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IMF On UK’s Financial Stability

The latest IMF Report on the Financial System Stability Assessment on the United Kingdom warns on the impact of a Brexit, and underscored concerns that 16 per cent of the residential property market are investors (remember in Australia, our is more than double, at 35 per cent!). The review assess the stability of the financial system as a whole and not that of individual institutions and was completed in June 2016 from visits to United Kingdom in November 2015 and in January-February 2016.

Property Sector

U.K. residential property prices reflect mostly long-standing supply-demand imbalances. While annual house-price growth slowed substantially between mid-2014 and mid-2015, it has accelerated again more recently, outpacing the growth of nominal GDP. This price growth largely reflects the realignment of relative prices of housing in light of tight supply constraints and growing demand. There is little evidence of a credit-fueled boom: the growth of mortgage lending and the number of housing transactions still remain well below their pre-crisis levels.At the same time, two particular segments of the property market show signs of overheating. First, lending in the buy-to-let sector has grown from 4 percent of mortgage stock in 2002 to 16 percent in mid-2015. In view of this, the FPC requested powers of direction over this sector. As the FPC already has these powers over the buy-to-own market, this would level the regulatory playing field for residential mortgages.

Second, the commercial real estate (CRE) market, has also been buoyant, with annual price growth around 10 percent as of mid-2015, although it has slowed somewhat in early 2016. The prices of prime U.K.—and especially prime London—CRE properties have grown rapidly since 2013. Although a recent analysis by the BoE shows that the overvaluation of CRE properties is limited to certain prime locations, continued rapid price growth could further reduce rental yields and increase the probability of price reversals. Credit risks to domestic banks from a CRE price reversal are reduced in comparison to the run-up to the 2008 crisis: U.K. banks have reduced their commercial real estate exposure, and international investors now account for more than half of CRE financing flows. But the sector can pose a macroeconomic risk since the majority of small and medium firms rely on CRE as collateral.

Their Overall Observations.

Since the last FSAP, the U.K. financial system has put the legacy of the crisis behind it and has become stronger and more resilient. Five years ago, the financial system had stabilized but still faced major residual weaknesses. This FSAP found the system to be much stronger and thus better able to serve the real economy. Like all systems, the U.K. financial system is exposed to risks. Given its size, complexity, and global interconnectedness, if these risks were to materialize they could have a major impact not only on the U.K. but also on the global financial system. Financial stability in the U.K. is thus a global public good. At the same time, understanding, mitigating, and staying a step ahead of the evolving risks in such a complex system is a constant analytical and policy challenge for U.K. policy-makers and regulators.

Its position as a global hub exposes the U.K. financial system to global risks. Regardless of the trigger, global shocks, such as a negative growth shock in emerging markets, a rapid hike in global risk premia, or renewed tensions in the eurozone, would impact significantly U.K. banks and, more broadly, the financial system as a whole. Moreover, as the domestic credit cycle matures while interest rates remain at historic lows, trends in some segments of the U.K. property market—notably buy-to-let and commercial real estate—could become financial stability risks.

In addition, the uncertainties associated with the possibility of British exit from the EU weigh heavily on the outlook. A vote in favor of leaving would usher in a period of uncertainty and financial market volatility during the negotiation of the terms of British exit, which could take years. And the eventual exit deal would have profound effects on trade and the real economy, the “passporting” arrangements for financial institutions, and the location decisions of major international financial firms now headquartered in London. Though highly uncertain, these effects would have major long-term implications for the U.K. financial sector, its contribution to the domestic economy, and its global standing. Needless to say, these economic aspects are only one element of the decision that is for British voters to make.

The main parts of the U.K. financial system appear resilient. At the core of the system, banks have more than doubled their risk-weighted capital ratios from pre-crisis levels, strengthened liquidity, and reduced leverage. Stress tests by both the BoE and the FSAP show that the largest banks would be able to meet regulatory requirements and sustain the capacity to finance the economy in the face of severe shocks. The possible impact of Brexit, however, though potentially significant, is inherently difficult to quantify and has not been covered in the stress tests. U.K. insurers, asset managers, and central counterparties (CCPs) also appear resilient, based on assessments by the BoE, FCA, European financial authorities, and the FSAP.

Despite the apparent resilience of individual sectors, interconnectedness across sectors has the potential to amplify shocks and turn sector-specific distress systemic. New patterns of interconnectedness are emerging due to structural market shifts and new entrants in some markets. These changes are not, by themselves, inherently risky. But they create a major challenge for the supervisors, who should upgrade their capacity and tools to connect the dots across sectors.

This resilience reflects to a large extent a wave of regulatory reforms since the crisis, which are now near completion. These were aimed at strengthening regulation and supervision, thus reducing the probability of failures; and lowering the cost of failures and safeguarding the taxpayer. They are aligned with the global regulatory reform agenda, where the U.K. has played a leading role, and were complemented by steps to enhance the governance and conduct of financial firms, as well as the decision to ring-fence retail banking and related services from riskier activities of U.K. banks. Many of these reforms correspond to the recommendations of the 2011 FSAP (Appendix I).

