Download Lydia Prieg

Lydia Prieg
New Economics Foundation
3 Jonathan Street
London
SE11 5NH
3rd March 2011
Dear Sir/Madam,
The new economics foundation’s response to the European Commission’s consultation on a possible
European crisis management framework
nef (the new economics foundation) is an independent think-tank that aims to improve quality of life by
promoting innovative solutions that challenge mainstream thinking on economic, environment and
social issues. We are unique in combining rigorous analysis and policy debate with practical solutions on
the ground. nef works with all sections of society in the UK and internationally - civil society,
government, individuals, businesses and academia - to create more understanding and strategies for
change. We thank you for the opportunity to comment on the EU’s current proposals.
Firstly, the New Economics Foundation believes that the focus should not be on creating a resolution
mechanism whereby systematically import financial institutions can be allowed to fail in an orderly
fashion. The focus should instead be on ensuring that no single financial institution becomes big-enough
to be of systematic importance. This is not just an issue of stability; it is also an issue of fairness.
Whilst systematically important institutions remain, there will always be a tacit understanding in the
market that, if a resolution mechanism proves ineffectual or impractical for one reason or another,
governments will ultimately intervene. This concern should not be trivialised, as some institutions are so
large and interconnected, and thus the systematic risks they pose are so extensive, that one seriously
questions whether such an institution would ever truly be permitted to fail. Thus, whilst the too-big-tofail problem may be mitigated by an EU resolution mechanism, it is extremely unlikely that it will be
completely eliminated. This, in turn, means that the too-big-to-fail subsidy will still remain in one form
or another, and large banks will be able to borrow at lower interest rates than would be the case in a
free, unprotected market. In addition to unfairly inflating their profits, this subsidy gives large banks a
huge commercial advantage over smaller banks, and it exacerbates the barriers new firms face when
trying to enter the market. This latter point is crucial, as a lack of competition is frequently cited as the
root cause of why the banking industry currently serves the privileged few rather than the wider
economy.
The best-known estimate of the monetary value of this hidden subsidy comes from Andrew Haldane,
Executive Director of Financial Stability at the Bank of England.i Credit rating agencies helpfully publish
the actual rating, and the rating they would give to a bank if there was a genuine risk of investors losing
their money, which with disarming candour is called the “standalone” rating. This is, of course,
theoretical because the banks do not stand alone. The difference between the two ratings can be used
to calculate the funding subsidy. Using this method Haldane suggested subsidies of between £11 billion
and £107 billion. Moreover, this is just the subsidy to UK banks! Whilst a convincing resolution
mechanism would obviously help limit the value of this subsidy, it will not realistically be eliminated until
no individual bank is permitted to be systematically important. Until this is achieved, the market will
continue to inefficiently allocate resources.
Furthermore, even putting this subsidy to one side, whilst the promise of government intervention
lingers, risks will not be fully borne by the risk-takers. Thus, one will not be able to rely on market
discipline, and once again excessive risk-taking will be commonplace.
In addition, there is a real risk that resolution mechanisms will distract policy makers from the real issue
at the heart of the recent banking crisis. To quote the Nobel Laureate, Joseph Stiglitz: “If they are too big
to fail, they are too big to exist.”ii The Governor of the Bank of England, Mervyn King, corroborates this
statement: “If some banks are thought to be too big to fail… then they are too big.”iii Moreover,
resolution mechanisms effectively legitimise super-sized financial institutions, when policy makers
should instead be taking action against them. Thus, resolution mechanisms are a white-wash; they do
not constitute true financial reform.
There are many reasons why the large banks should be broken-up. Firstly, these behemoths have an
effective oligopoly on many markets (and there is clearly a greater role that the Competition
Commission should be playing here), and thus innovation and quality are inherently going to be
lackluster, to the detriment of the consumer. Secondly, it is profoundly unfair that many of the financial
institutions that engage in highly speculative activities benefit from governments’ deposit guarantee
schemes. Legislation resembling the Glass-Steagall Act should be introduced, so that governments no
longer partially underwrite such business. Risky investment strategies should only be pursued by small,
non-depository institutions, where investors fully understand that their money is not guaranteed. The
existence of retail and investment banking under one roof also is facilitating the funnelling of capital
away from the real economy and toward unproductive speculation. For example, why should a bank
such as Barclays channel resources towards its retail business, when it can deploy these same resources
on the capital markets, and earn a much higher return? As a result of such decision-making, local bank
branches are rapidly being closed down throughout the UK, which perpetuates financial exclusion, and it
is becoming increasingly difficult for small and medium sized enterprises, the true engines of growth in
any economy, to obtain loans.
Finally, one should briefly note the inherent contradiction in a resolution authority’s dual mandate:
discouraging moral hazard and reducing systematic risk. A trade-off arises because removing the toobig-to-fail subsidy will automatically increase the cost of funding for large financial institutions, which
will increase the risk of these institutions failing. This, in turn, further reduces the credibility of the claim
that gargantuan institutions will ever truly be allowed to fail, especially if they get into trouble in the
middle of an already difficult global financial crisis.
In short, the New Economics Foundation encourages the Commission to rethink their approach to
tackling the “too-big-to-fail” problem, and to instead explore more radical and profound financial
reform.
However, to briefly touch on the EU’s current proposals, it is worth pointing out that many of the
initiatives outlined are somewhat worrying. For example, the emphasis on stress-testing, despite the
failure of previous European stress-testing to predict the recent Irish banking crisis, is deeply concerning.
Similarly, the extensive discussion surrounding which types of institutions should be covered by the
mechanism does not bode well. The chaos that surrounded Long-Term Capital Management in the late
1990s demonstrates that it is not just banks that are at risk of jeopardising the stability of the global
financial system. All large, complex financial institutions should be covered be covered by any resolution
mechanism, as they pose counterparty risk, which is particularly difficult for their counterparties to
quantify and, thus, demand appropriate collateral to compensate for, due to extensive, opaque OTC
trading. Additional externalities can arise, for example, from driving down asset prices during crisis fire
sales. Moreover, the resolution mechanism proposed in the US’ Dodd-Frank Act applies to all such
institutions, therefore if the EU were to go down another route, this would introduce regulatory
arbitrage, which the EU should categorically not be facilitating.
Finally, it is worth pointing out that the very fact that many banks support the introduction of such a
mechanism indicates that it is likely to prove ineffectual. The banks have no interest in eliminating the
too-big-to-fail subsidy, and would, of course, oppose any measure that would substantially increase
their cost of funding (as truly resolving the too-big-to-fail problem would).
Thank you in advance for your consideration. If you have any questions, or would like any further
information, please do not hesitate to contact me.
Best wishes,
Lydia Prieg
Researcher, New Economics Foundation
[email protected]
+ 44 (0) 207 820 6300
i
Haldane, A. (2010). The $100 Billion Question. London: Bank of England.
ii
Stiglitz (2010). Freefall: Free markets and the sinking of the global economy. Penguin.
iii
http://www.guardian.co.uk/business/2009/jun/17/king-in-bank-reform-call