House of Lords - Banking Supervision and Regulation

Banking Supervision and Regulation - Economic Affairs Committee Contents

Chapter 5: Financial Supervision in the United Kingdom

90. Financial stability is a central goal of financial regulation. Responsibility for financial stability in the UK is shared by HM Treasury, the Bank of England, and the Financial Services Authority (FSA), which together constitute the "tripartite authorities". The division of responsibilities between the tripartite authorities is set out in a Memorandum of Understanding (MoU)[14] as follows:

The Bank of England is responsible for the stability of the monetary system through its monetary policy function, for the oversight of financial system infrastructure that is systemically important to the UK, in particular payments systems, and for "maintaining a broad overview of the system as a whole"[15].
The FSA's role is set out in the Financial Services and Markets Act (FSMA) 2000. It performs micro-prudential supervision of financial intermediaries, and it supervises financial markets, securities listing and clearing and settlements systems. It also performs conduct-of-business supervision. The FSA's role with respect to what is now called macro-prudential supervision has been unclear. Whilst the objective defined in the FSMA of "maintaining confidence in the financial system" might be deemed to encompass macro-prudential concerns, the Memorandum of Understanding defines the FSA's responsibilities as "the authorisation and prudential supervision of banks, building societies, investment firms, insurance companies and brokers, credit unions and friendly societies"[16]. It is not clear how these responsibilities were believed to relate to the Bank of England's responsibility for "the system as a whole".
The Treasury is responsible for "the overall institutional structure of financial regulation and the legislation which governs it"[17]. It has no responsibility for the activities of the FSA and the Bank, but, if a financial problem arises with potentially system-wide consequences, the FSA and the Bank together decide whether the Treasury needs to be alerted[18].

91. The MoU states that "the authorities maintain a framework for co-ordination in the management of a financial crisis", and it delineates responsibilities for operational crisis management[19]. These procedures were first invoked when Northern Rock failed, and were again required later in the financial crisis, for example when Bradford and Bingley failed.

Supervisory Roles

92. The FSA is responsible for the prudential and conduct-of-business supervision of all regulated financial institutions in the UK. Previously, financial supervision was organised along institutional lines, so that, for example, banks and building societies were supervised by different agencies. Nine separate agencies were combined to create the FSA.

93. Integrated supervision was a response to a blurring of the boundaries between different financial activities. For example, banks are increasingly involved in securities markets, and, through the securitisation market, insurance companies have started to invest in banking assets. A system that regulates institutions according to their legal status is therefore likely to treat the same activity in different ways, which could result in wasteful regulatory arbitrage. Integrated supervision avoids this problem: activities are supervised on functional, rather than institutional, lines; at the same time, costly communication between agencies is unnecessary when there is one institutional supervisor, and regulated entities need only manage one supervisory relationship.

94. The setting up of the FSA in 1997 set a trend for the adoption of integrated supervision. Canada, Germany, Japan, Singapore, and Switzerland all have integrated supervision of the financial sector.

95. The FSA's performance before and during the financial crisis has nevertheless been criticised on three grounds. First, the effectiveness of communication between the FSA and other tripartite members during the financial crisis has been questioned; second, the FSA has been accused of neglecting macro-prudential supervision before the crisis; third, some critics have suggested that the FSA over-emphasised conduct-of-business supervision at the expense of micro-prudential supervision. We address these points below.

THE TRIPARTITE SYSTEM: COMMUNICATION AND COORDINATION

96. The Governor of the Bank of England characterised the tripartite committee as "a vehicle for communication and exchange of views". He argued that assignment of responsibilities was without ambiguity (Q 490). Lord Myners thought that the tripartite system worked very well (Q 556).

97. These perspectives were not shared by all of our witnesses. Professor Geoffrey Wood told us: "On occasions [the tripartite system] functioned with jaw-dropping incompetence and chaos" (Q 48). He went on to argue that no agreement, including the tripartite arrangement, can foresee every contingency, so that ambiguity is inevitable when surprises occur (Q 58). It was impossible rapidly to resolve this type of ambiguity when no one is assigned residual decision rights. Unanticipated ambiguity arose when Northern Rock failed. Professor Wood told us that "in the present tripartite structure it is clear that nobody was actually in charge ... So we do need to have a modification to the tripartite system where someone is clearly in charge from the beginning" (Q 56). Similarly, Lord Burns told us that "it did take a while before the Treasury really got itself in charge of this process. I think that was one of the possible effects of learning how to use for the first time this Tripartite System in a crisis; just what the respective responsibilities were and what the Treasury's powers were" (Q 169).

