BOE Governor Discusses Financial System Reform

In an October 20, 2009 speech before the Scottish Business Organizations in Edinburgh, Bank of England Governor Mervyn King weighed in on financial system regulatory reform. Among other things, he discussed moral hazard associated with governments coming to the rescue of troubled financial institutions and the need to address the “too big to fail” or, as he described it, “too important to fail,” issue. His insights are relevant far beyond the boundaries of the United Kingdom.

He asserted that there are two ways to address that problem: “One is to accept that some institutions are ‘too important to fail’ and try to ensure that the probability of those institutions failing, and hence of the need for taxpayer support, is extremely low” and “The other is to find a way that institutions can fail without imposing unacceptable costs on the rest of society.”

The first approach could be pursued by requiring banks to “take out insurance in the form of ‘contingent capital.’” Contingent capital would essentially be debt or preferred equity that automatically converts to common equity before a bank becomes insolvent. The theory behind contingent capital is that its highly dilutive impact would create disincentives for financial institutions to take the kind of excessive risks that would imperil their survival. Nonetheless, King argued that drawbacks would make prospects for that approach’s success uncertain.

The second approach would require segregating financial institutions’ basic role in intermediating savings to finance investment from their riskier activities such as proprietary trading. Under such an approach, the government would provide guarantees only for the basic banking services. Former Federal Reserve Chairman Paul Volcker supports a variant of this approach in which banks would be barred from owning or trading risky securities for their own accounts. Simon Johnson, former chief economist of the International Monetary Fund goes even farther in raising the question as to whether “we have to break up the biggest banks.”

For now, there remains no consensus on how to address the “too big to fail” issue. In the United States, the debate on financial system regulatory reform has taken a backseat to the health reform discussion and it remains to be seen whether King’s, Volcker’s, or Johnson’s insights will receive serious consideration. Historical experience suggests that the passage of time and onset of economic recovery will probably reduce the scope of financial system reform emerging in the wake of the recent crisis.

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