Regulation Banking

The purpose of this essay is to explain why banks are regulated in the UK and inadequacy of the previous regulatory framework linked with failing banks. Three banks will be discussed: Johnson Matthey Bankers (JMB), Barings and Northern Rock. The market conditions which contributed to cause difficulties for Northern Rock will be discussed. Why Regulate Banks? As Benston and Kaufman state in an article in the May 1996 issue of the Economic Journal, "they don't serve food that might sicken unsuspecting customers and they don't deal in dangerous materials that might explode or cause plagues.

Rather, they provide checking accounts and investment services, make loans, and facilitate financial transactions. "1 Why should we be concerned with banks, more than other business. Banking institutions act as intermediaries between lenders and borrowers, issuing loans(asset) and receiving deposits(liabilities). Depositors place money in a bank, this requires confidence with the bank. Asymmetric information could undermine the depositors confidence with the bank, and could create a " bank run"2 this happened to Northern Rock (NR), fortunately it didn't create a contagion affect.

3 According to Diamond and Dybvig4, even healthy banks may be subject to bank runs. 5 The whole financial system would fail if a contagion6 broke onto the financial system, systemic risk7 occurs as a result of contagion. Kaufman and Scott describe Systemic risk as "the risk or probability of breakdowns in an entire system, as opposed to breakdowns in individual parts or components". 8 If a "big" bank fails there would be a massive reduction in the money supply with the usual macroeconomic implications, such as consumer spending decreases, interest rates increase due to the limited amount of money available.

Hence the reason The Bank Of England(BOE) used the "lifeboat" operation in 1974. 9 The Treasury and BOE work together and use banks to control inflation. If the banks fail then there is no intermediary leaving no mechanism for money transmission, forcing the country to use barter exchange. Bank failures can also cause social costs10 such as e. g. Unemployment, investment decisions decline. Thus to minimise social costs, and prevent the financial system to collapse banks are prudentially regulated. Prudential regulation gives confidence to depositors to place their savings in banks, and prevent a bank run.

It could be argued that depositors may not have the expertise to assess the "soundness" of a bank, hence the reason for retail banks to be regulated. Under the 1979 Banking Act, depositors money is insured to prevent a run. Schmidt and Willardson state in a journal Banking Regulation: The Focus Returns to the Consumer June 2004 " while the safety net may limit costly bank runs and panics, it also creates incentives for banks to take larger risks than otherwise would- since the deposit insurance fund- and ultimately the tax payers- will incur the losses if those risks don't pay off"11

My discussion will now focus on three failed banks, and the regulatory failures that occurred. Johnson Matthey PLC(JM) bullion dealers created (JMB) its subsidiary in the 1960's. In 1984 JM approached BOE (prime regulator under the Banking Act of 197912), believed the problems arising from JMB would affect the whole group. BOE purchased JMB for i?? 1 (1984) and wrote of large amounts off its assets. This was the first rescue by BOE since the lifeboat operation(1974).

There was criticism of the lifeboat operation because other banks may potentially act less prudently and engage in riskier activities to boost profits, in the belief BOE will save them. This behaviour by banks introduces moral hazard into the banking system. BOE was concerned with JMB, because it could affect JM, therefore damaging London's reputation as the centre of bullion dealing. The BOE is therefore prepared to rescue an entire conglomerate, if it is an important player in the markets.

Reports suggested JMB loans were given to traders dealing with less economically developed countries, a very high risk area to invest due to the instability of markets. 13 JMB ignored BOE guidelines on loan concentration (JMB should limit loans or a group of borrowers to 10% of capital). The guidelines were broken on several occasions in 1983-1984 by over 76%, however BOE stated that the violation of the guideline were commonplace and complete dedication to the guideline seemed too restrictive.

Hence the 1987 Amendment rules were changed to allow the bank to issue loans of 10% of capital providing they inform BOE and 25% can be loaned with the consultation of BOE. As a result of failings at JMB the Board Of Banking Supervision was set-up, the board assists the BOE in its supervisory. The Financial Services Act 1986 was also newly created it introduced a self-regulation system which had one top tier and three bottom tiers. The three self-regulatory authorities reported to the single Securites and Investment Board, which had statutory powers, together they were responsible for ensuring good business investment in the Big Bang Era.

Barings was collapsed (1995) reciprocated by a "rogue trader" 'Nick Leeson' who created huge debts in Singapore at one of Barings subsidiaries, dealing with Futures and Derivatives at the Simex exchange. According to BOE Board of Banking Supervision14, BOE was deficient in several areas in its supervision of Barings. Alarmingly Barings was given solo consolidation status, which meant BOE had sole responsibility for the whole of Barings, even though the Securities and Futures Authority(one of the self-regulatory authorities under the Financial Services Act 1986) was newly set-up and had the expertise to deal with the subsidiary.

BOE also failed in detecting large sums of money being transferred from parent Barings to its subsidiary, which is against Banking Act (amended 1987) only 25% of the banks capital is allowed to be transferred with BOE consultation. Whilst losses accumulated in the subsidiary's account, Barings did not report this to BOE however, BOE should have spotted this through the monthly credit report. Barings was left to go bankrupt even thought BOE tried saving it using their preferred method of merging with other banks eventually it was bought by ING (March 1995).

