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


1 Introduction

Too important to fail—too important to ignore

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]

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]

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]

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]

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 was necessary:

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 important—not for this reason, by the way, but for public policy reasons—is 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 of scrutiny.[6]

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

TRADE-OFFS

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 be made.

UNCERTAINTY

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 disappointed.

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.[7]

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 that:

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.[8]

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.[9]




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 www.parliament.uk Back


 
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