98. Financial crises are always unexpected, and it is hard to plan for them. For crisis management to be effective, it needs to be clear who is in charge. The Memorandum of Understanding (MoU) governing the relationship between the Bank of England, the FSA and the Treasury should be modified so as explicitly to give decision-making powers to one of the tripartite authorities whenever they are not clearly assigned in the MoU, in such a way as to avoid ambivalence or dispute.

99. Effective communication between tripartite members is clearly important during a crisis. It is also important during normal business times. If the Bank of England does not know details of troubled banks before a crisis is triggered, it cannot function effectively during a crisis.

100. The Governor pointed to the importance of institution-specific information: the FSA would share information with the Bank when it was asked to do so, but the Bank needed the ability to gather information for itself: "I am still a bit surprised to find that a Banking Act which gives the Bank of England the explicit statutory responsibility for financial stability has not seen fit to include in it the Bank of England's statutory right to obtain information and data that it thinks it needs" (Q 503). Mr Paul Tucker, Deputy Governor, Financial Stability, at the Bank of England, agreed that institutional information was critical for the Bank's financial stability responsibilities (Q 505).

101. Mr Alastair Clark, formerly Adviser to the Governor of the Bank of England, told us that institution-specific information was essential both for assessing systemic risk and for providing "local colour", that is, "having a view about why business is evolving in a particular way, what factors are driving it, what the perceptions of risk on the part of practitioners are in doing that business". He added that, after the FSA assumed responsibility for bank supervision, "the habit of mind which perhaps existed in the Bank for the supervisors, at least at the senior level, to talk to others became less part of the environment". Although the FSA was willing to share information with the Bank, "knowing what questions to ask is partly a function of being at some level involved with the raw material as it comes in and that became more difficult", so that "it may have been that people in the Bank were less clear about what questions they should be asking" (Q 643).

102. Commentators in other countries have stressed the importance of market knowledge and of institution-specific information in a central bank's role in crisis management and as Lender of Last Resort. For example, the Chairman of the US Federal Reserve Bank recently stated: "The information, expertise, and powers that the Fed derives from its supervisory authority enhance its ability to contribute to efforts to prevent financial crises; and, when financial stresses emerge and public action is warranted, the Fed is able to respond more quickly, more effectively, and in a more informed way than would otherwise be possible"[20].

103. The Bank of England needs institution-specific information and a close understanding of the daily operations of the financial markets in order to function effectively during a financial crisis. We recommend that the Government should make changes to ensure that the Bank has access to the necessary information.

MACRO-PRUDENTIAL SUPERVISION

104. Sir Callum McCarthy, formerly Chairman of the FSA, told us that it adopted an institution-by-institution approach to supervision: in other words, that it had concentrated on micro-prudential regulation, rather than macro-prudential supervision (Q 127). Many of our witnesses agreed: for example Lord Burns (Q 167), Professor Perotti (Q 195), and Professor Goodhart, who argued that the problem arose because supervisory frameworks were designed by non-economists, who paid insufficient attention to the fundamental rationale for regulation (Q 194).

105. The Bank of England appears to have devoted fewer resources to macro-prudential matters relating to financial stability in the period leading up to the financial crisis. Mr Alastair Clark told us that about 100 people worked on financial stability in 1997, between 150 and 160 by 2003 and that it was subsequently reduced to between 110 and 120 (Q 649). The change arose because "Eddie [George] stood down and Mervyn [King] became Governor and they took different views on a number of things ... including the proper extent of the Bank's involvement in financial market, financial stability issues" (Q 658).

106. The Governor of the Bank of England argued that the Bank had some de facto, if not de jure, responsibility for macro-prudential supervision: "I learnt from the experience after Northern Rock, that even if the legislation says that you do not have responsibility for supervision, people out there, including in Parliament, obviously feel the Bank of England must have something to do with banks and therefore they hold us accountable". Although "I do not hanker for any extra jobs to be given to me … if Parliament expects us to be responsible in some way for financial stability, I do want it to be very clear that all we can do is to use the instruments which are given to us. If the only instrument given to us is that of voice, then it is wrong to hold us accountable for anything other than how we use that voice" (QQ 505-506).

