Banking Standards Joint Committee

Banking Standards Joint Committee Contents

2 The context

The banking crisis of 2007 and 2008 and its costs

14. The starting point for an understanding of the issues considered in this Report is the crisis that engulfed the UK banking sector from mid-2007 onwards. In the decade leading up to that crisis, UK-based banks expanded their balance sheets rapidly (see figure 1), for many of them leading to a reduction in credit standards. To grow their balance sheets, the banks had become reliant on funding from short-term wholesale markets. In the Summer of 2007, financial markets across the world entered a period of turbulence sparked off by a downturn in the US housing market. As a result, lending between banks and within the wider wholesale market fell sharply and eventually stopped. In September 2007, Northern Rock ran into problems, in part because it was heavily dependent on wholesale markets to fund its activities; this led to the bank being nationalised in February 2008. During the summer of 2008, financial markets remained dysfunctional and the global economy began to slow down. The collapse of Lehman Brothers in September 2008 caused widespread panic across the global financial sector, with dramatic consequences for several UK-based banks made vulnerable by a varying degree of recklessness and imprudence during the preceding years. The crisis revealed poor lending decisions, excessive leverage, weak risk management and vulnerable business models in banks involved in both retail and investment banking activities.

Source: 'residency basis' is UK resident banks' assets less derivatives, i.e. ONS series (NNST-NNUE)/YBHA. 'Domicile basis' is the sum of total liabilities and equity for major UK banks in table 3.01 of BBA Annual Abstract of Statistics, divided by ONS series YBHA

15. During the crisis, the UK authorities carried out a range of interventions to:

increase liquidity in the banking system;
facilitate resolutions of smaller financial institutions that got into difficulties; and
improve solvency and liquidity, including capital injections into RBS and Lloyds Banking Group and Government guarantees of bank assets and liabilities.

As at March 2012, the total outstanding support stood at £228 billion, down from the total a year before of £456 billion and a peak of £1.2 trillion. Of the £228 billion, £109 billion constituted outstanding guarantee commitments and £119 billion was provided as cash.[18]

16. The major social costs of the crisis did not result directly from the costs of bailouts of the banks, but rather from the recession and the ensuing rise in unemployment that the banking crisis caused. More than four years after the collapse of Lehman, the level of real GDP is still 3 per cent below its pre-crisis peak and more than 13% below its trend of the decade before the crisis.[19] Unemployment has risen by nearly one million. The public finances have deteriorated accordingly. As Lord Turner noted in evidence to the Joint Committee on the draft Financial Services Bill in November 2011:

It is very important for us to understand that the big harm which was done by the banking crisis of 2008 to UK citizens was not the explicit cost of new equity investment. The big harm was the macro-economic instability. Although it is important to have a mechanism which avoids the possibility of future public support for banks which would otherwise fail, it is even more important that we have created mechanisms whereby these banks are stable institutions able to keep a stable supply of credit through to the real economy.[20]

Why bank failure is so difficult

17. When large banks across the world ran into trouble during the crisis, in nearly every country its government stepped in to prevent them from failure and insolvency. As discussed above, in the UK this led to unprecedented cost and contingent liability for the Government. In some countries, in particular Ireland, the costs from preventing bank failures contributed to a sovereign debt crisis. In 2010 alone, the Irish deficit reached 32 per cent of GDP, of which 20 per cent of GDP was due to State support to the banking sector.[21] In June 2012, in response to mounting losses on real-estate lending in Spanish banks, the Eurogroup agreed to provide up to €100bn to support bank restructuring, on top of existing support from the Spanish government.[22] The reason that governments felt the need to step in was that, however undesirable it was to put public funds into bailing out the banks, letting them go into insolvency was felt to have carried an even greater cost. There are three main reasons why insolvencies in the banking sector are so problematic, in comparison to most non-financial firms:

