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---

### Overview and context
- Assessment prepared by the Monetary and Capital Markets and European Departments; Approved by José Viñals and Antonio Borges; July 11, 2011.
- Two missions: January 12–February 1 and March 24–April 5, 2011.
- Team members included Robert Sheehy and Ceyla Pazarbasioglu (co-heads), Li Lian Ong (deputy), Jennifer Elliott, Andreas Jobst, Vanessa Le Leslé, Christine Sampic, Rodolfo Wehrhahn (IMF/MCM); Sean Kerr (IMF/LEG); Marta Ruiz Arranz (IMF/EUR); and external consultants Nikil Chande, Nick Le Pan, Tom Karp, Göran Lind, Antonio Pancorbo, Pierre-Yves Thoraval, and Shane Tregillis.
- Purpose: FSAP Update to assess the stability of the U.K. financial system as a whole and identify weaknesses in financial sector structure; not intended to cover institution-specific risks such as asset quality, operational or legal risks, or fraud.

### Key findings and system-wide vulnerabilities
- Decisive policy responses during the crisis stabilized the financial system, but vulnerabilities remain and recovery is not yet assured.
- The size and role of the U.K. financial system in global intermediation make its stability a global public good and necessitate effective implementation of reforms.
- U.K. banks have made progress in repairing balance sheets following the crisis, but the recovery process is not yet complete.
- Restructuring of the two large banks with government stakes (RBS and LBG) is ongoing; rigorous follow-through is essential.
- Stress tests suggest adequate levels of capitalization under severe macroeconomic scenarios, with the caveat that lender forbearance may have masked the extent of risks given high indebtedness of the household and commercial real estate sectors.
- Liquidity positions have improved, but U.K. banks are vulnerable to sustained disruptions in funding markets.
- Aggregate balance sheet of the banking sector is about five times GDP.
- U.K. institutions hold about £11 trillion of assets in the United Kingdom and globally, equal to about nine times GDP, of which U.K. banks account for assets equivalent to five times GDP.
- International foreign bank subsidiaries and branches hold half of U.K. banking assets; U.K.-owned banks have over half of their assets outside the country.

### Stress testing: design, scenarios, and solvency results
- Stress-test sample and horizon:
  - Solvency BU sample: seven major U.K. banks that account for 71 percent of the assets in the system, 80 percent of loans, and 90 percent of retail deposits.
  - Stress-test horizon: 2011–2015 using end-2010 financial data.
- Adverse macro scenarios:
  - (i) “DD mild”: one standard deviation of real GDP growth from the baseline over the first two years.
  - (ii) “DD severe”: two standard deviations of the same.
  - (iii) “SG”: “prolonged slow growth” with a cumulative negative deviation of over 7 percentage points from baseline growth (average annual growth of almost 0.9 percent over five years).
- Solvency test approaches:
  - Bottom-up (BU), Top-down (TD) RAMSI, and Systemic Contingent Claims Analysis (Systemic CCA).
- Key solvency results (BU and TD summaries):
  - Distribution of Core Tier 1 ratios for individual banks remain over the regulatory minima over 2011–15 per the Basel III schedule.
  - Weighted-average capital ratios comfortably exceed regulatory minima.
  - Average leverage ratio remains over 4.5 percent.
  - BU: exposures to sovereign and bank debt estimated aggregate losses of around 0.2 percent of GDP (£3.5 billion) over five years.
  - TD (RAMSI): shocks to sovereign and bank debt can reduce core Tier 1 capital by up to 0.9 percentage points, but capital remains above hurdle rates.
- Systemic CCA quantified market-implied impacts:
  - Under median baseline conditions, impact on market-implied capital from declining profitability equals an average 0.03 percent of 2010 GDP (£0.4 billion) between 2011–15.
  - Under the severe double-dip recession scenario, market-implied capital levels could decline by up to an average 0.12 percent of 2010 GDP (£1.8 billion) over the next five years.
  - Under a “tail of the tail risk” scenario (0.1 percent probability event), market-implied capital levels could potentially be eroded by between 2.7–3.4 percent of 2010 GDP (£37–£50 billion) on average over five years.
  - Under this extreme scenario, an average capital shortfall of between 1.3–1.6 percent of 2010 GDP could materialize relative to the Basel III Tier 1 hurdle rates (and 1.6–1.8 percent of 2010 GDP relative to the FSA Interim Capital Regime Tier 1 requirements).

### Liquidity testing: methodology and exact quantitative outcomes
- Liquidity test sample and measures:
  - Sample: 16 institutions — the 7 major banks, selected foreign investment banks and building societies.
  - Tests: implied cash-flow tests over 5-day and 30-day horizons (based on QIS-6 assumptions) and quasi-Basel III measures (Quasi-LCR and Quasi-NSFR).
- 5-day test (All firms (16), Original assumptions):
  - Number of Banks below Defined Benchmark: 1
  - Cumulative Withdrawal of Deposits 1/: 0.03 (In percent of total deposits)
  - Cumulative Loss of Wholesale Funding 1/: 0.03 (In percent of total wholesale funding)
  - Total Shortfall (In percent of total sample assets included in the liquidity tests): 0.03
  - Average per Bank in Shortfall: 18.0 (In percent of total deposits); 25.5 (In percent of total wholesale funding)
- 30-day test (All firms (16), Original assumptions):
  - Number of Banks below Defined Benchmark: 14
  - Cumulative Withdrawal of Deposits 1/: 5.77 (In percent of total deposits)
  - Cumulative Loss of Wholesale Funding 1/: 0.41 (In percent of total wholesale funding)
  - Total Shortfall (In percent of total sample assets included in the liquidity tests): 5.77
  - Average per Bank in Shortfall: 43.8 (In percent of total deposits); 40.9 (In percent of total wholesale funding)
- 30-day test (Largest firms (7), Original assumptions):
  - Number of Banks below Defined Benchmark: 7
  - Cumulative Withdrawal of Deposits 1/: 6.64 (In percent of total deposits)
  - Cumulative Loss of Wholesale Funding 1/: 0.95 (In percent of total wholesale funding)
  - Total Shortfall: 6.64
  - Average per Bank in Shortfall: 44.6 (In percent of total deposits); 41.5 (In percent of total wholesale funding)
- Alternative 30-day assumptions (selected outcomes):
  - Alternative 1 (No withdrawal of retail deposits): All firms (16): 0 banks below benchmark in 5-day test; 4 banks below benchmark in 30-day test; 30-day Total Shortfall: 0.41.
  - Alternative 2 (Availability of intra-group funding): All firms (16): 1 bank below benchmark in 5-day test; 9 banks below benchmark in 30-day test; 30-day Total Shortfall: 2.22.
- Quasi-LCR distribution (FSAP Assumptions):
  - All firms (16): 11.4 (<0.25), 25.4 (0.25–0.50), 50.9 (0.50–0.75), 9.9 (0.75–1.00), 2.3 (>1.00).
  - Largest firms (7): 28.3 (<0.25), 58.2 (0.25–0.50), 19.0 (0.50–0.75), 6.3 (0.75–1.00), 0.0 (>1.00).
- Quasi-NSFR maturity tenor (All firms (16), In percent of total sample assets included in the liquidity tests):
  - less than 1 month: 11.6
  - within 1–3 months: 29.1
  - within 3–6 months: 22.3
  - between 6–12 months: 68.9
  - after 12 months: 89.2
- Quasi-NSFR after 12 months for Largest firms (7): 92.7.
- Interpretation:
  - The banking system in aggregate has adequate liquidity buffers for short-lived stresses, but the system remains vulnerable to sustained funding market disruptions and maturity mismatches at six-month horizons and beyond.

### Haircuts on non-AAA sovereign and bank debt — design and caveat
- Haircuts were informed by the forward term structure of five-year sovereign CDS spreads as at end-2010; the stress-test cut-off date: December 31, 2010.
- Aggregate losses from exposures to sovereign and bank debt estimated at around 0.2 percent of GDP (£3.5 billion) over five years in BU tests, but subsequent CDS spread widening since end-2010 implies potential additional losses not captured by the prescribed haircuts.
- Selected country haircuts (examples, in percent):
  - United Kingdom: 2011 0.10; 2012 0.27; 2013 0.25; 2014 0.10; 2015 0.16; Adverse 1 (5-year rate) 2011 1.19; 2012 1.39; 2013 1.31; 2014 1.02; 2015 1.03; Adverse 2 (DD Severe) 2011 3.16; 2012 3.41; 2013 3.23; 2014 2.69; 2015 2.60.
  - Ireland: 2011 6.12; 2012 5.55; 2013 4.77; 2014 4.26; 2015 3.78; Adverse 1 2011 13.83; 2012 12.81; 2013 11.39; 2014 10.56; 2015 9.59; Adverse 2 2011 26.35; 2012 24.71; 2013 22.35; 2014 21.05; 2015 19.34.
  - Greece: 2011 12.77; 2012 10.85; 2013 9.07; 2014 8.21; 2015 7.28; Adverse 1 2011 26.61; 2012 23.20; 2013 20.00; 2014 18.56; 2015 16.81; Adverse 2 2011 46.55; 2012 41.57; 2013 36.74; 2014 34.61; 2015 31.82.

### Macro-financial outlook, exposures, and principal risks
- Central macro scenario and projections:
  - Central scenario: moderate economic recovery and gradual return to the inflation target.
  - Real GDP growth expected to accelerate gradually to around 2.5 percent over the medium term.
  - Inflation projected to remain above 4 percent for most of 2011 and return to the 2 percent target by end-2012.
- Main macro and financial risks:
  - Sluggish growth from balance sheet repair across households, banks, and public sector.
  - Interest rate increases forcing faster policy tightening.
  - Reduced fiscal space after crisis-induced government debt increases.
  - Housing vulnerability: house price-to-income ratio remains 30 percent above its historical average.
  - CRE vulnerabilities: CRE accounts for half of total loans to non-financial corporates; concentrated maturities and negative equity for many borrowers.
  - Cross-border exposures (direct and indirect) to Greece, Ireland, and Portugal amount to $173 billion (approximately £111 billion; 2.8 percent of total assets), with $135 billion (£86 billion) to Ireland; exposures to Spain amount to $107 billion (£69 billion).
    - Major U.K. banks’ claims on Ireland and Spain (primarily to the nonbank private sector) are equivalent to about 50 percent of their Core Tier 1 capital (split evenly between the two countries).
    - Lending to Italy accounts for about 8.5 percent of Core Tier 1 capital.

### Insurance, markets, and hedge funds
- Insurance sector:
  - Financial condition generally improved; life insurance activity recovered to pre-crisis production levels.
  - About 10 percent of life insurers and 25 percent of nonlife insurers remain under regulatory observation, with Pillar II solvency ratios less than 130 percent.
  - FSA insurance stress testing (2010) of six largest insurance groups: firms passed all severe tests at group and solo levels.
  - Risk drivers for life insurers: credit risk largest; market and property risks significant.
- Hedge funds and prime brokerage (selected exact figures):
  - Approximately 20 percent of all hedge fund managers are registered in London with assets under management of approximately $380 billion as at end-2010.
  - U.K.-managed funds employed an average of 272 percent of assets to equity in April 2010 (up from 244 percent in October 2009).
  - 90 percent of European prime brokerage activity takes place in London.
  - FSA survey: maximum potential credit exposure to any one hedge fund was $500 million; maximum potential credit exposure of a single financial institution to a single hedge fund was $50 million.

### Financial Market Infrastructures (CCPs, FMIs), liquidity facilities, and resolution
- CCPs and cash settlement:
  - Most cash settlement of U.K. CCP transactions (mainly margin calls) is done through commercial bank books (commercial bank money), exposing CCPs to intraday credit risk.
  - Recommendation: CCPs should aim to reduce cash-settlement exposures through settlement in central bank money when possible.
- Funding options and emergency liquidity for CCPs:
  - Authorities should ensure safe and reliable funding options, including committed credit lines subject only to presentment and mutualization options.
  - BoE stance: no pre-arranged emergency overnight central bank liquidity for moral hazard reasons; discretionary provision possible.
- Discount window and permanent facilities:
  - The new discount window facility and pre-positioning of collateral are important for managing extreme stresses and facilitating access.
  - Permanent liquidity facility (June 2010): allows use of wider pools of collateral; facility serves as a diagnostic tool for market tensions.
- Resolution and SRR:
  - Special Resolution Regime (SRR) provides tools for bank resolution, including partial property transfer powers and creditor safeguards.
  - Recommendation: consider establishing resolution tools for systemically important nonbank firms not covered by the SRR (investment banks, insurance firms, FMIs, money market funds, hedge funds if systemic).
  - Limitation: SRR powers to suspend contractual termination provisions do not currently extend to derivatives contracts due to EU legislation protecting close-out netting provisions.
- Deposit insurance (FSCS) features and reforms:
  - FSCS coverage increased to £85,000 in 2010.
  - Faster payout rules: targeting payout within 7 days for most claims and within 20 days for the remainder.
  - FSCS funding is raised ex post and has standing access to HMT finance.
  - Recommendation: consider moving to a risk-based premia.

