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

2 The objectives of banking system reform

How to design a banking system

18.  Given the impact of the financial crisis on both the financial system, and the wider economy, we questioned witnesses as to what reforms there should be. Douglas Flint, Group Finance Director, HSBC, countered that he would first start with:

defining the purpose of the banking system. Everything else is at the micro level until you have said what we are actually trying to achieve, and then make sure, as best one can, that one understands what the appropriate capitalisation of that system would be, and that the system can make the appropriate return on the capital that is being required of it to have, because I think it is very important that the system is capable of attracting the capital that supports the level of risk within it.[10]

The same point was made by Professor Goodhart, who noted that:

One of the considerations that you have to have is actually what you want your banking system to do. One way or another [ ... ] we are likely to make our banking system safer and smaller. The question is: will that be a good idea? How safe and how small do you want the banking system to be? If you make your banking system safer and smaller, what happens to the financing of your companies? You are going to push all the financial intermediation probably back on to the market. Will that make the world safer or will it make it more dangerous? For example, a lot of mortgage origination you can do through the market rather than through banks. Will that necessarily be safer?[11]

19.  As Professor Goodhart implies, there are complex trade-offs between objectives and political and economic choices in deciding how to prioritise. Some of the questions he posed may only be answerable in the light of experience. In the rest of this chapter we explore some objectives against which we can both assess the banking system before and during the crisis, and any potential reforms currently under consideration. Policy makers, nationally and internationally, will need to decide on their priorities for the banking system. A lasting framework will only come about once these decisions have been made.

Objective 1: Protecting the consumer

20.  For most people most of the time banking provides a basic utility function, which they expect to be well regulated and reasonably safe. More intensive customer education about the relationship between risk and returns offered, and the extent to which protection was available might reduce the amount of protection necessary, but in a modern democracy, Governments cannot allow depositors in banks and building societies to lose significant amounts, and they have not done so.

21.  No UK saver in a UK bank or building society covered by the Financial Services Compensation Scheme has lost any money from the failure of their organisation during the crisis. This has meant action by the Government to protect deposits above and beyond that of the deposit protection system in place prior to the crisis.[12] The Chancellor, in a written direction, explained why such support was needed:

The Government has said that it will do everything it can to protect financial stability and ensure depositor protection. After the experience of the government's action to support both Northern Rock and Bradford and Bingley, most people understand this to mean that no depositor would lose money and that their deposits in UK outlets are safe. [ ... ] the sight of people losing their deposits will undermine confidence in the financial system further, especially in today's difficult conditions. [ ... ] There is a growing consensus in Europe and elsewhere that banks' customers deserve full protection in the event of bank failures.[13]

By providing this support, the Government gave an implicit guarantee for all retail savings in the UK.

22.  Before the crisis, consumers seemed largely unaware of the risks that might accompany retail savings. The guarantee weakened or even removed any incentive for consumers to monitor for themselves the financial institutions with which they deposit their money, even though experience should have raised their awareness of risk. As Mr Haldane said:

One of the consequences of the blanket guarantee on taking risk off the table is that the retail deposit market in the UK has become rather distorted, with firms playing leapfrog in the rates of return they offer to retail depositors, almost irrespective of risk—which is not a good outcome for depositors longer term.[14]

23.  Professor Kay was adamant that we should "escape" from this position as soon as possible.[15] He preferred a limit to the protection afforded to depositors:

The structure which I would like to see would be one in which people have deposits which were the deposits they needed to make the payment system function. That is essentially the utility and the bit of the financial services system we need every day.[16]

But in a speech in June 2009, Paul Tucker, Deputy Governor of the Bank of England, stated that "Nearly a decade ago I became convinced of the need for 100% insurance of a meaningful amount in order, as I put it in internal exchanges, 'to take politics out of crisis management'."[17] Mr Tucker noted that politics had been brought into the handling of banking crises because of "the hardship that could still be suffered by regular depositors when their bank failed".[18] He told us that he believed it was "foolhardy" to think that households should take some of the risk when depositing with banks because he did not think it was "realistic to expect households to monitor their banks".[19] This is consistent with Professor Kay's position, though for larger deposits Professor Kay would like to see a system:

[ ... ] of the kind of money market funds that exist in the United States, where people would be investing in a diversified portfolio of short-term obligations and would be taking a little bit of risk and would either have to judge that risk themselves or employ the fund managers to assess the risks for them.[20]