Banks provide essential services such as current accounts, overdrafts and the payment system in general on which the rest of the economy relies. Any interruption in these services, no matter how brief, would risk causing widespread damage. Unlike other firms providing essential services, such as utility companies, these services cannot be carried on whilst the business's balance sheet is being restructured. For banks, the balance sheet is the operating business: its creditors are its customers. Bank deposits are valuable because they are available on demand to make payments.
Insolvency destroys value. The losses involved in banking sector insolvencies are much greater than for non-financial companies. The greater leverage in banks implies bigger balance sheets and larger creditor exposures. Furthermore, unlike other corporate insolvencies, when the operating business can often be maintained or sold to maximise value, in the case of a bank, all that can often be done is to liquidate the assets. Combined with bank leverage this can magnify creditor losses, as the realisable value of assets in a forced sale, or crisis situation, is often very different from their carrying value.
Disorderly failure can cause contagion because banks in general are reliant on the confidence of depositors and other creditors to keep operating. Allowing one bank to fail in a disorderly way could spread panic among creditors of other similar institutions and cause a wider financial crisis. For systemically important firms, the fact that many other financial firms will suffer losses or disruption as creditors and counterparties of the failed bank can be a direct contagion channel, as was experienced in the case of Lehman Brothers.

The implicit guarantee and its effects

18. Before the crisis, it appears to have been assumed among bankers and bank investors that large banks were too important to be allowed to be put into insolvency and that without insolvency there was no workable mechanism for imposing losses on creditors. As a result, if large banks got into trouble, governments would have to step in and would shoulder many of the costs. As the President of the Federal Reserve Bank of Minneapolis wrote in 2004, "too big to fail is a problem of credibility: creditors of large banks do not believe that the government will make them bear all their losses from bank failure".[23]

19. When the crisis hit, this perception of an "implicit guarantee" was confirmed by the bail-outs that were given to most failing banks in the forms of generous loans, government guarantees or capital injections, all of which resulted in a cost or risk to public funds, and spared creditors of the banks from bearing the full cost of their mistakes. The result of this was not only to place a huge burden on the taxpayer—something particularly important to a country such as the UK with a banking sector equivalent to more than four times annual GDP—but also to force the realisation that an implicit guarantee would remain unless action was taken. As Sir Mervyn King warned in a 2009 speech, "The massive support extended to the banking sector around the world, while necessary to avert economic disaster, has created possibly the biggest moral hazard in history".[24]

20. The moral hazard caused by an implicit guarantee was highlighted by the ICB in their interim report:

As a result of the government guarantee, creditors will be prepared to provide cheap funding to a systemically important bank that conducts risky activities, rather than constraining such risk-taking by demanding a higher return to compensate for the risks. This is not only inequitable, but also further incentivises excessive risk-taking by banks.[25]

The size of the implicit guarantee in the UK and the extent of its effect on bank risk-taking provide the background against which the proposed reforms in this area should be judged. Andy Haldane estimated in 2010 that the size of the average annual subsidy for the top five UK banks between 2007 and 2009 was over £50 billion—roughly equal to UK banks' annual profits prior to the crisis.[26] There is a lack of consensus about how best to measure the implicit guarantee, although there is a consensus that such a guarantee exists, and that it should be eliminated over time. After taking evidence on the ICB's interim report, the Treasury Committee concluded:

The ICB, using the research of others, places the figure at considerably in excess of £10bn [per annum], but has not published detailed analysis as to how it arrived at this figure. The banks meanwhile have been reluctant or unable to come up with any credible figures. We have concluded there is an implicit subsidy. There is a need for at least some measure of agreement between the banks and the ICB about the minimum size of the implicit subsidy, now and in the past, as well as an agreed analytical framework for measuring the subsidy. The need for consensus in this area is critical because of the ICB's goal, shared by the large banks, to eliminate this subsidy. Without an agreed framework for measuring the size of the subsidy it will be difficult to assess when success in this area has been achieved.[27]

21. Sir Mervyn King pointed out in 2009 that there are only two logical ways to tackle the problem of banks that are "too important to fail":

One is to accept that some institutions are "too important to fail" and try to ensure that the probability of those institutions failing, and hence of the need for taxpayer support, is extremely low. The other is to find a way that institutions can fail without imposing unacceptable costs on the rest of society.

