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.
The same point was made by Professor Goodhart, who
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?
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. The
Chancellor, in a written direction, explained why such support
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.
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 riskwhich is not a good outcome for depositors
23. Professor Kay was adamant that we should
"escape" from this position as soon as possible.
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
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'."
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".
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".
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.
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".
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
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
Table 1: Support Packages
- "Money creation"
- Collateral Swaps
|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
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
- The Financial Services sector
has brought huge benefits globally. Through enabling globalisation
it has brought hundreds of millions of people into the global
- 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
- 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
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, includingin the good timesconsiderable
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
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
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
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
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.
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.
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.
The recent revelations about Lehman's use of Repo 105 illustrates
the extent to which audit reports can seemingly omit crucial information.
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.
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
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.
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".
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
COSTS OF FINANCIAL INSTABILITY
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."
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".
This larger loss was due to "volatile credit supply first
under-priced and too easily available and then severely constrained".
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.
SOCIALLY USEFUL ACTIVITY
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."
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".
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 economythere is a sound
set of economic theories about why the financial system is capable
of creating for itself rent-extraction possibilitiesyou
are on your guard [ ... ] It does not provide you with a nice,
easy rubric to determine what is and what is not socially uselessI
do not believe that is our rolebut it means we are not
open to the alternative argument that everything that exists must
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. 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
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.
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:
who are depositors in bodies covered by the Financial Services
Compensation Scheme are completely protected;
- The real economyhouseholds
and non-financial firmshas 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
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.
ENDING TOO IMPORTANT TO FAIL?
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.
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