New Bank watchdog's untested weapons face bank battle

LONDON Thu Apr 5, 2012 10:44am BST

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LONDON (Reuters) - The Financial Policy Committee, tasked with fighting off the next financial crisis, first faces a battle to convince Britain's banks that its untested weapons will do more good than harm.

The FPC, a division of the Bank of England, was created last year to plug a big gap in regulators' ability to tackle risks such as the credit and housing bubble that, on bursting, torpedoed banks across the world in 2008 and threatened the entire financial system.

Similar bodies elsewhere, such as the European Systemic Risk Board and the United States' Financial Stability Oversight Council, have been set up for the same purpose.

But the FPC's proposed powers, unveiled less than two weeks ago, have already drawn fire from bankers and politicians who fear, among other things, that the focus on future risks will hamstring them and the economy when emerging from a downcycle.

The FPC thinks that mindset has to change.

"There has to be a political will to accept that actions will be taken which are unpopular, and could even turn out to be unnecessary, but they were the best judgement at the time about what was necessary to fend off ... a financial crisis," FPC member Alastair Clark told Reuters.

A leverage cap is one of the three powers that the FPC has asked for, to limit banks' total balance sheet or lending.

The second is the power to impose tailored 'sectoral capital weights', so the BoE can address perceived risks by increasing or decreasing the cost of lending in specific areas such as mortgages or small business loans.

The third power is to require 'counter-cyclical capital buffers', which the FPC would increase in the run-up to a credit boom, applying a brake to lending, and then lower during a slump to give banks extra capital to keep lending going.

EXPERIMENTAL

The FPC approach, in a policy area that both Clark and BoE Governor Mervyn King have conceded is "experimental", has rung alarm bells with some bankers.

In a recent newspaper column, Peter Sands, chief executive of Asia-focused British bank Standard Chartered (STAN.L), damned the FPC as "simultaneously extremely interventionist and extraordinarily blinkered".

Behind closed doors, other banks have also expressed concerns to Reuters in terms almost as strong.

The British Bankers' Association said that while its members welcomed the FPC and macroprudential regulation in principle, there were worries that banks, not the BoE, would take the flak for the higher lending costs that might ensue.

"If the FPC decides to increase the risk weightings on products like mortgages ... it will be important for it to communicate this clearly so consumers understand why pricing has changed," BBA financial policy expert Adam Cull said.

The BBA fears that in practice the use of 'counter-cyclical capital buffers' will be one-sided.

"It will be vital that the buffer goes down as well as up to enable banks to lend to the economy during the recovery from an economic downturn," Cull said.

These worries might be dismissed as special pleading from within the industry, but the British parliament's Treasury Committee, the main public body that holds the BoE to account, is also concerned.

It has regularly challenged the BoE's Monetary Policy Committee over its apparent inability to spur small business lending, and seems to have similar concerns about the FPC.

"Just as they need the tools to take the punchbowl away when the party gets going, so too they need to be able to add a tonic at the other end of the cycle," Treasury Committee chairman Andrew Tyrie, a Conservative Member of Parliament, has argued.

NO TRACK RECORD

To convince the sceptics, the FPC will want the strongest possible evidence to defend its decisions, but regulators have precious little by way of a track record to call upon.

Federal Reserve Governor Ben Bernanke unwittingly highlighted regulators' inability to spot looming dangers when he gave a speech in May 2007 as defaults in one corner of the U.S. home loans market were gathering speed.

"We believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system," he said.

By the following year, the chain reaction triggered by the subprime crisis led to the collapse of U.S. bank Lehman Brothers and triggered near meltdown in the financial system. Some UK banks had to be nationalised like Northern Rock, taken over like HBOS or saved from collapse with taxpayers cash.

"It's still very much a work in progress. Everybody is now learning. The hardest part is understanding where we are in terms of systemic (risk) build-up," said Laura Kodres, chief of the International Monetary Fund's global financial stability division.

"It's an inherently difficult task they have set out to accomplish. It's akin to asking them to find a needle in a haystack before the sun heats it up to set the barn ablaze," said Thomas Huertas, a former senior regulator at the UK's Financial Services Authority.

MACROPRUDENTIAL TOOLKIT

Most of the experience with macroprudential tools have been in emerging economies.