107. Without a clear executive role, the Bank can do no more than talk about financial stability. This exposes it to reputational risk, without generating any clear benefit.

108. One way to resolve the ambiguities surrounding macro-prudential supervision would be to give the Bank of England complete responsibility for it. This is the approach favoured by Professor Goodhart, who believed that "the macro-prudential controls ought to be given to the Central Bank because they are macro; they concern interrelationships between markets and between banks and institutions, and that kind of study of interrelationships and study of markets is really the function of the economists and the economists are much more prevalent and have an influence in central banks—some people would say too much influence nowadays—whereas the micro-prudential and conduct of business work should continue at the FSA level" (Q 197).

109. Responsibility for macro-prudential supervision would play to the Bank's expertise in macroeconomics. Since macro-prudential problems occur largely in the banking sector, it would not move the Bank too far from historically familiar territory. Moreover, if, as Sir Callum McCarthy and other witnesses suggested (see paragraph 104), the FSA has performed very little macro-prudential supervision since its creation, this option would involve little in the way of changes to the FSA.

110. A clear lesson to be drawn from the recent financial crisis is that the current arrangements failed to recognise the natural affinity between responsibility for financial stability and for macro-prudential supervision of the banking and shadow banking sectors. The Government should allocate responsibility for macro-prudential supervision to the Bank of England, which already has macroeconomic expertise. Adjustment costs would be low, although there would be some overlap with the FSA's responsibility for micro-prudential supervision.

111. Macro-prudential supervision is concerned with the financial stability of the economy while micro-prudential supervision takes a view of individual companies. To be effective, macro-prudential supervision, will require a new policy instrument (just as the setting of interest rates is the policy instrument for the control of inflation). Deploying such an instrument, for example to dampen a housing price boom, may on occasion bring the supervisor into conflict with government.

112. Effective macro-prudential supervision may conflict with the goals of political and business groups, so needs to be exercised by transparent and accountable institutions with the appropriate authority to take action. The Banking Act 2009 gave the Bank of England a statutory responsibility for financial stability. The Act creates a new Financial Stability Committee (FSC), which will be a sub-committee of the Court of Directors of the Bank. The Act states that the FSC will make recommendations to the Court about the Bank's financial stability strategy. As currently envisaged, (in contrast to the Monetary Policy Committee) the Financial Stability Committee will have no executive role. There is thus a danger that it will lack focus and be ineffective.

113. The Turner Review[21] suggested that the FSC might be more effective if it were to be designated as a joint committee of the Bank of England and the FSA, which had responsibility for making the final judgement over macro-prudential conditions, and for selecting policy responses. The Governor acknowledged the wide range of opinions on the composition of the FSC: "There are as many different views on what the ideal Financial Stability Committee would be as there are people" (Q 497). It is clear, however, that the Financial Stability Committee should be able to draw upon as much expertise and information as possible. Some of this expertise resides in the Financial Services Authority.

114. The Financial Stability Committee should remain a Bank of England Committee, chaired by the Governor, but should include senior FSA representation in sufficient numbers. The re-constituted FSC should be the central institution for macro-prudential supervision, with executive responsibility for a macro-prudential policy instrument.

115. The FSC's use of a macro-prudential policy tool will have an inevitable impact upon the conduct of macro-economic policy by the Treasury. For example, quantitative limitations on the supply of credit via a pro-cyclical charge would have a direct impact upon firm and household expenditure similar to that of fiscal policies. The accountability of the FSC therefore raises quite different questions from those posed by an independent Monetary Policy Committee. As currently constituted, the FSC has a non-voting Treasury representative. The executive FSC recommended in this report should have senior Treasury representation, at or close to the level of the permanent secretary.

116. The question of whether the Bank of England should have responsibility for macro-prudential supervision is closely related to, but distinct from, the question of whether it should also assume responsibility for micro-prudential supervision. First, we turn to the relationship between micro-prudential supervision and conduct-of-business supervision.

