Regulating banks after 2008: Key issues for the 2015 Parliament

The decision by US regulators a month before to allow Lehman Brothers to fail had brought the financial world to its knees. RBS's balance sheet was about six times larger than Lehman's.

Mr Darling decided that the least worst option was to commit public funds to a rescue that, once other banks had requested assistance too, led to £1.2 trillion of taxpayers' money being pledged in support of UK banks.

Since then, at all levels of political, geographical and economic decision-making, vast effort has been expended to make the financial system more resilient, and to ensure that governments are never faced with such a choice again.

It will still be some years before these changes are fully implemented, and it may only be when another crisis strikes that we will know whether they have worked.

Work done

In the UK, a new regulatory framework has been created for banks. In April 2013, the Financial Services Authority was abolished and responsibility for ensuring individual banks are resilient was passed to the newly-created Prudential Regulation Authority, an arm of the Bank of England.

In line with EU rules, the PRA is also responsible for ensuring banks have plans in place (‘living wills') to allow regulators to wind them down quickly and predictably in the event of failure.

Meanwhile, the new Financial Policy Committee of the Bank has responsibility and powers for ensuring system-wide financial stability; it recently used its powers in response to fears of an emerging house price bubble in October 2014.

The Financial Conduct Authority, another new regulatory body, is responsible for supervising the conduct of banks and individuals within them.

New regimes are being drawn up that seek to improve individual accountability, particularly of banks' senior managers, and to reform remuneration to discourage excessive risk-taking and short-termism.

The UK will be imposing a leverage ratio that goes somewhat beyond proposed minimum international requirements.

And banks will be required to ‘ringfence' – in effect, structurally separate –their retail and investment banking activities, so that ordinary depositors are protected from risks elsewhere in the banking system.

At a global level, capital standards have been toughened to ensure that banks are resilient enough to withstand modest changes in the value of their assets, of the sort that occur during an economic downturn, with additional requirements placed on large banks.

Work still to do

Seven years after the crisis, there remains uncertainty and work still to do in several areas.

• The detail of many of the reforms, including the ring-fencing of banks' retail operations, is still being worked out. There remain opportunities for banks, having agreed the high-level principles of regulatory reform, to water down some of the details.
• While certain international standards have been agreed in some areas, different approaches have been pursued by national regulators in others. For instance, where the UK has a ringfence, the US has the Volcker Rule that prevents banks engaging in speculative trading that is not at the behest of their clients. This matters because large banks typically operate in multiple jurisdictions, and are thus subject to different regulatory requirements. It is not yet fully clear what irreconcilable demands exist.
• Linked to this, although the probability of a large international bank failing will be significantly reduced, there remain uncertainties about what exactly will happen when it does. The complexity of such institutions, combined with differences in legal regimes, corporate structures and banking practice in different countries, make the business of winding down a cross-border bank in an orderly fashion enormously challenging.
• The financial crisis was evidently not a sufficiently salutary experience to restrain individuals in banks from engaging in Libor and foreign exchange manipulation. It remains to be seen whether the new frameworks for remuneration and accountability will be sufficient to prevent such misconduct in future, and to hold individuals to account when it happens.
• Finally, the growth of the “shadow banking system” may indicate that some of the risks to stability addressed by the regulation of banks may have simply moved outside regulatory purview.

How will we know we're safe?

The measure of success will not be whether future bank failures have been prevented, but whether taxpayers are on the hook when they do happen.

That means not only reducing the likelihood of failure by ensuring banks are not run in a risky manner, but also ensuring that, when they fail, the contagion to other parts of the financial system is limited, and resultant losses are borne only by investors, just as they would be for any other company.

Whether the authorities have succeeded in this effort will only be known when the next crisis strikes, and the new regime is tested in practice.

Chart: Confidence in UK financial stability

Confidence or complacency? Market participants' confidence in UK financial stability is near pre-crisis levels

Capital confusion – understanding capital and leverage requirements

In highly simplified terms, banks' assets consist of loans they have made. Their liabilities consist of deposits, including those of ordinary retail customers, and other sorts of debt (e.g. bonds, short-term debt to other banks etc.). The difference between a bank's assets and its liabilities is equivalent to its capital. A bank's capital represents its ‘own funds': essentially, funds that (unlike deposits and bonds) it does not have a contractual commitment to repay. The most important sources of capital are share capital and retained earnings, but there are many definitions of what ‘counts' as capital.

Because it doesn't have to be paid back, capital can be used to absorb losses. Large amounts of debt with a thin capital base means that if a large number of loans go bad, the bank's capital may not be sufficient to absorb the losses. In this case, its assets fall short of its liabilities: in other words, it is insolvent. Capital and leverage requirements seek to reduce the likelihood of this eventuality.

Capital requirements mandate a minimum ratio of capital to total assets, with assets weighted according to their riskiness (for example, loans secured on property typically have a lower risk weighting than unsecured loans). For instance, under the international Basel III framework, among many other requirements, banks' common equity (i.e. share capital) must be at least 4.5% of their risk-weighted assets.

Leverage requirements similarly mandate a minimum ratio of capital to assets, but in this case the assets are not weighted according to their riskiness. For instance, following a Bank of England review, major UK banks must meet a minimum 3% leverage ratio (£3 of capital for every £100 of assets), with tougher requirements for globally important banks.

Party Lines

• Conservatives: complete ring fencing by 2019
• Greens: separate retail and investment banking
• Liberal democrats: complete separation of retail and investment banks