My Lords, this Government have undertaken the most fundamental programme of financial reform this country has ever seen. The Bank of England sits at the heart of this new system, with clear responsibility for maintaining financial stability. The Bank is supported by the firm-level supervisors: the Prudential Regulation Authority and the Financial Conduct Authority.
A key element of the new system is the Financial Policy Committee. The FPC is responsible for identifying, monitoring and addressing risks to the system as a whole. This macroprudential regulation was entirely absent from the system we inherited.
The FPC works to improve financial stability in two ways: first, through recommendations, which can be made to the regulators, industry, the Treasury, within the Bank and to other persons; and, secondly, through directions that can be given to the PRA and FCA. The FPC’s direction power is limited to macroprudential measures set out in orders like those currently before the House. The regulators must comply with a direction, but they will have discretion over its timing and implementation method.
The FPC has recommended that its powers of direction be expanded so that it may effectively tackle systemic risks within the financial sector. The Government agree with those recommendations and have brought forward the instruments that we are discussing today. These instruments will provide the FPC with powers of direction with regard to the UK housing market and a leverage ratio framework. I will discuss these powers in turn.
Owning a property is an aspiration for many people in the UK, and one which this Government support. However, we cannot be blind to the risks that can emerge from the housing market. More than two-thirds of previous systemic banking crises were preceded by boom-bust housing cycles, and recessions following property booms have been two to three times deeper on average than those without.
To solve this issue, we need to be clear about where the risks arise. They arise when people borrow too much and leave themselves vulnerable to changes in circumstances. Excessive debt can create serious difficulties for households and, given that mortgages are the single largest asset on bank balance sheets, it can result in significant vulnerabilities in the banking system. We all know from the experience of the financial crisis how important it is for the banking system to be resilient to all shocks, including those from the housing market. Excess debt can also force households to cut back on spending which can, in aggregate, create difficulties for the economy as a whole.
Let me be clear, there is no immediate cause for alarm. The FPC has itself stated that since taking action in June, there has been no increase in financial stability risk from the housing market. However, not to prepare for such events would be dangerously complacent. So we need to ensure the FPC has the tools at its disposal to deal with these risks should they arise, which is why we are giving the FPC far-reaching new powers over owner-occupied mortgages. Specifically, if the FPC judges that some borrowers are being offered excessive amounts of debt, they can limit the proportion of high debt-to-income—DTI—mortgages each bank can lend or, in extremis, simply ban all new lending above a specific ratio. Similarly, if the FPC is concerned by the risks posed by a housing bubble, it could impose caps on loan-to-value ratios. These additional powers over the housing market are commonly held by central banks in other countries, and the experiences of Korea, Singapore and Hong Kong confirm that DTI and LTV limits are efficient tools to address risks in the housing sector.
I now turn to the other instrument that we are considering today. The recent financial crisis revealed serious weaknesses in the existing framework of
internationally agreed standards of capital adequacy. Banks in most jurisdictions were only required to meet risk-weighted capital requirements and were not subject to leverage requirements. In the lead-up to the crisis, some banks’ balance sheets expanded significantly while average risk weights declined. Firms’ leverage ratios were a useful indicator of failure during the last crisis, and the period immediately preceding the crisis was characterised by sharp increases in leverage. Firms with high leverage ratios have greater amounts of capital to absorb losses which materialise and have less reliance on debt financing.
There is international agreement that the leverage ratio is a crucial complement to risk-based capital requirements. The usefulness of the leverage ratio as a regulatory requirement has been recognised by the Basel Committee on Banking Supervision, which has included proposals for a 3% minimum leverage ratio in the Basel III agreement. Countries such as Canada and the US already impose leverage ratio requirements and have also committed to going beyond the Basel III requirements.
In the UK, both the Independent Commission on Banking and the Parliamentary Commission on Banking Standards have recommended that banks should be subject to minimum leverage ratio requirements. On 26 November 2013, the Chancellor requested that the FPC undertake a review of the leverage ratio and its role in the regulatory framework. In light of international developments, the Chancellor judged that it was an appropriate time for the FPC to consider all outstanding issues relating to the leverage ratio, including whether and when the FPC needed any additional powers of direction over the leverage ratio, and whether and how leverage requirements should be scaled up for ring-fenced banks and in other circumstances where risk-based capital ratios are raised.
On 31 October last year, following almost a year of work and extensive consultation with stakeholders, the FPC published its response, The Financial Policy Committee’s Review of the Leverage Ratio. The review recommended that the FPC be given new powers of direction over the leverage ratio framework for the UK banking sector. The Chancellor agreed with these recommendations and, following a consultation on the implementation of the proposals, brought forward the instrument that we are considering today.
The instrument will grant the FPC powers to set: a minimum leverage ratio that all firms must meet; additional leverage ratio buffers for systemic firms, linked to their systemic risk-weighted capital requirements; and a countercyclical leverage ratio buffer for all firms, linked to the countercyclical capital buffer that is also set by the FPC. These powers will allow the FPC to ensure that firms are not allowed to take on excessive levels of leverage, that the most systemically important firms are more resilient than other firms and that resilience is built up for all firms when times are good. I beg to move.