### Too-important-to-fail (TITF), resolvability, and bank levy
- Progress and measures:
  - Strengthened regulatory ratios and introduction of a bank levy on wholesale funding.
  - Independent Commission on Banking (ICB) proposals: ring-fencing retail operations and depositor preference to improve resolvability of retail entities.
- Caveats and complementary measures needed for resolvability:
  - Ring-fencing must be complemented by measures that improve loss-absorption capacity (capital and liquidity surcharges, contingent capital, debt subject to bail-in), recovery and resolution plans, and cross-border resolution arrangements.
- Bank levy design and recommendation:
  - The bank levy is a tax on banks based on consolidated accounts (global balance sheets), designed to target risky funding models and excluding tier 1 capital and stable deposits from the liability base.
  - Recommendation: the levy should be refined to reflect individual institutions’ riskiness and contributions to systemic risk (size, interconnectedness, substitutability) and variations in risk over time.

### Supervisory and regulatory gaps — main recommendations (high-level synthesis)
- Overall Financial Sector Oversight
  - Revise legal framework to clarify mandates and include a specific financial stability mandate for the prudential authorities (Tripartite). Priority: High. Timeframe: Immediate.
  - Amend legislation to allow regulatory power over holding companies of regulated entities (HMT). Priority: High. Timeframe: Near term.
  - Enhance resources for supervision of banks, insurers and securities firms based on the agreed supervisory operating model and the new macro-prudential overlay (Tripartite). Priority: High. Timeframe: Near term.
  - Establish a forum for governance and coordination among organizations in the new regulatory structure (HMT). Priority: High. Timeframe: Near term.
  - Enforce public disclosure by banks, insurance and securities firms, including publishing prudential returns as appropriate (FSA). Priority: High. Timeframe: Near term.
- Banking Oversight
  - Enhance supervision via detailed reviews of credit and market risk assessment, model replication reviews, better integration of specialist work, and enhanced peer analysis (FSA). Priority: High. Timeframe: Near term.
  - Adopt a proactive intervention framework with triggers for contacts and coordination actions; amend legislation as needed (FSA). Priority: Medium. Timeframe: Medium term.
  - Develop comprehensive plan to enhance prudential reporting and review data quality (FSA). Priority: High. Timeframe: Near term.
- Insurance Sector Oversight
  - Extend intrusive risk-based supervision to a wider range of insurers (FSA). Priority: High. Timeframe: Near term.
  - Increase frequency and number of randomly conducted “transaction examinations” for largest and some smaller insurers (FSA). Priority: Medium. Timeframe: Medium term.
- Securities Markets Oversight
  - Clarify in legislation that the remit of the conduct authority includes market integrity and transparency (HMT). Priority: High. Timeframe: Immediate.
  - Increase intensity of supervision with greater use of on-site examinations and thematic work to supplement top-down analysis (FSA). Priority: High. Timeframe: Medium term.
- Payments and Securities Systems Oversight
  - Ensure sufficient and reliable funding options for CCPs, including committed credit lines subject only to presentment (BoE, FSA). Priority: High. Timeframe: Near term.
  - Develop contingency plans for potential failure of a CCP (BoE, FSA). Priority: High. Timeframe: Near term.
  - Offer central bank settlement to CCPs classified as systemic institutions (BoE). Priority: Medium. Timeframe: Medium term.
  - Monitor concentration of banks’ payment and settlements activities closely (BoE, FSA). Priority: Medium. Timeframe: Near term.
  - Undertake a unified assessment of the RTGS infrastructure, including finality of transactions (BoE). Priority: High. Timeframe: Medium term.
- Crisis Management
  - Establish appropriate resolution tools and framework for potentially systemically important nonbank firms not covered by the Special Resolution Regime (Tripartite). Priority: Medium. Timeframe: Medium term.

### Transition risks, governance, and international coordination
- Transition to the new “three peak” regulatory structure (PRA, FPC, FCA) by end-2012 carries risk of diverting resources from enhanced supervision; additional supervisory resources and clear legislative mandates are critical.
- Home-host cooperation, cross-border crisis management, and international collaboration (including advocacy in CRD4 for stronger standards and macroprudential flexibility) are essential given the U.K.’s global role.
- Authorities should continue exercising leadership on cross-border issues; absence of progress could push toward more ring fencing and subsidiarization with efficiency and stability implications.

*Source: INTERNATIONAL MONETARY FUND. Financial System Stability Assessment Update — United Kingdom. July 11, 2011.*

### 2011. The views expressed in this document are those of the staff team and do not necessarily reflect

### INTERNATIONAL MONETARY FUND — UNITED KINGDOM — Financial System Stability Assessment Update

### Overview and context
- Assessment prepared by the Monetary and Capital Markets and European Departments; Approved by José Viñals and Antonio Borges; July 11, 2011.
- Two missions: January 12–February 1 and March 24–April 5, 2011.
- Team members included Robert Sheehy and Ceyla Pazarbasioglu (co-heads), Li Lian Ong (deputy), Jennifer Elliott, Andreas Jobst, Vanessa Le Leslé, Christine Sampic, Rodolfo Wehrhahn (IMF/MCM); Sean Kerr (IMF/LEG); Marta Ruiz Arranz (IMF/EUR); and external consultants Nikil Chande, Nick Le Pan, Tom Karp, Göran Lind, Antonio Pancorbo, Pierre-Yves Thoraval, and Shane Tregillis.
- Purpose: FSAP Update to assess the stability of the U.K. financial system as a whole and identify weaknesses in financial sector structure; not intended to cover institution-specific risks such as asset quality, operational or legal risks, or fraud.

### Key findings
- Decisive policy responses during the crisis stabilized the financial system, but vulnerabilities remain and recovery is not yet assured.
- The size and role of the U.K. financial system in global intermediation make its stability a global public good and necessitate effective implementation of reforms.
- U.K. banks have made progress in repairing balance sheets following the crisis, but the recovery process is not yet complete.
- Restructuring of the two large banks with government stakes is ongoing; rigorous follow-through is essential.
- Stress tests suggest adequate levels of capitalization under severe macroeconomic scenarios, with the caveat that lender forbearance may have masked the extent of risks given high indebtedness of the household and commercial real estate sectors.
- Risks from exposures to vulnerable European sovereigns seem manageable, but potential major spillovers to the private sector in those countries and to core European banks could lead to liquidity and solvency concerns.
- Liquidity positions have improved, but U.K. banks are vulnerable to sustained disruptions in funding markets.
- The new discount window facility and prepositioning of collateral are important for managing extreme stresses.

### Major systemic characteristics and vulnerabilities
- Aggregate balance sheet of the banking sector is about five times GDP.
- U.K. financial system has specific vulnerabilities: large, complex, and interconnected institutions; significant hosted foreign branches; substantial market-intermediation role internationally.
- Supervisory transition risk: moving to the “triple peak” model (microprudential, financial conduct, and macroprudential) risks diverting resources and attention from enhancing supervision while the sector is still in recovery mode.

### Stress testing and buffer implications
- Regulatory actions requiring capital and liquidity buffers are appropriate and necessary given system vulnerabilities.
- FSA has imposed stringent capital and liquidity regulations; approval of dividends and variable remuneration is linked to stress-test outcomes.
- Home-host coordination is needed to address liquidity needs in times of stress, especially monitoring liquidity of large foreign branches that have systemic relevance for the U.K. financial system.
- The report underscores the importance of prepositioned collateral and the discount window facility to facilitate quick access in extreme stress events.

### Supervisory and regulatory gaps
- Supervisory approach strengthened but further embedding and enhancement required:
  - Need for improved assessment of banks’ loan classification, impairment determination, and valuation practices.
  - Need for a proactive intervention framework and greater senior management engagement in supervision.
  - Plans to enhance supervision are welcome but will likely require additional skills and staff.
- Insurance supervision:
  - Insurers generally weathered the crisis better than banks.
  - FSA needs to monitor systemic risks from insurers engaging in “bank like” activities and their interconnections with banking.
  - Regulatory authority should have enforcement and resolution powers at the holding company level, complemented by checks and balances to avoid moral hazard.
- Securities and market infrastructure oversight:
  - Oversight of investment banking activities and core market infrastructure requires strengthening.
  - Central Counterparties (CCPs) must maintain robust prudential and risk-management standards and have contingency plans.
  - International cooperation is critical, especially for institutions hosted in the U.K. (branches of foreign bank entities).

### Progress on too-important-to-fail (TITF) and resolvability
- Progress made: strengthened regulatory ratios and introduction of a bank levy on wholesale funding.
- Independent Commission on Banking (ICB) proposals: ring-fencing retail operations and depositor preference will improve resolvability of the retail entity.
- Ring-fencing must be weighed against costs and does not necessarily improve resolvability of the whole entity unless complemented by:
  - measures that improve loss-absorption capacity (capital and liquidity surcharges, contingent capital, debt subject to bail-in),
  - recovery and resolution plans,
  - cross-border resolution arrangements.
- International collaboration and U.K. leadership on cross-border issues remain critical.

### Transparency and data disclosure
- The United Kingdom lags behind many countries in public disclosure standards for financial sector data.
- FSA should enforce publication of regular and comparable institution-level data for banks, insurance companies, and securities firms, including prudential returns as appropriate, to enable market discipline.

### Main recommendations (high-level synthesis from Table 1)
- Overall Financial Sector Oversight
  - Revise legal framework to clarify mandates and include a specific financial stability mandate for the prudential authorities (Tripartite). Priority: High. Timeframe: Immediate.
  - Amend legislation to allow regulatory power over holding companies of regulated entities (HMT). Priority: High. Timeframe: Near term.
  - Enhance resources for supervision of banks, insurers and securities firms based on the agreed supervisory operating model and the new macro-prudential overlay (Tripartite). Priority: High. Timeframe: Near term.
  - Establish a forum for governance and coordination among organizations in the new regulatory structure (HMT). Priority: High. Timeframe: Near term.
  - Enforce public disclosure by banks, insurance and securities firms, including publishing prudential returns as appropriate (FSA). Priority: High. Timeframe: Near term.
- Banking Oversight
  - Enhance supervision via detailed reviews of credit and market risk assessment, model replication reviews, better integration of specialist work, and enhanced peer analysis (FSA). Priority: High. Timeframe: Near term.
  - Adopt a proactive intervention framework with triggers for contacts and coordination actions; amend legislation as needed (FSA). Priority: Medium. Timeframe: Medium term.
  - Develop comprehensive plan to enhance prudential reporting and review data quality (FSA). Priority: High. Timeframe: Near term.
- Insurance Sector Oversight
  - Extend intrusive risk-based supervision to a wider range of insurers (FSA). Priority: High. Timeframe: Near term.
  - Increase frequency and number of randomly conducted “transaction examinations” for largest and some smaller insurers (FSA). Priority: Medium. Timeframe: Medium term.
- Securities Markets Oversight
  - Clarify in legislation that the remit of the conduct authority includes market integrity and transparency (HMT). Priority: High. Timeframe: Immediate.
  - Increase intensity of supervision with greater use of on-site examinations and thematic work to supplement top-down analysis (FSA). Priority: High. Timeframe: Medium term.
- Payments and Securities Systems Oversight
  - Ensure sufficient and reliable funding options for CCPs, including committed credit lines subject only to presentment (BoE, FSA). Priority: High. Timeframe: Near term.
  - Develop contingency plans for potential failure of a CCP (BoE, FSA). Priority: High. Timeframe: Near term.
  - Offer central bank settlement to CCPs classified as systemic institutions (BoE). Priority: Medium. Timeframe: Medium term.
  - Monitor concentration of banks’ payment and settlements activities closely (BoE, FSA). Priority: Medium. Timeframe: Near term.
  - Undertake a unified assessment of the RTGS infrastructure, including finality of transactions (BoE). Priority: High. Timeframe: Medium term.
- Crisis Management
  - Establish appropriate resolution tools and framework for potentially systemically important nonbank firms not covered by the Special Resolution Regime (Tripartite). Priority: Medium. Timeframe: Medium term.

### Implementation timing terminology used in recommendations
- “Immediate” is within one year.
- “Near-term” is 1–3 years.
- “Medium-term” is 3–5 years.

