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

6 The future

Choosing a balance

156.  This Report has highlighted various trade-offs to be considered when considering potential reform of the regulation of the banking system. But there will be considerable difficulties in deciding what balance is appropriate, for it is not easy to quantify the costs and benefits of different solutions. Professor Goodhart was sceptical about the possibility of such quantification:

It is a nice idea but in practice it is so difficult. When you are changing the structure it is very hard to work out exactly what is likely to happen. The unexpected consequences of a structural change can be fairly profound.[186]

Professor Kay agreed:

I have spent part of my life inventing bogus numbers in order to justify particular policies, because there is a huge demand for these bogus numbers out there—but in the end we have to make these decisions on the basis of our own judgment and knowledge and your judgment and knowledge.[187]

157.  However what seems apparent is that one single reform will be insufficient. Mr Haldane pointed out that "It is the package that is going to matter. It needs to be a package, because no one measure is going to be sufficient, even though it might be necessary."[188] The Governor of the Bank of England reiterated this point:

I think the most important thing is that we are prepared to countenance radical reform, but I think the key thing to remember is that no one proposal or set of proposals will solve all problems [ ... ]and they are not designed to. [ ... ] If what we are going to do is to say, "We won't adopt anything unless it solves all the problems", then we are going to be stuck where we are, so I think we need to recognise that it will be a range of different policy instruments that will be required to solve the range of problems that the financial sector poses.[189]

A multifaceted approach underpinned the reform agenda proposed by the Governor of the Bank of England under the 'three-legged stool' analogy:

There is a three-legged stool on which it makes sense to try to rest our approach; we should not rest it on just any one approach. One is structure and it is important not to lose sight of that. [ ... ] The second is capital [ ... ] The third is resolution[ ... ] It will be difficult to push it far enough, but regulators must be tough enough on banks to say they do not believe their structure is simple or small enough for them to be able to allow them to fail and therefore they must change the way they organise their activities. We cannot end up in a situation where any regulator or government feels that an institution is just too important or big to fail [...][190]

158.  Mr Corrigan felt that there was an element of uncertainty in both the types of reform discussed in this Report, whether it be the structural, or as we have termed it, evolutionary approach: "In either case you are hoping. In one case you are hoping that the regulators are going to do a better job in the future than they did in the past. In the other case you are hoping that this radical or at least fundamental restructuring of the financial system is going to work. Either way you are hoping".[191]

159.  Economic theory suggests however that individuals may exhibit projection bias when considering what will bring them future utility (a measure of satisfaction). An article in the Economic Journal explains:

When making decisions about future consumption, people must make predictions about the utility they will derive from it. While economic theory typically assumes away any difficulty in making such predictions, abundant empirical work has shown that predicting future utility is actually quite difficult; for a review see Loewenstein and Schkade (1999). A particularly robust finding in this literature is that people tend to bias their estimates of future utility towards their current utility, a phenomenon labelled Projection Bias by Loewenstein et al. (2003). While it is sensible to base predictions about the future on the present, Projection Bias is a bias because predictions of future utility are systematically off in the direction of current utility, i.e. they are predictably wrong

In general, Projection Bias will lead to systematic errors when decisions are made in the presence of factors that influence current but not future utility. Prior research, for example, has shown that grocery shoppers buy more items if shopping while hungry (Gilbert et al., 2002), that current arousal influences predictions about future sexual behaviour (Ariely and Loewenstein, 2006) and that catalogue orders for winter clothing are more likely to be returned if ordered on colder days (Conlin et al., 2007).[192]

What this may mean is that when deciding where to trade-off between the different objectives we have outlined, there may be a bias to what is presently desired. Given that the UK has just been through a financial crisis, the current desire is for a safer, more secure banking system. But the redesign of the system should be for the long term. We must not replace irrational exuberance with equally irrational restrictions. What is needed is a regulatory framework that will not flex according to the moods of politicians, the markets or even regulators. Given the lamentable consequences of the previous regulatory approach, the Government should be prepared to embrace radical change, rather than settling for adaptation to an existing, failed model.

