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Too important to fail

So far, this section has argued that deregulation during the latter part of the 20th century freed competitive forces in the banking system and allowed banks to pursue efficiencies through functional and geographical expansion.

But, as banks grew and broadened their scope post-deregulation, they increasingly became ‘too important to fail’. This may have altered their private incentives in a

fundamental way. A financial institution becomes too important to fail when the

potential losses to the financial system and wider economy associated with its failure or distress would be so large for uncertain that a government is unable to commit credibly not to intervene in support. These costs might include disruption

to critical banking functions, such as payment and transaction

services. The potential economic costs associated with the default of a large, complex, universal bank — particularly one that combines the provision of payments services and trading activities in a single entity — would most likely be sufficiently

high that government support would be forthcoming. Such support was, of course, observed during the recent financial crisis. As a result, the banking structure in numerous jurisdictions now exhibits a greater incidence of full and partial

public ownership.

Once a bank is perceived to be too important to fail, a wedge is driven between private and social returns to scale and scope, since the bank does not internalise the potential economic costs of its failure. As such, too important to fail banks may be

subject to less market discipline, and are likely to grow more rapidly and become more dependent on debt funding — and hence more highly interconnected and leveraged. Indeed, over the period 1969 to 2009, retail deposits became a smaller

percentage of total liabilities, declining from 88% to less than 40%. Particularly in the years prior to the financial crisis, banks relied heavily on wholesale funding (Shin (2010)) and their leverage ratios increased rapidly.

Reliance on wholesale funding, as well as functional expansion into derivatives and securitisation markets, have led to the formation of highly connected bank and non-bank intermediaries. This complex network of exposures can propagate isolated shocks, such that distress at one node can quickly spread through the syste.

Institutions that are perceived to be ‘too important to fail’ may also engage in excessive asset and maturity transformation. As King (2010) remarked: ‘greater risk begets greater size, most probably greater importance to the functioning of the

economy, higher implicit public subsidies and hence yet larger incentives to take risk...’. Through this dynamic, too important to fail is likely to have amplified the evolution towards universal banking associated with underlying economic forces.

Conclusion

This article has illustrated the significant changes in the structure of the UK financial system over recent decades. It argues that evolution reflects a number of factors, including the natural economic drivers of economies of scale and scope, interacting with demand-side drivers and financial deregulation.



That expansion has given rise to a banking system with large balance sheets, significant functional and geographical diversity and complexity, a high level of leverage, and extensive network interconnectivity. The emergence of large institutions that are deemed ‘too important to fail’ presents important challenges for public policy. Before the crisis, commentators emphasised the efficiency gains associated with these structural changes, in terms of the availability of

credit to households and businesses, the decline in lending spreads, and the availability of a broad array of risk-insurance services. The IMF (2006), for example, observed that globalisation and financial innovation had increased credit

availability to the economy. Since the crisis, however, policymakers and governments have begun to examine the social cost of pursuing such efficiencies. And it is increasingly recognised that having too important to fail institutions is a paradox that must be tackled (Bank of England (2010)).

In response, an Independent Commission on Banking has been established in the United Kingdom to consider the case for structural reform in the banking sector. And, internationally, the Financial Stability Board is examining a broad range of

policy options to mitigate the financial stability risks posed by systemically important financial institutions.

 


Date: 2015-12-24; view: 820


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