflation expectations. Andrew notes that while inflation expectations in the UK have held up pretty well, this is something he is “watching like a dove.”

To guard against Hubris at the Bank, “all policy decisions … are made by Committee rather than an individual” which “provides some natural safeguard against over-confidence bias”. Andrew notes that external MPC members have contributed importantly to the diversity of opinion on the committee “on average they have been around twice as likely as internals to dissent from monetary policy decisions”.

Finally to ward off groupthink, each member of the policy committees is individually accountable for their vote or view, and this should encourage “a variety of analytical perspectives”. That said Andrew notes that analysis of MPC minutes suggests that they did not devote enough time to discussing banking issues in the run up to the financial crisis, something that in hindsight, “looks like a collective analytical blind-spot”. He argues that despite all the changes to the Bank’s policy responsibilities since the crisis, “it is too soon to tell whether any remaining blind-spots remain”. Also, in his view “improvements to the Bank’s forecasting process have some considerable distance still to travel”.

Andrew concludes by highlighting a key new development at the Bank – a “cultural revolution” for bank research work. Rather than being used solely to “nourish and support the Bank’s policy thinking”, as has typically been the case in the past, future Bank research will instead be published that challenges the policy orthodoxy as often as supports it . “This research will hopefully act as spur and springboard for new policy thinking”. “It will act as another hopefully powerful, bulwark against over-confidence biases and groupthink.

Managing Global Finance As A System

Andrew Haldane, Chief Economist of the Bank of England, gave the annual Maxwell Fry lecture on Global Finance at Birmingham University. There are some powerful observations here, relevant to the Australian context, as well as the potential to amplify risks associated with a more interconnected world. He also takes macroprudential discussions further.

Andrew’s main theme was the growing size and complexity of global capital flows between countries. He noted that ‘cross-border stocks of capital are almost certainly larger than at any time in human history’. And the apparent independence of domestic investment from domestic saving suggests that ‘measured levels of global capital market integration … remain at higher levels than at any point in history’. He discussed how this can be ‘double-edged’ from a financial stability perspective: it both shares risk (which can be stabilising) but also spreads and amplifies risk (which can be destabilising) – potentially generating ‘more frequent and/or larger dislocations’.

He argued that many lessons have been learned from the financial crisis, not least the need to ‘safeguard against systemic risk’. Yet when it comes to the fortunes of the international monetary system ‘it is far from clear that these lessons have been learned, much less that the international rules of the road have been reformed’. ‘Arguably, the rules of the road for this system have failed to keep pace with the growing scale and complexity of global financial flows’.

One of the consequences of the growth in cross border capital flows is ‘the steady rise in the degree of co-movement in asset prices over time’. Cross-border spillovers are becoming more important and global common factors more potent. A particular example is the behaviour of yield curves across countries. ‘To a first approximation, global yield curves appear these days to be dancing to a common tune’.

Andrew identified four areas where the global financial system could be strengthened:

a) Improve global financial surveillance, by tilting IMF surveillance away from monitoring individual country risk and towards multilateral surveillance and having more real-time tracking of the global flow of funds.

b) Improve country debt structures, for example by encouraging countries to issue GDP linked bonds, or Contingent Convertible (CoCo) bonds.

c) Enhance macro-prudential and capital flow management policies. For example, he suggests that ‘total credit follows a global cycle that has strengthened over time’ in which case ‘there may in future be a case for national macro-prudential policies leaning explicitly against these global factors’ taking international macro-prudential policy co-ordination ‘to the next level’. This next phase of macro-prudential policy may see measures ‘targeted at particular markets, as well as particular countries’.

d) Improve international liquidity assistance, for example by increasing the resources available to the IMF.

UK Bank Write-Downs Normalising

The Bank of England just released their latest datapacks. One interesting view is the loss trends reported by Banks and Building Societies.

The chart (shown by value) highlights the significant issues in credit cards amongst the UK banks in 2010/2011, and by contrast shows the value of write-offs from dwellings has been lower and more stable.

Losses are more normalised now, showing the UK economy is beginning to heal. But a case study in what happens in a significant financial crisis to household write-offs, and the relative risks of secured and unsecured lending.