Paul Tucker: A new regulatory relationship: the Bank, the financial system, and the wider economy

A new regulatory relationship: the Bank, the financial system, and the wider economy

On 28 May 2013, the Institute for Government held the third event in its Government and Business series, which sought to explore the relationship between the City, the Government, and wider society. Specifically, discussion centred around the reforms that took effect on 1 April 2013, establishing the Financial Policy Committee (FPC) and the Prudential Regulation Authority (PRA) within the Bank of England.

·         Paul Tucker, Deputy Governor of the Bank of England, was the keynote speaker.

·         The event was chaired by Peter Riddell, Director of the Institute for Government.

·         Thanks go to the City of London Corporation and the Financial Times for sponsorship of the event series.

Mark Boleat, Chairman of the Policy and Resources Committee, opened the proceedings with a word on behalf of the City of London Corporation. He emphasised the importance of mutual understanding between the City and Government and underlined the importance and timeliness of the evening’s discussion. He talked of an overwhelming desire, in the City, for Britain to remain at the heart of the Single European Market. Crucially, he suggested, the delivery of a high quality system of regulation must be matched, on the political side, by retaining a say in Europe’s future trajectory. 

Paul Tucker began by stressing that the changing role of the Bank of England in recent years has also brought about a fundamental shift in the way that it relates to society as a whole, and in particular to Parliament. He set out the framework in which he would proceed – first addressing the microeconomic role of the Bank of England as regulator, then discussing its macroeconomic role, and finally considering the inescapably global nature of work aimed at financial stability.

The microeconomic context

Paul observed that the role of the financial regulator is traditionally seen in terms of rule setting and enforcement. The regulator is a supervisor of banks and the other financial bodies under its remit. A key innovation of the Prudential Regulation Authority, though, is that it will practice judgement led supervision. He stressed that this ‘prudential supervision’ goes beyond checking compliance against rules, and cannot operate under a simple ‘tick box’ system.

Judgement led supervision requires the assessment of complex concepts such as ‘adequacy’, ‘competence’, ‘professionalism’ and ‘quality’. Past attempts to apply simple rules to complex concepts such as these had, in his opinion, invariably resulted in crude and inadequate regulations that undermined the objective which they were designed to safeguard. On the part of firms, he also pointed to a past tendency to seek out loopholes and “navigate around the rulebook”.

The backbone of a prudential system is therefore the use of indicators to underpin assessments, rather than the comparison of behaviour to predetermined rules.

He identified a major challenge – in the need to convince the City and wider society to embrace a judgement based approach. The City, in particular, had historically demanded certainty from regulatory systems. ‘Tick box’ systems had therefore been the inevitable result, with the concrete and predictable procedures that they entail. Another key challenge resulting from these new powers, he suggested, would be satisfying Parliament and wider society that the activities of the Bank of England are sufficiently transparent, and that it is being held accountable for its decisions.

The solution, he suggested, lies in the fact that, in exercising its statutory powers of judgement, the Bank of England must operate within the constraints of public law and due process, whilst being subject to judicial review and appeal.

The macroeconomic context

The Bank of England’s key role in this sphere is to maintain economic stability – requiring a keen focus on medium term goals. The pursuit of such goals, however, has short term consequences. Paul highlighted the fact that this is in many ways the advantage of placing unelected officials in this role. They are sufficiently removed from short term political pressures, so as to be able to keep the focus of present day measures on achieving medium term stability goals. However, a simultaneous challenge of this setup is that society must be satisfied in its ability to monitor the behaviour of unelected central bank officials, who are charged with managing the country’s short term economic trade-offs. 

He observed that the contemporary consensus on solving this problem has been to put in place quantifiable medium term goals (such as inflation targets) and to ensure transparency surrounding the methods employed in their pursuit. 

However, these debates have so far played out in an environment in which the principle role of the Bank of England has been to smooth adjustment. Its role has been to facilitate, and where necessary defer, adjustment. At most, he suggested, the role of the Bank of England has been to “nudge”, but never to hector, or intervene in policy decisions in other areas.

With the creation of the Financial Policy Committee, this picture has changed somewhat. The Bank of England now has a part to play in compelling the banks to strengthen themselves. This, he noted, represents the first significant intervention of ‘macro-prudential policy’.

The Financial Policy Committee is “an institutional device to ensure that the importance of stability is not overlooked again”

Part of the role of the FPC will be to keep the regulatory system up to date as the financial system evolves, through making recommendations to the Treasury. Another key aspect will be to “take away the punch bowl, just as the party’s getting going” – or to pre-empt and moderate bubbles, sacrificing short term gains to avoid eventual catastrophe when they burst. He observed that the extreme difficulty of taking such action from a political perspective is what makes the case for the operational independence of the central bank.