*Source: INTERNATIONAL MONETARY FUND. Financial System Stability Assessment Update — United Kingdom. July 11, 2011.*

### 1.      The United Kingdom is both home and host to large domestic and international

### 1.      The United Kingdom is both home and host to large domestic and international financial institutions

### System overview and scale
- International foreign bank subsidiaries and branches hold half of U.K. banking assets, while U.K.-owned banks have over half of their assets outside the country.
- Overall, these institutions hold about £11 trillion of assets in the United Kingdom and globally, equal to about nine times GDP, of which U.K. banks account for assets equivalent to five times GDP.
- The U.K. insurance industry is the third largest in the world, after the United States and Japan.
- The United Kingdom is an important host to the global funds industry and to derivatives business and plays a significant role in cross-border trading and clearing.
- Implication: U.K. financial institutions and market infrastructure are widely exposed to stresses originating elsewhere and act as conduits of shocks domestically and globally.

### Evolution of the U.K. banking system before the crisis
- Banks became larger, highly complex and leveraged, and relied increasingly on short-term wholesale funding.
- The trading book displaced loans as the most important balance sheet asset, reducing the importance of net interest income.
- Financial activity concentrated in a small set of institutions highly interconnected with other developed financial systems.
- Actual leverage was greater than was apparent because regulatory requirements did not capture key risks.

### Crisis revelations and regulatory shortcomings
- Heavy reliance on market discipline and the assumption of wide dispersion of risks proved inadequate.
- Substantial risks posed by large, complex, and interconnected financial institutions crystallized.
- Oversight framework weaknesses enabled expansion of banks' reach and complexity domestically and internationally.

### Report focus
- Crisis implications, current soundness of the financial system, and potential risks and vulnerabilities.
- Necessary improvements to the financial sector oversight framework and addressing the too-important-to-fail (TITF) problem.

### U.K. global market shares in financial services (as at June 2011) — selected highlights from Table 2
- International banking lending: 18 (percent) — Global Rank 1
- International banking borrowing: 21 (percent) — Global Rank 1
- European activities: 50 (percent) — Global Rank 1
- Global insurance premia: $309 billion — Global Rank 3 global and 1 Europe
- Pension fund assets: 9 (percent) — Global Rank 1 (Europe)
- Global foreign equity trading: 19 (percent) — Global Rank 2
- Number of international IPOs: 6 IPOs with 12 percent market share (comparators: 17 IPOs in Hong Kong; 12 in the United States)
- Turnover on the London Stock Exchange (LSE): 4 (percent) of global turnover / 7 (percent) of global equity market capitalization
- Euro-bonds secondary market: 70 (percent) of trading by bookrunners in London
- Securitization issuance: 6 (percent) — Global Rank 2 (behind the United States, 75)
- Fund management (source of funds): 9 (percent) — Global Rank 2 (behind the United States, 50)
- Hedge fund assets: 19 (percent) — Global Rank 2 (behind the United States, 68)
- Private equity investment value: 13 (percent) — Global Rank 2 (behind the United States, 36)
- OTC interest rate derivatives turnover: 46 (percent) — Global Rank 1
- Foreign exchange turnover: 37 (percent) — Global Rank 1
- Marine insurance premium: 21 (percent) — London is the leading center
- Emission allowances: The United Kingdom bought 37 (percent) of the Clean Development Mechanism (CDM). London is a leading center for energy brokers and carbon funds; the European Climate Exchange (ECX) in London is dominant in trading EU ETS futures and options.
- Islamic finance: Largest number of “sharia compliant” banks (22), exchange-traded funds (7), law firms (20) among Western countries; issued 31 sukuk on LSE.

### Bank lending and funding dynamics (summary of Figure 1)
- Lending to commercial and real estate sectors increased rapidly in the run-up to the crisis.
- Between 2005 and 2008, growth in lending remained relatively stable while growth in deposits slowed.
- The reliance on wholesale funding increased; debt issuance by major U.K. banks and building societies rose across unsecured, ABS, and covered bonds instruments.
- Concurrent increases in leveraged positions were not adequately captured in the data:
  - Financial leverage measured as ratio of unweighted assets to equity rose (chart reference).
  - Estimate of riskiness measured as ratio of RWAs to unweighted assets (in percent) changed (chart reference).
- Trends have partially reversed, but funding over the next few years remains a challenge; maturity profile of debt issued by major U.K. banks and building societies shows substantial unsecured and ABS issuance maturing through 2017 and beyond.
- U.K. Commercial Real Estate (CRE) debt maturity profile indicates concentration of maturities that could affect banks' ability or willingness to roll over CRE debt, which accounts for half of total loans to non-financial corporates.

### Crisis impact across institutions
- The crisis impact was highly polarized: some institutions emerged virtually unscathed while others (including two of the six largest banks and several building societies) required extensive official support.
- Differentiation reflected disparate business models and pre-crisis exposures, notably wide differences in loan-to-deposit ratios and reliance on wholesale funding.
- Insurance sector fared relatively well due to ahead-of-Solvency II risk-sensitive capital requirements and post-2003 adjustments; industry remained largely resilient despite life sector reverberations.
- Interbank and foreign exchange markets came under severe pressure, necessitating policy interventions; U.K. banks’ access to these markets depended on perceived counterparty risk and market functioning.

### Policy interventions and fiscal exposure
- Authorities introduced liquidity support and other measures including:
  - Special Liquidity Scheme (SLS) — allows banks to swap high-quality but illiquid mortgage-backed and other securities for U.K. treasury bills.
  - Credit Guarantee Scheme (CGS) — provides additional funding support.
  - Asset Protection Scheme (APS) — against future credit losses.
  - Asset Purchase Facility (APF) — to purchase high-quality assets from a broad range of corporates.
- Banks are ahead of schedule in repaying official liquidity support, but the government retains significant stakes after injecting a cumulative £70 billion of capital into several banks (including taking ownership of 41 percent and 83 percent of the total share capital of LBG and RBS, respectively).
- Net direct cost of fiscal support to the U.K. financial sector relative to GDP is one of the largest in the EU, after Ireland and Germany (Table 4).

### Soundness of the financial system after the crisis
- U.K. banks have progressed in repairing balance sheets via write-offs, capital-raising, asset sales, reduced lending growth, and retrenchment of cross-border exposures.
- Combined total assets of the seven major U.K. banks fell 20 percent from 2008 to 2010; risk-weighted assets fell by 7 percent.
- Deposits have grown faster than loans since 2009, reducing the funding gap, and use of wholesale funding has been significantly reduced.
- Core Tier 1 ratios of all the major U.K. banks are in double-digit territory.
- Some loan portfolios remain fragile and further provisioning is necessary:
  - Profitability in 2010 was largely attributable to significant drop in provisions.
  - Coverage ratios trending down close to 50 percent on average for the sector, with wide dispersion across banks.
- Lender forbearance and poor data quality may mask true extent of risks, especially in real estate; FSA conducted a thematic review and introduced formal guidance on reporting and classification of restructured loans and provisioning.
- Funding needs amount to about £400 billion through end 2012, including expiration of official funding facilities.
- Factors likely to put upward pressure on wholesale funding costs:
  - Rollover of cheaper debt into more expensive new debt amid elevated sovereign issuance.
  - Regulatory uncertainties regarding status of senior secured debt holders in a “bail in” and possible structural changes from ICB deliberations; overseas regulatory changes limiting traditional funding sources (e.g., U.S. money market mutual funds).
  - Potential changes in institutional investor preferences (e.g., pressure on insurance companies and pension funds to shorten durations) due to expected increases in sovereign yields and regulatory changes such as Solvency II.

### Condition of large government-stake banks
- RBS and LBG are in the third year of a five-year restructuring plan and are ahead of targets set by U.K. authorities and the European Commission state aid rules.
- Combined, these two banks shed a combined £235 billion of assets since 2008 and repaid a substantial amount of official funding; they reduced reliance on wholesale funding and lengthened liability duration.
- Remaining vulnerabilities include significant internal execution risks and sensitivity to disruptions that could derail asset reductions or wholesale funding.

### Insurance sector post-crisis
- Financial condition generally improved; life insurance activity recovered to pre-crisis production levels.
- Nonlife insurance reporting a slight premium decrease due to the economic downturn.
- About 10 percent of life insurers and 25 percent of nonlife insurers remain under regulatory observation, with Pillar II solvency ratios less than 130 percent.

### Macro-financial outlook and central scenario (IMF projections)
- Central scenario: moderate economic recovery and gradual return to the inflation target.
- Expected headwinds: soft housing market, fiscal consolidation, household and bank balance sheet repair.
- Real GDP growth expected to accelerate gradually to around 2.5 percent over the medium term.
- Inflation projected to remain above 4 percent for most of 2011 due to commodity price and tax hikes, and return to the 2 percent target by end-2012 as transitory factors dissipate.
- Current policy mix of tight fiscal and accommodative monetary policies seen as appropriate; central scenario incorporates gradual tightening of monetary policy with resumption of growth.

### Main macroeconomic and financial risks to the central scenario
- Sluggish growth: balance sheet repair by households, banks, and public sector could weigh more heavily than expected.
- Interest rate increases: higher-than-expected inflation could force faster policy rate hikes; low-income households are sensitive to real interest rate and income shocks.
- Reduced fiscal space: the crisis led to a sharp increase in government debt, limiting capacity to cope with adverse shocks.
- A new sharp downturn in the residential housing market: price-to-income ratio remains 30 percent above its historical average (OECD data), leaving household balance sheets vulnerable.
- Financial distress in the CRE sector: prices remain substantially below peak, many borrowers have negative equity and breach LTV covenants; macro shocks would disproportionately affect CRE.
- Spillovers from external financial market shocks: sustained disruptions in wholesale funding markets could create funding shortages.
- Cross-border exposures: direct and indirect exposures to the private and public sector in Greece, Ireland, and Portugal amount to $173 billion (approximately £111 billion; 2.8 percent of total assets), with $135 billion (£86 billion) to Ireland; exposures to Spain amount to $107 billion (£69 billion).
  - Major U.K. banks’ claims on Ireland and Spain (primarily to the nonbank private sector) are equivalent to about 50 percent of their Core Tier 1 capital (split evenly between the two countries).
  - Lending to Italy accounts for about 8.5 percent of Core Tier 1 capital.
- Depending on geographic footprint, banks are exposed to risks in the Eurozone, Asia, and Latin America; shocks to banks in core European countries could affect U.K. banks due to substantial interbank exposures.

*Source: IMF staff report (text and tables/figures as provided).*

### 18.      The analysis of banking sector conditions and stress tests aim to capture the most

### _cr11222 - 18.      The analysis of banking sector conditions and stress tests aim to capture the most

### Overview
- The analysis aims to capture the most salient risks to the U.K. banking system.
- Solvency stress tests were conducted on the major U.K. banks against the Basel III hurdle rates.
- Liquidity stress tests were undertaken for a larger set of institutions, including foreign subsidiaries of retail and investment banks as well as a broader group of building societies, incorporating quasi-Basel III measures.
- The FSA Interim Capital Regime requirements are also discussed in the source material.

### Key findings: solvency
- Banks’ solid capital buffers have reduced solvency concerns to a low-probability confluence of adverse macroeconomic developments.
- Substantial recapitalization of the U.K. banking sector, including by the state, and de-risking of balance sheets have been critical in boosting solvency.
- Lender forbearance may have masked the extent of credit risk in some institutions; the BoE Financial Stability Report (June 2011) estimates, as an upper bound, that 12 percent of U.K. residential mortgages could be receiving some kind of forbearance, while 12 percent of commercial property loans were in breach of financial covenant as at end-2010, but had not been declared in default.
- Aggregate losses from exposures to sovereign and bank debt are estimated at around 0.2 percent of GDP (£3.5 billion) over the five-year horizon under the baseline/stress assessments, and are identified as the greater risk unless stresses lead to severe disruptions in wholesale funding markets.

### Key findings: liquidity
- The banking system, in aggregate, has adequate liquidity buffers to withstand short-lived stresses.
- The overall liquidity shortfall remains contained even in a very severe 30-day stress test.
- The system remains vulnerable to sustained disruptions in funding markets, particularly if coupled with persistent declines in asset values.
- Funding sources are not sufficiently stable; banks, including major ones, have mismatched assets and liabilities at six-month maturities and longer.
- Substantial funding needs and interconnectedness with the global financial system amplify the risks.
- Policy measures noted as important: the new discount window facility and pre-positioning of collateral to facilitate quick use of the facility.

