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 dotcom 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 United Kingdom, 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 United Kingdom 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.
What 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."
There has been a great deal of emphasis on using existing tools to make the system safer. However, the report is doubtful about how far evolutionary reform can make sufficient changes. It is clear that many financial companies could and should improve their risk monitoring and their risk management but judgement will always play a role, and error is always a possibility, whether it be by firms or regulators.
Thus the possibility of the failure of a bank, or number of banks, always remains. Indeed, over time, it is certain that such failures will occur. While it may always be desirable to reduce risk, the primary objective of reform should be to ensure that the system is resilient if failures occur, the report says.
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."
The government has ruled out structural reforms such as narrow banking in its changes to the regulatory structure of the financial system. However, President Obama’s proposals do include structural reforms, suggesting that the Government’s conclusions are not universally accepted. The report calls for the debate on banking reform to remain as wide as possible.
As a counter to structural reform, it has been argued that narrow banks also failed during the current crisis. This, in part, may be due to how those 'narrow banks' were allowed to interact with the wholesale markets.
Moreover, this argument focuses on the system which existed before the crisis. Global responses to that crisis have created a new set of problems, in that markets now expect governments to support the banking system. Structural reforms may be one way significantly to alter those expectations, the report says.
One of the key failings of the current system is that it is extremely difficult to allow systemic institutions to fail smoothly. There are several reforms to ensure that this can happen already in development. Indeed, the UK has led the way in introducing legal frameworks to deal with bank resolution. However, much detail still needs to be put in place before we can be confident that it will be possible to ensure that a large, international bank will fail smoothly.
There is wide support for 'living will' type resolution regimes, which if they work, would allow the Government to inflict losses on all creditors of a bank because it would fail in an orderly way. This would remove some of the moral hazard, and ensure bank bondholders have to pay more attention to the banks’ management and solvency. The Committee looks forward to the FSA’s eventual announcement that all UK banks have in place an effective living will.
The report says:
"As a general proposition, we consider it likely that if an institution is too complex to prepare for an orderly resolution, it is too complex to operate without imposing unacceptable risks to the states in which it does business. Regulators should take account of any structural difficulties in the preparation of a living will. Living wills, fully applied, will necessarily lead to the structural reform of the banks."
John McFall said:
"Living wills should transfer some of the costs from the general body of taxpayers and place them firmly within the financial sector. This may raise the cost of credit, but it will do so because risk is priced more accurately. Moreover, the creation of living wills will make many financial firms, and their investors, think more carefully about how they operate their businesses."
The international agenda
The United Kingdom can only benefit from constructive international agreement. It would help safeguard the position of the City of London, which is a crucial part of the UK economy. However, the report is clear that prevarication on international agreement must not be used as an excuse to delay, or, at worst, prevent reform.
As Britain has a very large banking system relative to GDP compared to other countries, its reform is anyway in our own self-interest, even if it is not coordinated with reforms in other countries.
John McFall said:
"When we met him in the US, Paul Volcker expressed his desire to have the UK act with the United States. We remain fully behind international agreement, as long as it is does not become an excuse to stave off reform. The size of the UK’s banking sector means that it is not to our benefit to have a fragile banking system. Where we can lead on reform, we should."