Radical reform of banking system needed, says McFall

29 March 2010 | By Natalie Thomas

The report - Too Important to Fail - too important to ignore, says as a result of the government bailing out banks financial firms now operate on the assumption that systemically important firms will be rescued if necessary.

John McFall, chairman of the Treasury Committee, says: “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.”

He says that will require radical action in the UK, where the banking sector accounts for such a large share of the economy.

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 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.

McFall says: “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. 

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