Chancellor right that banks must be allowed to fail

Allister Heath
IT is a shame that much of the City will be focused on the crisis in Greece and its repercussions on global markets this morning, for there were some surprisingly good ideas on banking regulation at Mansion House last night. There was a clear shift in attitude on display: the chancellor’s pronouncements were by far the best speech to date from any government minister on the reform of the financial system. True, he endorsed the ringfencing of the retail divisions of universal banks, an incomplete solution that fails to realise that mortgage lending is actually often more dangerous than investment banking. Its other big flaw – apart from the fact that it would have done nothing to stop the demise of pure-play firms such as Lehman, Bear Stearns, Northern Rock, HBOS, the Spanish Cajas and so on – is that it introduces an incentive-distorting explicit bailout guarantee for retail banks.

Or so it would seem – but Osborne was at pains to put that policy in a broader context, which was much more pro-free market than expected and rightly supportive of a reformed, sustainable yet prosperous and growing City. The key idea is one which has received lengthy airings in this newspaper: bailouts should never happen again, taxpayers should always be protected and new mechanisms need to be found to allow all banks to fail in a controlled manner, protecting the overall system. Crucially, he emphasised that he wants “Britain to be the home of some of the world’s leading banks, but those banks cannot be underwritten by the British taxpayer”. He said that he would assess the findings of the Independent Commission on Banking (ICB) against four conditions: All banks should be allowed to fail safely without affecting vital banking services; this should happen without imposing costs on the taxpayer; it should be in a manner applicable across the sector; and it should be consistent with EU and international law. That is exactly right – and Osborne outlined all the ways that the government is now retreating from underwriting the financial system, including the looming reprivatisation of Northern Rock; the opening of the Credit Guarantee Scheme to early redemption; and the early repayment of the Bank’s special liquidity scheme.

It is not just the ringfencing part of the ICB that Osborne has pre-endorsed: he also accepts the call for a bail-in system to replace bailouts, by which debt would be transformed into equity in a crisis, thus recapitalising a bank by hurting security-holders, not taxpayers. Osborne also stated that deposit insurance was 100 per cent only up to £85,000 and that “there is no implicit taxpayer guarantee for sums above that level” – in other words, even depositors with large holdings would be expected to share in the cost of a bailout, not just bondholders. Osborne sees the “British problem” in the right way: it is in our national interest to attract very large banks to London, but we need to find a way to make sure they don’t bankrupt the UK if they run into trouble.

In his own speech, Sir Mervyn King argued that “until we find a solution to the ‘too important to fail’ problem, ...our banking system will remain too large for the taxpayer credibly to support in future”. He is right – hence why Osborne is spot on to focus on mechanisms to deal with failure, rather than deciding that the City is inherently too dangerous. In a fascinating (and in my view unconvincing) argument, King addressed the key issue that sterling’s collapse is a major reason for price pressures and conceded the MPC “could have raised the Bank Rate significantly so that inflation today would be closer to the target”. But it chose not to because, in his view, this would not have prevented the squeeze on living standards from higher commodity prices, would have meant a weaker recovery, forced wage cuts in cash terms (rather than real terms), and created “undesirable volatility in output”, in contradiction to the second part of the Bank’s remit. In other words, the Bank has deliberately downgraded its battle against inflation in a bid to promote growth. To me, that is playing with fire. He also highlighted wage settlements, the broad money supply and the spread between Bank rates and consumer rates as key variables that will determine when monetary policy will be tightened. Great stuff, whatever one thinks of it.
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