And in our Report on Northern Rock, we also emphasised the need for consumers to be aware of the overall scope and limits of any depositor protection scheme. We recommended that: "For the [depositor protection] scheme to have the maximum impact in protecting financial stability, the details of the scheme must be well-advertised, both in national and regional media, and through the display of posters in individual bank branches".[21]

24.  A robust banking system must include a high level of protection for the retail depositor. Investors and wholesale depositors must price the risk, as the majority of consumers are in no position to undertake due diligence on the banks with which they hold deposits. It is noteworthy that audit reports are for investors rather than depositors. But an explicit provision of a guarantee on all deposits, without limit, is a step too far. There will be trade-offs even in deciding which limit is suitable, and whatever limit is chosen, there must be clarity about the limit of depositor protection. This will require constant consumer education and clear information within all financial institutions.

Objective 2: Protecting the taxpayer

25.  Resolving the banking crisis has been a significant drain on government resources, in two ways. First, there has been the direct impact of the provision of public money for deposit protection and recapitalisation, as well as the continued risk to the public purse from loan guarantees under the asset protection scheme. In a recent speech, Piergiorgio Alessandri and Andrew Haldane highlighted the direct costs from the bailout. In Table 1, they provide "a snap-shot of the scale of intervention to support the banks in the UK, US and the euro-area during the current crisis. This totals over $14 trillion or almost a quarter of global GDP. It dwarfs any previous state support of the banking system".[22]

Table 1: Support Packages
($ Trillions)
Central Bank

-  "Money creation"

-   Collateral Swaps







-  Guarantees

-  Insurance

-  Capital









Total (% GDP)

Source: Bank of England Financial Stability Report,. June 2009. Figures for UK updated to November 4 2009.

Notes: (1) Exchange rates used: FSR Europe/US dollar exchange rate of 0.710. Sterling/US dollar exchange rate of 0.613. (2) Money creation includes both monetary and financial stability operations.

26.  Protecting the taxpayer is not just about avoiding downside risks. It is about capturing the benefits that the financial system sector can bring. As the Mayor of London said:

  • The Financial Services sector has brought huge benefits globally. Through enabling globalisation it has brought hundreds of millions of people into the global market economy.
  • The sector provides services for all other sectors. Examples are payments services, money transmission, investment services, finance, mergers and acquisitions services and insurance. [ ... ]
  • Economic contribution: In 2008, the FS sector contributed to around 24 per cent of London's total GVA (15.9 per cent coming directly from FS, the remaining 8 per cent indirectly from other sectors that FS assists).
  • Employment: More than one million people work in the industry, each contributing to GDP more than double the average for all employees. The industry accounts for around 8 per cent of UK output and contributes 14 per cent of tax revenues.
  • The sector maintains a liquid market for UK government debt, ensuring that the taxpayer pays the lowest cost possible for servicing the debt.
  • The insurance sector provides cover against disasters that could do immense damage to the wider economy.
  • The sector is innovative. New areas such as carbon trading and Islamic finance can help the environment and foster financial inclusion.[23]
  • An essential service provided globally: FS enables businesses and households to carry out transactions quickly, cheaply and reliably all over the world, through global payments, clearing and settlement systems for financial transactions.

This might appear to be a separate objective, but regardless of the benefits that financial services may bring, the Governor of the Bank of England was keen to stress that the market should determine the overall size of the financial system. He told us that:

  • We do not sit round here and say, 'How big should the motorcar industry be?' or any other industry, and we should not do the same for financial services either. The objective here is not to maximise activity or employment in the industry. The objective is to create a financial sector that provides the services that the non-financial sector needs, it is an intermediate industry providing services to the real economy, and to do so in a safe and robust way, so it is designing the structure of it that is important, and then the market will determine how big it is.[24]

The banking sector can also impose indirect costs on the economy and the taxpayer, which we discuss in more detail in paragraph 36.

27.  The banking system provides many benefits, including—in the good times—considerable tax revenues for the Government. But the banking crisis has required unprecedented support from the United Kingdom Government, and other governments. While it is possible that much of this support may be recouped, there can be no certainty about this. In any event, Governments have had no choice about the timing of the support. We believe that one objective for the banking system should be to ensure that the market does not anticipate and price for direct Government bailouts.