### Stress test design and scenarios
- Sample for solvency stress tests: seven major U.K. banks that account for 71 percent of the assets in the system, 80 percent of loans, and 90 percent of retail deposits.
- Stress-test horizon: 2011–2015 using end-2010 financial data.
- Baseline projections: consistent with the IMF’s World Economic Outlook.
- Adverse scenarios:
  - (i) “DD mild”: a “double-dip” recession scenario of one standard deviation of real GDP growth from the baseline growth trend over the first two years of a five-year horizon with positive adjustment dynamics during the subsequent three years.
  - (ii) “DD severe”: a double-dip recession scenario of two standard deviations of the same.
  - (iii) “SG”: a “prolonged slow growth” scenario with a cumulative negative deviation of over 7 percentage points from baseline growth, or an average annual growth rate of almost 0.9 percent over five years.
- Related key macro and financial variables are projected using the FSA’s macro models.

### Stress test approaches and results
- Approaches used:
  - Bottom-up (BU) solvency stress tests (core element).
  - Top-down (TD) tests, including the Bank of England’s Risk Assessment Model for Systemic Institutions (RAMSI).
  - FSAP’s top-down Systemic Contingent Claims Analysis (Systemic CCA).
- BU findings:
  - Distribution of Core Tier 1 ratios for individual banks remain over the regulatory minima at any time over the 2011–15 period, per the Basel III schedule.
  - Weighted-average capital ratios comfortably exceed the regulatory minima.
  - Average leverage ratio remains over 4.5 percent.
  - Capital buffers absorb credit losses from a sharp recession, with retail-focused banks hardest hit.
  - Buffers are sufficient to absorb market-risk charges due to exchange rate shocks and higher risk weights on securitization and counterparty risk exposures.
  - Exposures to sovereign and bank debt do not seem to represent a major source of risk in BU tests (aggregate losses of around 0.2 percent of GDP (£3.5 billion) over five years).
- TD (RAMSI) findings:
  - Show similar broad trends to BU under each scenario.
  - In contrast to BU, shocks to sovereign and bank debt can have greater effect on capital adequacy, up to 0.9 percentage points on core Tier 1 capital, which nonetheless remains well above the relevant hurdle rates.
- Systemic CCA findings:
  - Under median baseline conditions, the impact on market-implied capital from declining profitability amounts to an average 0.03 percent of 2010 GDP (£0.4 billion) between 2011–15.
  - Under the severe double-dip recession scenario, market-implied capital levels could decline by up to an average 0.12 percent of 2010 GDP (£1.8 billion) over the next five years.
  - Under a “tail of the tail risk” scenario (0.1 percent probability event), current market-implied capital levels over the five-year horizon could potentially be eroded by between 2.7–3.4 percent of 2010 GDP (£37–£50 billion) on average.
  - Under this extreme scenario, an average capital shortfall of between 1.3–1.6 percent of 2010 GDP could materialize relative to the Basel III Tier 1 hurdle rates (and 1.6–1.8 percent of 2010 GDP relative to the FSA Interim Capital Regime Tier 1 requirements).

### Policy implications and supervisory focus
- Findings support the supervisory focus in the United Kingdom to require banks to build up adequate capital and liquidity buffers.
- Supervisors should remain vigilant regarding the quality of insurers’ investment portfolios; under Solvency II, risk weightings may encourage asset allocation shifts and Pillar II requirements should be applied if necessary.
- Given vulnerabilities to sustained wholesale funding disruptions and funding mismatches at six-month maturities and longer, continued emphasis on improving funding stability is warranted (see discussion on banks’ Net Stable Funding Ratio in the source).
- The new discount window facility and pre-positioning of collateral are important operational measures to manage extreme stress events.

*Source: IMF.*

### 23.      An important caveat to the haircuts applied to banks’ debt holdings of all non-AAA

### _cr11222 - 23.      An important caveat to the haircuts applied to banks’ debt holdings of all non-AAA

### Caveat on haircuts for non-AAA sovereign and bank debt
- The severity and dynamics of haircuts applied to banks’ debt holdings of all non-AAA rated sovereigns and banks are informed by the forward term structure of 5-year sovereign credit default swap (CDS) spreads as at end-2010.
- Since end-2010, sovereign CDS spreads for select debtor countries of U.K. banks have increased commensurately with rising risks to the economic outlook (Figure 12), which are not reflected in the haircuts given the cut-off point for the stress tests.
- Implication: U.K. banks could be affected by additional losses—well beyond the prescribed haircuts—in the event that shocks lead to extreme stresses in the private sector in those countries or in core European banks to which they have large exposures.

### Liquidity tests: scope, methodology, and quasi-Basel III measures
- Sample: 16 institutions—the 7 major banks, selected foreign investment banks and building societies.
- Tests applied:
  - Two implied cash-flow tests (based on QIS-6 assumptions): gradual outflow of funding over five consecutive days and over a 30-day time horizon (reverse stress test rationale).
  - Quasi-measures interpreting proposed Basel III liquidity risk measures:
    - Liquidity Coverage Ratio (LCR): sufficiency of high quality liquid assets to meet up to 30 days of institution-specific and systemic stress.
    - Net Stable Funding Ratio (NSFR): insights into quality of liquid assets and maturity profile and stability of funding.
- Results summary (Tables 8 and 9):
  - 5-day (short-lived) test:
    - Banks have sufficient holdings of highly-liquid assets to offset outflows during five-day moderately severe cash-flow shocks, assuming deposits remain stable.
    - In the case of deposit outflows, the aggregate shortfall would equal 0.03 percent of assets for the sample of 16 banks.
    - Retail deposits are highlighted as a key source of funding; intra-group funding does not appear to play an important role for the foreign subsidiaries in the sample.
  - 30-day (very severe) test:
    - The overall liquidity shortfall remains largely contained even when deposit outflows and run-off of liabilities are doubled.
    - The FSAP’s assumed cumulative outflows of more than 40 percent of both wholesale and deposit funding under this test exceed current supervisory requirements and are greater than those experienced by Northern Rock during the crisis.
    - Given severity, the test functions as a reverse stress test to identify institutions’ “point of failure.”
    - Aggregate shortfall: about 6 percent of assets for 14 out of the sample of 16 banks, with significant impact concentrated in a few institutions.
  - Quasi-NSFR (maturity mismatch) findings:
    - Banks accounting for more than 95 percent of liquid assets do not have sufficient stable funding (i.e., NSFR ratio of less than unity).
    - In the 6–12 months maturity bucket, assets that are mismatched amount to about 70 percent of the total assets of all banks in the sample.
    - In the 12-plus months maturity bucket, the proportion goes up to around 90 percent.
    - For some banks, this vulnerability is amplified by reliance on wholesale funding.

### Liquidity test quantitative results (selected exact figures from Tables 8 and 9)
- 5-Day Test (All firms (16), Original assumptions):
  - Number of Banks below Defined Benchmark: 1
  - Cumulative Withdrawal of Deposits 1/: 0.03 (In percent of total deposits)
  - Cumulative Loss of Wholesale Funding 1/: 0.03 (In percent of total wholesale funding)
  - Total Shortfall (In percent of total sample assets included in the liquidity tests): 0.03
  - Average per Bank in Shortfall: 18.0 (In percent of total deposits); 25.5 (In percent of total wholesale funding)
- 30-Day Test (All firms (16), Original assumptions):
  - Number of Banks below Defined Benchmark: 14
  - Cumulative Withdrawal of Deposits 1/: 5.77 (In percent of total deposits)
  - Cumulative Loss of Wholesale Funding 1/: 0.41 (In percent of total wholesale funding)
  - Total Shortfall (In percent of total sample assets included in the liquidity tests): 5.77
  - Average per Bank in Shortfall: 43.8 (In percent of total deposits); 40.9 (In percent of total wholesale funding)
- 30-Day Test (Largest firms (7), Original assumptions):
  - Number of Banks below Defined Benchmark: 7
  - Cumulative Withdrawal of Deposits 1/: 6.64 (In percent of total deposits)
  - Cumulative Loss of Wholesale Funding 1/: 0.95 (In percent of total wholesale funding)
  - Total Shortfall: 6.64
  - Average per Bank in Shortfall: 44.6 (In percent of total deposits); 41.5 (In percent of total wholesale funding)
- Alternative assumptions reported in Table 8 include:
  - Alternative 1: No withdrawal of retail deposits (results for All firms (16): 0 banks below benchmark in 5-day test; 4 banks below benchmark in 30-day test; 30-day Total Shortfall: 0.41).
  - Alternative 2: Availability of intra-group funding (results for All firms (16): 1 bank below benchmark in 5-day test; 9 banks below benchmark in 30-day test; 30-day Total Shortfall: 2.22).
- Quasi-LCR and Quasi-NSFR outcomes (Table 9, selected ranges and tenor mismatches):
  - Quasi-LCR (FSAP Assumptions) ratio distribution for All firms (16): 11.4 (<0.25), 25.4 (0.25–0.50), 50.9 (0.50–0.75), 9.9 (0.75–1.00), 2.3 (>1.00).
  - Quasi-LCR (FSAP Assumptions) ratio distribution for Largest firms (7): 28.3 (<0.25), 58.2 (0.25–0.50), 19.0 (0.50–0.75), 6.3 (0.75–1.00), 0.0 (>1.00).
  - Quasi-NSFR (FSAP Assumptions) maturity tenor (All firms (16)): less than 1 month: 11.6; within 1–3 months: 29.1; within 3–6 months: 22.3; between 6–12 months: 68.9; after 12 months: 89.2 (all figures are In percent of total sample assets included in the liquidity tests).
  - Quasi-NSFR (Largest firms (7)) maturity tenor highlights: after 12 months: 92.7.

### Insurance stress testing: FSA practice and 2010 exercise
- Quality: The quality of insurance stress testing carried out by the FSA is high and consistent with market sophistication.
- ICA regime: Individual Capital Assessment (ICA) has required firm-level stress testing since 2005; industry-wide stress testing began in 2008.
- FSA 2010 insurance stress tests:
  - Target: six largest insurance groups based on end-December 2009 balance sheets.
  - Part of Core Prudential Program Insurance (CPPi); included a series of stress scenarios, including extreme tail-risk scenarios, to test regulatory surplus capital and group liquidity.
  - Outcome: The firms passed all severe tests at group and solo levels.
  - Risk drivers for life insurers: credit risk remains the largest driver of risks to solvency; market and property risks are also significant.
  - Supervisory recommendations stemming from results: changes to investment portfolios and strengthening of interest rate exposure management.
  - Actions: Based on extreme tests, a series of actions were imposed on firms to further improve their resilience beyond regulatory requirements.

### Stress testing scenarios, market-implied losses, and haircuts interaction
- Scenarios used across exercises: Baseline, Prolonged Slow Growth (SG), IMF mild double dip recession (DD mild; European Banking Authority 2011 adverse scenario), IMF severe double dip recession (DD severe; FSA 2011 anchor scenario).
- Figures and tables summarize distribution of Core Tier 1 ratios (2011–15), weighted-average core Tier 1 ratios (BU and RAMSI), and Systemic CCA estimates of market-implied joint capital losses and shortfalls (Table 7 and Figure 11).
- Table 7 and related notes:
  - Forecast period: 2011–15.
  - The estimations show joint capital requirements for maintaining market value of Tier 1 capital, with a gradual increase of the hurdle rate from 2013 onwards consistent with the Basel III proposal as at December 2010.
  - IMF satellite model uses macroeconomic variables (short-term interest rates, long-term interest rates, real GDP growth, and unemployment) and bank-specific income elements (operating profit, net interest income) to project expected losses generated by the CCA methodology.
  - Alternative satellite model integrates projected operating profit based on RAMSI model results; treatment of losses from haircuts on holdings of sovereign and bank debt differs between satellite model approaches (one adds these losses each year; the alternative subtracts them from projected operating profit each quarter).
  - Tail risk defined: 95th percentile represents average probability density beyond the 95th percentile as a threshold level.
- Table 7 numeric excerpts (average over time period, in billions of pound sterling unless stated otherwise; and in percent of GDP rows):
  - Forecast Period 2011–15 rows include sequences such as: 0.13 0.20 1.35 0.67 0.14 0.26 1.43 1.07 0.43 0.62 0.98 0.71 0.48 1.04 1.77 0.98 (appearing under Baseline/DD Mild/DD Severe/SG groupings).
  - Market-implied joint potential capital loss and resulting shortfall rows show multi-year aggregated numbers such as: 4.91 6.42 35.08 18.55 5.18 8.01 37.2 129.02 12.29 17.84 28.04 19.99 13.71 29.61 49.86 27.32 (presented as 2011–15 totals and in percent of GDP: 0.34 0.44 2.41 1.28 0.36 0.55 2.56 2.00 0.85 1.23 1.93 1.38 0.94 2.04 3.43 1.88).
  - Additional rows include annual and scenario-specific numeric sequences for 2011, 2012, 2013, 2014, 2015 with zero and non-zero values; exact reproduction requires reference to Table 7 itself for full layout.
- Interaction of haircuts:
  - Table 7 distinguishes estimates “Without Sovereign and Bank Debt Haircuts” and “With Sovereign and Bank Debt Haircuts,” and presents results for Median and 95 Percent (Tail Risk) across satellite and structural model approaches.
  - Haircuts on sovereign and bank debt can materially affect market-implied joint potential capital losses and shortfalls; the timing of the haircut cut-off (December 31, 2010) means later CDS spread widening is not captured in haircut calculations (see Figure 12).

