On Tuesday, the Bank of England’s Executive Director for Financial Stability, Andrew Haldane, presented a paper in which he discusses the costs and benefits of structural reform to the banking system. In particular, Mr. Haldane focused on whether regulatory policy should consider both the prohibition and taxation of activities.

In the paper, Mr. Haldane begins by considering the costs of the financial crisis that might be attributed to banks. He notes that existing metrics are likely to overstate or understate the effect that banks had on the recent financial crisis and states that “a more precise measure may be needed of banks’ distinctive contribution to systemic risk.”

Mr. Haldane then discusses the benefits of prohibition for financial system resilience under three headings:

  • Modularity - that a decentralized, modular structure, often brought about by policy interventions, has strengthened resilience in many types of networks and may be applicable to banks.
  • Robustness - that a regulatory regime needs simple rules focused on the avoidance of extreme outcomes, as is the case in other industries that manage systemic risk.
  • Incentives - that there are natural incentives within the financial system for banks to examine risks and avoid regulatory control.

In his discussion of limitations of bank size, Mr. Haldane refuted arguments related to the economies of scale enjoyed by large banks, saying limits on the optimal size and scope of firms may be required simply by the oversight abilities within individual firms. Specifically, Mr. Haldane noted that “this crisis has provided many examples of failures rooted in an exaggerated sense of knowledge and control.”

Finally, in summary, Mr. Haldane noted that “…it is possible that no amount of capital or liquidity may ever be quite enough. Profit incentives may place risk one step beyond regulation. That means banking reform may need to look beyond regulation to the underlying structure of finance...”.

Mr. Haldane’s speech and paper followed the release of a report by the House of Commons' Treasury Committee, entitled “Too important to fail–too important to ignore.” The report, issued last week, concludes that the actions governments had to take to ensure financial stability, resulted in a market which operates under the assumptions that systemically important firms will be rescued if necessary and that significant reform is needed. While that report recommended a thoughtful assessment of financial regulation, it warned that the U.K. “must not replace irrational exuberance with equally irrational restrictions. What is needed is a regulatory framework that will not flex according to the moods of politicians, the markets or even regulators. Given the lamentable consequences of the previous regulatory approach, the Government should be prepared to embrace radical change, rather than settling for adaptation to an existing, failed model.”