Banking reform

- Editor


His words were, at once, provocative and sobering. “We shall all be paying for the impact of this crisis on the public finances for a generation”, he said. The response to the crisis must address the underlying causes.
The UK faces two fundamental long-term challenges. Firstly rebalancing the economy, with more resources being allocated to business investment and net exports and fewer to consumption. Secondly, reforming the structure and regulation of banking.

The UK banks, Mr King said, had increased the size and leverage in their balance sheets to levels that had threatened the stability of the system as a whole. They remained extraordinarily dependent on the public sector for support – nearly a trillion pounds, or two-thirds of GDP of direct assistance and guarantees had been given to the UK banking sector – but this wasn’t sustainable in the medium term.

King asked why the banks were so willing to take risks that proved so damaging both to themselves and the rest of the economy. He proposed that a key reason was that the incentives to manage risk and increase leverage were distorted by the implicit guarantees from governments of banks that were “too important to fail”, i.e. moral hazard.

It was hard, he said, to see how the existence of banks too important to fail was consistent with their being in the private sector and concluded that there were logically only two ways the problem posed by moral hazard could be solved.

One was to reduce the probability of failure of those institutions to extremely low levels. The other was to find a way for them to fail without imposing unacceptable costs on the rest of the community.

The first route is the one being pursued by global banking regulators and relies on boosting capital requirements to create larger buffers against adverse events. But how much larger do the buffers need to be? Any fixed capital requirement ratio is bound to be arbitrary and taxpayers would still need to provide catastrophe insurance.

Banks could take out insurance in the form of “contingent capital” - capital that converts to common equity upon a trigger event such as Tier 1 capital falling below a certain limit. Whether investors would be prepared to provide such capital on the required scale would depend upon the price/ return but the banks woud be the ones paying.

Drawbacks to this approach are that taxpayers are still needed to provide back-stop insurance, risks are hard to assess and more detailed regulation would be likely to be required.

The second approach was to reject the idea that there were banks “too important to fail”. It would divide the functions of the banks into the utility aspects of making payments for goods and services and facilitating flows of savings into investment, and those of a more risky nature, such as proprietary trading. A complete separation of the two elements would allow the restriction of the government guarantee to utility banking.
The current arrangements, he said, were impractical.

“Anyone who proposed giving government guarantees to retail deposits and other creditors and then suggested that such funding could be used to finance highly risk and speculative activities would be thought rather unworldly,” he said. It is important that banks in receipt of public support are not encouraged to try to earn their way out of that support by resuming the very activities that got them into that trouble in the first place.

Maturity transformation occurs on a scale which could affect the economy through private sector entities outside the banking sector.  The government would not want to stand aside when such an entity fails, said Mr. King. Maturity transformation reduces the cost of finance to a wide range of risky activities, at least some of which are beneficial, but the implicit government guarantee means that the true cost of that maturity mismatch does not fall, as it should, on those who receive the benefits. The aim of the policy should be to minimise or eliminate that subsidy. Separation of activities helps this objective. It is in the collective interest to reduce the dependence of businesses and households on so few institutions that engage in so many risky activities.
 Whether the option turns out tobe separation of activities or increasingly detailed oversight, it is clear that ther is a strong case for a review of the way the banking sector is strucutred and regulated.

Mr King goes on to suggest that there is a need for additional policy tools, that can be used to moderate the growth of the financial sector or resist the macro-economic effects of the credit cycle. These tools would be used in much the same way as monetary policy is used currently - to moderate the swings away from financial stability.

Mr King believes that reform of the banking sector is essential and that the financial crisis was a result of the incentives that bankers faced.

Source: Speech by the Governor of the Bank of England, Mervyn King, 20/10/2009.