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Home > Blogs > Ian Fraser > No-one can afford “too big to fail” banks

No-one can afford “too big to fail” banks

Finance Blogger: Ian Fraser Ian Fraser

The thorny issue of what to do about institutions that are “too big to fail” has been addressed by Mervyn King, governor of the Bank of England. In evidence to the House of Lords Economic Affairs Committee, King said it is impossible to construct a credible regulatory system while dinosaurs that are “too big to fail” are still allowed roam the financial jungle.

By “too big to fail” King means banks and other institutions that are so large, or so pivotal to the financial system, that no government can risk allowing them to go bust. The fear of market dislocation or even blood on the streets would be too great. But having any institution in the category is “impossible to reconcile with the market discipline of a free market economy,” added King.

Such institutions invariably become a danger to themselves, their investors, and to wider society, said King. Neither management nor large depositors will have any real incentive to check the riskiness of activities a bank pursues—since, in the event of the whole thing going pear-shaped, they can be confident the government will step in and bail them out.

He may have been indirectly referring to the Royal Bank of Scotland and HBOS (now owned by Lloyds Banking Group), both of which came within a whisker of failing last autumn. King recently admitted that, over and above existing bail-outs, the Bank of England provided a “secret” £61.6 billion ($102 billion) loan to these Edinburgh-based banks last October.

King said: “The rule of a market economy is that if you make a mistake and your company fails, it fails. It does not get bailed out by government … That market discipline applies to everyone apparently—except banks. That cannot possibly be right.

“It will distort the incentives for the monitoring of risks by banks of creditors who fund those banks. If they think they are not lending to the bank but lending to the government then of course they will not bother to monitor the risk which banks are taking.”

King identified three ways of ensuring that no institution ever becomes too big to fail again, a solution he described as his “three-legged stool.”

The first is contingent capital, which automatically converts into equity in the event of a bank starting to run out of money. He said this reduces the need for regulators to precisely work out what the bank’s Basel ratio is. “That provides a big cushion of capital that can be converted to equity when necessary and the people who supply that—the creditors—will know there are circumstances when they would bear the burden and would not just be bailed out by the government.”

The second leg in King’s stool is “resolution,” by which he meant ensuring that, in the event of a bank failing, there are other banks capable of stepping into the breach and taking on its customers and assuming its role. “In other parts of the economy we have … frameworks for regulation that maintain the continuity of service to consumers without guaranteeing the continuity of the private-sector provider of that service.”

The third leg in King’s three-legged stool is “structure.” Given the UK state guarantee of investor deposits of up to £50,000, King said: “There have to be restrictions on the activities which insured retail deposits are allowed to finance.” That could involve a restructuring to ensure that a bank cannot channel guaranteed deposits into crazy risk-taking activities, such as gambling on so-called CDO squareds.

King admitted that regulators, however vigilant or well-paid, can never be 100% confident that the banks they are supervising are behaving responsibly. “There is a limit to what regulators can do.”

Speaking last October, King said: “The past few weeks have been somewhat too exciting … So let me extend an invitation to the banking industry to join me in promoting the idea that a little more boredom would be no bad thing. The long march to boredom and stability starts tonight.”



Tags: bank failures , banking , Mervyn King , regulation
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