CONDUCT-OF-BUSINESS AND MICRO-PRUDENTIAL SUPERVISION

117. There is a widely held perception that, in recent years, the FSA has emphasised conduct-of-business supervision at the expense of prudential supervision. Lord Turner acknowledged this: "It is broadly speaking true to say that in retrospect we focused too much on the conduct of business and not enough on prudential" (Q 518). Dividing macro-prudential and micro-prudential supervision between the Bank of England and the FSA as suggested in paragraph 110 would do nothing to counter this problem.

118. If the FSA did over-emphasise conduct-of-business supervision, it may have done so as a rational response to the institutional framework within which it operated. Conduct-of-business is important and politically sensitive, and its results are easy to measure. In contrast, prudential supervision, while arguably more important, is conducted privately; its success is less easily measured, and, most of the time, it has a lower political impact than conduct-of-business supervision though in times of crisis such as the present its political impact, its effect on businesses, individuals and the economy, is very much greater than conduct-of-business supervision. It is natural and rational for a supervisor with responsibility for both activities to concentrate on the one with the greater immediate political sensitivity. As Professor Wood told us, "Consumers do not write to the FSA or the Member of Parliament saying, 'I think Royal Bank is running an excessively risky business overseas.' They write and say—and do it daily or more frequently—'The Royal Bank', or whatever bank, 'has treated me badly'. That inevitably distracts attention" (Q 52).

119. Notwithstanding its emphasis on conduct-of-business supervision, the quality of the FSA's work in this area was criticised by Doug Taylor, personal finance campaign manager at Which?, who said: "We are not always convinced that [regulation and supervision] has been effective in terms of consumer protection, and where that is the case we make our views well-known to the Financial Services Authority" (Q 239). Because of these concerns Mr Taylor called for "explicit consumer representation" at the FSA (Q 238). These concerns were not the focus of our inquiry.

120. There is also a cultural difference between conduct-of-business and prudential supervision. Conduct-of-business supervision is often performed by lawyers. Prudential supervision is largely an economic activity, particularly at the macro level. It seems likely that either a lawyerly or an economic approach would dominate in a supervisory body that performed both prudential and conduct of business supervision, and that this dominance would reduce the effectiveness of the dominated half of the organisation[22].

121. Regulatory bodies are subject to conflicting political pressures. There is a danger that, when a single institution has responsibility for conduct-of-business and prudential supervision, one will be emphasised at the expense of the latter. Institutional arrangements in the future must be designed so as to minimise this danger.

DIVISION OF SUPERVISORY RESPONSIBILITIES IN THE UNITED KINGDOM

122. One way to avoid conflicts of interest between the conduct of prudential and conduct-of-business supervision would be to move micro-prudential supervision from the FSA to the Bank of England. The Bank would then perform prudential supervision of all financial institutions, both bank and non-bank, and the FSA would retain conduct-of-business supervision. This arrangement of responsibilities is known as the "twin peaks" approach: it would give the Bank access to necessary institution-specific information through on-site bank inspections, while avoiding overlapping responsibilities with the FSA.

123. This approach would avoid the danger identified by Mr Tucker, if the Bank and the FSA were both to gather institution-specific information for the purposes of financial supervision, that the Bank would be seen to be usurping some of the FSA's responsibilities, or as a "shadow supervisor", so that regulated firms saw themselves as facing "double jeopardy" (Q 505).

124. The twin peaks approach has been adopted by two countries: the Netherlands and Australia. In the Netherlands, the prudential supervisor also has responsibility for central banking; in Australia, it does not[23].

125. Lord Turner identified three problems with twin-peaks supervision: that it duplicates effort, that it is sometimes hard to distinguish between prudential and conduct-of-business supervision, and that it would involve significant adjustment costs in the UK (Q 518). Lord Myners argued that the twin peaks model would not be effective in the UK, also noting that increasing the number of supervisory agencies could raise costs, and observed that the Bank's record as a banking supervisor was not without blemish (Q 552).