### Selected market indicator: CDS spreads and stress test cut-off
- Figure 12 (Selected EU Countries: CDS Spreads) shows Greece, Ireland, Italy, Portugal, Spain CDS spread levels in basis points over Jan-10 to Jul-11 timeline.
- Stress test cut-off date: December 31, 2010.

### Toward a more effective oversight framework: institutional changes
- Rationale: The systemic importance, size, and complexity of the U.K. financial markets necessitate the highest quality regulatory and supervisory framework; domestic and global shocks transmit through the United Kingdom and may be amplified in transmission.
- Government decision (post-crisis) to overhaul domestic institutional framework; the existing tripartite regime will be dismantled and a “three peak” structure to be put in place by end-2012:
  - A new Prudential Regulation Authority (PRA), a subsidiary of the BoE, will carry out prudential regulation of financial firms, including banks, investment banks, building societies, and insurance companies;
  - An independent Financial Policy Committee (FPC) will be established at the BoE, with responsibility for regulation of stability of the financial system as a whole;
  - A new Financial Conduct Authority (FCA) will regulate the conduct of authorized financial firms providing services to consumers, ensure good conduct of business in U.K. retail and wholesale financial services, market regulation, and prudential regulation of smaller entities.

*IMF staff report: U.K. FSAP Update (selected excerpts as provided).*

### 29.      A key risk is that the transition to the new framework diverts resources from

### 29.      A key risk is that the transition to the new framework diverts resources from

### Risks from transition and legislative clarity
- A key risk is that the transition to the new framework diverts resources from efforts to enhance supervision of the financial sector, which is still in recovery mode.
- It is critical to build on progress made on strengthening supervision of the banking and insurance sector; this may require additional supervisory resources.
- The reform proposal to give explicit and clear mandate for financial stability to the prudential regulator is welcome.
- Concern: the broad remit of the new conduct authority may dilute the focus on market regulation and supervision, and prudential supervision of smaller entities, risking recreation of conditions that broadened the FSA’s objectives and diluted focus in the lead-up to the crisis.
- Recommendation: explicit clarity in legislation is needed.

### Governance arrangements, coordination, and crisis management
- Concern about challenges in implementing new governance arrangements to achieve desired results.
- While proposals include various cooperation and coordination mechanisms, experience suggests the need for one forum for formal and/or informal relationship building, cooperation, and coordination among authorities.
- These relationships are necessary for effective governance of the framework.
- There is no formal crisis management committee established in legislation, but coordination mechanisms are in place.
- A clear locus for all regulatory agencies to interact might assist the United Kingdom in interacting effectively with the new European Financial Stability Board (EFSB) and with the European Supervisory Authorities (ESAs).

### Macroprudential framework and the FPC
- Establishment of the FPC is an important step in developing mechanisms to mitigate systemic risk.
- For the FPC to be credible:
  - It will be important to set realistic expectations of what macroprudential regulation can achieve, especially in its early stages of implementation.
  - A range of macroprudential tools should be considered, given uncertainties regarding their effects and the nature of future risks.

### Dealing with Too-Important-to-Fail (TITF) and the international dimension
- Progress made on TITF, but more needs to be done:
  - Regulatory ratios have been strengthened, and a bank levy on wholesale funding has been introduced.
  - Ring fencing of retail operations (a form of retail subsidiarization) and establishment of depositor preference, as proposed by the Independent Commission on Banking, should help improve resolvability of the retail entity.
- Caveats on ring fencing:
  - Must be weighed against costs and does not necessarily improve resolvability of the whole entity unless complemented by measures that improve loss-absorption capacity (capital and liquidity surcharges, contingent capital, debt subject to bail-in), recovery and resolution plans, and cross-border resolution arrangements.
- International collaboration is critical; U.K. authorities should continue exercising leadership.
- If progress is not achieved, there will be a strong push toward more ring fencing and stand-alone subsidiarization, with potential efficiency and financial stability implications.

### Central Counter Parties (CCPs)
- CCPs enhance transparency and simplify counterparty exposures through multilateral netting and stand between counterparties, but they centralize and concentrate counterparty credit risk.
- Vital requirements for CCPs:
  - Maintain robust prudential and risk-management standards, including financial soundness requirements for access by their members, initial and variation margining, and levying contributions to a default fund.
  - Have a clear ex-ante framework and contingency plans, including the role of the surviving clearing members, to deal with implications of their failure.
  - Cross-border coordination is required, given their global nature, to avoid regulatory arbitrage and mitigate systemic risk and adverse spillovers across countries.

### Oversight of cross-border institutions and home-host cooperation
- U.K. powers vary depending on whether incoming institutions are branches or subsidiaries and whether the parent entity is in the EU or not:
  - Strong powers over subsidiaries.
  - Very limited powers (liquidity supervision only) in relation to EU branches; cannot prevent an incoming EU branch from establishing itself.
- The United Kingdom is a major home-state jurisdiction; many host jurisdictions have U.K. firms playing a systemic role.
- Gaps must be addressed through international cooperation, in particular across key financial centers.
- Needs:
  - Better collaboration between home and host authorities, including joint inspections and decision-making processes.
  - Enhanced sharing of information using both formalized channels such as colleges and well-developed bilateral contacts.
- Important unresolved cross-border crisis management and resolution issues include burden sharing and harmonizing legal frameworks.

### Investment banking oversight
- Investment banking is a particular challenge to cross-border oversight due to the international nature of wholesale and trading activities.
- Without intensive supervision of investment bank risk taking, domestic and global financial stability cannot be assured.
- The U.K. is one of the major international markets; with cross-border coordination, authorities are well placed to have oversight of investment banking activities to avoid overlooking developing risks in wholesale markets.

### International regulatory reform advocacy (CRD4 and macroprudential flexibility)
- U.K. authorities should continue to work toward an ambitious international package of regulatory reform.
- Authorities advocate for European legislation under the EU Capital Requirements Directive (CRD4) that enables:
  - (i) establishment of strong standards that exceed the Basel III minima, including by setting ambitiously high capital requirements together with significantly topped-up capital demands on systemically important financial institutions; and
  - (ii) flexibility for national authorities to introduce macroprudential tools, including adjusting capital and liquidity requirements or varying risk weights to address emerging financial and systemic risks.
- Collaboration with other macroprudential bodies will be important to ensure home-host coordination and reciprocity where appropriate.

### Improving the supervision of banks
- Crisis revealed serious deficiencies in risk measurement and supervisors’ ability to identify and rectify those deficiencies.
- Following the Turner Report, the FSA embarked on a program of supervisory enhancement, articulated as the “intensive and intrusive” approach and “close and continuous supervision” for the larger banks.
- The supervisory framework was assessed according to the revised Core Principles for Banking Supervision (2006), important because:
  - (i) revised principles have heightened focus on risk management and its practice by supervised institutions, and its assessment by the supervisory authority; and
  - (ii) standards are evaluated in the context of a financial system’s sophistication and complexity vis-à-vis the capacity and resources for adequate oversight.

### Supervisory process shortcomings and programs
- Authorities need to address shortcomings in supervisory processes: clarifying the prudential mandate, improving data quality, supervisory approach, techniques, and reporting.
- The Supervisory Enhancement Program (SEP) and the Core Prudential Program (CPP) have been put in place by the FSA, but:
  - Insufficient time for these programs to become adequately embedded.
  - Need for more detailed proactive verification than currently planned, better integration of specialist work into supervision, and more thematic peer analysis.
- Efforts should focus on identifying actual or potential risks and addressing risk-management deficiencies.

### Enforcement at holding company level
- Recommendation: regulatory authority should be provided with enforcement powers at the holding company level.
- Current FSA powers target regulated entities within the consolidated group; FSA can only impose consolidated obligations by acting through U.K.-regulated entities, which may not be effective when those entities are small relative to non-U.K.-regulated entities in the group.
- Legislation should be amended to provide holding company level enforcement powers.

### Capital, liquidity, and stress testing
- The FSA has been effective in enhancing the quantity and quality of banks’ capital.
- Capital rules are compliant with Basel and European requirements, including Basel III trading book capital charges, according to the agreed gradual phase-in schedule, to balance potential adverse implications on lending.
- FSA promulgated an Interim Capital Regime starting in 2009, based on capital expectations in normal and stressed conditions, ensuring U.K. banks are well placed to meet Basel III capital requirements; approval of dividends and variable remuneration is linked to stress tests.
- Robust stress-testing for major banks allows the FSA to set further capital buffers for major banks, above normal individual capital guidance.
- Banks are operating with material cushions above guidance and buffers that appear able to withstand severe shocks as prescribed in the FSAP stress tests.
- FSA recently introduced formal guidance regarding reporting, classification, and provisioning for loans subject to lender forbearance.

### Liquidity supervision and branches
- FSA has appropriately required banks to build up liquidity buffers; liquidity supervision of branches should be improved.
- Extensive monitoring, stress testing, and assessment of liquidity positions, including setting individual bank liquidity guidance, are in place and will be further enhanced.
- Liquidity positions of major banks have improved.
- Plan to extend detailed assessments to a wider range of high-impact banks needs to proceed expeditiously.
- FSA does not collect sufficiently detailed liquidity information on large foreign branches that may have systemic relevance for the U.K. financial system.
- FSA applied liquidity stress tests to foreign banks’ group data before granting “whole firm modifications,” whereby it delegated responsibility for liquidity supervision over foreign branches located in the United Kingdom, even though it has powers under EU rules to do so.
- As a result, FSA does not have specific information on activities of U.K. branches of foreign banks, e.g., on rehypothecation, an area in which foreign branches dominate.

### Home-host information sharing and supervisory resources
- Achieving highest standards on home-host relationships is paramount given the U.K.’s central role.
- Appropriate legal authority to preserve confidentiality is in place; need to improve information sharing between the United Kingdom and other countries on both home and host basis.
- Additional supervisory resources—a combination of enhanced skills and additional persons—may be needed.
- Resources in supervision have been increased, as have specialist support resources in various risk areas.
- Authorities need to agree on a supervisory operating model and the extent of resource requirements for the new macro-prudential overlay to determine further resource needs.

### Staged intervention scheme and disclosure
- Plans to introduce a staged intervention scheme are welcome:
  - Scheme will include indicators which, when triggered, lead to gradually more-intrusive actions by the FSA.
  - Scheme should include an appropriate degree of discretion while ensuring appropriate action is taken well before insolvency.
  - Should include triggers for contacts and coordination actions with other authorities, including the resolution authority and the Financial Services Compensation Scheme (FSCS).
- The United Kingdom lags many other countries in standards for public disclosure of bank data.
  - Such disclosures are important for enabling market discipline.
  - Recommendation: FSA should enhance publication of regular and comparable data on a bank-by-bank basis, including data from prudential returns, whenever appropriate.

### Strengthening insurance supervision
- New intrusive risk-based approach to supervision by the FSA is in early stages; should be extended proportionately to a wider range of insurers.
- Greater use of in-depth analysis should be applied to general insurers.
- More frequent transaction examinations (underwriting, reinsurance, claims, investments) for both largest and some smaller insurers on a random basis can help reveal problems.
- Implementation of Solvency II, on target for 2013, may necessitate additional resources:
  - Approval of internal models is crucial and will require sufficient resources and expertise to assess and verify models and adequacy of resulting capital levels.
- Need to improve scope and frequency of prudential data and its disclosure:
  - Published standard return information has not been substantially reviewed for a number of years in anticipation of Solvency II, which is on target to be adopted in 2013.
  - Solvency II will lead to a new basis for both qualitative and quantitative reporting, including much greater public disclosure.

### Regulation of securities markets
- Robust market surveillance systems are in place and the FSA has full powers to address market abuse.
- Enhanced enforcement program begun in 2007 appears to have yielded results in creating a more credible deterrence to improper behavior.
- Investment firms and managers are subject to risk-based supervision adequate for firms identified as high impact.
- Greater attention should be paid to mid-sized firms (across all securities-related activities) and a greater need exists to implement “bottom-up” analysis of firm operations using on-site examinations to supplement “top-down” risk analysis.
- Many supervisory initiatives, such as the CPP, are still taking hold.