The first major plank of the reforms was to overhaul financial sector oversight and focus it on systemic stability. The new macroprudential framework provides clear roles and responsibilities, adequate powers and accountability, and promotes coordination across agencies. Its track record to-date, albeit short, is encouraging. Microprudential and conduct oversight have also become more rigorous and hands-on. The focus of supervisory effort and resources on the resilience of the most important firms is appropriate from a systemic perspective, but it inevitably implies less individual attention to small and mid-size companies, for which supervisors rely more on data monitoring, thematic reviews, and outlier analysis. This tradeoff warrants constant vigilance, because the business models of smaller firms tend to be correlated and, regardless of their systemic impact, failures of even small firms can be a source of reputational risk for the supervisor. In view of the downward trend of the ratio of risk-weighted to total assets and methodological inconsistencies across banks, internal models should be reviewed closely. A new, sophisticated framework for annual stress tests of major banks is a key link between the microprudential and macroprudential frameworks, but further investment is needed to ensure it can deliver on its ambitious goals.

The BoE’s new liquidity framework is a key shock absorber, and attendant risks seem adequately managed. By ensuring the Bank is “open for business” in the event of distress, the BoE’s flexible framework can help stop the propagation of a shock through liquidity contagion. Access by a broader range of entities, including broker-dealers and CCPs, is a major plus, made possible by the fact that all entities with access to the framework are supervised by the BoE and PRA. Because the relative ease of access to BoE liquidity risks distorting over time the incentives of participating firms, the BoE needs to monitor their behavior for signs of moral hazard or regulatory arbitrage.

The other major plank of the agenda was to ensure that the failure of a financial firm, regardless of its size, would not compromise financial stability or burden the taxpayer. The transposition of the EU Bank Recovery and Resolution Directive has completed the reform of the U.K.’s Special Resolution Regime for banks, which is now broadly aligned with global standards. The resolution powers, tools, and coordination arrangements for crisis management domestically and cross-border are now much stronger. The key challenge now is to complete the process that will facilitate the resolvability of U.K. financial firms. This is a complex, multi-year task that involves, inter alia, the implementation of ring-fencing and Minimum Requirements for Own Funds and Eligible Liabilities (MREL). The authorities should also build on current arrangements to develop operational principles for funding of firms in resolution and establish an effective resolution regime for insurance companies whose failure could be systemic. Finally, given the systemic role played by U.K. banks in smaller jurisdictions that are not part of the Crisis Management Groups (CMGs), the U.K. authorities should develop appropriate cooperation arrangements with such host countries.

UK Regulator Seeks To Lift Banking Competition

The UK’s Competition and Markets Authority (CMA) has outlined a wide-ranging package of proposals to tackle the issues hindering competition in personal current accounts (PCA) and in banking services for small and medium-sized enterprises (SMEs). It includes new protections for overdraft users. They expect the package of remedies, taken together with ongoing technological developments, to result in significant changes to the operation and structure of retail banking markets in the UK.

At present, it is hard for bank customers to work out if they are getting good value. Bank charges are complicated and opaque and many customers think it is difficult and risky to change banks.

As a result, nearly 60% of personal customers have stayed with the same bank for over 10 years and over 90% of SMEs get their business loans from the bank where they have their current account.

This means that competitive pressures are weak, so banks do not need to work hard enough on price or quality of service.

The CMA considered whether the largest banks should be broken up but it came to the view that this would not address the fundamental competition problems. Having more and smaller banks, which customers still couldn’t easily choose between because of lack of transparency on fees and charges, would not significantly improve the market or give customers a better deal.

The CMA also considered whether to get rid of ‘free if in credit’ (FIIC) current accounts. Even though FIIC accounts are not really ‘free’, they do work well for many customers, and banning particular products would simply take away choice and risk the overall cost of accounts rising, not falling.

To transform the market the CMA believes banks instead need to be made to provide their customers with the right information so that they can easily find out which provider and type of account offers best value for them. The CMA also proposes to push the development of new online comparison tools and improve the current account switch service (CASS) to make switching banks more straightforward and give customers more awareness of, and confidence in, the process.

FIIC accounts are certainly not free for overdraft users, who represent nearly half of personal customers. The CMA’s proposals include new measures targeted at overdrafts, with a particular focus on users of unarranged overdrafts; in 2014, £1.2 billion of banks’ revenues came from unarranged overdraft charges.

The CMA proposes requiring banks to set a monthly maximum charge for unarranged overdrafts on personal current accounts. Customers may not even be aware of when they go into unarranged overdraft or realise the costs they are incurring, so the CMA also wants banks to alert people when they are going into unarranged overdraft, and give them time to avoid the charges.

Big technological changes are happening in banking, and the CMA wants to harness them to empower customers to compare and switch accounts. The CMA is proposing to require banks to move swiftly to introduce an Open API (application programming interface) banking standard. This standard will enable personal and SME customers to safely and securely share their unique transaction history with other banks and trusted third parties. This will enable bank customers to click on an app, for instance, and get comparisons tailored to their individual circumstances, directing them to the bank account which offers them the best deal.

The CMA also proposes that banks should be made to regularly prompt their customers to check that they are getting good value from their banking provider. When these prompts direct customers to digital comparison services which give tailored price-comparison and service quality advice, the foundation has been laid for a major change in the retail banking sector.

