The banking crisis of the last two years resulted
in government support for the sector around the world amounting
to almost a quarter of global GDP. One of the factors contributing
to the crisis was that banks had been carrying out risky activities,
and had mispriced and misallocated that risk. The actions Governments
took to prevent financial meltdown may have been necessary, but
they also revealed the implicit subsidy to the financial services
sector from states which could not afford to let their banks fail.
The bail-outs have not ended the mispricing of risk, and have
arguably made it worse: ratings agencies now provide a 'support
rating' which takes into account the likelihood that a government
would not allow a particular bank to fail.
Banking reform is needed. First, both global and
national regulation must be made better and more effective. Secondly
the comparatively narrow capital base upon which banks operate
should be addressed. The Basel Committee is currently working
on reforms to capital and liquidity ratios which should go some
way towards this. There is indeed scope for better regulation.
But while better regulation and higher capital ratios could mean
that crises are less severe, they can not stop them. History is
littered with examples of financial boom and bust, from the tulip
boom in 17th century Netherlands, to the South Sea Bubble, to
the dot-com boom. The challenge is to make sure that the financial
system itself is not, as it has been recently, a prime cause of
such instability, and to ensure that, in so far as possible, financial
institutions bear the consequences of their own actions. That
will require more radical action.
Reform is particularly pressing for the United Kingdom.
In the 1970s the UK banking sector had a balance sheet of 50%
of United Kingdom GDP; it is currently 500% of GDP.
During the financial crisis, governments have effectively stood
behind the banking system. If international banking in the United
Kingdom is to remain credible, reform must ensure that the tax
payer is better protected from picking up the bill.
This Report looks at the range of reforms currently
under consideration, and assesses them against the objectives
of an orderly banking system such as protecting the consumer,
protecting the taxpayer, setting an appropriate cost of doing
business and providing lending to the economy. There are trade-offs
between these objectives: the more consumers are protected, the
more risks tax payers may have to bear; the more banks have to
pay for their capital, the higher the rates they will charge their
customers. Policymakers will have to decide where the trade-offs
should properly be made and how this should be explained to the
public who understandably want to see rapid and sustainable change.
Successful reform would transfer risk away from Government
and back into the banking sector. We are clear that radical reform
is necessary but it cannot be achieved immediately: if it were
done too quickly the cost to banks and to their customers would
increase too quickly to be absorbed. But it has to be done. The
collapse of Lehman Brothers showed that the failure of an interconnected
systemically important international firm has widespread and cataclysmic
implications. An indication of improvement will be a system which
enables a large international institution to go bankrupt smoothlyand
where prices in financial markets do not implicitly or explicitly
assume a government guarantee.
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