The Bank of England Sows the Seeds of the Next UK Crisis

“The Bank of England plans to adopt a less-intrusive approach to overseeing U.K. banks when it takes over the role of Britain's primary financial supervisor in 2012, according to people familiar with the matter. Central-bank officials in recent weeks have privately told bankers that they will no longer deploy armies of examiners to pore over banks' books and demand reams of detailed information, abandoning an approach backed by the current regulator, the Financial Services Authority. Instead, the Bank of England—which will take over the FSA's responsibilities under a new regulatory structure devised by the coalition government—intends to place a greater emphasis on understanding macroeconomic issues and on requiring the banks to disclose more information to the markets, these people said. The Bank of England has been telling industry executives it plans to be "less in their hair at a detailed level" and that there will be "more market discipline in the equation" by increasing the amount of information banks release publicly, said a person familiar with the matter. On its face, the shift represents an unexpected retreat from the U.K.'s recent in-your-face policing of the financial sector. It could prove controversial in a country where distrust of banks runs high following the financial crisis. But Bank of England officials believe the new tack will be more effective than the FSA's current approach and will mesh neatly with the central bank's responsibility for monetary policy and for spotting potential systemic risks before they reach critical mass. One of the first decisions by the U.K.'s coalition government, which came to power in May and is headed by the Conservative Party, was to announce the dismantling of the FSA. Starting in 2012, responsibility for supervising the financial sector will fall to a newly created unit of the Bank of England. The FSA's aggressive oversight of the industry is a recent phenomenon. Until the financial crisis hit, the agency had prided itself on regulating with a light touch, which helped lure companies to London. But the near-implosion of the U.K.'s banking system in 2007 and 2008 exposed shortcomings in the FSA's hands-off approach. While trying to reinvent the discredited agency in 2008, Chief Executive Hector Sants announced a new era of "intensive supervision" in which the FSA would proactively intervene in banks' affairs when they engaged in risky behavior. Recently, though, Bank of England officials have revealed plans for significant shifts. In a private meeting with senior industry executives late last month, a top Bank of England official, Andy Haldane, said the new regulator will curtail the FSA's practice of dispatching dozens of examiners to banks to collect loads of granular information, according to people who attended the meeting in the central bank's imposing stone headquarters. Mr. Haldane noted that the industry finds those visits frustrating and time-consuming, and that they rarely yield much useful information for regulators, who can find themselves overwhelmed by the quantity of data, these people said.”

“[S]upervisors were not in a position to warn top policy-makers of the major asset risks or of some crucial problems of governance in banks, on the eve of the crisis – a failure that had very serious implications…. [M]any supervisors – faced with complex assets and operations, and with banks' ability to work around specific rules – moved to rely more on banks' own risk assessment systems and to supervise processes and principles, with some moving very far in the direction not just of “principles-based” but of “light-touch” supervision.”

“There were four main failings of [Irish] supervision: (i) The supervisory culture was insufficiently intrusive, and staff resources were seriously inadequate for the more hands-on approach that was needed.”

“Prior to the financial crisis in 2008, there were no sanctions imposed on credit institutions and none that might be said to have reflected significant prudential concerns. 5.14 The financial crisis has made it clear, though, both in Ireland and elsewhere, that effective bank supervision simply cannot be performed with the thin staffing that was applied to frontline operations of the FR. [n. 88] n. 88 In the post-financial crisis world, combined with the failure of prudential regulation in Ireland, there is an emerging consensus for more intrusive prudential regulation and a greater readiness to impose regulatory sanctions. Section 5: Conclusions 4.49 The philosophy of regulation employed by the Financial Regulator was inherited from the past practice at the Central Bank. It relied on the deferential view that, as long as there was a good governance structure, decisions of the people actually running the banks could normally be trusted to keep the banks safe and sound, and their decisions did not need to be second-guessed. Voluntary compliance was the preferred enforcement strategy. The status quo: Walk softly and carry no stick”