On these foundations, the CMA proposes to build a strong package of measures to deliver better banking services to SMEs. Making it easier for SMEs to shop around and open a new current account will reduce business owners’ reliance on their personal bank when choosing a bank for their business. By making the prices and availability of lending products more transparent, the majority of SMEs need not, as is the case now, turn directly to their existing bank for finance without considering other offers.

The package of changes could bring benefits to bank customers to the tune of £1 billion over 5 years.

Already, if personal customers switched to a cheaper product for them, annual savings could be on average £116; ranging from £89 on average for customers who do not use an overdraft, to £153 on average for overdraft users.

Alasdair Smith, Chair of the Retail Banking Investigation, said:

For too long, banks have been able to sit back and not work hard enough for their personal and small business customers. We believe the strong and innovative package of measures we are proposing will give customers the information and tools they really need to get a better deal out of the banks. They will also protect those who fall into overdraft from being stung with unexpected fees.

New entrants into a market are an important source of competition and innovation, and we are well aware of the current barriers to challenger banks in UK retail banking. What’s really holding them back is their ability to highlight to customers how new offerings compare with their current deal. Our package of banking reforms will help new competitors get a stronger foothold in a market which is of vital importance to the whole economy.

The CMA invites submissions in writing by 7 June. They will publish the final report in early August.

UK bank commission head asks central bank to think again on capital

According to Reuters, the Bank of England is too optimistic about being able to close big banks smoothly if they run into trouble and lenders should hold far more capital to keep the financial system safe, the architect of a major banking reform said on Tuesday.

The Independent Commission on Banking (ICB) chaired by John Vickers recommended after the financial crisis that banks ring-fence capital equivalent to 3 percent of risk-weighted assets, while the Bank of England says the level should be 1.3 percent.

In response to previous criticisms from Vickers, BoE Governor Mark Carney published a 13-page letter to parliament on Friday, setting out how why banks in Britain generally hold enough capital to act as a buffer against systemic risk.

But Vickers told an audience including former regulators, central bank officials and Clara Furse from the BoE’s Financial Policy Committee that the assumptions underpinning the bank’s arguments were not realistic.

“The BoE should think again,” Vickers said in his speech at the London School of Economics on Tuesday.

“The Financial Policy Committee should use to the full the opportunity it now has to make UK retail banking safer, and introduce a 3 percent systemic risk buffer for all major ring-fenced banks,” Vickers, a former BoE chief economist, said.

“With more prudent and realistic assumptions, the BoE’s own analysis indicates the need for that. The BoE’s current proposal falls short,” he said.

The spat between Vickers and the BoE over capital levels has irked the central bank and prompted parliament’s Treasury Select Committee to review bank capital requirements.

Carney has said no significant extra capital was needed because banks face other requirements, such as a counter-cyclical capital buffer, and changes that make them easier to close down – two reforms which Vickers said were no foolproof substitute for higher capital.

Under current plans, the deposit-taking divisions of banks must have the extra ring-fenced capital in place from 2019.

The reform is considered among the toughest of its kind in the world and has forced HSBC, Barclays, Lloyds and RBS to make internal changes.

Vickers’ comments also come at a time when the finance ministry wants a “new settlement” with banks, which has raised concerns among some lawmakers that banking rules are being watered down.

Here’s what David Cameron could learn from a history of social housing

From The Conversation.

There’s a housing crisis engulfing the UK, and London is at its epicentre. In his recent vow to regenerate over 100 so-called “sink estates”, David Cameron would have us understand that public housing has failed: that the result is poor people, living in poorly designed homes, that were poorly managed. But this version of history is not definitive – nor even particularly accurate.

So what can history tell us about what works and what doesn’t, when it comes to housing? As planners and politicians cast about for solutions to the current crisis, the answer may well be found at their feet – or rather, under them.

In 1892, parliament realised that the building of the Blackwall Tunnel would require hundreds of homes to be demolished. This resulted in a new act of parliament, which stated that no work could commence on the tunnel until those evicted had been rehoused. And so, with private builders unable to supply these new homes, the first council housing in London was built.

But while the new estates sheltered those displaced by construction, their rent was still relatively expensive, so the nation’s poor and vulnerable remained in the private rented sector. So-called “slum landlords” routinely exploited the high demand for housing, leaving vulnerable tenants with substandard and overcrowded accommodation.

The pioneers of housing philanthropy – Joseph Rowntree, George Peabody and Octavia Hill, to name a few – battled to tackle poor housing conditions, homelessness and poverty. But it was often difficult to attract the required support from investors for philanthropic housing projects, when the alternative profits from being a slum landlord were so high.

Meanwhile, the government’s view was that – whatever the solution to the urban housing crisis may be – it most certainly was not state-owned housing. The parallels with 2016 are obvious.

Search for solutions

But all that rapidly changed in the first half of the 20th century – particularly following World War I and World War II – as successive governments took greater responsibility for the social welfare of citizens. Building programmes were supported by government grants and subsidies, which allowed rents to drop below market levels and made housing available to lower income households.