160.  This Report sets out a number of objectives against which to compare potential approaches. The Government must be clear in its response where it believes it has made the trade-offs against those objectives, in order to ensure the financial services industry serves the interests of the wider economy.

The international agenda

161.  Throughout this Report, we have seen areas where the contrast between the international nature of banking against the national nature of regulation and fiscal support has led to vulnerabilities in the financial system. A coordinated reform of the financial system would, to some, therefore be a desirable outcome. Lord Turner provided the following description of the international work currently being undertaken:

I would describe it in three layers. There is an overall high-level political dynamic driven by the G20 and G20 summits of which there will be one in Seoul this year. Beneath that there is the Financial Stability Board (FSB) which brings together representatives of financial ministries, central banks and regulators from the G20 countries. It has the job of ensuring that the political desire and commitments of the G20 are translated into an integrated set of reforms. The third level is the Basel Committee. That committee as such does not specifically report to the FSB. None of these things, as it were, has firm reporting lines because none of them is treaty based, but it is the case that the FSB is continually reviewing where the Basel Committee has got to. The detailed work on how a capital requirement actually works, how it would be done, what should be the precise ratios and how it would be operationalised is done by the Basel Committee with regular reports back to the FSB. For instance, next Monday in Basel there is a meeting of the FSB steering committee. We will then review the full set of the work programmes in place and will hear from the Basel Committee on the progress it is making with the development of a new capital requirement. It is architecture that is working as best as possible and it is one that is created by political declaration and does not have a firm set of treaty-defined reporting lines.[193]

162.  The banks considered there was a need for international consensus on reform. The BBA provided us with the following comments on the need for international coordination:

There is significant advantage for the UK in banking reform being delivered within an international framework as this provides the best assurance of reforms enhancing financial stability at a global level. There is little or no 'first mover advantage' arising from national action and measures introduced in a piecemeal fashion may reduce the prospect of international agreement. The UK should align its change programme with the international timetable.[194]

163.  Given this desire by some for an internationally agreed reform plan, President Obama's proposals for the reform of the US financial system have caused consternation. Mr Varley voiced his concerns as follows:

It is so important, it seems to me, given that risk is cross-border, given that risk is global, that the initiatives that are taken to create reform are consistent. What I lament about what has happened in the United States, is that the United States, in many senses the leader of the capital markets of the world, has gone in its own direction, whereas I think what we need is convergence of regulatory activity rather than independent regulatory activity.[195]

He went on to explain that

I do see, and indeed I would share, a strong reaction to a unilateral move by the United States, because the language of G20 as the leaders emerged from Pittsburgh was, ªWe will move in convoy.º The importance of the convoy is that it is the best way of managing cross-border risk. What has happened here is that a member of the convoy, quite a big member of the convoy, has just left it and gone in its own direction. I do think that is bad for the world, struggling as it is to create consensus around a package of reforms that the world needs to prevent this happening again. There, I think there are strong feelings. I certainly hear them among my peers [ ... ][196]

164.  Professor Lamfalussy also raised his objections to the way in which the US were stepping out alone in making their reforms. He stated that:

I am no longer in any supervisory, regulatory or political position at all, but the way in which the Americans have been acting is not acceptable. There have been discussions going on here and there; there is a work plan for the G20, and they suddenly come out with a plan which, as regards Volcker, was not new, because Volcker had said it a year earlier. No one took it seriously but it received the President's formal support, and that is not a good way of handling these problems. That is why I would urge that we in Europe, and this is not a euro area question it is for the European Union, speak with one voice and tell the Americans: "Look, you raise a number of very valid questions, let's sit down and see what we can do", and not wait until the Americans implement whatever they are going to do. No one knows what is going to happen to the Volcker plan exactly but something will happen, and if we simply wait until then we will have absolutely no bargaining power.[197]

165.  When we met him in the US, Mr Volcker expressed his desire to have the UK act with the United States, a sentiment he repeated in his testimony to Senate Banking, Housing and Urban Affairs Committee later that day. He made the following comments to us:

But the fact of the matter is if you get the US and the UK, the two big financial centres agreeing on this, you are a long way towards getting the consensus you need. But I think it would be very nice, at the very least to get the Europeans, in addition to Britain, on board. If you get them on board there's nobody left really [ ... ].[198]