### Financial Market Infrastructures (FMIs) oversight
- FMIs are governed by a consistent set of laws, regulations, and contractual arrangements; role and responsibilities for oversight are clearly defined and transparent.
- Euroclear U.K. & Ireland Limited (operator of CREST) and recognized CCPs are regulated and supervised by the FSA.
- Interbank payment systems including CHAPS; CLS; BACS; Faster Payment Services (FPS); and those operated as part of CREST, LCH, and ICE are overseen by the BoE.
- Oversight of FMIs is risk-based; BoE and FSA have taken steps to strengthen supervision since the crisis.
  - FSA is now analyzing CCPs’ internal risk-management models in detail.
  - FSA placing greater emphasis on close and continuous supervision, use of regulatory judgment, proactive anticipation of issues, and ongoing supervisory programs.
- BoE operates RTGS infrastructure for CHAPS and CREST and assesses RTGS against the CPSS Core Principles through oversight of recognized systems that rely on RTGS; this approach is indirect and fragmented and may not include all transactions.
- BoE does not agree with FSAP recommendation to undertake a direct, unified assessment of RTGS; views RTGS as an accounting infrastructure supporting some payment systems.
  - BoE accepts recommendation to assess finality of a small number of transfers on RTGS accounts made independently of schemes designated under the Settlement Finality Directive and that these transfers should meet equivalent risk standards.
  - BoE intends to conduct in 2011 a unified assessment of the RTGS infrastructure based on its existing internal risk assessment.

### Concentration and tiering vulnerabilities in payment and settlement systems
- U.K. payment and settlement systems are highly tiered, posing vulnerabilities.
- If a major clearer were to become unavailable, significant liquidity pressures would likely result.
- CHAPS payment flows concentration:
  - five most active banks account for approximately 80 percent of payment value.
  - two most active banks account for half of the total value.
- Significant amount of large-value payment activity settles in commercial bank money on the books of main CHAPS members despite settlement in central bank money.
- Exposures to commercial settlement banks are significantly concentrated in CREST, since two of them account for around 50 percent of the settlement value in sterling.
- Authorities should institute close monitoring of concentration of payment and settlements activities in banks and have made efforts to encourage second-tier banks with significant activity to become direct members.

*IMF Financial System Assessment Program (FSAP) — United Kingdom (excerpt).*

### 57.      Most cash settlement of U.K. CCP transactions (mainly margin calls) is done

### _cr11222 - 57.      Most cash settlement of U.K. CCP transactions (mainly margin calls) is done

### Cash settlement of CCP transactions and intraday credit risk
- Most cash settlement of U.K. CCP transactions (mainly margin calls) is done through commercial bank books (in commercial bank money), which exposes CCPs to intraday credit risk.
- Recommendation: CCPs should aim to reduce their cash-settlement exposures through settlement in central bank money when possible and practicable.

### Funding options, emergency liquidity, and resolution planning for CCPs
- Authorities should work with CCPs to ensure safe and reliable funding options are in place, including:
  - Committed credit lines subject only to presentment.
  - Other options such as mutualization of liquidity risk among CCPs’ membership.
- Bank of England (BoE) stance:
  - For moral hazard reasons, the BoE does not want to provide emergency access to overnight central bank liquidity on a pre-arranged basis.
  - There is no legal impediment for the BoE to provide emergency liquidity facilities, if deemed necessary, on a discretionary basis.
- Recommendation: Authorities should identify in advance applicable resolution arrangements for CCPs, and implement necessary legal and operational means.

### Crisis management and liquidity facilities
- Discount window facility:
  - Introduced after the crisis and is filling a useful role; pre-positioning of collateral facilitates access.
  - Perceived stigmatization remains an issue; bank avoidance of extraordinary facilities is a concern.
  - The BoE has mitigated stigma by inviting a broad group of institutions to use the facility on a regular but low-level basis.
- Permanent liquidity facility (introduced by BoE in June 2010):
  - Allows use of wider pools of collateral.
  - Counterparties can bid for funds against a narrow set (high-quality debt expected to remain liquid in all but the most exceptional circumstances) and a wider set (high-quality debt expected to remain liquid in most circumstances).
  - The facility serves as a diagnostic tool: increasing demand against the wider pool could indicate growing market tension or funding difficulty.

### Resolution regime and coverage of resolution tools
- Special Resolution Regime (SRR):
  - Provides legal tools for resolution of distressed banks; notable are partial property transfer powers with creditor safeguards that:
    - Protect depositors.
    - Facilitate resolution through transfers of assets and liabilities.
    - Permit loss allocation to shareholders and other creditors.
    - Ensure all creditors are left no worse off than in a liquidation.
- Recommendation: Authorities should consider establishing resolution tools for other potentially systemically important firms not covered by the SRR, which may include investment banks, insurance firms, FMIs, and, if systemic, money market funds and hedge funds.
  - Certain SRR features (particularly private sector transfer arrangements) could be useful for nonbank resolution, but design should address moral hazard through checks and balances and require sufficiently strong supervision of designated firms.
- Limitation: SRR powers to suspend contractual termination provisions do not currently extend to derivatives contracts due to applicable European legislation protecting close-out netting provisions; EC awareness and EU-wide reform on this technical point is being considered.

### Deposit insurance (FSCS) — mandate, reforms, and funding
- FSCS improvements and mandate:
  - Co-insurance (where scheme provided only 90 percent coverage beyond the first £2,000 of any claim) was eliminated in October 2007.
  - In 2010, enhancements included:
    - Increase in coverage levels to £85,000.
    - Faster payout rules: targeting payout within 7 days for most claims and within 20 days for the remainder.
    - Gross payouts (ring fencing the deposits of customers holding savings and loans with the same institution).
  - Since the adoption of the Banking Act 2009, FSCS may—if required to do so by HMT—participate in resolution transactions by providing funding to support transfers of assets and liabilities to a private sector purchaser or a “bridge bank.”
  - Further improvements to consider: moving to a risk-based premia.
- FSCS funding and operational developments:
  - FSCS funding is raised ex post, creating survivor bias, and the scheme has standing access to HMT finance.
  - FSCS coverage levels are in line with EU Directives.
  - FSCS is working with U.K. banks to develop operational systems that provide a “single depositor view” to permit more rapid satisfaction of depositor claims.

### Bank levy
- The recently introduced bank levy is to be regarded as a tax on banks and is not intended to build any fund to finance future bank resolution costs.
- Features:
  - Based on U.K. banks’ consolidated accounts—on global balance sheets, not solely on their U.K. operations—as well as the U.K. operations of banks from other countries.
  - Designed to target risky funding models; excludes tier 1 capital and stable deposits from the liability base subject to the levy.
  - It is not linked to a credible and effective resolution mechanism as proposed by the IMF.
- Recommendation: The levy should be further refined to reflect individual institutions’ riskiness and contributions to systemic risk—such as those related to size, interconnectedness, and substitutability—and variations in overall risk over time.

### Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT)
- FATF evaluation:
  - The United Kingdom’s AML/CFT framework was evaluated by the Financial Action Task Force (FATF) in 2006/2007.
  - The FATF June 2007 mutual evaluation report (MER) indicated that the United Kingdom had a comprehensive AML/CFT system in place but noted further improvements were needed, notably customer due diligence (CDD) measures in the financial sector and supervision of small financial institutions.
- Legislative and supervisory developments:
  - The United Kingdom updated its AML CFT legislation in 2007 with the Money Laundering Regulations (MLRs) to improve compliance with FATF Recommendations and implement part of the Third EU Money Laundering Directive.
  - FATF follow-up reports in June and October 2009 indicated significant progress overall; deficiencies noted with respect to CDD have been addressed.
  - FSA actions:
    - Commenced a project looking at AML/CFT systems and controls in small firms: 159 small firms were selected across the wholesale and retail sectors and a report was published in May 2010.
    - The FSA’s Financial Crime Operations Team now routinely visits small firms as part of its case work and ongoing thematic work, and has visited a total of 337 firms from 2007 to 2010.

### Box 1 — Trading activities and bank vulnerability (key findings)
- Empirical test setup:
  - Sample comprises 79 banks across Asia, Europe, and the United States, including commercial, investment, and universal banks; Asian banks used as a control group.
  - A survey by the FSA of 10 investment banks suggests some $240 billion of losses on trading positions between January 2007 and March 2009 were attributable to structured credit products, mostly linked to the U.S. housing market.
  - Method: proportion of total trading income to total revenue calculated; filter rule test applied using means and standard deviations for 1999–2007 with filter Mean + k*SD where k=1 and k=2.
- Results (predictive ability of filter rules):
  - 1*SD filter:
    - 72 percent of European LCFIs identified as potentially vulnerable actually required official assistance.
    - In this group, 4 out of 7 U.K. banks are highlighted, and three of them did eventually receive government support.
    - U.S. proportion: 67 percent.
    - Asia: 13 percent.
  - 2*SD filter:
    - Predictive ability for Europe and the United Kingdom remains the same; improves for U.S. to 80 percent and for Asia to 33 percent.
- Policy implications:
  - Trading activity can increase bank vulnerability during crises.
  - Considerations for policy: (i) distinguish trading purposes (market-making, proprietary trading, hedging, rehypothecation); (ii) improve transparency by mandating reporting of trading income by types of transaction; (iii) consider capital charges based on business lines and the riskiness of activities.
- Sample note: Sample taken from 1999-2007. United States, 15 banks; Europe (including United Kingdom), 46 banks; Asia (including Australia & Japan), 18 banks; United Kingdom, 7 banks.

### Box 2 — Systemic risk and the U.K. banking system (key findings)
- Context: U.K. is a major global financial center; high transaction volumes and inter-linkages imply potential for domestic distress to transmit internationally and for foreign-origin stress to affect the U.K.
- Methodology: market-perception indicators constructed from CDS and equity data using a nonparametric empirical copula to measure coincidence of dispersion (“entropy”) of a time series of default probability observations across multiple entities; computed Joint Probability of Distress (JPoD) and Conditional Probability of Distress (CoPoD).
- Main findings:
  - Systemic tail risks (market’s estimated probability that all U.K. banks would default simultaneously) increased during the crisis but receded significantly thereafter; these risks peaked in 2009 Q1.
  - CoPoD: individual U.K. banks became more susceptible to distress spillovers since the crisis onset but exposures moderated somewhat since 2010 Q2; CoPoD remains elevated compared to pre-crisis levels.
  - U.K. banks were seen as more exposed to one another and to European LCFIs than to U.S. LCFIs.
  - The implied spillover threat from U.K. banks to foreign LCFIs rose sharply during the crisis but fell back to almost pre-crisis levels:
    - Derived probability that a default in a U.K. bank would have systemic consequences for a foreign LCFI declined to around 20 percent for both European and U.S. LCFIs, from 40 and 50 percent, respectively, at the height of the crisis.
- Policy implication: Findings emphasize the importance of ensuring an adequate crisis management and resolution framework for dealing with shocks to the domestic or international financial system.

*Source: IMF staff report content provided in the supplied PDF excerpt.*

### Box 2. Systemic Risk and the U.K. Banking System (Concluded)

### Box 2. Systemic Risk and the U.K. Banking System (Concluded)

### Key findings on systemic distress dependence
- Analysis is based on information contained in market prices of CDS and equities, rather than any actual information on the actual business inter-linkages among banks.2/
- Distress dependence metrics (JPoDs and CoPoDs) do not account for the stochastic nature of actual recovery rates and the price of risk; probabilities of distress could be over-estimated on some occasions but under-estimated at other times.5/
- U.K. banks peer group comprises: Banco Santander, Bank of Ireland, Barclays, Hong Kong and Shanghai Banking Corporation (HSBC) Holdings, Lloyds Banking Group (LBG), National Australia Bank, Nationwide Building Society, Northern Rock and Royal Bank of Scotland (RBS). Co-operative Financial Services is omitted as CDS spreads are unavailable; FTSE100 share price index is used as proxy for Nationwide’s share price.4/
- LCFIs comprise BNP Paribas, Credit Suisse, Deutsche Bank, Société Générale and UBS (all Europe); and Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase & Co., Morgan Stanley (all United States).4/

### Implication for cross-border coordination
- Results underscore the need to continually improve collaboration and coordination with other European countries.5/

*Prepared by Hiroko Oura and Ryan Scuzzarella (both IMF/MCM).1/*

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### Box 3. Vulnerabilities of U.K. Household and Corporate Balance Sheets and Risks to the Financial Sector (Concluded)

### Overview and channels of risk
- The financial crisis significantly affected U.K. household and corporate sector balance sheets. Balance sheet repair is underway, but vulnerabilities remain in:
  - commercial real estate (CRE),
  - unsecured household debt,
  - some segments of the mortgage debt market.
- Key triggers that could materially affect banks’ asset quality: a rapid increase in interest rates, a sustained rise in unemployment, a sharp decline in real estate prices, or a combination thereof.

