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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