Again, he stressed that this necessary independence must be accompanied by a clear objective for macro-prudential policy, and operate within a system of transparency and accountability. In this realm, however, it is difficult to achieve adequate transparency, whilst respecting the sensitive nature of information regarding individual banks. It is as an attempt to resolve this tension that the FPC has recommended the use of “stress testing”.

Stress tests help to quantify the degree of resilience that is required of banks. He observed that being able to see whether banks have passed or failed stress tests, based on defined resilience criteria, will result in much greater transparency. He was also careful to highlight the fact that the process of quantifying resilience criteria would better enable Parliament to scrutinise the plans and priorities of the Bank of England.

A global perspective

The UK, in particular, is highly economically integrated at the global level – to a greater extent than most other economies. Paul noted that London is so far from financial autarky that it has perhaps the greatest stake in the strength of international economies. He therefore stressed the shared interest of the Government, the Bank of England and firms in seeing a level international playing field in terms of standards of regulation. He equally identified two problems that are inherent in this goal:

1)     Speed will have to be sacrificed in order to develop and agree international regulatory standards. The business community is continually frustrated by this fact, as continuing uncertainty impedes strategy formation

2)     Some key policy discussions will have to be taken away from home. And these, he observed, tend to get less coverage in the UK media than more domestic discussions

In addition to the long recognised monetary ‘trilemma’ (the inability to simultaneously control capital flows, domestic monetary policy and the exchange rate), Paul also identified a ‘Financial Trilemma’. This states that you cannot combine an integrated international financial system, financial stability and national policies focussed solely on domestic stability. 

The solution, he suggested, does not lie in insulating ourselves from the rest of the world, but rather in cooperation and coordination. Nor does it lie in making the banks “too safe to fail”. Rather in a cooperative and coordinated international system, the potential for ‘orderly failure’ creates interrelated stakes in the stability of all domestic banks – a situation which the UK, as a trading nation, should welcome.

He brought his remarks to a close by emphasising the centrality of transparency in making the new regulatory system work. The Bank of England, he felt, is ultimately in the business of trust.

***

Speaking from the chair, Peter Riddell pointed to the fact that, contrary to the monetary arena, financial regulation involves more complex targets and is more internationally determined. He asked what implications this would have for the accountability of the FPC.

Paul Tucker agreed with the problem that this new arena posed. His feeling was that stress tests, as a means to provide structured transparency, were the most adequate solution to these concerns. By stating publically how well individual banks have performed in certain stress tests allows transparency without contravening business privacy.

Peter Riddell also asked what the role of the Treasury would be in this new regime.

Paul Tucker highlighted two things on this point: (1) that the Treasury has a special role in ensuring that the architecture of the new regime functions correctly, and (2) in enabling public funds. On this point he reflected that putting the losses of banks onto the taxpayer would not always be the backstop – instead suggesting that the burden should be placed on the creditors of the highly leveraged banks.

Peter Riddell asked how the extreme complexity of the international dimension would affect the success of the new regime

Paul Tucker agreed that financial stability as an issue area, in comparison to the “beguiling simplicity” of the monetary regime, is so complex and multifaceted that it alienates the public and the media. There is no question from any party, he noted, in the worth or soundness of financial stability as a policy objective. Rather, the challenge would come in making it accessible without simplifying issues to the point of being misleading.

Finally, Peter Riddell asked, given that much of the financial turmoil still persists, how do we move on?

Paul Tucker agreed that the chapter will not be closed until the economy has healed. The debate on regulatory reform won’t be complete until we are able to assess the true extent of the damage caused by the crisis. This, he saw, would be a profound problem in “designing a new world”.

Questions from the audience focussed on: The European dimension, the mechanisms for holding the Bank of England to account, and when the “fiscal backstop” for banks could become a thing of the past.

Paul Tucker’s key insights in response to these questions were that:

-       Systems such as the Bank of England’s Open Letters to the Chancellor are not just ceremonial. Rather they allow the legitimacy of the regime to be renewed continually and reaffirmed – something that is crucial to the proper accountability of an unelected public body.

-       When asked how ‘prudential regulation’ would fit into a European arena that was heavily rules-based, he pointed to the importance of threshold conditions as the “supervening criteria” for decision making. Meaning that judgement-led decision making ultimately still has a useful place.

-       He also emphasised that his strong belief that taxpayers would  one day be removed from the equation of financial stability

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Previous events in this series

Breaking down the barriers: How government and business can work better together, 23 January 2013