166.  Professor Kay was adamant that the UK should go it alone if necessary: "Saying we must wait for international agreement before acting is a recipe for inactivity, and most of the people who say it do so with that outcome in mind."[199] He expanded his views in oral evidence:

We have to go it alone, and we have to go it alone in two ways. One is, essentially, if British financial institutions are to operate overseas, we make it clear that we want them to do that but we do not want, as the British taxpayer, to give people any impression that we are underwriting these activities [ ... ] They must operate as subsidiaries and we will let these subsidiaries go, as the UK Government, if need be. Conversely, we do want banks from other countries to operate in the UK but, if they do so, as the world is now they are going to have to maintain assets in the UK which we could seize in the event of a failure of that institution, because there is no other mechanism by which we can ensure that UK depositors get paid if that happened. These are the things that are essential to safeguard the interests of UK customers and UK taxpayers. Just to repeat what I have said several times earlier: these are the things that matter, and the interests of UK financial institutions are secondary.[200]

167.  In the 1970s the UK banking sector had a balance sheet of 50% of United Kingdom GDP; it is currently 500% of GDP.[201] 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 not expected to pick up the bill. As the Governor of the Bank of England said:

it is not an attraction to a country to have a banking system which is five times GDP, if—if—there is a real risk that the taxpayer may have to bail it out. We have to get to a point where that risk is not realistic. Then it becomes credible for a country the size of the UK to be home to a very large international banking centre. It is not credible to be home to that if the British taxpayer is taking the risk of the whole of the balance sheet.[202]

168.  The United Kingdom can only benefit from constructive international agreement. It would help safeguard the position of the City of London, which is a crucial part of the UK economy. However, the prevarication on international agreement must not be used as an excuse to delay, or, at worst, prevent reform. Britain has a very large banking system relative to GDP compared to other countries, and its reform is anyway in our own self-interest, even if it is not coordinated with reforms in other countries. A strong banking system is good for the country, and as the Governor of the Bank of England said "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."

The pace of reform

169.  According to the Financial Times in January, in an invitation to one of their meetings, the Bank of International Settlements warned that "financial firms are returning to the aggressive behaviour that prevailed during the pre-crisis period".[203] Professor Lamfalussy was also concerned by "the growing reluctance of market participants—and this is an understatement—to support genuine reforms. A striking example is the powerful lobbying against the badly needed reforms of the CDS (the credit default swap market), standardisation, central clearing counterparty, trading on authorised exchanges."[204] And in a speech announcing his proposals for reforms to the US financial system, President Obama suggested that there was concerted resistance by the financial industry. He remarked that:

My message to members of Congress of both parties is that we have to get this done. And my message to leaders of the financial industry is to work with us, and not against us, on needed reforms. I welcome constructive input from folks in the financial sector. But what we've seen so far, in recent weeks, is an army of industry lobbyists from Wall Street descending on Capitol Hill to try and block basic and common-sense rules of the road that would protect our economy and the American people.

So if these folks want a fight, it's a fight I'm ready to have. And my resolve is only strengthened when I see a return to old practices at some of the very firms fighting reform; and when I see soaring profits and obscene bonuses at some of the very firms claiming that they can't lend more to small business, they can't keep credit card rates low, they can't pay a fee to refund taxpayers for the bailout without passing on the cost to shareholders or customers—that's the claims they're making. It's exactly this kind of irresponsibility that makes clear reform is necessary.[205]

The Governor warned that "Most of the changes that would be made would have the result that the profitability of equity in banks would be lower in the future than it is now. It is hardly surprising that the people currently in the industry will fight those proposals. After all, if you have an implicit subsidy from government, why would you want voluntarily to give it up?"[206]

170.  When asked whether he agreed with the Bank for International Settlements warning, Mr Corrigan noted that the industry had taken a number of steps to strengthen the system