The vision of Anuerin Bevan – a key architect of the NHS – was that council housing, owned and managed by local authorities and built to a high standard, would be home to a diverse range of social classes. Bevan’s vision was not achieved in its entirety: some architectural design and building materials did not meet the needs of residents. Even so, by the 1960s, more than 500,000 flats had been added to the housing stock in London alone.

Worse for wear. sarflondondunc, CC BY-NC-ND

From the late 1970s, council housing was seen as increasingly problematic. As well as an ideological shift away from state provision, the government had concerns about the cost of maintaining council-owned houses, and the higher concentration of poor and vulnerable citizens living in them. It appeared that the 20th century’s use of council housing to provide accommodation for lower income households would not be a 21st-century solution.

Instead, the Thatcher government’s Right to Buy policy for council tenants sought to cement the UK as a nation of home owners. As well as being sold off, council housing stock was transferred to housing associations or arms length management organisations. Together with housing cooperatives and mutuals, these new arrangements became known as “social housing” and “registered social landlords”.

The idea was that housing associations would be able to borrow on the markets to invest in their housing stock – making them less dependent on government funding – and that tenants would have a strong influence about housing management decisions. Tenant participation was certainly strengthened in all forms of social housing, particularly where associations were local and community-based. Greater private investment was also secured to enhance housing quality.

Yesterday’s issues today

In 2010, the coalition government began referring to “registered providers of housing”, dropping the “social” altogether. That said, it should be noted that in other countries in the UK, housing policy has moved in different directions since the issue was devolved to the governments of Scotland, Northern Ireland and Wales.

Now, the Conservative government is introducing the Right to Buy for housing association tenants, as well as implementing fixed-term tenancies and the policy that tenants on higher incomes should pay more rent or leave. This all sounds like the final death knell for mixed income, long-term and secure public housing. In its place comes “affordable housing” – a term which is stretched to describe homes costing up to £450,000.

The current housing crisis is displacing lower income families from many parts of our cities. Young people have much worse housing prospects than their parents. Recent research says that in less than ten years time, only the rich will own their homes. And new cases of slum landlords have been reported in London. It is 2016 but, when it comes to housing, in many ways it could actually be 1891.

The key difference now is that we can look to the past for lessons. We have learned that private developers and landlords cannot be the entire solution. We know how to deliver very large scale housing programmes in periods of debt and austerity. And we can do so again now – while avoiding the pitfalls – with a diversity of social housing models and new roles for private developers, landlords and investors.

Author: John Flint, Professor of Town and Regional Planning, University of Sheffield

Debt, Demographics and the Distribution of Income

In a speech to the London School of Economics Dr Gertjan Vlieghe – an external member of the UK Monetary Policy Committee – examines the effects of debt, demographics and the distribution of income on growth and interest rates. In his first public speech since joining the MPC, Jan argues that these 3 Ds “are interacting powerfully to create an environment where a given level of growth might be consistent with substantially lower interest rates than in the past”. Jan explores these forces in turn and concludes by looking at the implications for UK policy. The 3 Ds in combination with the current outlook mean he continues to be “patient” about the need for a rate rise.

“Debt matters.” The crisis has shown that households with high debt levels reduce spending more sharply in response to a downturn than less leveraged households. This in turn makes recessions that follow a substantial build up in debt “more severe and longer-lasting”. Monetary policy is likely to have to respond to a significant debt overhang by cutting and maintaining low interest rates. This has been seen in the UK where, following almost 7 years of Bank Rate at 0.5%, private (non-financial) sector debt to GDP ratio has fallen from 190% in prior to the recession to 160% today. However, many other advanced economies have not reduced their debt burden and many emerging economies are still increasing their indebtedness. “This has the potential to create persistent spending disappointments, if monetary policy is unable to stimulate other spending sufficiently.”

Simultaneously we have seen two important demographic changes. We are living longer and having fewer children. The interaction between these two forces is complex and further research is required to understand the likely consequences. However, initial studies and the experience of Japan suggest that overall demographic shifts will lower the equilibrium rate of interest and “there is at least the possibility that the effect is quite large”. Moreover, “demographic effects are even more slow-moving than debt effects, so the impact on real interest rates might be even longer-lasting.”

The monetary policy implications of the third D, the distribution of income, are the least well understood but the work so far “suggests it matters greatly” for our understanding of the monetary transmission mechanism and that rises in inequality could “affect both total savings and reinforce the rise in debt and associated deleveraging effects”.

In sum, “it is not hard to imagine – though very hard to model – a story where all three Ds interact. A high debt economy faces headwinds and needs lower interest rates. A high debt economy with adverse demographic trends needs even lower interest rates. And a high debt economy with adverse demographic trends and higher inequality … well you get the picture.”

Current economic models do not reflect these changes, but policy makers must not assume “that the future will look like the past” and they must “be prepared for the possibility that real interest rates will remain well below their historical average for a very long time”.
Both these considerations make Jan “relatively more patient before raising rates” and in combination with the recent slowing in UK growth, continued weak inflation and an absence of upward wage pressure mean current conditions do not “warrant an increase in Bank Rate”. Jan adds that the need for patience is reinforced by the current asymmetry in monetary policy in that policy makers’ ability to stimulate spending is smaller than their ability to restrain it. This “potentially makes the effects of bad news more persistent even when monetary policy does all it can”.

