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

Conclusions and recommendations

Too important to ignore

1.  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. (Paragraph 7)

2.  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. (Paragraph 8)

3.  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. (Paragraph 19)

Protecting the consumer

4.  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. (Paragraph 24)

Protecting the taxpayer

5.  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. (Paragraph 27)

Risk and return

6.  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. (Paragraph 31)

7.  We call for progress on our earlier recommendations, to ensure that audit reports are an effective tool for investors. (Paragraph 32)

Sustainable lending

8.  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. (Paragraph 36)

9.  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. (Paragraph 38)

10.  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. (Paragraph 41)

Reducing moral hazard

11.  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. (Paragraph 44)

12.  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. (Paragraph 45)

13.  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. (Paragraph 46)

14.  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. (Paragraph 47)

Better risk management

15.  It is clear that many financial companies could and should improve their risk monitoring and their risk management. But we agree with those who consider risk measurement is an incomplete science, and that there will always be significant uncertainties. Judgement will always play a role, and error is always a possibility, whether it be by firms or regulators. The possibility of the failure of a bank, or number of banks, always remains. Indeed, over time, it is certain that such failures will occur. While it may always be desirable to reduce risk, the primary objective of reform should be to ensure that the system is resilient if failures occur. (Paragraph 54)

16.  We must also be wary of 'survivor bias'. The firms that have made it through the crisis have much to teach us on how to build more resilient banks. But we must also recognise that a shock or event of a different nature would probably have resulted in different survivors. (Paragraph 55)

17.  Better risk management may go some way to meeting our objectives, but it cannot remove the risk that Governments will have to provide support for the sector. It can only guarantee a stable flow of lending to the economy if financial firms can consistently immunise themselves from the enthusiasms of the market or the failures of their own judgments. We do not believe this is possible. (Paragraph 56)

Better supervision

18.  A more active and effective regulator will, of course, be beneficial, as would a change in the culture of financial services. But we must accept we will never have a perfect regulator. So while better supervision may reduce the probability of firms failing, it will not eliminate it. Regulators are as prone to herd thinking and belief in current wisdom as those they regulate, and are under pressure to be so. The chance of a catastrophic failure within the financial system will remain, and Governments will remain obliged to provide emergency support. (Paragraph 62)

19.  Regulators can never be fully effective. Individual companies are responsible for their own actions. We must be careful, when considering a more active regulator, not to overly raise either consumers' or financial firms' expectations of its role. The regulator can not and should not replace due diligence by market participants. A system which assumes that regulators can be completely effective reduces the incentive for market participants to monitor the risks they are taking, whether they are banks, investors in banks or counterparties. Furthermore, such unattainable expectations raise the risk that should financial firms fail, the regulator will be found liable, and the Government will once again have to foot the bill. This, in turn, reduces incentives for consumers to monitor their own risks and ensure they understand their investments. The regulator is not the first but the last line of defence. (Paragraph 65)

The Basel reforms

20.  Capital and liquidity reform is on its way. It will, at best, ensure a lower probability of default, and a lower loss given default, for financial firms. Higher capital and liquidity requirements will also impose a cost on firms and their customers. They may go some way to meeting our objective of an appropriate correlation between risk and reward. We also consider that more emphasis on anti-cyclical capital requirements should go some way to ensuring a more stable supply of credit to the real economy. We welcome this even though the changes will also result in lower profits to banks and higher costs to consumers. Banks taking advantage of differing regulatory environments may limit the scope for such action. (Paragraph 71)

21.  However the financial crisis occurred despite repeated attempts to reform the capital and liquidity regimes. The lessons of this and preceding crises can be used to improve the capital and liquidity regimes, but that will at best be only a contribution to the wider structural reforms that are required. (Paragraph 72)

22.  Given that capital and liquidity reform will not be sufficient, and that leverage appears to be an indicator of potentially increasing risk, we support the introduction of a leverage ratio. Such a ratio does not adjust for risk, and thus is not satisfactory on its own, but it is a useful addition to (inevitably imperfect) risk weighted measures. (Paragraph 76)


23.  The US proposal for an ex-post levy on the financial system to repay the Government for the support provided during the banking crisis has some attractions. It would meet the objective of reducing the costs to the US Government. (Paragraph 81)