“But also, at the heart of the crisis in some of the worst-affected countries lay problems of a quite different order. [S]ome banks and other financial institutions, riding on the back of a generalised property boom, engaged in lending practices that were simply dangerous in an old-fashioned way. These were practices that did not require special supervisory imagination or moral courage to penalise. They were noted above in terms of serious failures of bank management and governance. The failure of [Irish] supervisors to act strongly against such practices is much harder to understand, and is not much mitigated by the more broadly shared issues of supervisory culture cited above. [There] were very specific and serious breaches of basic governance principles concerning identifiable transactions that went far beyond any question of poor credit assessment. The Government's notice on the nationalisation of Anglo Irish Bank, for example, refers to “unacceptable corporate governance practices” as a triggering factor in the nationalisation. Ireland was one of those cases where there were at least some instances of extremely serious breaches of corporate governance, going well beyond poor risk assessment, and eventually having a systemic impact…. The first category of failures seem to have been quite widespread - not just limited to one or two institutions. These failings concerned weak risk management, including poor credit appraisal and the overriding of internal guidelines and processes that should have prevented the build-up of such high and risky concentrations of credit risk exposure – in property generally but especially in the field of credit related to commercial real estate. More broadly there was a failure of corporate checks and balances that should have served to restrain management's enthusiasm for rapid and concentrated credit growth. This kind of weakness in governance was detected by supervisors…. [Ireland suffered from a ] straightforward property bubble, compounded by exceptional concentrations of lending for real estate – and notably commercial real estate – purposes. [The CRE bubble and exceptional concentrations] constituted a sword of Damocles hanging over the banking system. This is an area where senior management insight in the regulatory authority could have overridden systems, if needed, to prioritise the documentation of such system-wide concentrations of lending to individual or connected borrowers. Supervisors, at one level or another, were aware of most of the risks, and they did take some actions. [However,] the supervisory culture was insufficiently forceful and pre-emptive. On-site inspections were infrequent. Targeted follow-up was weak, including crucially on governance issues. Supervisors were perceived as reluctant to impose severe penalties, and during the key period when major governance problems arose, they imposed no penalties on banks at all.”

“Starting in the early 1990s, the Irish government made a strategic decision to become a world-leader in “offshore” financial services. For foreign financial services firms willing to set up operations in Ireland, the main attractions were an educated, English-speaking workforce, a Western European location, and light-touch, almost nonexistent, tax and regulatory oversight. This very lax supervisory regime led The New York Times to call Ireland “the wild west of European finance.” An unintended consequence of the extremely light-touch financial regulatory regime in Ireland was to hobble Irish regulators in their oversight of domestic banks. [WKB note: it is unlikely that this consequence was unintended.] Ross (2009) … argues that the regulatory regime for domestic Irish banks during the pre-crisis period was extremely weak and ineffective. For example, for eight years, the board chairman and other directors at Anglo Irish Bank hid very large personal loans by temporarily transferring them just prior to accounting year-end to other banks complicit in the scheme, and then by pre-agreement rolling the loans back into Anglo Irish immediately after the publication of the annual accounts.” [WKB Note: Anglo Irish made approximately 180 million Euros in loans to its directors. It did not disclose this exposure. The loans overwhelmingly have not been repaid.] “Anglo Irish Bank deliberately understated its loans-to-deposits ratio through sham transactions – this took the form of agreed interbank lending by Anglo to another Irish domestic bank just before reporting yearend, and then immediately accepting the funds back from the other bank as “customer savings deposits.” In this case there is considerable evidence (obtained via media leaks) that the Irish financial regulator informally approved of the stratagem. In 2007, Anglo Irish became aware that a large shareholder was preparing to sell a 10% position in Anglo Irish shares. To prevent this share sale from impacting its share market price, Anglo senior management organized a secret circle of ten wealthy bank clients, lent each of them €30 million for the purchase of Anglo shares, with limited recourse on the loans beyond for the purchased shares as collateral. Since the loans were without recourse to the borrowers, Anglo was the at-risk investor in the shares, and was essentially using €300 million of its depositors' funds to secretly purchase its own equity shares.” [WKB note: the updated figure is that the loans totaled 451 million Euros.] “Irish Nationwide is a building society established to provide mortgages to its members. Yet it was allowed by the regulator to put its members' funds at risk by lending 80% of its funds to a small number of property developers.” [WKB note: Irish Nationwide was one of the institutions that engaged in secret transactions with Anglo Irish to hide transactions designed to benefit Anglo's controlling officials.]

“Weak law enforcement was another source of moral hazard in Ireland….”

“This is where regulation can, and has to, play a crucial role. That role – never an easy one for public officials to play with confidence and credibility – is to be right, against the market. Ireland's mounting financial vulnerabilities meant that strong action was called for to over-ride the prevalent light-touch and market-driven fashions of supervision: to call a spade a spade, in terms of mounting systemic risk, and to head off the risks of a crisis. [There are successful regulatory] examples in other advanced economies of supervisors standing out against the crowd on one or more key issues, thus mitigating the economic and social fallout from unwise banking decisions. The over-arching lessons from the experience in Ireland fall into seven broad categories, and they are flagged here to highlight points that are explored more fully in earlier pages: In an adaptive financial system, there is a case for principles-based supervision, in conjunction with clear rules. But the “light-touch” approach to supervision has been discredited: it sent wrong signals to banks and left supervisors poorly informed about banks' management and governance, potentially impairing crisis response capacity also.”