| 1 Introduction
Too important to failtoo important
1. The emergency actions taken by governments across
the world during the banking crisis appear to have identified
a type of financial firm, or group of financial firms, so integral
to the financial system ('systemic') that the respective governments
were forced to bail them out in some form, rather than let them
fail as an ordinary firm would. Box 1 describes how the Financial
Services Authority suggests such systemic firms could be identified.
These firms are collectively known as 'Too important to fail'.
This Report examines the structure of the financial system that
has led to the existence of such firms, the benefits and costs
from allowing such firms to exist, and what objectives should
be considered should we modify how the financial system is run
to minimise the problem.
Box 1: Identifying systemic financial institutions
The FSA's Turner Review Conference Discussion Paper highlighted
three potential reasons why a financial institution (or set of
institutions) may be systemic, and therefore under the current
regime are difficult to unwind:
i) systemic by size. This can be a function of the firm's
absolute size or in relation to a specific financial market or
product in which a firm is particularly dominant. The channels
through which systemic risks would crystallise as a result of
the failure of such a firm include: losses to uninsured creditors
and depositors through high bankruptcy costs and reduced recoveries;
disruption to financial services (such as to payments, clearing
and settlement, extension of credit); and losses to insured depositors
because the DGS [Deposit Guarantee Scheme] could not pay out sufficiently
quickly or because the aggregate payout imposes unsustainable
costs on those who fund the DGS. In addition and crucially, systemic
risks can take a macroeconomic form, with the loss of credit extension
capacity leading to, or exacerbating, a downturn in economic activity
which then has consequences for the rest of the financial system.
ii) systemic by inter-connectedness. Links and inter-connections
can include, inter alia, inter-bank lending, cross holdings of
bank capital instruments, membership of payment systems, and being
a significant counterparty in a crucial market. The channels through
which such problems manifest themselves include:
- interbank exposures. The domino effect where the collapse
of one firm leads to major losses at others, and then in turn
leads to their collapse. This can then trigger a chain reaction;
- the confidence channel. The collapse of a systemically
important firm leads to a crisis of confidence in financial
markets. The confidence channel is particularly important to
the 'systemic as a herd' category (see below), given the perceptions
by the market that a number of firms are exposed to the same
set of risks;
- the asset margin spiral channel. Firms increasingly
finance themselves through repo and reverse repo arrangements.
The haircuts charged on the collateral underlying these contracts
dictate the extent to which firms can leverage themselves. In
a crisis, both funding conditions and credit concerns will lead
counterparties to increase haircuts, triggering a deleveraging
process. This will in turn be disruptive, through a self-reinforcing
spiral between lower market liquidity and funding liquidity.
iii) systemic as a herd. The market can perceive a group
of firms as part of a common group (for example, because they
have a similar business model, such as building societies in the
UK and the savings and loans banks in the US), or common exposures
to the same sector or type of instrument. A single firm in this
group may not be systemic in its own right, but the group as a
whole may be.
2. One of the characteristics of firms that
are classified as 'too important to fail' can be that they operate
across borders. Such international financial institutions bring
benefits both to the firm and countries in which they operate.
But they can also be more difficult to resolve (i.e. close down
or make bankrupt) should the firm run into difficulties. The most
recent Financial Integration Report prepared for the European
Commission considers the integration of the countries of Central
and Eastern Europe into the European financial system, and describes
the following benefits:
EU financial integration, through cross-border establishment,
has risen sharply over the past decade and has brought with it
a range of benefits to both home and host countries. Benefits
range from increased income generation, improvements in technology
and risk management, increased access to funds, risk diversification
and deepening of financial markets.
3. However, it also recognises that such integration
is not without difficulties:
The current crisis has demonstrated that there is a risk in
building up major concentrated exposures. If several CESE use
a 'common funding channel', such as Austria or Sweden, this significantly
increases their risk and vulnerability to fluctuations in home
countries. The same conversely applies for home countries in the
event of excessive concentration of the cross-border lending business
of their banking sector on a few countries. [ ... ].
Swedish bank establishments in the Baltic region provide an
illustration of the difficulties that may occur for both home
and host countries [ ... ].
