01 May 2013

PRA/Bailey: The new approach to financial regulation

In his speech, Bailey gave several reasons as to why he believed the reform of financial regulation was an important step forward. He then went on to talk about developing bank resolution and the too-big-to-fail issue.

It starts with establishing very clear public policy objectives for financial regulation to which we, as the regulators, are fully committed. For both banks and insurance companies, the PRA will have the objective of promoting the safety and soundness of firms. Consistent with this objective, it will focus on the potential harm that firms can cause to the stability of the financial system in the UK. We define a stable financial system as one that is resilient in providing the critical financial services that the economy needs. And this supply of services is a necessary condition for a healthy and successful economy, as demonstrated by the costs imposed by the financial crisis on the public and society at large.

For insurance companies, the PRA will have the second objective of contributing to securing an appropriate degree of protection for policyholders. Why do we need a second objective for insurance? One reason is that in taking out some forms of insurance policies, the public can become locked into very long-term contracts, much longer often than is the case in banking with deposit contracts. Bearing this in mind, the public interest I think justifies a second objective for insurance, which is more directly targeted at the situation of individual policyholders...

There is another major public interest in the banking system, namely that by becoming too big to fail, the largest banks have developed an implicit, and in some cases explicit, dependence on public money. This is unwelcome, for the public, and for the banks, the former because of the unwanted cost, and the latter because of the intense scrutiny and oversight of the banks, which must be more intense as long as this state of affairs lasts.

Now, I recognise that we have a lot to do still on resolution planning to be comfortable about our objective of avoiding a no failure regime and thus solving the Too Big To Fail problem. For large banks, we are making progress on resolution planning, and this world is different to five years ago, but we are not there yet by any means. I have a background in resolving banks, and I regard having the capacity to resolve failed large banks – including the largest – as the holy grail of resolution. Unlike the legendary Holy Grail, I think there is a good reason to believe that the objective of being able to resolve large banks that fail can be within our grasp.

I am very clear that when firms mess up, they should be allowed to fail, and by doing so they are putting at risk the money of their shareholders and if necessary after that those who provide debt funding according to levels of seniority. But I am also very clear that really achieving the objective of avoiding a no failure regime requires a fundamental change of mindset both inside firms, the authorities and in society more broadly.

Fear of failure is an important conditioner of behaviour in a financial regulator, and achieving a change on this front depends on establishing a wide acceptance of our approach that orderly failure which does not compromise our public policy objectives is an acceptable outcome. To be clear, we should be criticised where failure compromises those objectives and we could have taken steps to avoid it. But if failure is orderly, and does not compromise our public policy objectives, the responsibility should rest with the board and management for failing to serve the private interest of their shareholders and creditors.

Last on the theme of failure, having firms that are either too big or too important to fail is bad for competition in the industries that we regulate. An industry where exit is too difficult is one where entry is likewise inhibited. This is what we see in the banking industry. Embedding resolution into the public policy objectives of financial regulation matters for two reasons relevant to competition: first, because, to repeat, exit enables entry; and, second, because if, as we will, we require new entrants to satisfy us on their resolvability in order to be authorised, we will lower the barriers and costs of opening for business. Put simply, if we don’t know how to deal with a failed firm, we will inevitably set a higher barrier to entry. We have already started to put this new approach into operation.

Resolution of failed firms consistent with the public policy objectives is one key plank of the new approach to financial regulation. Another key plank concerns the macro-prudential approach to regulation. The legislation has formally established the Financial Policy Committee (FPC) charged with the primary objective of identifying, monitoring and taking action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system...

In summary, there is a strong public interest in the banks, which has been sharpened by the crisis. One element of that public interest is permanent – the role of banks in supporting the real economy. Another is permanent, and like the first should be in the category of a given – namely, good conduct by banks. But the third – the dependence on public money – should not survive, hence the strong focus on developing bank resolution and ending too big to fail.

Full speech

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