Bank: financial system still vulnerable
Updated on 26 June 2009
Another financial shock could still find the British banking system vulnerable, according to a new Bank of England report. Ben King reports.
The British banking system is still on life support - and though it's not in critical danger, it could still be vulnerable if the economy suffers another economic shock in the coming months.
The warning comes in the bank's bi-annual Financial Stability Report, which sets out a series of proposals to strengthen the nation's financial system.
The report warns that the banking system has improved but is still fragile. One particular measure of risk is banks' leverage ratios: the amount of money they have lent out relative to the money they have on reserve in case loans never get repaid. By some measures, these are still at the same levels they were in 2007, at the height of the boom which precipitated the credit crunch.
The Bank of England believes that banks need to increase those capital cushions and cut those leverage ratios; but simply obliging them to do this could force them to cut lending to an economy which is already suffering from an acute lack of credit.
The report explores many existing proposals for reducing risk-taking in the banking system without cutting off the supply of credit to the economy - such as measures to oblige banks to build up reserves in good years to keep them safe in the bad.
It explores two crucial issues in particular. What should be done about very big banks, such as the behemoth which emerged from the Lloyds-HBoS merger?
Lloyds now controls one third of the mortgage market in the UK. So does such a huge bank pose an unacceptable risk to the system? And if so, should it be broken up? And how?
The merger was mainly sold to Lloyds TSB shareholders and management as a once in a lifetime opportunity to create a vastly profitable megabank. So would their shareholders get compensation?
A second key problem is how to let banks die. If bankers know that the government will bail them out if things go wrong, they can take all kinds of crazy risks.
But when the authorities let Lehman Brothers collapse in September 2008, they grossly underestimated the damage it would cause across the financial system. It brought the economy to the brink of chaos.
So the report explores the need for a mechanism which would let banks fail in an orderly manner, minimising the collateral damage to other institutions.
It is a report that raises more questions than it answers. But it serves as a reminder in the apparent calm in the financial markets at the moment, that the banking system remains extremely vulnerable if the economy takes another serious turn for the worse.
Paul Tucker, the Bank of England's deputy governor in charge of financial stability, said: “The policy debate now underway matters enormously if we are to achieve a more stable financial system in the future. No particular initiative will be sufficient by itself.
"Greater resilience will need to be based on a variety of measures, some of which are discussed in this Report as a contribution to the wider national and international debate.”