For the home country, Sweden, the establishment of banks in
the Baltic countries has had significant benefits for the Swedish
banking sector, in particular in terms of market expansion and
creation of new revenue streams. However, when the global crisis
emerged, the credit expansion came to an end and credit losses
started to increase in the Baltic region. Many commentators then
explained the fall in the Swedish Krona and falls in market confidence
as directly stemming from Sweden's high exposure to the Baltic
region. Swedish banks also experienced substantial loan losses,
estimated to be in the order of SEK 30 billion for the first six
months of 2009, with 44 percent of these losses directly attributable
to the Swedish banks' operations in the Baltic Member States.
[ ... ] For the Baltic region the rapid increase of foreign
bank presence has had considerable, but different consequences.
On the one hand, it contributed to the growth of financial infrastructure,
facilitating economic growth. [ ... ]
On the other hand, the high concentration of exposures and the
lack of adequate risk management and regulation contributed to
the building up of major imbalances. The easy access to foreign
loans, denominated in euro, also resulted in the building up of
a speculative property bubble as well as substantial current account
deficits in the Baltic region. When the financial crisis hit,
and sources of credit dried up, assets were re-valued and credit
ratings were downgraded, leaving these Member States highly exposed
to foreign exchange denominated debt, falling property prices
and internal revaluations.
4. The Report concludes "While integrated financial
markets have brought clear benefits, the financial stability aspects
have not received sufficient attention. In an integrated market
safeguarding financial stability should be a common interest."
5. As the Financial Integration Report notes, integration
can expose both home and host countries to risks from poorly managed
and poorly regulated institutions in other countries. Recent press
attention has focused on the discussions between the United Kingdom,
the Netherlands and Iceland about how Iceland might repay the
compensation to depositors in Landsbanki provided by the British
and Dutch governments. However, other cross-border institutions
have also faced dangers, such as the Swedish banks noted above.
Fortis bank needed to be rescued in Belgium and the Netherlands.
We recently visited Germany, Austria and Hungary to explore the
exposure of European banks to branches in accession countries.
The difficulties there appeared to be limited, but that was, in
large part, due to IMF intervention. Our Report takes account
of the fact that financial services are increasingly international.
6. The financial crisis has seen significant public
support extended to the financial system, and consequently, significant
political interest in how the financial system operates. Stephen
Hester, RBS, when he gave evidence to us, accepted that such scrutiny
until the banking industry can demonstrate that in times of
crisis it does not need public support in the level that has been
given, the banking industry I think has invited on itself this
kind of scrutiny and intervention. One of the things that I think
is most importantnot for this reason, by the way, but for
public policy reasonsis that the far-reaching reforms of
the banking industry that are going on globally over the coming
years do indeed get to the point where a crisis can happen and
banks do not need to call on this level of public support. So
I do completely understand for all of those reasons the level
This Report looks at how far the financial system will ever
be able to move away from having the government as its final port
in a storm.
7. For the past two years financial services have
been under unparalleled political scrutiny. As bank executives
acknowledged, this will continue at least until the banking industry
can demonstrate that in times of crisis it can survive without
significant public support. One thing at least is now abundantly
clear: the public will not stand for another bailout. The political
case for action is as strong as the economic one.
8. Central banks will always have a function as
lenders of last resort. In exceptional circumstances, governments
may have to step in to address systemic crises. There must not
be an assumption that this will always happen.
Difficulties in policy making
9. This Report is centred around the consideration
of solutions to the problem that some banks have become 'too big
(or too important) to fail', and to the distortion to the market
the existence of such firms creates. We have encountered a number
of trade-offs in our inquiry, such as that between the stability
of the financial system, and economic growth. We identify several
objectives that the financial system should meet, and then assess
potential reforms against those objectives. However, the decisions
on which reforms to accept will be swayed by society's preferences
on the objectives. For instance, do we wish to protect consumers
by implementing an upfront cost on firms to pay into a deposit
protection fund, or are we prepared to have an ex-post fee, and
allow the Government to pay out for consumer protection in the
first instance? Do we wish to maximise the global flows of capital
which international banks facilitate, or are we more concerned
about the ability of individual countries to protect their own
financial systems? Only by ranking the objectives can a decision
10. While such a ranking of objectives would be useful,
one of the problems in our inquiry has been that the measurement
of the impact of the reforms is difficult. We have repeatedly
been told that it is impossible to quantify the effect of even
a single reform, let alone the interplay between different types
of reform. Moreover, even if it were possible to model the expected
impact of a particular change under expected circumstances, there
will always be uncertainty in the system, 'unknown unknowns',
which mean that a definitive answer may always be unavailable.
