Recent developments on the Bank of England, concerning liquidity auctions during the financial crisis in 2007-2008 and U.S.-based banks stress tests, the fifth round led by the Federal Reserve since 2009 and the third round required by the Dodd-Frank Act. are encouraging efforts of building strong banks and the surveilance role to regulate and supervise financial institutions, including bank holding companies.
Capital is important to banking organizations, the financial system, and the economy because it acts as a cushion to absorb losses and helps to ensure that losses are borne by shareholders, not taxpayers. Although Northern Rock was not a particularly large bank (it was at the time ranked 7th in terms of assets) it was nevertheless a significant retail bank and a substantial mortgage lender that grew rapidly. Its assets doubled from $ 16 billion in mid 2005 to $ 32 billion at year end 2007 and it more than tripled its share of the UK mortgage market between 1999 and 2007 from 6% to 19% (Bank of England, 2007).
Higher capital levels at large banks increase the resiliency of our financial system. There was always a fear that this could spark a systemic run on bank deposits. Before the Northern Rock crisis, little attention was given to crisis management arrangements. This was true in the UK as well as in the US. Even, after the crisis there were, weaknesses in the workings of the emergency liquidity assistance arrangements. For example, before the crisis, banks became dangerously over-exposed to AAA-rated senior tranches of asset backed securities partly because, wrongly, they saw the risks as very low and partly because the capital requirements were vanishingly small.
During that time the Bank of England, promoting the good of the people of the United Kingdom by maintaining monetary and financial stability, lent money against low and negative interest rates in return for asset-backed securities, in a bid to keep lending markets open as the credit crunch struck.
In August 2007 the United Kingdom experienced its first bank run in over 140 years. Of course, since Northern Rock failed the world has experienced what is arguably its most serious financial crisis ever and in the US much larger and more significant banks have failed. The BoE can now confirm that it commissioned Lord Grabiner QC to conduct an independent inquiry into liquidity auctions during the financial crisis in 2007 and 2008.
In the wake of the crisis an attempt was made to draw a sharp boundary between bank regulation and supervision on the one hand, and the Bank of England’s role in promoting financial stability on the other. The quantitative results from the Dodd-Frank stress tests are one component which is an annual exercise to evaluate the capital planning processes and capital adequacy of large financial institutions. The Comprehensive Capital Analysis and Review CCAR results will be released on Wednesday, March 11, 2015.
Surveillance and resolution–involve issues that are at the core of the financial sector, paying greater attention to the banking sector, institutional development work, the sustainability of capital flows, and situations where crises could spill over into other markets. As a number of recent financial crises have demonstrated including 2008 financial crises. Emergency lending to one or a few nonsystemic institutions will necessarily differ from the support given to systemically important institutions, whose troubles could threaten serious banking sector instability.
An advantage of concurrent stress testing across major banks is that policymakers can consider the wider systemic impact of the scenario. They can also test whether buffers are sufficient even if regulators prevent banks from modelling management actions that would be harmful to the wider economy: for example, if banks propose to reduce new lending in order to conserve capital. Used in this way, stress testing may inform calibration of the system-wide, countercyclical buffer if macro-prudential policymakers identify elevated systemic risks.
Leverage and stress testing are best seen as complements rather than alternatives to risk-weighted measures of capital, producing a more robust overall framework. Risk weightings will likely remain the binding constraint for most banks most of the time. The central conclusion is that the Northern Rock crisis was a crisis of securitisation and capital. Securitisation is an example of an area where regulators find it hard to measure risk, say David Rule, Executive Director, Prudential Policy, in Speech given at the Institute of International Bankers Annual Conference, Washington