Lessons from northern rock how to handle failure

Lessons from northern rock how to handle failure

The authorities are effectively proposing to set up place the type of legal and regulatory arrangements currently within america and several other countries. A particular resolution regime (SRR) will be created, led by a fresh authority (I will call it the special resolution regime authority or SRRA, never to be confused with SSRI, lest we get some good very depressed bankers), who could manage a troubled bank before it hit the standard insolvency buffers – inability to service its debt. The assets of the pre-failing bank, or some of its activities and business, could possibly be transferred to a number of healthy banks or various other alternative party; a ‘bridge bank’ could possibly be created to permit the SRRA to manage all or part of a bank or of its assets and liabilities; a ‘restructuring officer’ could possibly be appointed by the SSRA to handle the resolution; and lastly, if the judgement is reached that pre-insolvency resolution isn’t feasible, a particular bank insolvency procedure could possibly be invoked to facilitate swift and efficient payment of insured depositors. Public ownership of most or part of a bank as a final resort is also the main package. The Treasury document identifies it as temporary public ownership, but unless therefore a set time table should be provided, the term ‘temporary’ only indicates hope or intent and isn’t operational.

The federal government proposes that the FSA will be the SRRA, and I trust that. It will not be the lender of England (as the job of the SRRA is too political) or the Treasury (as the Treasury is too political for the work of the SRRA). A fresh separate entity will be possible, but further balkanisation of the duty for financial stability in the united kingdom appears to be undesirable (anyone would like a Quadripartite Arrangement?).

The main element issue may be the specification of the circumstances under that your SRRA can impose the SRR on a bank. Exactly what will be the threshold conditions or triggers (quantitative or qualitative) that could cause the SSRA to compel a bank to enter the SRR? If the threshold is defined too low, competition is distorted. If the threshold is defined too high, there could be threat of systemic instability. Of course, with adequate deposit insurance and a proper bank insolvency procedure, contagion effects and other systemically destabilising manifestations of panic ought never to happen. Even the failure of a big bank shouldn’t be of greater public interest compared to the failure of a ball-bearings manufacturer in Coventry with equal value added.

The Treasury believes your choice on whether so when a bank ought to be ordered in to the SRR should be predicated on a regulatory judgment exercised by the FSA after consultation with the lender of England and the Treasury. Provided it really is clear that the best decision lies with the FSA, I’d trust this proposal.

I really believe that the brand new deposit insurance arrangements ought to be situated in the same institution which has the SRRA, that’s, with the FSA. The prevailing Financial Services Compensation Scheme should either be moved in to the FSA or finished up. In its current form, it really is useless.

In regards to the limits of the insured amount, the existing UK figure of £35,000 (since October 1, 2007, the idiotic run-inducing 10% deductible following the first £2000 has been abolished) is apparently in the center of the 19-country pack reported in the Treasury document. Eyeballing the charts, it looks as if about 97% of most retail deposit accounts hold significantly less than £35,000. Simultaneously, the very best 3% of deposit accounts hold about 50% of total deposits in the united kingdom. This means that a rise in the limit would improve the value of the deposits included in significantly more than it could improve the number of depositors covered. I cannot visit a strong case for raising the limit, no case for raising it above £50,000. What counts may be the speed with which insured deposits could be paid should a bank enter trouble.

It really is apparent that the lender of England, because it became operationally independent for monetary policy, and lost banking supervision in 1997, did a far greater job in regards to its monetary policy mandate of price stability than it has in regards to its financial stability mandate. There’s been really only 1 serious test of the UK’s Tripartite Arrangement for financial stability between your Bank, the FSA and the Treasury. It failed the test. A lot of the blame lies with current and past Treasuries and with the FSA, however the Bank contributed to the issues through its mismanagement of market liquidity. The Treasury Report will not address this problem at all.

It really is key that the lender of England should follow the exemplory case of the ECB and extend its set of eligible collateral at the standing lending facility and in open market operations to add routinely private securities, including asset-backed securities. It will also extend the maturity of its standing lending facility loans from overnight to up to 1 month, going for a leaf from the Fed this time around. Finally, it will extend the set of eligible counterparties at the standing lending facility and in its repo operations to add not only banks and similar deposit-taking institutions. Currently, open market operations are available to non-Cash Ratio Deposit-paying banks, building societies and securities dealers that are active intermediaries in the sterling markets. Usage of the standing facilities is fixed to participants in the lender of England’s Reserves scheme and some others. Both OMOs and standing facilities ought to be accessible to all finance institutions regulated in a way approved of by the lender.

While in a first-best world, the lender wouldn’t normally be the active player in LoLR operations, it’ll always be involved with funding liquidity matters through its standing facilities. Hence, it is key that the usage of the typical lending facility be de-stigmatised. This is often attained by abolishing the unbelievably complex operational procedures for setting the state Policy Rate or Bank Rate (official policy sets the prospective for the overnight unsecured sterling interbank rate) and managing short-term liquidity.

The existing framework has three main elements: rather plain-vanilla standing facilities and OMOs and a mysterious and pointless reserves-averaging scheme (from the Bank’s Redbook):

Reserves-averaging scheme . UK banks and building societies that are members of the scheme undertake to carry target balances (reserves) at the lender normally over maintenance periods running in one MPC decision date before next. If a member’s average balance is at a variety around their target, the total amount is remunerated at the state Bank Rate.’

The reserves-averaging scheme is going. There must be no reserve requirement at all. THE LENDER should stand prepared to repo (against eligible collateral) or reverse repo any amount anytime at the state Policy Rate. That, in the end, is what this means to set the state Policy Rate. Other things is an try to set both price and quantity – and is doomed to failure.