Objective 3: An appropriate correlation between risk and return

28.  Banking is a business and those who fund businesses require a return on their investment. Mr Varley explained that:

whatever the cost of capital is, it is the expectation and I would say entitlement of shareholders over time in any event to receive a return in excess of the cost of capital, and they will demand that if they are going to be suppliers of capital to banks.[25]

It should also be noted that as well as a return to shareholders, there are rewards to management and employees, which can also influence the risks being taken by financial institutions.

29.  The resolution of the crisis has seen costs borne not just by the Government, but also by shareholders. In contrast, consumers have been protected, and perhaps more surprisingly, banks' wholesale creditors have, in the most part, not suffered during the crisis in the UK. The FSA explained that this was because:

when very large banks get into trouble, the pattern of the last year has been to use government capital injections to rescue the bank so that it remains a going concern in its existing entirety, with common equity holders facing loss but debt capital or senior debt providers protected. This policy has been followed throughout the world for two reasons: (i) fears that any other approach would result in systemic knock on consequences; and (ii) operational difficulties of rapidly executing any other approach[26]

This misalignment has also arguably led to banks taking excessive risks and bank owners and customers expecting excessive returns. The Governor contended that the financial system had been engaged in some kind of "alchemy". He explained that:

The basic problem is that you cannot really pretend to have a large financial system with assets that, on the one hand, are risky and desirably risky, we want the financial system to be able to take risks, but, on the other hand, pretend that the vast bulk of the liabilities which finance those assets receive safe returns. That would be alchemy and that is simply not available, so, one way or another, we have to reform the financial system in such a way that it is quite clear that, where risky assets are being financed, those who provide the finance know that their funds are at risk and it is not the taxpayer who has to step in.[27]

30.  Given the strength of the United Kingdom's financial sector, there may be a further decision to be made about how great an emphasis there should be on the role of the financial services sector as a source of comparative advantage. As the Governor of the Bank of England said, this is not simply a choice between a lightly regulated and a heavily regulated sector:

It is not to the benefit of the City of London to be known as a place with a fragile banking system which is neither safe nor robust.[28]

31.  Whenever one considers any regulatory reform, one must be wary of placing unacceptable burdens on the industry in question. But the payoffs in the banking system as revealed by the crisis suggest that there was too little risk taken by wholesale investors for the reward they received. The Government has been forced to protect them. Risk in bank investments must be correlated with return, as it is in other fields. Losses should not be borne by taxpayers and shareholders alone.


32.  If investors are to assess properly the level of risk they are prepared to take, they need clear and impartial information about the companies in which they invest. Company audits should provide such material, but as we concluded in our Report on Banking Crisis: reforming corporate governance and pay in the City, the current audit process results in "tunnel vision", where the big picture that shareholders want to see is lost in a sea of detail and regulatory disclosures.[29] The recent revelations about Lehman's use of Repo 105 illustrates the extent to which audit reports can seemingly omit crucial information.[30] We call for progress on our earlier recommendations, to ensure that audit reports are an effective tool for investors.

Objective 4: Ensuring sustainable lending to the economy

33.  Both Lord Turner and the Governor of the Bank of England defined the financial system as an "intermediate" one, in that its activities are not an end in themselves, but rather facilitate the activities undertaken by the real economy. Lord Turner considered that the intermediate sector contained:

both the bureaucracy of the public sector but also the intermediate goods of the financial sector, and here the crucial distinction is between final goods purchased by consumers and intermediate rather than public and private goods.[31]

34.  Banking is not a risk-free operation. Banks engage in maturity transformation, which is where a bank borrows short-term (either from the market or from depositors) and lends long-term. This maturity transformation has benefits for the real economy, but it also carries risks to the bank which is in danger of being unable to meet its commitments should it have a sudden need to meet its short-term liabilities. Mr Varley "particularly" regarded "maturity transformation/extension of credit" as one of the "core functions" banks should reliably undertake.[32]

35.  Yet the banking crisis had a severe impact on the availability of credit to the real economy. We have been monitoring this since the crisis began. In our Pre-Budget Report 2008 we noted:

The lack of bank lending remains the single most critical problem for the economy in the near term. The Government must ensure that the availability of credit, both to households and businesses, increases.[33]

Unfortunately, it is clear that problems still exist. We note, for example, the most recent lending figures from the Bank of England indicate "In 2009 Q4 the stock of lending to companies fell across all the main sectors of the economy for the third consecutive quarter".[34] Some of this may be the result of reduced demand, but we receive a flow of correspondence from businesses complaining about higher prices for credit, and reduced credit limits.