Jan concludes: “In order to be confident enough of the medium-term inflation outlook to raise Bank Rate, I would like to see evidence that growth is not slowing further, and that a broad range of indicators related to inflation are generally on an upward trajectory from their current low levels.”

UK’s Financial Conduct Authority’s review of banking culture is scrapped

The City regulator, the Financial Conduct Authority (FCA), has shelved plans for an inquiry into the culture, pay and behaviour of staff in banking.

The FCA had planned to look at whether pay, promotion or other incentives had contributed to scandals involving banks in the UK and abroad.

The FCA said it had decided instead to “engage individually with firms to encourage their delivery of cultural change” according to UK reports.

The move means the watchdog’s so-called “banker bashing” review has effectively ended after only a few months.

The decision comes after the FCA’s chief executive, Martin Wheatley, announced in July his decision to quit the post when the Chancellor George Osborne refused to renew his contract, which was due to end in March next year.

In a statement the FCA said: “A focus on the culture in financial services firms remains a priority for the FCA.

“There is currently extensive on-going work in this area within firms and externally.

“We have decided that the best way to support these efforts is to engage individually with firms to encourage their delivery of cultural change as well as supporting the other initiatives outside the FCA.”

Earlier this year, the FCA told banks to sharpen up their efforts to learn lessons from scandals such as foreign exchange and Libor rate-rigging, which have already cost them billions of pounds in fines.

The body said companies’ progress in making improvements as part of the review – designed to examine and compare behaviour within the banking sector, including staff pay and complaints procedures – was initially disappointing and improvements “had been uneven” across the industry.

They also often lacked the urgency required given the severity of recent failings, the watchdog said.

But it also said “some progress had been made on improving oversight and controls and benchmarks” following the scandals involving the benchmark rates in Libor – the interbank lending rate – as well as in foreign exchange and gold markets.

A number of banks have already signalled that changes are being made to their operations.

Conservative Mark Garnier, who sits on the Treasury select committee, suggested Chancellor George Osborne may have been behind the move.

“I am disappointed about it. It remains to be seen whether this is a cancellation or a delay but I fear it probably is a cancellation,” he told BBC Radio 4’s Today programme.

Mr Garnier said there was a “difficult balance” between a strong regulatory regime and “over doing it”.

He added: “There has always been this great argument that perhaps the Treasury is having more influence over the regulator than perhaps it ought to and certainly if I was looking for a Machiavellian plot behind what’s happened here and the tone of the regulator then I suppose I would start looking at the Treasury.

“But I equally think that the regulator has a very, very difficult job to do, which is striking the balance between looking after the people who are its members, the financial institutions, and the consumer.

“And it has certainly been widely talked about that the Treasury thought the regulator was over doing it in favour of the consumer and, certainly from my point of view on the Treasury select committee, I thought otherwise.”

Bank of England maintains Bank Rate at 0.5%

At its meeting ending on 4 November 2015, the Bank of England’s Monetary Policy Committee (MPC) voted by a majority of 8-1 to maintain Bank Rate at 0.5%. The Committee voted unanimously to maintain the stock of purchased assets financed by the issuance of central bank reserves at £375 billion, and so to reinvest the £6.3 billion of cash flows associated with the redemption of the December 2015 gilt held in the Asset Purchase Facility.

All members agree that, given the likely persistence of the headwinds weighing on the economy, when Bank Rate does begin to rise, it is expected to do so more gradually and to a lower level than in recent cycles. This guidance is an expectation, not a promise. The actual path Bank Rate will follow over the next few years will depend on the economic circumstances.

The MPC sets monetary policy in order to meet the 2% inflation target and in a way that helps to sustain growth and employment.

Growing Your Business in the Global Economy: Not all Doom and Gloom

In a speech to the Brighton and Hove Chamber of Commerce external MPC member Professor Kristin Forbes sets out her view that that although “the risks and uncertainties in the global economy have increased”, the current level of pessimism about the outlook for emerging markets “is overstated”. Instead, she argues, UK businesses should consider the opportunities available from engaging with emerging markets in the longer term.

This argument is also used to support Kristin’s view that though there is a risk of “a sharper slowdown” in emerging markets or a financial crisis from which “the UK economy is unlikely to be immune”, the UK’s relatively small exposures to these countries mean events thus far are “manageable”. And, she adds, the UK’s domestic-led expansion “shows all signs of continuing, even if at a more moderate pace than in the earlier stages of the recovery. As a result, despite the doom and gloom sentiment, the news on the international economy has not caused me to adjust my prior expectations that the next move in UK interest rates will be up and that it will occur sooner rather than later.”

Kristin argues that recent events need “to be put in context of the historic swings in commodity cycles, albeit a cycle amplified by China’s recent evolution.” Despite earlier optimism that a ‘great moderation’ would bring “an end to the business cycle” all countries “will continue to experience periods of expansion and contraction when growth rates fluctuate around longer term trends” and emerging markets will continue to experience the greatest fluctuations.

“Some of the recent negative headlines merit a closer look, and after considering the actual data and differences across countries, the actual news for this group is much more balanced (albeit not all bright).” For example, those emerging markets that are net commodity importers will benefit from lower prices. Others used high commodity prices to pay down debt and make reforms to make them more resilient to global economic shifts. In fact overall, “the downgraded growth rate expected for emerging markets in 2015 that has garnered such negative headlines is still likely to be around twice as fast as in advanced economies.”