If you take Goldman Sachs for example, these days our tier one capital ratio is something around 15%. Far more importantly, our tier one common equity ratio, which of course takes account of the quality of capital, not just the amount, itself is something like 12.5%. I think both of those numbers are at or near high industry standards, but I think as a general matter they are representative of industry standards today and both are substantially higher than would have been the case prior to the crisis. I would also note that institutions both in the United States and elsewhere and through the BIS discipline are now publishing and paying more attention, as they should, to so-called leverage ratios. Again, if you look at leverage ratios at the end of, say, 2009 at Goldman Sachs, which is broadly representative of other firms as well, they are now in the range of 12% or 13%, which is about half of what they were prior to the crisis. Finally and most importantly—I can only cite Goldman Sachs numbers because the others I do not think are particularly well known—what we call our core excess liquidity, which essentially is unencumbered government securities, cash, things like that, at the end of the past year were about $160 billion odd or 18% of the total balance sheet. If you take those three metrics as examples, recognising that roughly speaking they are representative of broad industry standards, I am not sure I would say that is business as usual;[207]

However, Mr Corrigan did acknowledge some concerns: "I will say that I do have some concerns that, if we are not very careful, at some point we can see animal spirits beginning to pop up here and there again. We have to be much more aggressive and vigilant in the future than we have in the past to deal with those problems earlier rather than later".[208]

171.  Given the potential for the banking system to return to 'business as usual', we asked how much time would be needed to reform the system. Professor Goodhart told us:

[ ... ]while you want the banks to be safer and to have more capital and more liquidity, if you force them to do it too quickly, then you are going to get the banks continuing to de-lever and cut back on lending to ordinary people with spreads increasing. There is a problem, a trade-off, between the desire to get the banks to be in a better position and yet the desire to keep credit flowing to people in industry around the country. The way that everyone is dealing with this is trying to have a transitional period so that you say that you want the banks to reach a particular state by, shall we say, 2015 and move relatively steadily and slowly in the intervening period. I do not actually see a better way of doing it than that.[209]

Mr Tucker also considered that the reform would take time:

The root of this, as the Governor said, is to ensure that, when a bank gets into distress, wholesale creditors take some of the pain. Shareholders are taking pain, management have taken some of the pain, insured depositors are insured and they are meant to be insured, and it is the people in between that matter. It is going to be a long endeavour, quite frankly, to get to a structure of a banking system that puts wholesale creditors at risk without them fleeing the system and damaging the recovery of the economy in the meantime, but that we have to do, and there is a whole range of ways of doing it.[210]

172.  Mr Corrigan though was in favour of a more rapid reform programme:

The fact of the matter is that when you look at the crisis of the past two years, and every single crisis in my professional lifetime, going back more than 30 years, the thing that has driven every crisis has been failures in credit origination and lending, whether it was the LDC debt crisis in the early 1980s, the real estate leverage finance crisis in the late 1980s or the experience of the past two years. Moreover, even if you think you can make it work, when you set out in effect to carve up or recreate, whatever words you want to use, the core of the financial system that transition— even the Governor admitted this in his appearance before your Committee—would take years. Part of my thought process is we do not have years to spare. What we have to do is to really attack in the short term this reform agenda that I spell out in my statement.[211]

173.  Banking sector reform will take time, as illustrated by Basel II. Knee jerk reforms are unlikely to stick, and as much international agreement as possible is needed. The risk is that as companies make adjustments in the meantime, there will be a slow resumption of unacceptably risky behaviour. That cannot be allowed. Both policymakers and market participants have to remain focussed on this issue until the necessary, durable, reforms have been completed.

Future work

174.  This inquiry has touched upon several areas which will be important when considering future bank reform, but for which a wider inquiry may be necessary. We discuss these briefly below.