36.  The banking system is one of the main conduits for lending to the real economy. As such, the objective should be for it to provide a steady and appropriately priced supply of credit. However, the present crisis was preceded by cheap and plentiful credit. We have now seen a significant and sudden reduction in the availability of credit to the real economy. Reform to the banking system must try to ensure that the market for credit operates efficiently, and prices credit more reliably.


37.  Another result of the interplay between the financial sector and the rest of the economy has been an indirect second cost to Government from the recession caused by the banking crisis. Lord Turner told us that the "overt public rescue costs, while very significant, may turn out to be small relative to the overall costs produced by financial instability."[35] He thought that while it was "quite possible that the total overt costs of the UK's big bank rescues will not exceed 5% to 10% of GDP", following this crisis "UK fiscal debt will rise by about 50 percentage points of GDP and many people have lost jobs, houses and income".[36] This larger loss was due to "volatile credit supply first under-priced and too easily available and then severely constrained".[37]

38.  The costs of a banking system crisis are not limited to the overt or immediate payments to the banking system or for consumer protection via the Financial Services Compensation Scheme. As a result of the banking crisis, the economy was pushed into recession. This loss in output is resulting in job losses, hardship and lower living standards for many, as well as placing considerable stress on the Government's balance sheet.


39.  One of the concerns has been that some activity within the financial sector has not served any purpose for the real economy. Mr Haldane provided the following cautionary note on the growth of the balance sheet of the financial sector: "Too much of the balance sheet growth was re-financing stuff within the financial system rather than financing stuff in the real economy."[38]

40.  Lord Turner has been more critical of some of the activities that the banking sector has undertaken. He has referred to some of them as "socially useless".[39] When we asked Lord Turner to define what would make a product "socially useless" he replied:

it is reasonable for society to ask: are we getting these plumbing bits of the economy as efficiently and as at low a cost as possible? Are we getting only those things that are useful? Just as you can ask whether a quango performs a useful function for society, it is also possible to ask whether or not an intermediate function like a derivatives market has value. Having said that, to determine in concrete terms what is valuable or not is incredibly difficult, but at least if you are aware that the financial system is capable of generating activity that does not have value added for the economy—there is a sound set of economic theories about why the financial system is capable of creating for itself rent-extraction possibilities—you are on your guard [ ... ] It does not provide you with a nice, easy rubric to determine what is and what is not socially useless—I do not believe that is our role—but it means we are not open to the alternative argument that everything that exists must exist.[40]

However, when we questioned Lord Turner as to whether it was possible to identify 'socially useless' packages in advance, he replied "I cannot say that I would necessarily have spotted them in advance".[41]

41.  It is important that banks can function as intermediaries in the real economy. The nature of the services offered will vary over time. Only 'useful' products will survive. However, the financial system can at times develop products which are ultimately dangerous rather than useful, and which survive for long enough for those dangers to materialise. We do not believe that it is possible to define in advance whether or not a particular product or activity will be useful, or will be a source of long-term profit for its issuing bank. However, when a new product becomes well established, regulators should analyse how far it helps the bank to perform its intermediary role, and take action to ensure that any risks identified are correctly priced. This should be an important role for regulatory authorities.

Reducing moral hazard

42.  Faced with the financial crisis in the UK, the actions of the Tripartite authorities (the Bank of England, the Financial Services Authority and HM Treasury) have illuminated the extent to which it is possible to balance the different objectives of the financial system as outlined above under the current regulatory system. In practice, it has been possible to protect depositors, and to take some limited action to preserve banks' intermediary functions. It has not been possible to avoid government bailouts, or to prevent the financial crisis impinging on the wider economy.

43.  Their actions have also illuminated several examples of moral hazard within the system. Moral hazard matters because it reduces the incentive for market participants themselves to balance risk against reward. Effective consumer protection means that consumers do not have to worry where they store their money, as the Government will foot the bill in case of failure. And moral hazard has not been limited to the consumer sphere. In certain cases, due to the need for speed or the systemic implications of action, the Government was unable to ensure that wholesale creditors suffered from the failure of the banks they have money invested in. Accordingly, these actions have reduced the need for firms to monitor the banks in which they hold stakes. Indeed, as Mr Haldane told us, there is empirical evidence that moral hazard is misallocating potential costs from the banks to the Government:

rating agencies typically assign two sets of ratings to banks, one, the so-called 'stand-alone rating' which tells you how risky a bank might be without any state support, but then what they do is take that rating and ratchet it upwards based upon their guess as to the likelihood of the State providing support to that institution and that is called the 'support rating'. [ ... ] What we have seen in consequence of the crisis is really two things: one is that the gap between those two ratings has grown or, in other words, there has been an expectation, at least among the rating agencies, of banks generally being more likely to receive support; and point two is that that difference between the support and stand-alone ratings has grown by more among the bigger banks, so the expectation of a bail-out post the crisis is particularly strong among the larger institutions. Of course, to the extent that those ratings translate, as you would expect them to, into the cost of borrowing by institutions, those moral hazard indicators will translate into a lower cost of funds for banks and, other things equal, bigger profits.[42]


44.  The current financial system and its safety nets have developed in an ad-hoc way. There has been little explicit consideration of the trade-offs implicit in the policies of regulators and governments. So, for example, the market has been left to develop mortgage products, without restrictions on loan-to-value ratios. This has an immediate advantage for customers, but in the long-term it may have adverse consequences for those same customers, and the wider banking system.

45.  The current policies have had the following effects:

  • Consumers who are depositors in bodies covered by the Financial Services Compensation Scheme are completely protected;
  • The real economyhouseholds and non-financial firms—has been provided with a volatile flow of credit;
  • The system's cost base does not currently cover the cost of the Financial Services Compensation Scheme upfront, let alone the cost of wider support for the financial system.

This has meant that during the crisis, the Government has had to act to balance these provisions. It has paid upfront for consumer protection and supported the economy when credit has become unavailable. This is the ideal opportunity for Governments, regulators, financial market participants and representatives of the real economy to decide whether or not they are prepared to accept these trade-offs. There is a danger that Governments will constrain the activities of financial markets so much that valuable economic activity is lost. That must be avoided. However, the result of the crisis has been that the expectation of a bailout has increased, and banks profits may be boosted by this. That must be changed.


46.  The moral hazards in the banking system are largely generated by the perception that many financial firms are 'too important to fail' and have to be supported by the government. This crisis has now provided empirical evidence to support this perception, making the implicit, explicit. As we explored earlier, it is essential that government support for banking should be minimised to protect the public purse. This will not be easy, given the key role that banks play in national economies, and the global economy. But even apart from reducing taxpayer exposure, there are sound reasons for reducing expectations that Governments will protect banks from losses.

47.  As we have seen from our discussion of the objectives for reform, the classification of some banks as 'too important to fail' leads to these firms carrying too low a burden of cost upon themselves, while the Government is forced to step in to cover that burden. In the reforms we consider next, tackling this problem will be key.

10   Q 390 Back

11   Q 17 Back

12   Treasury Committee, Fifth Report of Session 2007-08, The run on the Rock, HC 56-i, paras 217-266 Back

13   Letter from the Chancellor of the Exchequer to Nick Macpherson, 8 October 2008 Back

14   Q 111 Back

15   Q 21 Back

16   Q 20 Back

17   A speech by Paul Tucker, Deputy Governor, Financial Stability, Bank of England, at the British Bankers' Association Annual International Banking Conference: Restoring Confidence - Moving Forward, London, 30 June 2009, pp 3-4 Back

18   Ibid. Back

19   Q 86 Back

20   Q 20 Back

21   Treasury Committee, Fifth Report of Session 2007-08, The run on the Rock, HC 56-i, para 243 Back

22   A speech by Piergiorgio Alessandri and Andrew G Haldane, Banking on the State, Bank of England, November 2009 Back

23   Ev 135 Back

24   Q 89 Back

25   Q 220 Back

26   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 3.8 Back

27   Q 76 Back

28   Q 138 Back

29   Treasury Committee, Banking Crisis: reforming corporate governance and pay in the City, Ninth Report of Session 2008-09, HC 519, para 221 Back

30   Lehman Brothers Holdings Inc. Chapter 11 Proceedings, Examiner's Report, Section III.A.4: Repo 105 Back

31   Q 467 Back

32   Q 205 Back

33   House of Commons, Treasury Committee, Pre-Budget Report 2008, Second Report of session 2008-09, HC 27, para 17 Back

34   Bank of England, Trends in Lending, February 2010 Back

35   Q 460 Back

36   Q 460 Back

37   Q 460 Back

38   Q 155 Back

39   Prospect, How to tame global finance, Issue 162, September 2009 Back

40   Q 467 Back

41   Q 483 Back

42   Q 100 Back

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