Another important factor to consider is the relative size of these economies in the future. PwC analysis suggests that in 2050 India and China will be the two largest economies in the world with Indonesia, Mexico and Brazil in 4th, 5th and 6th place respectively. The UK, in contrast, “will be one of the remaining developed economies in the top-15, predicted to hold a respectable 11th place position.” Add to this the growing middle classes in these countries and many UK brands could see demand in these countries grow significantly.
Kristin’s analysis shows that if UK businesses increased exports to emerging economies to a similar proportion to that of the US, this increased exposure when combined with growth differentials (even under conservative assumptions), could increase UK exports by £23 billion in 2020 relative to that based on the UK’s current exposures. This could make a sizeable reduction in the UK’s trade deficit.

Kristin concludes that though risks in many emerging market economies have recently increased “much of the current gloomy discussion appears to be overblown. It is overshadowing important differences across countries and strengths in some economies as they make beneficial transitions toward more sustainable and balanced growth.”

Bank of England To Strengthen the UK Financial System

The Bank of England has today published two consultation papers: one on ring-fencing and one on operational continuity. These proposals will ensure that ring-fenced banks are protected from shocks originating in other parts of their groups, as well as the broader financial system, and can be easily separated from their groups in the event of failure.

Well-capitalised, resilient firms mean that when problems occur, critical economic functions, including retail banking, can be maintained and economic growth can be supported through ongoing banking activity.

Today’s proposals seek to ensure that ring-fenced banks have sufficient capital resources on a standalone basis, sheltering them from risks originating in other parts of their groups. The proposed rules also mean that a ring-fenced bank can be more easily detached from the wider group by ensuring intragroup arrangements operate on an arm’s length basis – helping ensure important services remain available in the event of a failure of other parts of the group.

The publication of these two consultation papers means firms will be able to put in place detailed plans to ensure that they are prepared to ring-fence their core retail activities from 1 January 2019. These consultation papers also provide greater clarity on the operational continuity rules affecting other firms providing functions that are critical to the economy.

Andrew Bailey, Deputy Governor of the Bank of England and Chief Executive of the Prudential Regulation Authority (PRA) said:

“Making our firms more resilient has been at the forefront of our post-crisis reform agenda. Today represents an important step forward in achieving this aim. We have provided clarity for affected banks on how we will implement ring-fencing and this will enable firms to take substantial steps forward in their preparations for structural reform.”

Proposals for ring-fenced banks

The PRA is required under the Financial Services and Markets Act 2000, as amended by the Financial Services (Banking Reform) Act 2013, to make policy to implement the ring-fencing of core UK financial services and activities.

From 1 January 2019, banks with core deposits greater than £25 billion (broadly those from individuals and small businesses) will be required to ring-fence their core retail activities. To prepare for this, the PRA published near final rules on 27 May 2015 on governance, legal structure, and operational continuity and consulted on the approach to ring-fencing transfer schemes on 18 September 2015.

The proposals in today’s consultation papers look to ensure:

a ring-fenced bank has sufficient financial resources and liquidity;
intragroup exposures and arrangements between the ring-fenced bank and the rest of the group are managed in a prudent manner, at arm’s length;
the ring-fenced bank is clear on the PRA’s expectations on the use of financial market infrastructures; and
the ring-fenced bank can demonstrate the ability to continue to provide critical economic functions during resolution.

This consultation closes on 15 January 2016.

Operational continuity proposals

The PRA is also consulting on rules to ensure a broader range of banks, building societies and PRA-authorised investment firms structure their operations in a way that allows critical shared services to continue even in times of stress or failure.

Ensuring operational continuity is a necessary condition to make certain that firms can be resolved in an orderly fashion to support financial stability.

The PRA invites feedback on the proposals set out in this consultation paper, but respondents may wish to wait for the publication of the addendum, which will set a closing date for the consultation period.

Risks To Financial Stability; A UK Perspective

In a speech, Richard Sharp, member of the UK Financial Policy Committee, outlined the range of risks within the financial system. One topic he discusses is the buy to let sector, because investors may increase selling pressure in a downturn, if their rental incomes fall below their interest payments or if they observe or anticipate falling property prices. HM Treasury intends to consult this year on whether the FPC should have Direction powers over the buy-to-let mortgage market.

The complexity of global financial systems and markets requires that we aren’t exclusively concerned about the capitalisation of financial institutions. We are also concerned about risk of contagion and amplification and therefore we monitor systemic resilience and vulnerability wherever we see them.

The crash certainly demonstrated how specific vulnerabilities can have massive implications through amplification when the systemic is fragile or stretched. For example, although this summer’s fall in the Shanghai stock market saw peak to trough losses of 2.9 trillion dollars, there was no contagion or amplification in any way comparable to the experience of the 2007-2008 financial crisis. By comparison the US subprime losses which precipitated the financial crisis of 2007-2008 are estimated at around 400 billion dollars but, as we know now, have had a devastating impact. Unfortunately these losses were heavily concentrated on highly leveraged, systemically important financial institutions. As a result of a loss of confidence in the banking system, the subsequent contagion created profoundly greater costs. For example, economists at the IMF estimate that the aggregate cost to the US economy alone was 4.5 trillion dollars in the period of 2007-2009.Comparable UK costs over the same regime were £370 billion.