In advanced, complex financial systems, one of the few tried and tested tools has been the use of leverage caps at U.S. deposit-taking banks, which needed less help in the financial crisis than investment banks, where no such curb was in force.

While the FPC is likely to have a leverage cap, it considers it a relatively crude tool, a backstop if banks circumvent more specific controls.

The second power, to impose 'sectoral capital weights', is under fire from Standard Chartered's Sands as it would allow the regulator to micro-manage banks' lending decisions in a way that consumers would find hard to grasp.

The third, the 'counter-cyclical capital buffers', could, as feared, turn out to be more in evidence as a brake than as a boost when emerging from recession. The FPC's Clark said evidence of the latter effect was limited, constraining the FPC's ability to 'add a tonic' as Tyrie and the BBA would like.

Moreover, counter-cyclical buffers hinge critically on an ability to accurately predict the path of a credit cycle - the challenge that IMF official Kodres alluded to - an ability that to date has defeated economists.

"It would have been nice to have further developed the theory, but the problem is that theory is usually informed by practice, so you have to have some experimentation," Kodres said.

TRIED AND TESTED

One tool that does have a good track record in advanced economies such as South Korea and Hong Kong is a direct curb on how much someone can borrow to buy a home. But despite Britain's history of rapid rises in house prices, the FPC has said it is too early to ask for such politically charged powers.

Some say this will make its job harder.

"It's the tool which in other countries has been used with the greatest success," said Charles Goodhart, a former Bank of England monetary policy committee member.

"One has to recall that the main driver of the financial crisis has not been fancy derivatives but it has actually been real estate, and we have had three real estate bubbles in Britain in my lifetime," Goodhart said.

Kodres said it was best for macroprudential supervisors to have a broad arsenal.

"Not using the tools we know work, even if only partly, will be just as much a mistake," Kodres said.

The FPC insists it will be still be able to influence home loans, albeit indirectly, through slapping higher capital charges on banks offering very high loan-to-value mortgages.

Nevertheless, critics fear that by not equipping itself with powers from the outset to curb home loans, the FPC is at a greater risk of failing.

The UK government and lawmakers are also putting pressure on the FPC to come up with a set of benchmarks to highlight potential overheating, such as a rise in the ratio of credit to gross domestic product, or an increase in bank leverage.

Such indicators could help the BoE build arguments for action. One bank has suggested that, just as the MPC uses interest rates to target a government-set inflation rate, the FPC should be mandated to target a specific government-set average leverage ratio.

However, Huertas said it was unrealistic to expect the same degree of precision as found in monetary policy.

"The danger is that you constrain the doctor to rely on one particular test. The purpose of creating these systemic risk boards is to exercise judgements as to what could cause a problem," he said.

COORDINATION CHALLENGE

Apart from having the right tools and knowing when to use them, experts say the FPC and similar bodies face other hurdles. These include the need for macroprudential policy to be aligned with monetary and fiscal measures, and the need for other countries to take similar actions to avoid banks shifting risky activities to countries that take a more lenient view.

"The FPC says that it hopes there will be some kind of cooperation from other jurisdictions, which you can't necessarily take for granted," said David Green, a former Bank of England and FSA official who now advises the Irish central bank.

Others say macroprudential supervisors are simply dealing with symptoms of deeper problems, such as lax interest rates or tax policies, requiring a coordinated approach both within the BoE and between the BoE and Britain's finance ministry.

The financial cycle and economic cycle don't overlap perfectly, making coordination harder. And policy measures must avoid getting caught in the crosshairs of election cycles too.

"It will be more of an art than a science and a lot more explanation will be expected," Green said. "What will happen is that attempts will rightly be made to introduce measures in relation to developments as they emerge and they will provide grit in the wheels but they may not work for very long. That would be the lesson of history."

Philip Turner of the Bank for International Settlements, a forum for central bankers, said the starting point would often be very imperfect information.

"New policies inevitably involve trial and error," he said in a BIS paper. But the lack of decisive evidence on how macroprudential supervision will work "is not a reason for not acting when the likely alternative would be worse."

(Reporting by Huw Jones and David Milliken; Editing by Will Waterman)

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