Lenders too important to fail?

Nia Williams

March 29, 2010

The report is released following an investigation into the existence of a type of financial firm, or firms which are ‘too important to fail’ – so integral to the financial system that it was necessary for governments to bail them out during the banking crisis.

The report concludes that the actions governments had to take to ensure financial stability have resulted in a market which operates on the assumption that systemically important firms will be rescued if necessary and radical reform is needed.

Treasury Committee chairman John McFall said: “History is littered with examples of financial boom and bust, from the tulip boom, to the South Sea Bubble, to the dot-com frenzy. The challenge is to make sure that the financial system itself is not, as it has been recently, a prime cause of such instability, and to ensure that, in so far as possible, financial institutions bear the consequences of their own actions.

“That will require radical action. Reform is particularly pressing for the UK, where the banking sector accounts for such a large share of the economy. During the financial crisis, governments have effectively stood behind the banking system. If international banking in the UK is to remain credible, reform must ensure that the tax payer is better protected from picking up the bill.”

The report looks at the range of reforms currently under consideration, and assesses them against the objectives of an orderly banking system; protecting the consumer, protecting the taxpayer, setting an appropriate cost of doing business and providing lending to the economy. It emphasises that successful reform would transfer risk away from Government and back into the banking sector. If moral hazard is reduced, market participants will have an incentive to apply market disciplines. The report is clear that radical reform is necessary but it will take time to achieve.

The Report says: “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.”

John McFall said: “There are trade-offs between the objectives of reform: the more consumers are protected, the more risks tax payers may have to bear; the more banks have to pay for their capital, the higher the rates they will charge their customers. Policymakers will have to decide where the trade-offs should properly be made and how this should be explained to the public. Today’s report is based on evidence we took from a wide range of key international figures on this issue and was agreed unanimously. We hope it will feed into the long term policy debate we need.”

The report notes that capital and liquidity reform is on its way. Higher capital and liquidity requirements may go some way to meeting the objective of an appropriate correlation between risk and reward. 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.

John McFall said: “We can never guarantee failures will not occur again. It is crucial therefore that in addition to improving risk management, regulation and raising capital and liquidity requirements, wider structural reform remains on the agenda.”

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