He went on to say that the first solution, while worth trying, should not be relied on, warning "The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion".[28] Implementing the second solution, in other words reaching a position where banks can fail and be resolved, in practice means a combination of two things:

Developing resolution tools to apply to a failing bank, which allow its essential services to be continued without having to rescue the whole bank; and
Making structural or operational changes to banks, to facilitate the application of such tools or to reduce the societal costs from a failure, managed with the use of such tools, to an acceptable level.

Reforms already underway

22. On the first solution, of reducing the probability of large banks failing, there has been significant strengthening of international capital requirements. Changes have been made both to the ratio of capital held by banks and that ratio's calculation. When fully brought into force, these changes will bring about around a five-fold increase in bank capital compared to levels before the crisis.[29] New liquidity requirements are also being introduced under the Basel III regime to make banks more resistant to the kind of liquidity shocks which occurred during the crisis. These measures are already beginning to have an effect. Finally, the Financial Services Act 2012 introduces a new framework for financial regulation and supervision in the UK, including the creation of the Prudential Regulatory Authority and the Financial Policy Committee.

23. One of the first reforms relating to resolution during the crisis was the extension of deposit insurance. This was first extended to cover 100 per cent of deposits below £35,000, in response to the run on Northern Rock. The pre-existing partial guarantee[30] had not prevented a run. Later it was extended to 100 per cent of deposits up to £85,000.[31] The Financial Services Compensation Scheme (FSCS) was also given a target: it should be able to pay out to most depositors within seven days. The FSCS has worked with banks to develop the data and systems needed to support this.[32] A new "Bank Insolvency Procedure" was introduced in the Banking Act 2009 to support rapid payout in the case of banks placed into insolvency. These measures, taken together, ensure that for smaller banks, where the main essential service provided is deposit-taking, insolvency can be a more orderly process. It should have less impact on ordinary customers, most of whom will get all of their money bank very rapidly. The Chancellor referred to a failure in 2011 that was the first to be managed under this process:

It was unremarked on that I allowed an institution to fail. I think it was at the end of last year. Ironically, it was the Southsea Mortgage and Investment Company, which was based in Hampshire, and some depositors lost their money above £85,000. We have demonstrated, and we wanted to demonstrate, that we are in the business of protecting £85,000 of deposits, and not beyond that.[33]

However, this bank had only about 250 customers, of whom only 14 had deposits above the £85,000 level.[34] This solution cannot necessarily be applied to larger bank failures. As Sir Mervyn King pointed out:

If you have a very small bank that fails and only 12 people hold deposits above £85,000, in three different constituencies, I am convinced that the Chancellor will decide not to intervene. If you have thousands of people involved, I think the pressure on the Chancellor will be enormous.[35]

24. The "Special Resolution Regime" created by the Banking Act 2009 therefore also created "pre-insolvency stabilisation tools" for dealing with a failing bank. The Bank of England, as the body charged with reorganising banks that get into difficulties—the "resolution authority"—now has powers to break up failing banks up and transfer the pieces which provide essential services to private sector purchasers or a bridge bank (a temporary bank set up as a subsidiary of the Bank of England), keeping these parts running but leaving the rest of the bank and any remaining creditors to enter a modified form of insolvency. These powers were used in the case of the Dunfermline Building Society to move the deposits and some matching assets to the Nationwide Building Society.[36]

25. However, the transfer powers can still result in a cost or risk to the taxpayer. Additionally, it is widely recognised that these powers would be difficult to deploy in the case of a large, complex bank. Andrew Gracie, the head of the Special Resolution Unit at the Bank of England, has acknowledged this:

these transfer powers do not necessarily offer a fully effective solution in the face of the failure of a large, complex and international financial firm. The critical economic functions of a G-SIFI [Global Systemically Important Financial Institution] are intertwined legally, operationally and financially across jurisdictions and the firm's legal entities. As a result, it can be almost impossible to separate and transfer parts of a financial group to purchasers or a bridge in a short timeframe.[37]