Those looking for easy, quantifiable, answers are likely to be
SYSTEMS WITHIN SYSTEMS
11. This Report focuses on the banking system, and
a particular problem, 'too important to fail', within that system.
The banking system itself though is part of a wider financial
system, with other markets, institutions and instruments. The
interaction between these different players will impact upon the
banking system, for instance, some witnesses discussed the need
for reform in the 'naked' Credit Default Swap markets, and the
need for reforms to the over-the-counter market.
12. The financial system is also part of a wider
legal system, setting out matters such as permissible ownership
structures and insolvency procedure. It is also affected by the
fiscal system, which may or may not include particular taxation
regimes for financial services. Again, examples were raised of
interactions between these different systems. Lord Turner noted
If you look at Mervyn King's and John Kay's standard textbook
on UK Corporate Taxation, which I believe was first published
in 1977, you will find discussion of how tax deductibility of
interest is creating a bias in the tax system. This is one of
the things that has been around for ever. All economists have
identified that this must create an incentive for non-banks and
banks to leverage themselves up. One of the reasons banks do not
like us requiring them to hold a lot of equity is that it means
we are forcing them to hold capital in a non-tax-deductible rather
than tax-deductible fashion. Could you ever change it? I do not
know. [ ... ] it means that in all our other policies if we cannot
change it we need to be aware that we have a very big bias in
the system continually to try to select a higher level of leverage
than is optimal in terms of the management of risk.
13. In the time available to us before the election
we have focused on issues relating to the banking system and its
regulation. This of course cuts across the linkages between the
banking system and others. We do not think these linkages are
unimportant; readers are encouraged to look through the evidence
provided by this inquiry for further discussion of these issues.
However, too great an emphasis on system complexity can lead to
inaction. Reform may have to come gradually, and any new system
may require many iterations before it is fully satisfactory.
Conduct of the inquiry
14. This is the latest in a series of inquiries into
matters relating to financial stability we have conducted over
the past two years. Whether looking at the impact of the failure
of the Icelandic banks, governance structures within the City
or reforms to the Tripartite Structure of regulation, the Committee
has tried to provide to the House a body of evidence on these
important topics, as well as a view on the relevant issues, and
government policy in these areas. This inquiry is a continuation
of that work, building upon our previous Reports and their conclusions.
15. Our inquiry spanned seven oral evidence sessions.
We are grateful to Professor Charles Goodhart, Professor John
Kay, Mervyn King, Governor, Paul Tucker, Deputy Governor (Financial
Stability), and Andrew Haldane, Executive Director, Financial
Stability, Bank of England, E. Gerald Corrigan, Managing Director,
Goldman Sachs Bank USA, Douglas Flint, Group Finance Director,
HSBC, John Varley, Chief Executive, Barclays, Alfredo Sáenz,
Vice Chairman and Chief Executive, Santander, Lord Turner, Chairman,
Financial Services Authority, and Professor Alexandre Lamfalussy,
for sharing their views on this important subject with the Committee.
We are also grateful to those who submitted written evidence.
16. We undertook two overseas visits in relation
to this inquiry. On 30 November-4 December we visited Frankfurt,
Vienna and Budapest and on 1-5 February we visited New York and
Washington. We are extremely grateful to all those who hosted
our visits. In particular, we thank the Foreign and Commonwealth
Office. The help we have received from the Ambassadors and the
staff they lead has been vital to our work. We are also extremely
grateful to the staff of all the institutions we visited for their
excellent assistance and support.
17. We would also like to thank Professor Geoffrey
Wood of the CASS Business School, London, for his expert advice
and assistance in this inquiry and on the other inquiries relating
to the banking crisis.
2 Financial Services Authority, Turner
Review Conference Discussion Paper, A regulatory response to the
global banking crisis: systemically important banks and assessing
the cumulative impact, October 2009, Para 3.18 Back
3 European Commission, European
Financial Integration Report 2009, January 2010 , P 37 Back
4 European Commission, European
Financial Integration Report 2009, January 2010 , p 37 Back
5 Ibid. , p 38 Back
6 Q 11, HC 259-i Back
7 Qq 512, 529 Back
8 Q 511 Back
9 Relevant declarations of
interest relating to Geoffrey Wood can be found in the Minutes
of the Committee. See www.parliament.uk/parliamentary_committees/treasury_committee/treasury_committee_formal_minutes_by_session.cfm