Page last updated at 12:52 GMT, Wednesday, 8 July 2009 13:52 UK

Key issues: Financial regulation

By Steve Schifferes
Economics reporter, BBC News

Skyline of Canary Wharf
A new committee could be set up to oversee financial regulation

The UK government has announced its plans to reform the financial system to prevent future crises.

New powers have been proposed to curb bank lending and prevent asset bubbles, such as the housing boom undermining the real economy.

The aim, according to Chancellor Alistair Darling, is a "significant toughening up of the regulatory system" in order to "learn the lesson of what went wrong... and make sure we reduce those risks".

But critics say many of the proposals are still too vague, and the plans lack teeth.

The government says it will need to consult the City and international regulators before moving forward on some proposals - therefore delaying their implementation until after the next election.

KEY PROPOSALS: WHO WILL BE REGULATED

There will be broad power to regulate any financial institution that poses a "systemic" threat to the financial system.

So investment houses as well as commercial banks will be regulated.

And the Treasury is suggesting that banks which pose a bigger risk to the financial system as a whole, because of their size or inter-connections with other banks, will be regulated more heavily.

Other off-balance sheet activities which banks used to hide their risky lending, such as structured investment vehicles, will be brought under regulation.

The government will also assert its right to examine the books of hedge funds and private equity funds if they pose big risks to the system.

But it is resisting EU proposals for even tighter hedge fund regulation that it says would be anti-competitive.

The government says that regulation will have to be agreed at a global level, to avoid firms migrating to "softer" jurisdictions.

KEY PROPOSALS: WHO WILL BE THE REGULATORS
Mervyn King
Mr Kings says the Bank needs new powers

The White Paper endorses the current system of "tripartite regulation" where responsibility in a financial crisis is shared between the Bank of England, the Financial Services Authority (FSA), and the Treasury.

The government will set up a new Council for Financial Stability, with statutory powers, bringing the three key actors together on a regular basis to review risks to the system and publish their results.

However, the Bank, which has been given the legal mandate for maintaining financial stability, has been arguing that it needs more powers beyond raising interest rates to carry out its mandate to ensure financial stability.

The governor of the Bank of England, Mervyn King, has said that without such powers, his role is merely to "preach sermons".

He has been backed by the Conservatives, who have pledged to give the Bank of England a lead role in financial regulation and abolish the tripartite system.

Shadow chancellor George Osborne says that the Bank of England, not the FSA, should have the power to set counter-cyclical capital requirements and the power to force banks to change their structure if it would jeopardise the financial system.

He said he would also introduce a stronger regulator to protect consumer interests and cut bank charges.

KEY PROPOSALS: WHAT NEW POWERS THEY WILL HAVE

The key objective of the White Paper is to strengthen what is called "macro-prudential" regulation, which aims to ensure that the regulators look at the whole financial system, not just the state of individual banks.

The FSA will have new powers to introduce tougher standards for big banks - so that they have to put aside more of their funds for a rainy day - and also hold more in cash equivalents, to prevent a bank run.

It will also have new powers to wind up any financial institution that could pose a risk to the system.

And the FSA will have new legal responsibilities for ensuring financial stability as well as regulating individual banks.

But the White Paper ducks the question of how to prevent asset bubbles in the future - when banks lend too much money, for example, producing a housing boom.

It says that it accepts the "principle" that there should be further "counter-cyclical" measures to limit credit growth - and that the Bank of England would need to play a central role in such measures.

But the Treasury argues that there is no clear consensus as yet as to what those powers would be - and in any case they would need to be discussed with international regulators first.

Some of these measures - such as restricting the volume of available mortgages - could be politically unpopular, and by putting these issues up for discussion the government has ensured that they will not be implemented before a general election.

There will be discussion of other ways of regulating credit creation, from the restriction on the size of consumer mortgage loans (or a loan-to-value limit) or a higher tax on incremental bank lending when there was a risk of overheating. It is also unlikely that these would be implemented before the next general election.

KEY PROPOSALS: RESTRICTING THE SIZE OF BANKS

One key issue is whether banks should be allowed to grow so big that they pose a risk to the global financial system.

In last month's Mansion House speech, Mr King said: "If some banks are thought to be too big to fail, then, in the words of a distinguished American economist, they are too big."

But the chancellor said it would be "simplistic" to believe that the banking crisis could have been averted if banks had been broken up into smaller units, or if banks had been forced to choose between retail and investment banking, as was the case in the US before 1999.

However, he does accept that the banking sector needs more competition to encourage more consumer choice, and said that he would be encouraging the existing competition authorities, the Office of Fair Trading and the FSA, to ensure that there were not unfair barriers to entry preventing new banks from setting up.

KEY PROPOSALS: LIMITING EXECUTIVE PAY

The chancellor is keen that the banks get the message that excessive risk-taking should be a thing of the past, and that executive pay systems should be changed to take this into account.

The concern has been that the system of high rewards for short-term profits encouraged bank bosses to lend too much.

The White Paper gives powers to the FSA to review how well banks are implementing the new code of conduct on remuneration, and suggests that it will have the power to impose penalties if banks do not follow its guidelines.

It also wants to strengthen the role of the shareholders and independent board directors in determining pay.

A new code of conduct for boards is likely to be the centrepiece of proposals next week from Sir David Walker in his review of banking management.

KEY PROPOSALS: MORE CONSUMER PROTECTION

The Treasury says that new rights for consumers are vital in order to rebuild confidence in the financial system.

It is strengthening the system of depositor protection, and requiring the banks to contribute more money to make that scheme effective.

The government will require the private sector to provide more financial education and advice for consumers as they take more responsibility for their own financial affairs, including a national money advice line.

And it may look at tougher controls on overdraft charges levied on small businesses and on individuals.



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