Financial stability and depositor protection: strengthening the framework
The ABI’s Response to the Tripartite Authorities’ consultation paper

Introduction
1. The Association of British Insurers (ABI) represents the collective interests of the
UK’s insurance industry, including in the role of its members as major
institutional investors. The ABI speaks out on issues of common interest; helps
to inform and participate in debates on public policy issues; and also acts as an
advocate for efficient capital markets and high standards of customer service in
the insurance industry.
2. ABI members have a strong interest in the health of the City and the stability of
the financial system. Insurers play a key role in the financial services sector
generating employment for 324,000 people. As investors of funds totalling £1.3
trillion on behalf of policyholders and savers, insurance companies rely on the
smooth operation of the markets. They are major providers of funds to banks
both through their ownership of equity shares and their investment in bonds and
other debt instruments issued by banks.
3. All of this gives the insurance industry a significant stake in financial stability,
and we therefore welcome the opportunity to respond to this consultation.
Overall comments
4. We believe the government is right to draw lessons from the credit crunch and
the failure of Northern Rock. This is a rare opportunity to strengthen our
arrangements for financial stability and one that should not be squandered.
There are three criteria against which the proposals should be judged. They
should:
• focus particularly on systemic risk
• identify and address the relevant issues in a proportionate way, and
• be carefully considered to avoid unintended consequences.
Our members consider that the proposals set out in the consultation are deficient
on all three counts. They are drawn too narrowly on the UK retail market
experience of Northern Rock. They fail to take sufficient account of the reasons
behind the paralysis of the money and asset-backed securities market, which is
where systemic risk currently lies, and they are part of a legislative timetable
which allows inadequate time for proper analysis and the identification of
downside risks.
5. We are particularly concerned about the proposals for a Special Resolution
Regime (SRR), which are presented as the cornerstone of the consultation
paper. As shareholders we clearly understand and accept that banks, like all
businesses, will sometimes fail. Wherever possible, the market should be
allowed to operate. Intervention by the authorities in a failing bank will mean
overriding the rights of shareholders and wholesale lenders. It must always be a
last resort and only be undertaken in response to genuine systemic risk.
6. Premature intervention that removes these rights, especially where there is no
systemic risk, would lead to a general loss of confidence in London as a financial
centre and make the market less willing to provide finance even to healthy
banks. The risk of contagion and loss of confidence in the money markets is
considerable if the intervention were poorly handled. Little or no regard appears
to be paid to institutional investors whose confidence is vital to the UK economy
and who could be part of a recapitalisation solution. The current proposals
damage this prospect. Our members have been impressed by the speedy,
decisive and coherent way the US authorities dealt with Bear Stearns and
believe any proposals should draw lessons from this.
7. For these reasons, and based on our experience of Northern Rock, we do not
support the consultation proposals. Were, nevertheless, an SRR regime to be
introduced we believe it should be authorised and supervised by the courts and
we are not currently confident of the rigour of a public interest test conducted by
the government.
8. In contrast we support the proposal to give the Bank of England a statutory
responsibility for financial stability. We believe this responsibility should
specifically require it to ensure the smooth day-to-day operation of financial
markets and of the payments system. Giving the Bank accountability in these
areas should ensure better balance in the Tripartite arrangements, help identify
looming problems and create a more rounded approach to systemic risk. This
proposal should have priority.
9. All of these proposals require careful consideration, however. We remain
concerned that rushing prematurely into legislation could result in arrangements
that are not fit for purpose and end up damaging confidence in the City of
London, making it less competitive internationally. It would be counterproductive,
for example, to introduce arrangements that deterred sovereign
wealth funds and other international investors from recapitalising banks thereby
adding potentially to the burdens on the taxpayer. A more measured timetable
would also allow time to take account of measures under way in the EU and in
the international financial institutions.
