The FPC: Running the financial economy?

BBC business editor Robert Peston on the Financial Services Authority

The Treasury's paper on breaking up the Financial Services Authority and reforming the Bank of England, published today, represents something of a revolution not only in the regulation of the City of London but also in the management of the British economy.

Because it heralds the creation of a new institution within the bosom of the Bank of England, to be called the Financial Policy Committee (FPC), which can in some ways be seen to be as powerful and important as the Monetary Policy Committee, which sets interest rates.

For the UK's big banks - the infrastructure of the British economy - the FPC will probably be regarded as more relevant to their fortunes than the MPC.

And for the rest of us, arguably the FPC will also be more important in determining the long-term structure, stability and growth potential of the British economy than the MPC.

How so?

Well the FPC's mandate will be to identify where dangerous risks are developing within the financial system - as opposed to risks at individual banks - and then do something about those risks.

The Treasury highlights two potential sources of risk in particular:

1) Systemic risks attributable to structural features of financial markets or to the distribution of risk within the financial sector; and

2) Unsustainable levels of leverage, debt or credit growth.

It is giving four general capabilities to the FPC to address such risks, as and when they emerge:

a) The FPC would make public pronouncements and warnings when it sees dangers in the system;

b) When the flaws in the system are global or international in nature, the FPC will try to negotiate reforms with international regulatory bodies;

c) The FPC will provide advice to the two soon-to-be created new bodies that will regulate individual firms, the Prudential Regulation Authority(PRA) and the Financial Conduct Authority (FCA), on what they might do to ward off potential risks through interventions with banks and other firms;

d) Finally, the FPC will have powers over the PRA and FCA to make recommendations, which the PRA and FCA will either have to implement or explain publicly why not; and most importantly of all, the FPC will have powers from secondary legislation to significantly influence the behaviour of banks and other financial institutions, by directing the PRA and FCA to do certain things on its behalf.

So the creation of the FPC may well be seen as the formal death announcement of a laisser-faire ideology that prevailed in the City of London until the great crash of 2008.

For example, if the FPC believed banks were in general lending too much and too cheaply, it could direct the PRA to raise the capital requirements of banks (the minimum amount of capital they have to hold in relation to the loans they make) - which at a stroke would significantly reduce the flow of credit and also increase the costs for banks of lending (in normal conditions, capital cannot be raised by banks either cheaply or quickly).

Or the FPC could direct the PRA to increase the risk weighting attached to certain categories of credit - which would have the effect of forcing banks to hold more capital relative to that kind of lending, and thus nip an incipient bubble in a particular market in the bud. So for example if regulators had done this for mortgages in the five years before 2007, it would have been more expensive for banks to provide mortgages, and there might not have been quite such a dangerous boom in the housing market as the one we experienced.

Other possible tools for the FPC would be the ability to require that banks set aside funds to cover the risks of losses on certain kinds of lending and investing, in a process known as dynamic provision - whose point is to build up reserves at banks to protect them and their depositors if the loans go bad.

The Treasury paper also talks about possibly giving the FPC powers to force banks to demand more collateral from borrowers in certain circumstances. In a housing boom the FPC could - as an example - ban mortgages worth more than 90% of the value of properties.

In addition, the FPC could force banks to make greater disclosures about their activities, so that creditors and shareholders would have a greater ability to assess the risks taken by the banks and respond accordingly.

The explicit scope of how the FPC could intervene is therefore pretty board. What's more if other ad hoc tools are deemed to be required to tackle an incipient crisis, the Treasury would be able to legislate instantly to provide those powers - with approval by Parliament required within 28 days.

To sum up, the FPC is set to be given unprecedented powers over financial institutions en masse, over the financial economy as a whole. In terms of determining the long-term flow of credit, it may well turn into the most powerful body in the land.

Which is why checks and balances are being built into the new system.

The FPC will publish minutes of its deliberations (though it will have the ability to redact the most sensitive parts of its discussions).

It will be accountable to the Treasury Select Committee, in the way that the Monetary Policy Committee has been for years (is there a danger of the TSC becoming over-burdened?).

And what some will see as most important of all perhaps, there will be a legislative requirement on the FPC not to take actions that would "in its opinion be 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".

Here, of course, is the tension that the FPC will have to confront every waking minute: how to take risk out of the system without stymieing the supply of vital credit, or crushing those creative instincts of banks that are benign (some of you won't believe this, but not all innovation by banks is an attempt to gull the customer).

You can keep up with the latest from business editor Robert Peston by visiting his blog on the BBC News website.

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