175.  Lord Turner was keen to emphasise that solving the problem of 'too important to fail' may not conclude the work that is needed to be done. He told us that:

[ ... ] it is important to understand that addressing the "too big or important to fail" problem is a necessary but not sufficient response to the financial crisis. [ ... ] it is quite possible that the total overt costs of the UK's big bank rescues will not exceed 5%-10% of GDP; indeed, it is possible that the figure will be much less. [ ... ]. Following this crisis, UK fiscal debt will rise by about 50% of GDP and many people have lost jobs, houses and income. The key driver of these much bigger costs is volatile credit supply first under-priced and too easily available and then severely constrained. It is important to realise that that problem might continue even if we successfully address the "too big to fail" problem. If the big UK banks which we needed to rescue in the autumn of 2008 had been multiple smaller banks we might still have had just as much over-exuberant lending to commercial real estate developers funded by risky short-term wholesale deposits. I believe that is the evidence which emerges from the US on this subject. Therefore, tighter capital and liquidity requirements on all banks and new counter-cyclical macro-prudential tools which can constrain credit supply in the upswing may be even more important than specifically fixing the "too big to fail" problem.[212]

176.  Others also warned us not to forget the macroprudential aspects of reform. Mr Sáenz pointed out that:

[ ... ] at some point you have to connect and establish some connection between this kind of micro supervision and some kind of macro supervision. The micro supervision may be at an individual level but you have to connect the findings and the conclusions of this supervision with, let us say, some body that has a broader view about the systemic consequences of the behaviour and the numbers found out in the micro supervision. This kind of connection should be made in probably a more efficient way. That exists in a natural way in the instance where the central bank and the supervisor are the same. This has to be guaranteed when the central bank and the supervisor are different.[213]

Professor Portes also urged further work at the macroprudential level, but also warned of the implications that this might have:

We know what to do for macroprudential regulation, an essential new component of a reformed regulatory regime: some combination of countercyclical capital ratios, liquidity ratios, leverage ratios, and perhaps mortgage loan-to-value ratios. The banks will complain that this is all too complex, too constraining, so the outcome is likely to be a relatively weak set of requirements, with the ratios set too low to make much difference. There is one important consequence of such macroprudential regulation, however, that has been somewhat neglected. Although business cycles may be more highly correlated across countries now than in the past, they are still to a considerable extent national, as are some asset price bubbles (eg, within the eurozone, we saw housing price bubbles in Ireland and Spain while German housing prices actually fell). That implies that the parameters of countercyclical macroprudential regulation have to be set at a national level, which in turn implies that the host regulator rules. That means that branches of global banks would be treated differently in different countries—an unsustainable position. Hence there will be pressure on cross-border banks to go from branches to subsidiaries.[214]

This Report has been focussed on the issue of 'too important to fail'. Yet the debate on macroprudential tools demonstrates the links between the financial system and the wider economy. We recommend that the Committee in the next Parliament should undertake further work in this area.


177.  Another aspect of the banking system that we touched on in this inquiry, but which deserves greater focus is competition. Professor Portes outlined his thoughts on this issue as follows:

The banking sector was already overly concentrated before the crisis. It is now more so, and there will be many more failures of small and medium-size banks, with resulting further 'consolidation'. The remaining big banks have even more power. Far from being humbled by their egregious errors, they are vigorously—and successfully—opposing reforms that might reduce their profitability or their capacity to 'innovate', for which read 'generate new kinds of overly complex, opaque, highly profitable financial instruments and activities.' The banks are not just too big to fail, they are too big and too complex to regulate, even to manage effectively, or to control risk. But only Neelie Kroes has any apparent desire to break them up because they are oligopolists—the UK Competition Commission and FSA and US Department of Justice and financial regulators have no appetite for this, nor do finance ministries.[215]

178.  Virgin Money submitted evidence to the Committee on the importance of competition. As a potential new entrant to the market, their views are of interest:

It is vital that a competitive banking market emerges from the financial crisis. Competition has an important role to play in helping to mitigate risk, providing customers with more sustainable, straightforward banking services and, ultimately, rebuilding consumer trust.

More effective competition, combined with robust depositor protection, will be particularly important in the future; a market comprising a greater number of smaller banks that, individually, pose less of a threat to financial stability than large banking groups, could help to dilute systemic risk.

A competitive market for banking services also encourages innovation in product design, product distribution, pricing and customer service. Innovative, consumer-focused banking facilities that are sensible and safe are more likely to emerge in a competitive environment than one where the market is dominated by a small number of large, complex institutions.