10. We do not, therefore, believe that the case for a SRR is proven and urge the
Tripartite Authorities to give deeper consideration to the issues involved and the
best response to them before rushing into legislation
Regulatory regime
11. We do not believe that the Tripartite System is fundamentally broken, but it does
need to work better. The necessary ingredients are: an approach that identifies
emerging risks in a timely and robust way; improved communication between the
authorities; a clear delineation of responsibilities; and better processes for crisis
management. The regulators need to ensure that they have suitably qualified,
high calibre staff to operate the system and need to ensure that they can retain
these staff – the FSA should consider the extent to which it needs to improve
remuneration of its supervisors in order to attract and retain the best staff.
12. We support the FSA’s role as a single financial regulator. This makes particular
sense to those of our members whose insurance business forms part of a larger
banking group. However, the smooth operation of the money markets is also
crucial to stability. Formal allocation of responsibility to the Bank of England in
this area would ensure that this is recognised by all parties as one of the
priorities of the Tripartite System
13. The objective of regulation should not be to prevent any bank from failing.
Rather it should be to ensure the stability of the system and a level of consumer
protection sufficient to ensure confidence without creating a situation where
consumers are encouraged to ignore risks they are taking because they know
they will be compensated.
14. The regulator’s ability to identify and address looming problems before they
become critical is vital to confidence. This is also the key to avoiding rescue
operations which end up being a burden on the taxpayer. The document
acknowledges the need for a period of heightened regulation before recourse to
an SRR but fails to develop this theme fully. Nor does it focus sufficiently on the
importance of ensuring that banks are adequately capitalised.
Deposit protection and the Financial Services Compensation Scheme
15. A robust system of retail depositor protection is important to confidence but we
believe the current limit of £35,000 per customer should be retained. This covers
the overwhelming majority of depositors in full and is sufficient to alleviate
hardship. A larger amount would distort the savings market by deterring savers
from considering other products that might be more suited to their needs. It
would also compound the moral hazard problem. We agree in principle that
payment of compensation to depositors should be done as quickly as possible.
However, we are not convinced of the practicality of many of the proposals in the
consultation paper for achieving this.
16. We believe that the events at Northern Rock have shown that the problems that
can arise at even relatively small banks are different in kind and in scale from
those likely to arise at other institutions and are best dealt with through special
arrangements. However, the FSA has recently put in place reforms to the
Financial Service Compensation Scheme (FSCS) introducing a considerable
element of cross-subsidy between different sectors. Essentially the failure of a
retail bank would quickly mean that life and general insurance companies as well
as asset managers and others would be levied to provide compensation for
depositors.
17. We continue to see no grounds for one part of the industry to underwrite
weakness in another, particularly when that underwriting would provide a
commercial advantage, as well as increase the risk of contagion. Further, there
is no real reciprocity to the proposed arrangements: in most cases problems with
an insurance company take many years to unfold and the likely cost of claims
can be met from regular annual levies by the FSCS on the insurance sector.
We, therefore, continue to oppose the FSA’s reforms and believe that any further
changes to the FSCS should separate the deposit protection element of the
scheme from the insurance and investment components.
Other points
18. More attention needs to be given to the way in which banks account for their offbalance
sheet business and to the role of audit committees in ensuring that risks
are understood, properly managed and that relevant disclosures are complete
and timely. The IASB has now signalled it intends to consider what greater
disclosure of off-balance sheet interests should be required. This seems the
right approach to ensuring that, at least in the short term, accounts can be made
to provide the necessary information to enable users to make properly informed
judgments.
19. Much blame has been attached to credit rating agencies. As large investors our
members do not rely heavily on ratings, regarding them as only one factor in a
decision to invest. We do not currently consider regulation is appropriate as this
might lead to standardisation and lack of choice, but the rating agencies’
involvement in structured finance has raised a series of particular problems. We
would prefer these to be addressed through a robust code of best practice,
which addresses conflicts of interest and lack of transparency. This should be
agreed at an international level. Regulation should follow only if it fails.