BOE announced it would provide liquidity to stabilise the markets, but refused to bail out Barings as it was a small merchant bank which did not pose systemic risks. BOE saved JMB, because it could affect the bullion market in London, if BOE logic is to save banks who are too big, it creates moral hazard and a safety net for big banks to take riskier activities to boost profits as Schmidt and Willardson stated. According to Stephen Fay in his book The Collapse of Barings "Barings management, the Bank of England and the Singapore Exchange were to blame for the collapse of Barings.

15" The failure of the two banks aforementioned, raised doubts over the authority of BOE. With each bank failure, new regulation evolved filling the loophole, however regulators have stressed that BOE was increasingly cumbersome and ill-fitted because financial firms had different authorities to answer to. 16 In both cases, BOE was a state regulator which will always be less informed. It was argued that state regulators can develop a close relationship, with banks causing laxity in regulations.

In May 1997 the Chancellor announced BOE would be "independent" from the Treasury17, less than a fortnight later the SIB(the upper tier of self-regulatory) was abolished, and the newly created FSA took its place as the single state regulator. It seems a number of events discussed, was responsible for a major shake-up of the financial regulation in the UK. Later on under the Banking Act 1998, BOE's supervisory role was transferred to the newly created Financial Service Authority (FSA).

The FSA was asked to conform to the Banking Act 1987, the BOE still shares responsibility with the FSA and the Treasury known as "tripartite arrangement" set out in the Memorandum of Understanding. 18 This stipulates how the three organisations are expected to work together. 19 The FSA also had the duty to regulate the investment industry under the Financial Services Act 1986. The most recent regulation came into force (Financial Services and Markets Act 2000) in 2000, in which the FSA assumed its full powers by 2001, and has regulated banks, building societies, insurance firms, markets and exchanges "independently" from BOE ever since.

What happened to Northern Rock (NR)? Why did it happen, and the regulatory responses. On the morning of 13 September 2007 the Northern Rock crisis unfolded. NR reportedly asked BOE for financial support. 20 This created the unwanted bank run. Reports suggest i?? 2bn was withdrawn, which put a further strain on NR's capital. According to financial experts, had the money stayed in NR, they would have been in a more stable position. Hence the reason the Chancellor Alistair Darling swiftly announced the government will guarantee NR deposits to halt the bank run. 21

The US sub-prime22 crisis was responsible for the NR liquidity crisis. In 2007 due to the demise of the US housing bubble, which saw property prices declining and the defaults on loans increasing, lenders couldn't recoup their losses which created bankruptcy among some lenders. This crisis was a global one because most of the mortgage debt had been re-packaged and sold to other banks, therefore wholesale money markets dried up, banks were reluctant to lend to each other because they didn't know who was affected by the crisis23. Therefore NR couldn't borrow from other banks which it relied heavily on.

Whereas traditionally banks relied on depositors money, NR used different methods of raising finance mainly through securitisation24 and inter-lending with banks; this proved their downfall. Under the Basel II agreement which NR joined in January 2007,25 it is required that they have less capital depending on the risk, securitisation was the key for NR to keep their capital low but still have the "earning power". These two methods aren't risky, but as NR whole business concept was based on using these two methods instead of depositors money, inevitably trouble was round the corner.

The Treasury report said the FSA should have spotted the banks "reckless" business plan, the FSA admitted regulatory failings at NR. 26 The treasury report also concluded the FSA systematically failed in its regulatory duty to ensure that NR would not pose a systemic risk". 27 On 14th August 2007, a month before the NR problems became public, Mervyn King (Governor of BOE) alerted the tripartite members about the sub-prime crisis may affect the NR business but nothing was done until the crisis materialised a lax of regulation maybe?

According to Buiter, professor in economics and a former member of BOE Monetary Policy Committee, said "the tripartite arrange hasn't worked",28 He believes the the FSA or BOE should have separate information and money to do something sooner, to prevent bank runs. 29 The Commons committee agree with Buiter, they accused the tripartite members "of being too slow to finalise the Rock's emergency government loan and of dithering over the announcement of a guarantee to protect the bank's customers".

30 The treasury report also mentioned " there was no sign of communications strategy of the Tripartite authorities during the crisis of September 2007"31 On the 19th September 2007 BOE announced it would inject i?? 10bn into the inter-lending of money markets, to bring down the cost of inter-bank lending, critics say they should have acted sooner and the "bail out" plan should have been confidential to prevent the bank-run.

According to King he was obliged to disclose this "bail out" plan due to the EU Market Abuse Legislation which forced him to disclose, he had wanted this affair to be secret to prevent a bank run. However EU experts argue that the EU Market Abuse Legislation has certain provisions that would have allowed BOE to aid NR and delay the public announcement. "There is no obligation for central banks to disclose its activity under the market abuse directive"32 comments made by a source at the European Commission.