NEW regulations cannot absolutely prevent the possibility of another financial crisis or of banks failing, a Bank of England policy maker announced just days after the Bank had pushed for stronger powers over the industry.
The culture within banks, as well as changes to the structure of incentives, will be the most important changes, financial policy committee (FPC) member Michael Cohrs said, arguing the pre-crisis regulatory structure was “myopic” and “dangerously focused on individual firms,” rather than the financial system as a whole.
As the Bank is given more powers, it should also be made robustly independent – if it needs to burst a credit boom, the FPC must be able to stand up to the howls of protest, he said.
On Friday the FPC announced it had requested powers to adjust capital requirements through the economic cycle, charge banks for lending to sectors vulnerable to bubbles, and impose a maximum leverage ratio of total liabilities to capital.
The Committee also discussed pushing financial institutions to hold buffers of more liquid assets in case of a crisis, but has to wait for more international agreement on the topic.
Governor Mervyn King conceded “we know absolutely nothing about how these instruments are going to work – it is very important we play it safe and be cautious.”
The FPC has not asked for the power to limit loan-to-value mortgage levels, stepping back from King’s earlier suggestions that loans should be capped to avoid another sub-prime bubble, fearing this may be an unpopular step.
However, it did not rule out using such powers in the future, when they may be less controversial.
Meanwhile the Bank’s Andy Haldane yesterday called for banks to cut bonuses and dividends to free up cash to use building up capital buffers.
“Financial market conditions have improved somewhat and the European situation has normalised to a degree but the risk is still very considerable,” he said.
“Our message to the banks is to build their defences, do some more insurance, guard against the chance of things taking a turn for the worst perhaps later in the year.”
AT A GLANCE: FPC’S NEW POWERS
● What the FPC has asked for
The Bank of England’s Financial Policy Committee (FPC) has asked the Treasury for three main new powers that it hopes will help maintain financial stability and reduce risks to the system as a whole. It wants to be able to alter the size of banks’ capital buffers depending on the state of the economy; set different buffers depending on the sectors each bank is most exposed to; and set an overall capital level that banks must maintain, regardless of the riskiness of their balance sheets.
● The counter-cyclical buffer
Banks are required to keep a certain stock of capital aside as a buffer to protect against losses on bad loans. The FPC wants to be able to vary the size of this buffer depending on the state of the economy – in good years, banks would have to hold more capital against unexpected losses, and in bad years they would be able to run down the losses and lend more, preventing, or at least slowing, a fall in lending. That could “stem over-exuberance in UK credit growth in some circumstances and support credit growth in others,” the Committee hopes.
● Buffers by sector
The FPC believes it can identify bubbles building in a particular sector, and by forcing banks to hold more capital against loans in that sector both slow the bubble’s development, and ensure banks are well protected against its bursting. In particular it points to commercial and residential property bubbles as examples of ruinous booms in the recent past, as well as lending to other parts of the financial sector.
● Total leverage ratios
Although bank lending will be constrained by capital requirements, which are based on risk, banks should also face a maximum ratio of total liabilities to capital, the FPC believes. This would be changed over time, but have the broad benefits of being transparent, simple and free from an assessment of the riskiness of assets.
● Loan-to-value ratios
The FPC has not asked for the power to limit loan-to-value ratios in mortgage lending, though it has not ruled out asking for the power in future. Similarly, it may in time ask for the power to impose more stringent liquidity requirements on banks, as well as the power to force disclosure of the details of more activities, allowing it to better combat potentially risky activities. The FPC is also currently campaigning for banks to cut bonuses and use the cash to boost capital levels.