24.  An ex-ante levy, with ring-fenced resources, would also ensure there were resources in place at a time of crisis. Such a levy would, though, place additional costs on financial firms, and their customers. (Paragraph 82)

25.  Ex-ante levies have also been mooted as a measure to curtail risk-taking. But it has been suggested to us that in the face of such a levy financial institutions may take on more risks, both because they believe they are covered by insurance and to recover at least some of the costs of the levy. There are also other proposals to curtail risk taking, and the cumulative effect of all these proposals must be considered, before determining whether such a levy is desirable to curtail risk-taking. (Paragraph 83)

Deposit protection

26.  Given that one of our objectives is to reduce the role for the Government in the financial system, and that protecting the consumer in the face of bank failure will always remain a priority for government, we continue to recommend that the deposit protection system should be pre-funded, despite the costs it imposes on firms. (Paragraph 85)

Contingent capital

27.  Contingent capital has significant support in the Bank of England. It has also been used by Lloyds Banking Group. Yet market participants remain wary, either concerned there will be little demand if they issue such capital, or worried that it could diminish actual core capital. Experience will show whether these fears are justified. If contingent capital does place more risk back onto the financial market, rather than the Government, it seems likely to be useful in a crisis, and in addition gives its holders an incentive to monitor the banks in which they are invested, with the result that movements in the price of the debt on the market would be a source of information for the bank itself and for its regulators. (Paragraph 88)

Are large banks good for the economy?

28.  We have received evidence asserting the benefits of large banks in two areas: their ability to serve the wider economy, and their ability to diversify risk. Yet there are strong counter arguments to these assertions. We recommend that the Tripartite authorities commission research on the alleged benefits of diversification, and whether the market might be better served by a larger number of providers, with more specialised firms. (Paragraph 93)


29.  The first benefit from subsidiarisation would lie in ensuring that local regulators, if informed and competent, have greater control over subsidiaries, and are able to impose the policy trade-offs that their country requires. If it becomes necessary for a subsidiary to be closed down, it will be helpful to have access to its capital, and as international firms will be less complex, resolution may be easier. (Paragraph 101)

30.  We accept that there are powerful reputational incentives on banks not to let subsidiaries fail. However, regulators might step in to prevent a parent company attempting a rescue which threatened the viability of the overall group to the disbenefit of a group of taxpayers in a particular country. (Paragraph 102)

31.  The use of subsidiaries may also prevent regulatory disputes. If the head office of an international group is closed down by its own country regulator, the knock-on effects in other countries can be severe. While the use of subsidiaries may not entirely prevent this (as can be seen in the case of Lehman's failure), it may give host country regulators more influence. In a world without seemingly effective cross-border financial supervision and cooperation, subsidiarisation may be necessary to protect individual countries' fiscal bases and financial systems. (Paragraph 103)


32.  The financial crisis was not wholly the product of European banks, or European regulatory systems. However, it was exacerbated within the EEA by a system which placed undue faith on the harmonisation of regulatory structures, and discouraged national regulators from inquiring into banks headquartered in other Member States. While also considering wider international reform, there are powerful arguments for strengthening the role of national regulators within the single market. (Paragraph 110)

33.  We stress that, if achievable, better coordination between regulators of international institutions is desirable, and consistent thoughtful frameworks for regulation are likely to be helpful. However, as we have said earlier, we do not believe that regulation will prevent financial crises. We believe that the financial system should contain what the Governor of the Bank of England described as "firebreaks and firewalls", to lessen the impact of crisis when it inevitably occurs. We agree with the Commission that the "overriding policy objective is to ensure that it should always be possible— politically and economically to allow banks to fail, whatever their size" We believe that it would be desirable to revisit the principles of European regulation to assess the extent to which they achieve this. (Paragraph 111)

34.  One possible reform would be to allow national regulators to require that foreign owned banks operated as subsidiaries rather than branches. As we have pointed out, requiring international banks to operate through subsidiaries would not solve all problems. However, it deserves serious consideration. It would be perverse if the European Union ruled it out on the questionable basis that the right of banks to operate through branches rather than subsidiaries was essential to financial integration. As Professor Lamfalussy said, the problems posed by cross-border banks were conveniently swept under the carpet. The scale of the crisis means that Europe now has no choice but to confront those problems, and, if necessary, revise the Treaty. It cannot help European financial integration if the Governments and populations of Member States associate cross-border banking with financial instability. (Paragraph 112)