126. Combining the Bank's responsibility for monetary policy with responsibility for bank supervision could create two further problems. First, the Bank's reputation would be at risk from failures in either activity. Errors in prudential supervision might damage its credibility in monetary policy. Second, the Bank's two responsibilities might create a conflict of interest: for example, it might be unwilling to tighten interest rates when doing so would harm the banks it supervised. Banks that appreciated this problem might be inclined to extend credit recklessly. In short, a twin peaks approach to financial regulation runs the risk that one conflict of interest, between conduct-of-business and prudential supervision, is replaced by another, between prudential supervision and the conduct of monetary policy. Nevertheless, the latter conflicts do not appear to have been a major concern in the US, where the Federal Reserve has responsibility for monetary policy and the supervision of US banks[24].

127. The Government should carefully consider the case for and against a "twin peaks" system of financial supervision in the UK. It would involve giving the Bank of England responsibility for micro-prudential as well as macro-prudential supervision of the financial sector, in addition to its monetary policy role, leaving responsibility for conduct-of-business supervision with the FSA. A twin peaks approach would ensure that the Bank had the information needed to manage financial crises, and would obviate the need identified in paragraph 114 for FSA representation on the Financial Stability Committee. It would also reduce the potential for conflict between conduct-of-business and prudential supervision. However, the case for a twin peaks system of regulation is by no means as clear-cut as that for locating an executive FSC with responsibility for macro-prudential supervision within the Bank. The Government would need to consider whether giving the Bank responsibility for micro-prudential supervision would create countervailing organisational problems concerning the governance of the Bank and the role of the FSA.

International Supervision

128. International coordination occurs via the Basel Committee on Banking Supervision. It was established by the Central Bank Governors of the G10 countries in 1974; its members are now drawn from 13 countries[25]. It serves as a forum for information exchange between national supervisors, and it develops guidelines and supervisory standards. It is best-known for its work on capital regulation. More recently, it has started aggressively to promote sound supervisory standards. The Basel Committee meets at the Bank for International Settlements, which also provides the Basel Committee's secretariat, but the two organisations are distinct.

129. The Basel Committee's recommendations have no legal force. Financial regulations in Europe are created in EU directives. For example, the Basel II Accord is implemented in the European Union by the Capital Requirements Directive (CRD). The CRD is part of a wider effort to achieve an integrated European market for banks and financial conglomerates, by the mutual recognition of one country's rules in all of the others, and through the "single banking passport".

130. The single banking passport was introduced by the Second Banking Directive of 1989, which was implemented in 1993. The single banking passport entitles a bank entitled to do business in an EEA state to open a branch in any other state; under the second banking Directive, the branch bank is supervised by the authorities in its home country.

131. Lord Turner noted that when a multinational bank fails, its losses can overwhelm the country that licensed it. This happened in the case of the Icelandic bank Landsbanki, whose UK subsidiary was the internet bank Icesave. The FSA had only "very mild influence over some aspects of liquidity and no influence at all over aspects of capital" for Icesave despite the fact that, when it failed, the UK taxpayer "effectively picked up the bill for the UK side of that failure" (Q 527).

132. Problems with supervision of multinational banks could be addressed in two ways. First, a stronger international framework could be created, including multinational regulatory and supervisory bodies with the ability to impose solutions upon nation states. Second, national supervisors could assert themselves more strongly, to ensure that banks taking local deposits were safe and sound.

133. Large banks operate internationally. The current crisis, which was triggered by problems in the US subprime mortgage market, provides ample evidence that systemic problems do not respect national boundaries. There is clearly a strong argument for stronger international cooperation on regulation and supervision.

134. But supra-national supervision of financial markets is a remote prospect fraught with practical difficulty and political sensitivity. Even if it were achieved, international judgements on macro-prudential supervision would sometimes conflict with the judgements of national governments. Mr de Larosière stated: "When you exercise macro-prudential regulation you are bound to ask yourself questions of economic policy. Let us not hide ourselves from that reality. Often, as I have explained, official policies, fiscal policies can be part of the systemic risk" (Q 354).

135. An effective international supervisor would need the power to resolve conflicts with national governments, which they would not easily yield. International agreement would be difficult, slow, and costly. Even if an international supervisory body were created, it would be impossible to guarantee that national governments would abide by its decisions.

136. The experience of the Basel Committee illustrates the difficulties of reaching consensus on global financial regulations. Agreement on the relatively simple question of capital definition and regulation was difficult and time-consuming. As Dr Danielsson noted (Q 115), the reason the Basel II Accord looks the way it does is that it uses techniques that were state-of-the art in 1995.