### Household sector vulnerabilities
- Household debt relative to disposable income remains high by both international and U.K. historical standards, leaving households vulnerable to income and interest rate shocks.
- Unsecured debt is a relatively small share of bank lending to U.K. resident sectors (5 percent), but absolute losses from unsecured debt have so far surpassed losses from mortgage defaults.
- Low-income households account for just over a quarter of banks’ unsecured lending to households; banks could sustain losses if interest rates normalize rapidly to or above pre-crisis levels (Box Figure 4).
- With the ratio of house prices to income still significantly above the historical average, further sharp declines in house prices could impact household balance sheets.
- Empirical evidence shows higher arrears in the North and in Wales (regions with large house price declines and slower housing market recovery).
- Risky borrowers (high loan-to-value (LTV) or buy-to-let loans) have tended to post higher arrears and present additional credit risk.

### Household stress-test results (sensitivity analysis)
- The analysis assumes an extreme 300 basis points rise in interest rates; a 20 percent drop in income; and a 20 percent fall in house prices.2/
- Sensitivity analysis suggests:
  - Loan losses from household mortgages for the banking sector would be manageable under interest-rate and income shocks.
  - A house price shock could result in a significant threat to banks’ asset quality.
- Mitigating factors:
  - Most household bank debt is secured.
  - Low-income households, most sensitive to interest rate and income shocks, account for a relatively small proportion of bank mortgage lending (see Box Figure 5).

### Corporate sector vulnerabilities
- Overall corporate sector weathered the crisis relatively well: leverage declined and profitability strengthened.
- Increase in company liquidations during the crisis was moderate vs. previous crises and has been declining since late-2009.
- Sector appears relatively resilient to interest rate shocks:
  - A 300 basis points increase in interest rates would increase debt-at-risk (ICR < 1) by 3 percentage points.
  - A 30 percent decline in profits would increase debt-at-risk by 2 percentage points.
- Contingent claims analysis (CCA) suggests market expects losses from corporate defaults one year ahead to be limited to between 0.2 percent to 0.7 percent of GDP.

### Corporate real estate (CRE) as a concentrated risk
- CRE represents almost half of total bank loans to the nonfinancial corporate sector.
- CRE loans are a large share of those due to be refinanced over the next few years, creating potential funding gaps if banks unwilling or unable to roll over or restructure loans.
- CRE remains exposed to further declines in prices; many borrowers are in negative equity or breach LTV covenants despite partial rebounds from peak declines.
- Real estate sector represents a relatively small share of total corporate sector liabilities and less than 8 percent of bank loans to U.K. residents (mitigating factor).
- CRE lending is highly concentrated among a few big banks; large exposures could cause severe bank-specific losses in adverse scenarios.

### Additional caveats
- Headline figures of write-offs and liquidations may understate financial distress and credit risks due to:
  - concentration of credit risks in some large banks;
  - widespread lender forbearance (overlooking breaches in LTV covenants or evergreen loans), which has contained defaults to date, particularly in CRE.
- Additional risks may arise from significant exposures to real estate markets outside the United Kingdom.

*Prepared by Marta Ruiz-Arranz (IMF/EUR).1/*
*The analysis assumptions: extreme 300 basis points rise in interest rates; 20 percent drop in income; and 20 percent fall in house prices.2/*

---

### Appendix I: United Kingdom — Risk Assessment Matrix (Selected threats 1–6)

- Presentation format: Nature/Source of Main Threats — Overall Level of Concern — Likelihood of Severe Realization of Threat in the Next 1–3 Years — Expected Impact on Financial Stability if Threat is Realized (high, medium or low).

1. Global “double-dip” recession
- Overall level of concern: Medium.
- Likelihood: Medium.
- Key points:
  - IMF WEO projections place a low probability on a double-dip recession.
  - U.K. exposed to drop in demand for exports and financial services.
  - Solvency stress tests suggest major banks could absorb losses due to a severe double-dip recession; extreme “tail of the tail” risks could result in a capital shortfall of up to 1.6 percent of 2010 GDP relative to Basel III Tier 1 hurdle rates (and up to 1.8 percent of GDP relative to FSA requirements).

2. Continued slow growth and sustained low interest rates
- Overall level of concern: Medium.
- Likelihood: Low.
- Key points:
  - Medium-term growth could be sluggish as balance sheet repair weighs on domestic demand; interest rates could remain low for an extended period.
  - FSA stress tests suggest most insurers would be resilient.
  - Solvency stress tests indicate banks have sufficient buffers; extreme tail capital shortfall would be less than 1 percent of GDP.

3. Inability of banks to meet refinancing needs
- Overall level of concern: Medium and rising.
- Likelihood: High.
- Key points:
  - Market access outlook highly uncertain; Eurozone turmoil makes issuance and rollovers difficult.
  - U.K. banks have significant refinancing needs through end-2014, including public support schemes.
  - FSAP liquidity stress tests (Basel III standards) indicate institutions representing almost 70 percent of assets lack sufficient stable funding beyond six months.

4. Significant deterioration in real estate prices
- Overall level of concern: Medium.
- Likelihood: Medium.
- Key points:
  - CRE prices rebounded somewhat from a 40 percent decline; rent and occupancy outlooks uncertain.
  - House price-to-rent and price-to-income ratios are about 30 percent above historical averages.
  - Loans to CRE account for around half of domestic lending to nonfinancial corporate and about a fifth of total banking sector loans.
  - FSAP analysis indicates macro shocks would disproportionately affect CRE; low-income households are most sensitive to house price declines and real interest rate shocks.
  - Lender forbearance practices could mask increased risks.

5. Intensified sovereign and banking sector distress in EU periphery or bursting of asset bubble in Asia
- Overall level of concern: Medium and rising.
- Likelihood: High.
- Key points:
  - Sovereign and financial sector distress in weak-fundamentals countries could worsen absent cohesive European approach, leading to contagion.
  - U.K. banks’ direct exposure to vulnerable European countries amount to more than 50 percent of core tier 1 capital.
  - Two largest foreign-owned banks in U.K.: Santander U.K. (household exposures) and Allied Irish (corporate exposures).
  - Solvency stress tests suggest risks from exposures to vulnerable European sovereigns seem manageable, but spillovers to private sector and core European banks could have major implications; extreme tail risks could result in some capital shortfall.
  - Banks vulnerable to sustained funding disruptions from sovereign risks.
  - Two of largest U.K. banks have very large exposures to Asia but are relatively less exposed to the United Kingdom.
  - Strong capital inflows into Asia continue to fuel asset bubbles.

6. Uncertain impact of ongoing regulatory reforms
- Overall level of concern: Medium.
- Likelihood: Medium.
- Key points:
  - Basel III implementation phased in; U.K. authorities considering acceleration and further SIFI requirements.
  - ICB proposed ring-fencing of retail banking operations in interim report; final report expected in September.
  - Solvency stress tests indicate major banks are well-placed to meet Basel III requirements.
  - FSAP liquidity stress tests confirm vulnerabilities at six-month maturities and beyond.
  - ICB deliberations (potentially breaking up banking groups) may unsettle funding markets.
  - Solvency II for insurance firms by January 1, 2013; could have unintended consequences for insurers’ financial performance.
  - Proposed risk weights expected to encourage insurers to hold more low-yielding assets (e.g., sovereign bonds), which given low interest rates could encourage risk taking to meet nominal returns.
  - Operational risk rising due to uncertainty around regulatory/supervisory reforms, higher staff attrition from the FSA, potential loss of experienced human capital affecting supervision quality.

*Appendix prepared as part of the FSAP technical material.*

### 69.      Policy actions taken by the U.K. authorities during the crisis to stabilize the

### Policy actions taken by the U.K. authorities during the crisis to stabilize the financial system

### Temporary liquidity and emergency lending
- The BoE provided temporary liquidity support as a lender of last resort to Northern Rock in 2007 and to HBOS and RBS in 2008.
- Collateralized loans to HBOS and RBS reached a combined maximum amount of nearly £62 billion in October 2008, but were repaid by mid-January 2009.
- In April 2008, the BoE introduced exceptional liquidity support through the SLS to allow banks to swap their high-quality but illiquid mortgage-backed and other securities for U.K. treasury bills for up to three years.
  - The SLS was extended in October 2008, leading to a total utilization of £185 billion by the end of the drawdown period on January 30, 2009.
  - At end-May 2011, £37 billion remained outstanding, with banks ahead of their voluntary repayment plans agreed with the BoE.
  - The SLS will expire at the end of January 2012.

### Government guarantees and asset protection
- In October 2008, HMT introduced the CGS providing government guarantees for short- and medium-term debt (one month up to three years) issued by banks.
  - The CGS closed to new issuance at end-February 2010 and, as at December 2010, the total debt guaranteed under the scheme was £115 billion.
  - Eligible institutions can still finance debt already guaranteed under the scheme without restriction until April 2012, and until April 2014 conditional on total scheme drawdown remaining below £83.3 billion.
- In January 2009, the government created the APS to provide participating institutions with protection against future credit losses on defined portfolios of assets in exchange for a fee.
  - The initial plan insured £260 billion of assets from LBG and £325 billion of assets from RBS.
  - LBG subsequently took steps not to participate in the scheme, while the conditions for RBS were reviewed—the insured assets amounted to £282 billion as at December 31, 2008 and first loss protection increased to £60 billion, covering 90 percent of subsequent losses net of recoveries.

### Asset purchase and market facilities by the BoE
- In January 2009, the government authorized the BoE to set up an APF to buy high-quality assets financed by the issue of treasury bills and the DMO’s cash-management operations to improve liquidity in credit markets.
- In November 2010, the BoE provided notice of its intention to withdraw the Commercial Paper Facility for companies.
  - The BoE announced continuation of the Corporate Bond Secondary Market Scheme (introduced in March 2009 to both buy and sell corporate bonds).
  - The BoE intended to make purchases through its Secured Commercial Paper Facility (announced in July 2009) to allow the BoE to purchase high-quality sterling commercial paper securities that support the financing of working capital.

### FSAP update: macro-financial stress-testing framework and satellite models
- Macro-financial variables were generated by a macro model with Bayesian updating and served as inputs to both Bottom-Up (BU) and Top-Down (TD) stress tests.
- WEO baseline and three adverse macro scenarios were used: Double-dip mild, Double-dip severe, Slow growth.
- Idiosyncratic variables were generated by the RAMSI model as inputs to IMF satellite models and BoE models.
- Two satellite models described:
  - Satellite Model 1: Dynamic panel regression using macro and firm data (producing net interest income, operating expenses, trading income, non-interest income, credit losses).
  - Satellite Model 2: Adjust option formula by net operating profit only (generating idiosyncratic variables).

### Key institutions and coverage in stress tests
- Bottom-Up by Banks: Seven SIFIs (Barclays, HSBC, LBG, RBS, SCB, Santander U.K., Nationwide); 71 percent of banking system assets; 89 percent of total lending.
- Top-Down by Authorities (BoE RAMSI): Five SIFIs (Barclays, HSBC, LBG, RBS, Santander U.K.); 65 percent of banking system assets; 79 percent of total lending.
- Top-down by FSAP Team (Systemic CCA): Seven SIFIs (Barclays, HSBC, LBG, RBS, SCB, Santander U.K., Nationwide); 71 percent of banking system assets; 89 percent of total lending.
- Stress test horizon: Years 2011‒2015.
- GDP shock scenarios:
  - One standard deviation from the WEO baseline.
  - Two standard deviations from the WEO baseline.
  - Prolonged slow growth (with greater than 7 percentage points in cumulative deviation from the WEO baseline over five years).

### Treatment of losses, profitability, and funding in stress tests
- Credit losses:
  - BU: Based on banks’ satellite models.
  - TD (Authorities and FSAP Team): Based on satellite models using various macro and bank-specific variables.
- Profitability:
  - Profit (interest income, interest expense, net fee and commission income, operation expenses) should be based on banks’ satellite models or expert judgment.
  - Trading income derived from banks’ satellite models or statistical matching with GDP growth (conditional on changes in trading assets).
- Funding costs:
  - Derived from either satellite models for interest expense or an IMF-provided methodology.
  - Changes in costs due to solvency conditions cannot be smaller than those generated.