Commercial banks would therefore be borrowing from the lender of England on a regular basis, as a matter of routine, no stigma would be mounted on such operations. This might also keep carefully the overnight interbank rate nearer to the state Policy Rate than it really is under current procedures, decoupling the Monetary Policy Committee’s interest decision from the liquidity policy not managed by the MPC but by the Bank’s Executive.THE LENDER still could retain its standing lending facility by accepting a wider selection of assets as collateral at the standing lending facility than it accepts in repos to peg the state Policy Rate.

In its open market operations, the lender should become market maker of final resort, by standing prepared to purchase, at an adequately conservative/punitive price, normally liquid assets which have become illiquid through a systemic flight to quality and liquidity due to fear, panic and other contagion effects. For the securities acceptable for rediscounting at the standing lending facility, there must be a positive set of securities (including private securities and even private ABS) that are acceptable as collateral by the lender. This might help concentrate the minds of (the supervisors of) those maniacal financial engineers generating a lot more complex and opaque financial structures, which will be unlikely to figure one of many eligigble collateral.

It really is obvious that, whenever taxpayers’ money is jeopardized, the Treasury should be consulted and really should have a veto over the operation. The Treasury document makes this clear. The Treasury can be ‘in charge of’ the complete arrangement, though it appears obvious there are certain things it cannot instruct both other parties to accomplish without risking damaging resignations. I doubt whether it might supply the Bank instructions on its collateral policy, OMOs and standing facilities operations. In my own view it ought never to manage to do so. Additionally it is unclear as to if the Treasury expects to maintain a position to teach the SRRA (that’s, the FSA) to invoke or never to invoke the SRR for a specific bank. I’d hope it could not have the ability to do so. What the role of the Treasury will be in your choice to invoke the brand new bank insolvency procedure remains unclear. Obviously, nationalisation could only be authorised by the Treasury.

In the proposals of the Treasury, the FSA is still the regulator and supervisor of the banking sector (and of all other finance institutions). It remains in charge of the default risk (solvency), the funding liquidity of the institutions it supervises and other risks, including operational and reputational risk. It’ll lead the SRR and become the SRRA. I suppose it would also lead to the management of the deposit insurance scheme, although the Treasury document isn’t clear on this. THE LENDER of England does get its nose in to the tent for most of the activities and responsibilities, however. To my mind this further troubles the allocation of responsibility and authority.

The financial cost of the deposit insurance scheme can only just be borne by the participating institutions (either through pre-funding or ex-post funding) if the banking sector trouble causing the scheme to be asked for a pay-out is a ‘local’ problem affecting only a minority of the banks. When there exists a systemic bank run (or bank default), only the Treasury can credibly meet up with the insurance claims. This will be recognised. Any serious deposit insurance scheme represents a contingent claim on the Treasury.

THE LENDER of England remains in charge of market liquidity, both in normal times and, under disorderly market conditions, by acting as market maker of final resort. It is involved with funding liquidity through the (on demand against the correct collateral) standing lending facility. The Treasury Report (and much more strongly the Treasury Committee Report) favours a sophisticated role of the lender of England in the LoLR process. The Treasury Report wants the lender to invest time and resources becoming and remaining informed of the liquidity situations of the average person UK banks. This clearly would additionally require it to understand the solvency- areas of the total amount sheet and operations of individual banks. THE LENDER and the FSA would effectively become joint supervisors with shared responsibility for funding liquidity and solvency. I doubt whether this arrangement works well.

So far as I could tell, the Treasury Committee wants most of banking supervision and regulation to be returned to the lender of England, with the FSA taken completely out from the game. A fresh Deputy Governor and Head of Financial Stability would take the lead in every financial stability matters, and may even order the FSA around.

It really is clear that the Treasury Committee’s proposal would put strains on the lender of England’s independence in monetary policy. The Committee therefore raises the chance that the brand new Deputy Governor/Financial Stability Czar is probably not an associate of the MPC. I still cannot view it. What will be the authority relationship between your new Deputy Governor/Financial Stability Czar and his/her notional boss, the Governor? If the lender of England is usually to be devote charge of (the operational end of) Financial Stability, do not to appoint a fresh Deputy Governor but to provide the work to the Governor also to take MPC out from the Bank of England. The Governor of the lender would, under this model, definitely not be the Chair of the MPC or perhaps a person in it.

Instead of putting money and individual bank-specific information together in the same institution by making the lender of England in charge of banking supervision again, I’d move in the contrary direction. The lending company of final resort (which wouldn’t normally be the lender of England although the lending company of last resort, if it’s not the lender of England must have an open-ended uncapped line of credit or overdraft facility with the lender of England, guaranteed by the Treasury), ought to be the SRRA, that’s, the FSA. It could make liquidity open to a troubled bank that could no more fund itself in the interbank markets, the repo markets or at the standing lending facility. The collateral that might be accepted, the terms which it could be accepted, and the other conditions and terms mounted on LoLR funds will be decided by the SRRA (the FSA) on a case-by-case basis.

The existing Tripartite arrangement is sketched in Figure 1. The Treasury Committee’s proposal is in Figure 2, the Treasury’s proposal in Figure 3 and my very own proposal (for a minimalist central bank) in Figure 4. Finally, Figure 5 shows how, under my proposed arrangement, a potentially troubled bank will be handled.

With effective deposit insurance and a sensible insolvency regime for banks, all proposals share the feature that it might, finally, become conceivable a non-trivially small bank in the united kingdom might fail. That might be the very best guarantor of greater future financial stability.