Reform of banking regulation must therefore avoid inadvertently curtailing competitive forces or establishing new barriers to entry. Competition and consumer choice in financial services, involving existing market participants and new entrants, will be vital to delivering growth, prosperity and a good deal for consumers. This must not be overlooked in any redesign of the financial sector.[216]

179.  The Governor of the Bank of England considered that new entrants might be deterred by the implicit subsidy given to existing, very large banks, due to the assumption that large banks would be rescued by the Government.[217] The Governor then explained that:

This is a pretty good time to set up a new bank because the problem that existing banks have is the legacy problem of their balance sheet. A new bank starting up does not have that problem. Given the margins at present in much of the business, there is plenty of scope to set up a new bank and try to compete away the margins. The difficulty is whether you think that after five, six or whatever years it is before we get back to the more normal levels of margins, you will then be able to compete against the small group of very large banks that dominate the market. That is something for the competition authorities.[218]

When asked whether the Bank of England could intervene, the Governor of the Bank of England told us that "We are very enthusiastic about having more new entrants and encouraging more competition in banking. I am not sure we have any policy instruments at our disposal to do anything about it".[219] Mr Tucker, Deputy Governor of the Bank of England (Financial Stability) then explained how some of the reforms may aid competition:

I think it is fair to say that the introduction of a resolution regime ought to reduce barriers to entry from the official side. If a new venture gets into difficulty and fails while it is still modestly sized, it is easier to put it to bed now than it was in the past. But I say that subject to a proviso, which is that it remains incredibly important that the deposit protection scheme, the financial compensation scheme, is able to pay out to depositors in a failed bank very quickly, within a week, because that way savers need not be deterred from putting their money with a new venture if they think it is going to be a safe venture, because they can get paid out by the insurance fund. That does not address the implicit subsidy for those that are too big to fail, but at one end of the spectrum, the barriers have been reduced slightly, arguably.[220]

180.  We also questioned Lord Turner on whether the FSA should have any responsibility for competition. He replied:

I do not believe we need to be a competition authority as it relates to our prudential responsibilities. If one goes over to the conduct of business and retail customer protection side obviously it is possible to ask questions about whether or not there should be an integration between the tools that relate to the creation of competition and the other tools available to protect customers. At the moment we have a disconnect between the competitive tools residing in the OFT and Competition Commission and all other tools of customer protection that reside with the FSA. I believe that it is an open issue.[221]

181.  The financial crisis has significantly reduced the number of banks and building societies operating within the United Kingdom. We believe the next Treasury Committee should undertake work in the area of competition and banking. It is clear from the Governor's evidence, and from the events of the past few years, that effective competition will be inhibited for as long as incumbent companies are too big—or too important—to fail. That is yet another reason why the financial system must be reformed, as quickly as practicable, to ensure that financial institutions are, like the rest of the economy, properly subject to the discipline of the market place.

186   Q 5 Back

187   Q 6 Back

188   Q 115 Back

189   Q 79 Back

190   Oral evidence taken by the Treasury Committee on 24 November 2009, HC 34, Q9 Back

191   Q 339 Back

192   AU: Uri Simonsohn, TI: Weather To Go To College, SO: The Economic Journal, VL: 120, NO: 543, PG: 270-280, YR: 2010 Back

193   Q 521 Back

194   Ev 126 Back

195   Q 224 Back

196   Q228 Back

197   Q 545 Back

198   Ev 148 Back

199   ' Narrow banking: FAQs', John Kay, pp 6-7 Back

200   Qq 12-13 Back

201   Q 110 Back

202   Q 139 Back

203   Financial Times, Top banks invited to Basel risk talks, 6 January 2010 Back

204   Q 529 Back

205   The White House, Office of the Press Secretary 21 January 2010, Remarks by the President on Financial Reform  Back

206   Q 141 Back

207   Q 317 Back

208   Q 317 Back

209   Q 57 Back

210   Q 77 Back

211   Q 306 Back

212   Q 460 Back

213   Q 419 Back

214   Ev 110 Back

215   Ev 110  Back

216   Ev125 Back

217   Q 144 Back

218   Q 146 Back

219   Q 147 Back

220   Q 147 Back

221   Q 518 Back

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