137. There are conflicting views about the scope for regulation in Europe. Mr de Larosière favoured a European Systemic Risk Council, which would formulate macro-prudential policy for onward dissemination to national central banks for action, and a new European System of Financial Supervision, which would be able to apply "graduated sanctions" if national supervisors performed inadequately[26]. The Turner Review proposes the creation of a new European Union Institutional structure, which "would be an independent authority with regulatory powers, a standard setter and overseer in the area of supervision, and would be involved, alongside central banks, in macro-prudential analysis"[27]. However, in contrast to Mr de Larosière, the Turner Review takes the view that European regulators should have "no powers over national supervisors to change individual regulatory decisions, nor to prescribe detailed supervisory practice"[28]. Lord Myners told us that the Treasury rejects the proposal that there be a European-wide regulator (Q 570). He explained to us later that, although the Government does not support any proposals for a single European supervisor for financial services, the Government agrees that on the macro-prudential side an EU body is needed to act as an effective early warning system, complementing the international role proposed for the IMF/Financial Stability Forum (FSF) (pp 194-5).

138. Even when an international body has only advisory powers, it should seem disinterested. Lord Turner argued "crucially, we do need institutions like IMF to write reports which are in no way watered down by the influence of large powerful governments" (Q 526).

139. Primary responsibility for banking regulation and supervision should remain with national authorities. Notwithstanding the difficulties at the international, or even European level, international macro-prudential financial supervision should be encouraged. A purely advisory international body with a remit for surveillance of the financial system and identification of nascent systemic problems could serve a valuable purpose and help national governments and regulators to identify critical stresses in the financial sector. Such a body should be sufficiently independent to avoid the suspicion that its objectives were subservient to the national interests of one or more of its members.

140. An independent international body capable of international monitoring of systemic risks may be the Financial Stability Board (FSB) announced in the London G20 communiqué[29] as an expanded and stronger replacement for the Financial Stability Forum[30]. The British authorities should work to ensure that the Financial Stability Board announced in the G20 London communiqué is sufficiently independent and well-resourced to provide international monitoring of financial stability, and to disseminate credible recommendations to national governments and regulatory bodies.

141. Financial markets are global not regional. Where European-level coordination on macro-prudential supervision is contemplated, it should be aligned with the broader international coordination contemplated under the Financial Stability Board.

142. Even if international surveillance develops on these lines the problems identified in paragraph 131 with the European bank passport scheme will remain: namely, that UK taxpayers may bear the costs of the failure of an EU or EEA bank with branches in the UK. Lord Turner argued that the scheme requires reform (Q 527). More generally, branch banks present a problem to national supervisors. The experience of this crisis has been that, when a home bank experiences problems, it repatriates capital from branch banks in order to protect its home depositors. This action is unlikely to be criticised by the home regulator, which is naturally more concerned with stability and consumer protection at home than in foreign countries.

143. The Government should work towards acceptance that branches of foreign multinational banks in the UK, whether European or not, should be subject to a greater degree of oversight by the British authorities and that local capital requirements should be introduced for these banks, under which repatriation would need those authorities' permission, bearing in mind that reciprocal requirements might be sought by countries in which British banks operate and that this type of capital requirement would increase the costs to multinational banks domiciled overseas of doing business in the UK.

Deposit Insurance

144. Deposit insurance schemes provide depositors in regulated banks with full or partial protection against the loss of their funds in the event that their bank fails. They make less likely runs on banks, which might trigger wider problems. They also acknowledge that, since consumers cannot monitor banks, the state does so on their behalf.

145. Deposit insurance in the UK is provided by the Financial Services Compensation Scheme (FSCS). It was insufficient to prevent a run on Northern Rock after its problems were revealed, perhaps because bank insolvency procedures in the UK were unclear at the time, and because the level of compensation for depositors was inadequate. Both these problems have now been resolved.

146. There are problems with the financing of the FSCS. The FSA authorises levies on financial firms in proportion to their size, up to a maximum amount[31]. Because the scheme is funded on a "pay-as-you-go" basis, levies are highest when the cost of failure is greatest, which is likely to be when banking firms are most fragile and can least afford to pay them. The Banking Act 2009 gives the Government the power to switch to a pre-funded scheme. Such a scheme operates in the US, where the Federal Deposit Insurance Corporation's fund stood at $45 billion in September 2008[32].