Consequently, in fulfilling its primary responsibility to contribute to UK financial stability policy, the FPC has to monitor the banking system, the financial system as a whole, and global and domestic potential sources of instability.

A particular challenge is that the UK is the home for an outsized financial sector. Bank of England economists have calculated that in 2013 the UK banking system was 450% of GDP – compared to around 100% in 1975 – larger than in Japan, the US and the ten largest EU economies.

However, a vibrant and successful financial sector is indeed a precious asset for our nation. It is a source of employment for millions of people; it is a critical source of tax revenue; it supports a number of other leading industries based in the UK, such as accounting and law; it provides for inward capital investment; it is one of the few industries in which the UK is a world leader. The FPC is building the capital and resolution framework to contribute to financial stability and to ensure there are no more bailouts.

The importance of the financial services industry to the UK is recognised by the remit the Chancellor has provided for the FPC. He charges the Committee, subject to fulfilling its primary objective on financial stability, to consider the government priority of maintaining the international competitiveness of the UK financial system. However, it is unequivocal government policy that it is unacceptable that UK citizens should underwrite banks’ balance sheets. One of the FPC’s priorities is to provide a capital and resolution framework for banks which ensures that they are capable of absorbing their own losses and are not ‘too big to fail’.

The actual losses borne by the banking system in the UK were unquestionably significant and life threatening; the six largest UK banks faced losses of up to 15% of risk weighted assets (nearly £67 billion in aggregate), with the largest losses concentrated in two institutions, Lloyds and RBS. Of course, the FPC doesn’t exist to stop any financial institution or group of institutions experiencing severe losses. Indeed, and inevitably, there may be severer losses arising from poor credit or investment judgement in the future. Our responsibility is to have the insight to ensure that we are aware of risks to the financial system and that, in particular, the systemically important institutions are well capitalised and that any severe losses don’t threaten the financial system.

However, recognising the risk of excessive regulation, the Chancellor told MPs when discussing the creation of the FPC and its objectives in 2011 – “we don’t want the stability of the graveyard.” What he meant was that although the FPC has been granted significant powers, in using these powers we have to ensure that we don’t unwarrantedly undermine economic growth through excessive regulation.

This highlights that there are real trade-offs for us, as we seek to fulfil our mandate. Firstly, we want to have well-capitalised banks but we don’t want to diminish the provision of credit to the real economy. Secondly, whilst we want the provision of credit, we don’t want to risk promoting asset bubbles. Thirdly, given its scale and importance as a source of household indebtedness, we want a disciplined property lending market; on the other hand, we don’t want unreasonably to restrict any individual’s ability to enrich his or her life through a housing purchase. Fourth, we may want to move quickly to ensure resolution, but we have to move in a globally coordinated way, which unavoidably has lengthened the process to agreeing a new resolution regime. Fifth, we want to have a safe and stable financial system, but we do not want to encourage financial services firms to feel incentivised to locate in other jurisdictions with lighter touch regulation, or to inhibit the development of new innovative sources of finance.

The FPC has been granted considerable powers to give Directions to the PRA and the FCA in relation to the use of certain macroprudential tools specified in secondary legislation. So far, in the area of bank capital requirements, Parliament has given the FPC macroprudential tools over sectoral capital requirements, and leverage ratio requirements. The FPC is also responsible for setting the countercyclical capital buffer for the UK. Further it has Direction powers also in relation to tools with respect to the housing market – currently loan to value and debt to income limits in respect of owner-occupied lending. HM Treasury also plans to consult by the end of this year on whether the FPC should be provided Direction powers over buy-to-let mortgages.

In seeking to preserve financial stability, the FPC can also make Recommendations to anybody, including to the PRA and the FCA on a “comply or explain” basis, and to HM Treasury, including on the boundaries within and around the perimeter of the PRA and FCA regulatory regimes.

In addition to these formal powers, the FPC also works closely with other authorities and committees within the Bank of England on issues of joint interest. For example, the FPC and PRA Board both agreed the design of the annual and concurrent UK bank stress test scenario, the results of which will help inform judgements by both committees.

Before using its powers, the FPC considers a wide range of information, including market and supervisory intelligence.

The Committee has developed a set of Core Indicators that it will consider when using its powers of Direction. These are indicators of key areas where vulnerabilities may build and signal an increase in financial stability risks. For example, the level of credit-to-GDP above its long-run trend (the ‘credit-to-GDP gap’) is one of the key metrics the FPC considers when setting the countercyclical capital buffer, as research suggests that periods of excess credit growth often precede financial crises.

In addition, the FPC is required by law to conduct and publish cost-benefit analysis before using its tools (unless, in the Committee’s opinion, it is not reasonably practicable to do so). In the remit that the Chancellor set out for the FPC in July, he emphasised that the Committee must communicate how decisions to use its powers are compatible with its objectives, including its judgement as to the balance of risks to its objectives, how those risks are judged to have evolved and how they are expected to evolve.

