In a speech delivered last night in Scotland, the Governor of the Bank of England, Mervyn King, stressed his feeling that – now that banks had been rescued by the government – they needed to slim down and hive off retail operations from riskier ones. Here are some key extracts and a link to the full text.
In a speech delivered last night in Scotland, the Governor of the Bank of England, Mervyn King, stressed his feeling that – now that banks had been rescued by the government – they needed to slim down and hive off retail operations from riskier ones. Here are some key extracts and a link to the full text.
WHY WERE BANKS willing to take risks that proved so damaging both to themselves and the rest of the economy? One of the key reasons – mentioned by market participants in conversations before the crisis hit – is that the incentives to manage risk and to increase leverage were distorted by the implicit support or guarantee provided by government to creditors of banks that were seen as “too important to fail”. Such banks could raise funding more cheaply and expand faster than other institutions. They had less incentive than others to guard against tail risk. Banks and their creditors knew that if they were sufficiently important to the economy or the rest of the financial system, and things went wrong, the government would always stand behind them. And they were right.
The sheer scale of support to the banking sector is breathtaking. In the UK, in the form of direct or guaranteed loans and equity investment, it is not far short of a trillion (that is, one thousand billion) pounds, close to two-thirds of the annual output of the entire economy. To paraphrase a great wartime leader, never in the field of financial endeavour has so much money been owed by so few to so many. And, one might add, so far with little real reform.
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Related
TO REDUCE THE likelihood of failure, regulators can impose capital requirements on a wide range of financial institutions related to the risks they are taking. This is the current approach underpinned by the Basel regime. In essence, it makes banks build a buffer against adverse events. It has attractions but also problems. First, capital requirements reduce, but not eliminate, the need for taxpayers to provide catastrophe insurance. Second, the “riskiness” of a bank’s activities and the liquidity of its funding can change suddenly and radically as market expectations shift. This means that what appeared to be an adequate capital or liquidity cushion one day appears wholly inadequate the next.
Indeed, the Achilles heel of the Basel regime is the assumption that there is a constant capital ratio which delivers the desired degree of stability of the banking system.
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THE SECOND APPROACH rejects the idea that some institutions should be allowed to become “too important to fail”. Instead of asking who should perform what regulation, it asks why we regulate banks. It draws a clear distinction between different activities that banks undertake. The banking system provides two crucial services to the rest of the economy: providing companies and households a ready means by which they can make payments for goods and services and intermediating flows of savings to finance investment. Those are the utility aspects of banking where we all have a common interest in ensuring continuity of service. And for this reason they are quite different in nature from some of the riskier financial activities that banks undertake, such as proprietary trading.
In other industries we separate those functions that are utility in nature – and are regulated – from those that can safely be left to the discipline of the market. The second approach adapts those insights to the regulation of banking. At one end of the spectrum is the proposal for “narrow banks”, recently revived by John Kay, which would separate totally the provision of payments services from the creation of risky assets. In that way deposits are guaranteed. At the other is the proposal in the G30 report by Paul Volcker, former Chairman of the Federal Reserve, to separate proprietary trading from retail banking. The common element is the aim of restricting government guarantees to utility banking.
There are those who claim that such proposals are impractical. It is hard to see why. Existing prudential regulation makes distinctions between different types of banking activities when determining capital requirements. What does seem impractical, however, are the current arrangements. Anyone who proposed giving government guarantees to retail depositors and other creditors, and then suggested that such funding could be used to finance highly risky and speculative activities, would be thought rather unworldly. But that is where we now are.
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To download the full speech, click here
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