13.2 Financial regulation in the uk

secondary banks in the early 1970s, the need for the Bank to rescue the Johnson

Matthey Bank in 1984, and concerns about the capital adequacy of the major banks

in the wake of the debt crisis of developing countries in the mid-1980s led to a

considerable formalisation of the Bank of England’s role through the introduction

of new banking acts and the issuing by the Bank of prudential rules it expected

banks to follow. With the further realisation that the banking industry was chang-

ing rapidly with the formation of nancial conglomerates associated with Big Bang

and with the development of new market places and new nancial instruments,

the Banking Act of 1987 produced a new framework of supervision for the banking

aspects of nancial services.

The Act created one class of ‘authorised institutions’, all subject to the same rules

and regulations. It established requirements for banks to report any large individual

lending exposure and dened more precisely than previously the circumstances

under which the Bank might determine that an individual was not a ‘t and proper’

person to run a bank. It also set up a new board of banking supervision to assist the

Bank in its supervisory role; gave the Bank power to veto acquisition of a share-

holding of more than 15 per cent in an authorised institution; made it a criminal

offence to ‘knowingly or recklessly’ provide false information to the Bank; allowed

increased cooperation between supervisors and auditors of banks; and enabled the

Bank to seek opinions from reporting accountants on banks’ accounting records and

internal control systems and to commission reports by accountants or consultants

on the information obtained by the Bank. Further, the Act described in general terms

the information to be provided to the Bank, dened by circumstances in which an

institution might dene itself as a bank or as carrying on a banking business, and

gave the Bank powers of entry to banking premises where contravention of the Act

was suspected.

The Act was supported by a large number of papers setting down prudential

rules. These related, among other things, to capital and liquidity ratios which banks

were expected to maintain, the measurement of capital, the supervision of the

off-balance-sheet business of banks, and the suitability tests the Bank will apply to

people wishing to become large shareholders in UK banks. Until 1975, the Bank of

England had assessed the capital adequacy of a bank by looking at its gearing ratio:

the relationship between the bank’s capital and its total public liabilities. From then

on, however, it began experimenting with the use of risk–asset ratios (comparing

total bank capital with bank assets rather than liabilities). In January 1987, the Bank

of England and the Federal Reserve System of the US announced their intention

to bring the supervision of banks’ balance sheets in the two countries into line on

this basis. More detail concerning the calculation of risk–asset ratios is provided in

section 13.4 below.

The new system was concerned with the quality of bank assets, not just the

quantity. Further, the agreement between the US and Britain allowed the inclusion

of off-balance-sheet risk in the calculation. These risks would also be weighted and

added to the risk-adjusted balance sheet of banks to arrive at a nal estimate of their

nancial soundness. Again, an increase in off-balance-sheet risk would produce a

lower risk–asset ratio.

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Chapter 13 • The regulation of nancial markets

Off-balance-sheet activities:Activities that earn income for banks in the form of fees

without corresponding assets and liabilities appearing on the balance sheet such as the

guaranteeing of commercial bills or of swaps or the issuing of commercial paper.

The Financial Services Act also gave to the Bank of England responsibility for

regulating UK wholesale markets in sterling, foreign exchange and bullion.