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Too important to fail-too important to ignore - Treasury Contents


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.[1] 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 smoothly—and where prices in financial markets do not implicitly or explicitly assume a government guarantee.

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Prepared 29 March 2010