Professor Kay's proposals

35.  Professor Kay's reforms are ambitious, and would further alter the architecture of the financial system. We recognise that while his proposals demand a radical restructuring of banking, that may be needed in respect of the radical changes which have already developed in an ad hoc way, with ill consequences, over the last two decades. We also recognise that, if they worked as intended, his proposals would protect consumers who used narrow banks, and reduce the role of the Government in a financial crisis, insofar as it proved possible for the Government to let firms in the wider banking system fail. There would be a likelihood of a significant transfer of risk into the unregulated sector. We would need to address whether the resulting financial system could provide sustainable lending. (Paragraph 120)

Proprietary trading

36.  There is a consensus that proprietary trading is a riskier activity than others banks undertake, and therefore may require closer control in deposit-taking institutions. There is a strong case in principal for such control. However, the definition of proprietary trading appears to be a 'grey area'. This may well mean that bold structural reform is difficult to implement, although Mr Volcker was confident that these definitional objections could be overcome. In practice, Mr Volcker's proposals may be implemented by higher capital charges on activities regulators deem risky. (Paragraph 128)

Ownership structure

37.  Banking has progressively been shedding unlimited liability as part of its ownership structure. This may well have increased the riskiness of the financial system, and led to a greater level of financial activity. It is interesting to note that limited liability is particularly beneficial to those undertaking riskier transactions. (Paragraph 132)

The Government's position

38.  The Government has ruled out structural reforms such as narrow banking in its changes to the regulatory structure of the financial system. President Obama's proposals do include structural reforms, which suggests that the Government's conclusions are not universally accepted. The debate on banking reform should remain as wide as possible. Structural reforms should not be ruled out. (Paragraph 134)

39.  As a counter to structural reform, it has been argued that narrow banks also failed during the current crisis. This, in part, may be due to how those 'narrow banks' were allowed to interact with the wholesale markets. Moreover, this argument focuses on the system which existed before the crisis. Global responses to that crisis have created a new set of problems, in that markets now expect Governments to support the banking system. Structural reforms may be one way significantly to alter those expectations. (Paragraph 135)

Living wills

40.  There is wide support for 'living will' type resolution regimes. If they work, they allow the Government to inflict losses on all creditors of a bank because it will be possible for the bank to fail in an orderly way. This will remove some of the moral hazard, and ensure bank bondholders have to pay more attention to the banks' management and solvency. It should transfer some of the costs from the general body of taxpayers and will place them firmly within the financial sector. This may raise the cost of credit, but it will do so because risk is priced more accurately. (Paragraph 145)

41.  Moreover the creation of living wills will make many financial firms, and their investors, think about how they operate their businesses. That would be an initial, potentially large, benefit, as with the mapping of a bank's structure to a regulator. (Paragraph 146)

42.  We look forward to the FSA's eventual announcement that all UK banks have in place an effective living will. (Paragraph 147)

43.  As a general proposition, we consider it likely that if an institution is too complex to prepare for an orderly resolution, it is too complex to operate without imposing unacceptable risks to the states in which it does business. Regulators should take account of any structural difficulties in the preparation of a living will. Living wills, fully applied, will necessarily lead to the structural reform of the banks. (Paragraph 150)

International resolution authorities

44.  An international authority able to take the lead in the resolution of cross border financial institutions would make wind-down simpler and smoother. Unfortunately, we simply do not believe that such an authority could be introduced in the near future. Even if nation states were prepared to surrender their interests to such an authority, which we doubt, the difference between bankruptcy laws in different countries would prove a significant barrier. The steps taken to put recovery and resolution arrangements in place in the United Kingdom should continue, even if negotiations to establish an international resolution authority are proceeding at the same time. This reform must be pursued regardless of what is happening elsewhere. The primary duty of the UK Government should be to protect the UK taxpayer and consumer. (Paragraph 155)

Choosing a balance

45.  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. (Paragraph 159)

46.  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. (Paragraph 160)

The international agenda

47.  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." (Paragraph 168)

48.  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. (Paragraph 173)

Microprudential tools

49.  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. (Paragraph 175)


50.  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. (Paragraph 181)

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