147. A pre-funded deposit insurance scheme would have a counter-cyclical effect: money levied in boom times would be returned to the banking sector during times of financial fragility. It would also increase depositor confidence. The Government should move towards pre-funding of the Financial Services Compensation Scheme as soon as practicable.

148. Levies to the FSCS depend upon the size of the contributing institution, not the riskiness of its business. This is an obvious source of moral hazard: deposit insurance makes depositors risk-insensitive, and so lowers the cost of depositor finance. This weakens market discipline for firms with insured depositors. If deposit insurance premia do not reflect bank riskiness, banks will naturally assume higher risks, because they are not charged for doing so.

149. Some of our witnesses also argued that such a scheme is unfair. Levies on building societies are calculated on the same basis as those of banks, but, partly because of regulatory restrictions on their sources of funding and the assets in which they invest, building societies have a different risk profile to banks. The Building Societies Association argued that FSCS levies represent an unfair tax on their saving members, which is used to underwrite the riskier businesses of non-building societies (p 118).

150. Mr Graham Beale, the chief executive of the Nationwide Building Society, told us: "The cost to Nationwide of [non-building society failures] so far is going to be around about a quarter of a billion pounds, that is quarter of a billion pounds of costs that our membership is having to bear for the failure of Bradford and Bingley and the Icelandic banks. That is not right" (Q 463). Mr Matthew Bullock, chief executive of the Norwich and Peterborough Building Society, told us: "In our case over 50% of last year's profit went to pay the FSCS. [My members] cannot believe that the building societies are having to pay this kind of money to someone who de-mutualised and left the building society camp and took their business elsewhere" (Q 466).

151. In practice, it is impossible accurately to measure the riskiness of bank portfolios. It is in the nature of banks to take hard-to-evaluate positions and to run opaque loan portfolios. Some inequity in the levies charged by the Financial Services Compensation Scheme (FSCS) is inevitable. The current scheme is nevertheless clearly unfair to institutions which, like the building societies, are constrained from the riskiest business. It is also a potential source of destabilising moral hazard. The Government should promote changes to ensure that contributions to the FSCS should be at least broadly related to the riskiness of the business in which regulated firms engage. In particular, it should consider the introduction of a different basis for calculation of the levy on mutual building societies, or the creation of a separate depositor protection scheme for building societies.

14 "Memorandum of Understanding between HM Treasury, the Bank of England and the Financial Services Authority", available from http://www.bankofengland.co.uk/financialstability/mou.pdf Back

15 MoU, paragraph 2. Back

16 MoU, paragraph 3. Back

17 MoU, paragraph 4. Back

18 MoU, paragraph 5. Back

19 Paragraph 16 of the MoU discusses the framework for managing a financial crisis; paragraph 17 discusses operational crisis management. Back

20 See Ben Bernanke's speech "Central Banking and Bank Supervision in the United States", at the 2007 Allied Social Sciences Association Annual Meeting, Chicago, which is available at http://www.federalreserve.gov/newsevents/speech/bernanke20070105a.htm Back

21 Turner Review, FSA. March 2009, p. 84 Back

22 For a discussion of this point, see Goodhart, C.A.E. (2000) "The Organisational Structure of Banking Supervision" Financial Stability Institute Occasional Paper 1, Bank for International Settlements Back

23 In the Netherlands, the central bank (De Nederlandse Bank) performs prudential supervision and the market authority (Autoriteit Financiële Markten, or AFM) looks after conduct of business rules. In Australia the Australian Prudential Regulation Authority (APRA) performs prudential supervision, the Australian Securities and Investments Commission (ASIC) is responsible for conduct of business supervision, and the Reserve Bank of Australia acts as the central bank, in particular acting as lender of last resort. Because three bodies are concerned with the Australian system, it is sometimes characterised as "triple peaked". Back

24 The Federal Reserve has responsibility for national banks in the US, and for state banks that have chosen to join the Federal Reserve System, as well as for bank holding companies and foreign banks in the US. See http://www.federalreserve.gov/pf/pf.htm. Back

25 The Basel Committee members come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States. Each country is represented by its central bank and also by its banking prudential supervisor when this is a different institution. Back