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The Financial Services Authority (FSA) has today issued a discussion paper (DP) focusing on policy measures to address the problem of systemically important ‘too-big-to-fail’ banks. The paper also examines the trade-offs involved in increasing capital and liquidity requirements, and stresses the need to assess the cumulative impact of multiple reforms.

The paper identifies the dangers posed by those firms that are seen as too-big or too-interconnected-to-fail, or too-big-to-rescue.  It describes the full range of policy options - including the creation of ‘narrow banks’ – in order to provide the basis for an informed debate, but also outlines the position which the FSA is currently proposing in international fora, namely that:

• There is a strong case for applying some form of capital (and perhaps liquidity) surcharge internationally for systemically important banks; surcharges could be proportional to continuous and increasing measures of systemic importance, avoiding the dangers created by specific thresholds of systemic importance.
• A capital surcharge could be combined with an approach to global banking groups which places greater emphasis on the standalone sustainability of national subsidiaries, with overt understanding that home country authorities will not be responsible for the rescue of entire groups.  The more that groups are organised on this basis, the less the required surcharge at group level might need to be.
• Action should be taken to reduce inter-connectedness in wholesale trading markets, with much over-the-counter (OTC) derivative trading moved to central counterparties (CCPs), and with effective collateral and margin call arrangements for bilateral trades which reduce the dangers of strongly pro-cyclical margin call effects.
• Reform to trading book capital should significantly increase capital requirements and differentiate more strongly between basic market making functions which support customer service and riskier trading activities, with a bias for conservatism in relation to the latter.
• Systemically important banks should be required to produce recovery and resolution plans (‘living wills’) which set out how operations would be resolved in an orderly fashion.  If supervision examination of these plans reveals serious obstacles to resolution, then steps will need to be taken to reduce or remove them – this could require restructuring certain parts of the group.  Restructuring could include clear separation between retail deposit taking business and businesses involved in proprietary trading activities, with the latter able to fail even if the former were supported in crisis conditions.

The DP also stresses the need to assess the possible cumulative impact of multiple reforms to capital and liquidity regimes now being considered by international standard-setting bodies.  It describes the case for significant increases in capital and liquidity requirements to reduce financial instability risks, while recognising the potential implications for lending volumes and the cost of credit intermediation.  It considers methodologies which can help inform judgements on the trade-offs involved.

The DP makes clear, however, that the potential trade-off between improved stability and constrained lending does not arise in relation to required changes in trading book capital, nor where capital enhancement can be achieved by moderation of bonus payments.  It therefore reasserts the Financial Stability Board message that the priority use of high investment bank profits must be to enhance capital levels rather than to support excessive bonus payments.

Lord Turner, FSA chairman, said:

"The direction of travel is clear: the overall level of capital required in the banking system must be significantly increased over time, while liquidity standards must be significantly tightened.  These changes are required to create a more stable financial system for the long-term: the challenge now is to determine the precise long-term objective and the appropriate transition path. 

"Meanwhile, the FSA has to reduce the danger that authorities in future will be faced with only one option – using public funds to rescue whole groups with only equity holders suffering loss.  And we must also limit the extent to which implicit government guarantees support unnecessary levels of risky proprietary trading.  The way to achieve this is likely to be a number of mutually reinforcing policies, not a single silver bullet."

Next steps

• Living wills: The FSA intends to press ahead with resolution and recovery plans in the UK and work is underway to produce guidance for systemically important firms to use in developing living wills.  The plans will build on requirements the FSA has already put in place that contribute to a firm’s preparedness for recovery.  By the end of 2009 a small number of major UK banking groups will have begun to produce living wills as part of a pilot exercise intended to help the FSA develop policy in this area.
• Cumulative impact of capital and liquidity reforms: The FSA acknowledges that given the inherent uncertainties involved in assessing optimal capital and liquidity levels, it means that models such as those described in the DP can never provide ‘the answer’.  However, the FSA believes that the conceptual approach described can help inform an effective global debate on optimal capital levels.  It will, therefore, encourage global regulatory bodies, industry groups and academics to conduct similar analysis.
• Conference: The issues discussed in the DP will set the agenda for the second Turner Review conference which is being held on 2 November 2009.

The deadline for responses to the DP is 1 February 2010.

Notes for editors

1. The Discussion Paper can be viewed in full on the FSA website.
2. Details of the second Turner Review conference can be found on the FSA website.
3. The Turner Review feedback statement can be found on the FSA website.
4. The Turner Review can be found on the FSA website.
5. The discussion paper that accompanied the Turner Review can be found on the FSA website.
6. The FSA regulates the financial services industry and has four objectives under the Financial Services and Markets Act 2000: maintaining market confidence; promoting public understanding of the financial system; securing the appropriate degree of protection for consumers; and fighting financial crime.