26. The third stabilisation tool in the Banking Act 2009 is the last resort of Temporary Public Ownership. This allows the Treasury to seize the shares of a failing bank, which does not in itself stabilise the bank but does give the Treasury control and ownership to go alongside any other support that might be provided, such as a capital injection or a guarantee of the bank's debts. Use of this tool is a last resort which does not meet the objective of avoiding putting public funds at risk.

27. The Financial Services Act 2010 introduced a requirement for banks to prepare Recovery and Resolution Plans—sometimes referred to as "living wills"—in coordination with the FSA, in order to make them both less likely to fail and easier to resolve if they do. The "recovery" element of the plan requires a bank to identify in advance a menu of credible options for generating capital or liquidity in the event that it encounters stress. The "resolution" element requires a bank to provide the authorities with a range of legal, financial and operational information which would be useful in planning a resolution. The authorities can then consider likely resolution strategies, identify any potential barriers to successful resolution and, if necessary, require the bank to remove those barriers.[38]

28. Recovery and Resolution Plans are still not a formal requirement for UK banks, because the FSA has yet to publish its final rules for their implementation.[39] Additionally, the resolution strategies that are being developed are currently limited by the tools described above. The Bank of England published a paper on 10 December 2012 which pointed out that developing strategies that could handle the orderly resolution of a systemic bank seemed likely to depend on reforms and tools which are still under development, including through the draft Bill:

the authorities in the United States and the United Kingdom have been working together to develop resolution strategies that could be applied to their largest financial institutions. These strategies have been designed to enable large and complex cross-border firms to be resolved without threatening financial stability and without putting public funds at risk. [...]

In the UK, the strategy has been developed on the basis of the powers provided by the [...] Banking Act 2009 and in anticipation of the further powers that will be provided by the European Union Recovery and Resolution Directive and the domestic reforms that implement the recommendations of the [...] Independent Commission on Banking.[40]

29. The Bank of England stressed to us that a number of further legal changes are required in order for their resolution strategies to become operational:

The necessary wider reforms [for the delivery of the preferred resolution plans] are: full implementation of the Key Attributes across the G20 jurisdictions; within the EU, implementation of the RRD; and, within the UK, a widening of the scope of the Special Resolution Regime as set out in the Financial Services Bill currently before Parliament and the implementation of the ICB proposals in the Banking Reform Bill.[41]

18 HM Treasury, Annual Report and Accounts 2011-12, HC (2010-12) 46, p 91 Back

19 Bank of England, Speech by David Miles to Society of Business Economists Annual Conference, 24 May 2012 Back

20 Oral evidence taken before the Joint Committee on the Draft Financial Services Bill on 10 November 2011, HC (2010-12)1447, Q 941 Back

21 Treatment of Special Bank Interventions in Irish Government Statistics, Central Bank of Ireland Quarterly Bulletin October 2011 Back

22 Eurogroup statement on Spain, 9 June 2012 Back

23 Gary Stern and Ron Feldman, Too Big to Fail, (Washington, DC, 2004) Back

24 Bank of England, Speech by Sir Mervyn King to Scottish business organisations, 20 October 2009 Back

25 Independent Commission on Banking, Interim Report, April 2011, p 20 Back

26 Andy Haldane speech, "The $100 billion question", 30 March 2010 Back

27 Treasury Committee, Nineteenth Report of Session 2010-12, Independent Commission on Banking, HC 1069, para 22 Back

28 Bank of England, Speech by Sir Mervyn King to Scottish business organisations, 20 October 2009 Back

29 Bank of England, Speech by Sir Mervyn King to Scottish business organisations, 20 October 2009 Back