### Haircuts on sovereign and bank debt applied in solvency stress tests (as at December 31, 2010)
- Haircuts applied to debt holdings of all non-AAA rated sovereigns as well as all exposures (debt and loans) to banks in these countries on an ultimate-risk basis.
- Severity and dynamics informed by forward term structure of five-year sovereign CDS spreads as at end-2010.
- Table excerpt (selected country-year haircuts, in percent):
  - Belgium: 2011 1.76; 2012 1.88; 2013 1.79; 2014 1.66; 2015 1.55; Adverse 1 (5-year rate) 2011 4.56; 2012 4.74; 2013 4.61; 2014 4.42; 2015 4.26; Adverse 2 (DD Severe) 2011 9.49; 2012 9.84; 2013 9.55; 2014 9.12; 2015 8.71.
  - France: 2011 0.00; 2012 0.04; 2013 0.05; 2014 0.03; 2015 0.01; Adverse 1 2011 0.77; 2012 1.03; 2013 1.09; 2014 0.99; 2015 0.90; Adverse 2 2011 3.18; 2012 3.66; 2013 3.79; 2014 3.62; 2015 3.45.
  - Germany: 2011 0.00; 2012 0.00; 2013 0.02; 2014 0.00; 2015 0.00; Adverse 1 2011 0.30; 2012 0.41; 2013 0.45; 2014 0.43; 2015 0.43; Adverse 2 2011 1.37; 2012 1.66; 2013 1.84; 2014 1.82; 2015 1.79.
  - Netherlands: 2011 0.30; 2012 0.34; 2013 0.35; 2014 0.34; 2015 0.34; Adverse 1 2011 0.61; 2012 0.68; 2013 0.71; 2014 0.70; 2015 0.70; Adverse 2 2011 1.81; 2012 1.90; 2013 1.99; 2014 2.00; 2015 2.03.
  - United Kingdom: 2011 0.10; 2012 0.27; 2013 0.25; 2014 0.10; 2015 0.16; Adverse 1 2011 1.19; 2012 1.39; 2013 1.31; 2014 1.02; 2015 1.03; Adverse 2 2011 3.16; 2012 3.41; 2013 3.23; 2014 2.69; 2015 2.60.
  - Greece: 2011 12.77; 2012 10.85; 2013 9.07; 2014 8.21; 2015 7.28; Adverse 1 2011 26.61; 2012 23.20; 2013 20.00; 2014 18.56; 2015 16.81; Adverse 2 2011 46.55; 2012 41.57; 2013 36.74; 2014 34.61; 2015 31.82.
  - Ireland: 2011 6.12; 2012 5.55; 2013 4.77; 2014 4.26; 2015 3.78; Adverse 1 2011 13.83; 2012 12.81; 2013 11.39; 2014 10.56; 2015 9.59; Adverse 2 2011 26.35; 2012 24.71; 2013 22.35; 2014 21.05; 2015 19.34.
  - Italy: 2011 2.75; 2012 2.78; 2013 2.72; 2014 2.55; 2015 2.44; Adverse 1 2011 5.66; 2012 5.64; 2013 5.58; 2014 5.36; 2015 5.18; Adverse 2 2011 10.77; 2012 10.67; 2013 10.60; 2014 10.31; 2015 10.01.
  - Portugal: 2011 2.25; 2012 1.76; 2013 0.94; 2014 0.27; 2015 0.00; Adverse 1 2011 10.72; 2012 9.72; 2013 8.06; 2014 6.77; 2015 5.64; Adverse 2 2011 24.40; 2012 22.68; 2013 19.82; 2014 17.60; 2015 15.63.
  - Spain: 2011 1.90; 2012 1.73; 2013 1.56; 2014 1.37; 2015 1.25; Adverse 1 2011 6.10; 2012 5.74; 2013 5.44; 2014 5.17; 2015 5.02; Adverse 2 2011 13.35; 2012 12.66; 2013 12.16; 2014 11.76; 2015 11.56.
  - United States: 2011 0.14; 2012 0.17; 2013 0.20; 2014 0.21; 2015 0.23; Adverse 1 2011 0.36; 2012 0.49; 2013 0.65; 2014 0.75; 2015 0.85; Adverse 2 2011 1.34; 2012 1.74; 2013 2.14; 2014 2.39; 2015 2.60.
- Memo item: CEBS haircuts (absolute) listed for comparison (selected examples):
  - Belgium: 1.40; 3.10; 3.47; 6.51 (various years/scenarios).
  - United Kingdom: 5.00; 6.90; 2.56; 5.52 (various years/scenarios).
  - Greece: 3.90; 4.30; 22.60; 30.22 (various years/scenarios).
- Memo item: Difference between new haircuts and CEBS haircuts also provided (selected examples):
  - Belgium: 0.36; -1.22; 1.09; -1.77 (various comparisons).
  - Greece: 8.87; 6.55; 4.01; -7.03 (various comparisons).

### Liquidity stress tests: tests, definitions, and key parameters
- Tests and definitions:
  - 5-day test: Consecutive outflow of liabilities over five days.
  - 30-day test: One-off aggregate outflow of liabilities for 30 days.
  - Quasi-Liquidity Coverage Ratio (LCR): Stock of high-quality liquid assets would need to cover short-term net cash outflows.
  - Quasi-Net Stable Funding Ratio (NSFR): Available stable sources of funding need to exceed the required level of required funding.
- Asset-side haircuts (one-off) applied in tests (in percent where given):
  - 5-day test: (i) cash and cash-equivalent positions (haircut: 0 percent); (ii) government debt holdings (0); (iii) investments (securities) (20); (iv) trading securities (20); (v) derivatives (50); (vi) high-quality investment securities (1); (vii) secured assets (up to one month) (1).
  - 30-day test: (i) cash and cash-equivalent positions (0); (ii) government debt holdings (1); (iii) investments (securities) (10); (iv) trading securities (40); (v) derivatives (50); (vi) high-quality investment securities (5); (vii) secured assets (up to one month) (75).
  - Quasi-LCR: high-quality bonds and covered bonds (rated "AA-" and higher) (15); sovereign, central bank and PSE assets qualifying for 20 percent risk-weighting (15).
- Liability-side outflow assumptions:
  - 5-day test: (i) demand deposits (5 percent per day, except from sovereigns (0 percent per day)); (ii) term deposits (1 percent); (iii) secured/unsecured wholesale funding (5/15 percent).
  - 30-day test: (i) demand deposits by non-financial/financial entities (50/75); (ii) term deposits by non-financial/financial entities (20/30); (iii) secured/unsecured wholesale funding (40/50); (iv) intragroup funding (20).
  - Quasi-LCR: (i) term deposits with residual maturity > 1 month (0); (ii) stable/less stable retail deposits (5/10); (iii) unsecured wholesale funding with/without operational relationship/funding from other entities (financial institutions) (25/75/100); (iv) percentage of interbank market funding secured with illiquid assets (100); (v) secured funding backed by "Level 1" assets/"Level 2" assets and by other valuable assets (close to "Level 2") (0/15/25); (vi) portion of high-quality liquid asset needed to satisfy margin calls (10); (vii) market value change on derivatives (20).
  - Quasi-NSFR required stable funding and available stable funding definitions include precise percentage weights for different asset and liability categories (e.g., capital and long-term debt (> 1 year) (100); stable deposits of retail and SMEs (< 1 year) (90); etc.).
- Basic assumptions for implied cash flow test:
  - 10 percent of the liquid assets are encumbered (used as collateral to receive funding) except cash/cash-equivalents.
  - No offsetting cash inflows from wholesale lending (at contractual maturities).
  - No inflows of interbank lending in times of stress.
  - No consideration of access to the Bank of England discount window.
- FSA practices:
  - The FSA collects daily cash flow data for three months from the reporting date in respect of wholesale secured and unsecured cash flows to assess if a firm can withstand lock-out in wholesale funding markets by using a stock of high-quality marketable assets.
  - Survival days metric: defined as the first day on which the cumulative wholesale refinancing gap after adding the high-quality assets turns negative.
  - For this exercise, the FSA finds that 75 percent of all firms in the full sample ... (text continues in source).

*Prepared by: BoE; and IMF staff.*

### 70.      Approximately 20 percent of all hedge fund managers are registered in London

### _cr11222 - 70.      Approximately 20 percent of all hedge fund managers are registered in London

### Overview and market presence
- Approximately 20 percent of all hedge fund managers are registered in London with assets under management of approximately $380 billion as at end-2010.
- Europe’s share of fund managers grew from 12 percent in 2002 to 23 percent in 2009, eroding the U.S. position from 82 percent to 68 percent, with most of that business moving to London.
- An estimated 85 percent of the assets of these funds are domiciled in offshore locations.

### Strategies and market footprint
- U.K. fund managers employ a range of strategies with the largest share (35 percent) in long/short equities.
- FSA findings on market dominance:
  - U.K.-managed funds hold only about 1 percent of the European equity market.
  - U.K.-managed funds held 8 percent of the world’s convertible bond market as at April 2010.
  - Except in the case of convertible bonds, U.K. hedge fund managers do not control a significant portion of any given asset market.

### Leverage and funding composition
- FSA measurement of fund leverage (not accounting for short/long position netting) indicates:
  - U.K.-managed funds employed an average of 272 percent of assets to equity in April 2010.
  - This was up from 244 percent in October 2009.
- Funding mix trends:
  - Increase in borrowing under repo agreements.
  - Decline in borrowing through collateralized prime brokerage, reflecting lessons from the Lehman collapse.

### Prime brokerage concentration and exposures
- Prime brokerage features:
  - 90 percent of European prime brokerage activity takes place in London.
  - Heavy concentration of administration and other services used by hedge funds in London.
- Market share and exposures:
  - Goldman Sachs, JP Morgan, and Morgan Stanley are the three largest players, with 52 percent of the global business.
  - FSA hedge fund survey suggests the maximum potential credit exposure to any one hedge fund was $500 million.
  - Maximum potential credit exposure of a single financial institution to a single hedge fund was $50 million.
  - The survey shows a trend of increased margin requirements for collateralized borrowing by hedge funds.

### Rehypothecation: practice, legal framework, and risks
- Re-use of customer collateral (rehypothecation) is widespread in the London financial markets.
- Legal and contractual features:
  - Under repurchase agreements, title to the collateral is formally transferred from the customer to the lender.
  - Most prime brokerage agreements involve loans secured by a fixed charge under U.K. law over assets held in a nominee company.
  - In the event of default under either arrangement, the collateral is sold to reimburse the lender.
- Mechanics and incentives:
  - In rehypothecation, instruments taken as collateral are on-lent to other customers or used as collateral for financing by the prime broker.
  - The repurchase counterparty or prime broker profits from re-use via stock lending fees or by borrowing at lower rates.
  - Rehypothecation is common across all asset classes, both equity and fixed income, and is carried out in the trading book (not the banking book).
- Comparative legal frameworks:
  - The rehypothecation legal framework in the United Kingdom is different than that in the United States and has greater appeal for certain kinds of assets.
  - The U.S. framework is very efficient for purely U.S. portfolios.
  - The U.K. framework is based on U.K. commercial and trust law and involves much more specificity in contracts to cover bankruptcy, security, tax, and accounting regimes.
  - The U.S. regulatory framework generally imposes greater limits on how much collateral can be taken and how it can be reinvested, though with significant exceptions; the United Kingdom does not impose such limits through regulation, but they are instead set out contractually in each transaction.

### Systemic risks, failures observed, and regulatory responses
- Central risk: rehypothecation increases counterparty risk and interconnectedness, complicating transaction unwinds.
- Issues exposed by Lehman Brothers collapse:
  - Some contracts lacked netting provisions.
  - Some client assets held in custody were commingled with prime brokerage assets.
  - A bankruptcy-law provision led to estate administrators potentially having personal liability for distribution decisions, complicating recoveries—some hedge funds did not have assets returned and remain claimants against the Lehman estate.
- Post-Lehman responses:
  - Contracts with prime brokers have been tightened to include netting provisions and to proscribe or specifically limit use of client assets.
  - The FSA implemented stronger client asset rules and has undertaken targeted on-site evaluations of firms’ systems and controls in this area.
- Accounting and measured leverage:
  - Under IFRS accounting conventions, all lending transactions involving rehypothecation are shown in gross terms on the balance sheet, resulting in a higher measured level of leverage than for comparable U.S. transactions where netting is permitted for certain types of exposure.
- Rehypothecation effect on liquidity:
  - Rehypothecation facilitates the movement of liquidity through the system, but does not add to it.

### Data gaps and surveillance implications
- The presence of the hedge fund industry in the United Kingdom does not in itself represent a vulnerability for the U.K. financial system.
- Key surveillance concerns:
  - Interconnectedness of funds and their importance to asset markets are key issues for financial stability surveillance.
  - The FSA tracks U.K.-managed funds but does not have information on the remaining 80 percent of the global industry, which actively trades or seeks prime brokerage services in the United Kingdom.
  - This lack of data is a matter of global concern as U.K. authorities, along with others, address data gaps for macroprudential surveillance.

*Source: _cr11222 - 70.      Approximately 20 percent of all hedge fund managers are registered in London*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11222.pdf_