Since its formation in April 2013, the FPC has made 15 Recommendations or Directions on a wide range of topics, including on: bank capital and liquidity requirements; the UK housing market; and the resilience of the UK financial system to cybercrime. We set out our Recommendations in the biannual Financial Stability Report.

So the FPC has been fairly active in addressing risks. But what risks are we concerned about now? In July, the Committee published its Financial Stability Report, which highlighted the six major risks which, in the Committee’s judgement, are facing the UK financial system. These were risks from: (1) the global environment; (2) potential illiquidity in markets; (3) the UK current account deficit; (4) the UK housing market; (5) misconduct in the financial system; and (6) cybercrime. The Committee provided an update on some of these risks in the Record of its meeting in September.

With respect to the global environment, the Committee reported that, for the moment, things are getting somewhat less fragile in the euro area, in particular as a result of the fact that the immediate risks in relation to Greece have been addressed by the new programme agreed between the Greek government and its European partners. However, there are signs that risks to emerging market economies, particularly commodity exporters, have risen and are significant. This is partly as a result of a slowdown in China and the prospects of a potential ‘spill over’ from tighter monetary policy in the US, which could cause a material retrenchment in capital flows, as well as wealth effects. It is worth observing that one effect of US quantitative easing has been a considerable jump in the emerging market credit to GDP growth ratio. Moreover, many of the EMEs have raised significant external capital in US dollars and are therefore also exposed to the risk of currency mismatch. We need to consider whether capital markets can effectively trade such debt given liquidity concerns.

In fact we are concerned that global markets may not be able to absorb large shifts in assets, hence we are examining the capital market provision of liquidity very carefully. This year, there have been a number of short-lived, non-systemic periods of very high market volatility, which exposed the fragility of market liquidity and that disorderly conditions in one market could spill over to others.

In considering the risk of fragile market liquidity, for example assessing dealers’ ability to act as intermediaries in markets, the Bank and the FCA are working at an international level. The Committee is also closely monitoring risks from the UK’s current account deficit. However, despite the deficit being close to record highs (at 5.2% in 2015 Q1), the capital flows funding the deficit are mostly long-term in nature, reducing the risk of investor flight, and do not yet appear to be creating vulnerabilities in specific sectors.

One risk which received a lot of publicity following the publication of the September Record was the UK housing market. It is worth observing how secure the UK housing market has been to investors historically. This can be partly attributed to the fact that mortgages are typically well backed by housing assets, and that in the UK, unlike the US, mortgages are recourse loans, so homeowners can’t just walk away from their debts. However, the rapid growth in the buy-to-let market has caught our attention – the stock of buy-to-let mortgages has increased by over 40% since 2008. Why could this be a cause for concern? Buy-to-let mortgages are typically extended on interest-only terms, meaning their loan-to-value levels fall more slowly over time than owner-occupied mortgages. In addition, buy-to-let mortgages can add to procyclicality in the housing and credit markets, as investors may increase demand for property in an upturn, as they seek capital gains. Buy to let investors may increase selling pressure in a downturn, if their rental incomes fall below their interest payments or if they observe or anticipate falling property prices. As I mentioned earlier, HM Treasury intends to consult this year on whether the FPC should have Direction powers over the buy-to-let mortgage market. I believe it is important that the Committee is provided with powers. Beyond the risks the Committee have identified and, looking longer term, what troubles me?

It’s worth observing that – worryingly – global debt has increased considerably since the crash. It has increased by 57 trillion dollars since 2007 – 2014, outpacing global GDP growth over that period. As I mentioned, I’m most concerned about the fragility arising from this with respect to emerging markets.

Inevitably I have to be concerned that there are even greater risks out there which aren’t anticipated by even the best modellers of risk. As a member of the FPC, I’ve had the benefit of seeing how governmental institutions approach forecasting. It is well known that the Bank, the IMF, and other august institutions failed to anticipate the crash. Here for example is the IMF’s 2007 global financial stability map. The 2007 version singularly failed to reflect the incipient instability which was present and emerged so devastatingly – notice the radically different 2008 version.Modelling is hard – In fact, when I first encountered the optimism of some modellers, it brought to my mind a story told by the educator Ken Robinson:

A teacher noticed that a 6 year old girl was working very hard on a drawing and he asked her what she was drawing. She said she was drawing a picture of God. When the teacher said, “But no one knows what God looks like”, she replied – “they will in a minute”.

The Bank’s own approach to forecasting underlines that they recognise limitations which any forecasters must confront. It is clear that a single point one year forecast can be materially different from the outcome in reality. Hence, the Bank produces fan charts which highlight the amplitude of uncertainty. For our Committee, which does have to be concerned about fat tail events, it is worth observing that even the fan chart approach failed to capture the extreme events that occurred in 2007/08.

However, as a practitioner, I think that general expectations of precision from central bank forecasters maybe too great. In the financial sphere we are well aware that not one of all the outstanding brains in the world can, with predictable regularity, determine which way the markets will be even in the next 24 hours let alone the next year. Consequently, whilst, I’m content that the FPC should take account of its indicators and its forecasts, it must always provide for resilience and capital strength that takes account of the reality of unpredictable events.