The FPC's new tools

The interim Financial Policy Committee (FPC) has recommended that the following macro-prudential tools should be made available to the statutory FPC in order to meet its proposed objective:

• counter-cyclical capital buffers: adjusting required capital ratios through a time-varying capital buffer in certain circumstances (e.g. increasing the buffer to mitigate systemic risks, reducing the buffer to mitigate contractions in lending supply);
• sectoral capital requirements: scaling up the amount of capital that firms are required to hold against certain types of exposure relative to the micro-prudential requirement; and
• leverage ratios: constraining the ability of financial institutions to increase the overall size of their exposures relative to their capacity to absorb losses.

This advice will help shape the Government's proposals, which are to be the subject of further public consultation during the passage of the Financial Services Bill.

Once the Financial Services Bill is enacted, the statutory FPC will be empowered to direct the new Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) to exercise their functions so as to ensure the implementation of certain macro-prudential tools. 

The power of direction is to be used in order to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system, but not in a way which is likely to have a significant adverse effect on the capacity of the financial sector to contribute to the growth of the UK economy in the medium or long term.   The tools can be applied to all, or to a specified class of, regulated persons, including not just banks, but also building societies, investment firms, insurers and a variety of funds and investment vehicles.  The precise scope of the FPC’s instruments should be specified in secondary legislation. 

The PRA and the FCA will be required to comply with such directions, although they cannot be required to anything they do not have the power to do.   The macro-prudential tools in respect of which a direction can be given are to be prescribed by HM Treasury.   

In producing its advice on the tools that should initially be prescribed for this purpose, the interim FPC also considered other potential tools which might appropriately be prescribed after further analysis and reflection, including:

• a liquidity tool, possibly with time-varying features: this would require agreement to have been reached on international micro-prudential standards;
• a collateral requirements tool: this would require a high degree of international coordination and further development of standards;
• a disclosure tool: powers to require financial institutions to publish consistent information in a timely manner about their activities could be effective in enhancing market discipline; the interim FPC suggested the grant of a broad power of direction over disclosure, should be considered, with any appropriate constraints, since it was not clear what specific future disclosure the FPC would judge necessary to tackle systemic risks; and
• loan to value and loan to income restrictions:  might prove effective in limiting financial instability, and could be applied to all regulated UK mortgages, whether or not the provider was prudentially regulated in the UK, but the tool would require a high degree of public buy-in.

The interim FPC also noted that other macro-prudential tools could be the subject of the FPC's power to make recommendations rather than directions.

It is important to note that although the tools which the FPC has recommended essentially form part of the Basel III package of reforms and have been fully endorsed by the G20, the empirical evidence of the potential effects and impacts of the use of these tools in isolation, and the likely interaction of the effects of the use of various different macro-prudential tools simultaneously, is still nascent.  The interim FPC's acknowledgement of the need to avoid an excessively activist, fine-tuning approach in setting any sectoral capital requirements is therefore welcome. 

It is to be hoped that the statements of policy which the statutory FPC will be required to prepare, publish and maintain will reflect this acknowledgment and will also confirm the importance of having regard, not only to any international law constraints, but also to the potential impact of any action that other regulatory bodies (particularly the European Supervisory Authorities) may be considering or taking, and to the cumulative effects of such action and of the FPC's own proposals.