Not far enough: Recommendations of the UK's Independent Commission on Banking

Charles Goodhart, Avinash Persaud 13 May 2011



Despite the intellectual firepower of the UK’s Independent Commission on Banking, the reforms proposed in the interim report will not make the UK financial system any safer. The commissioners’ intentions were waylaid by the absence of an analytical framework of financial stability or, what might have sufficed, a rigorous analysis of what actually went wrong. The political imperative to be seen slapping banks for their misdeeds – though not so hard as to undermine them – would also have been distracting.

At the centre of the financial crisis was a nexus of excessive leverage and an unsustainable expansion in housing markets, accelerated by the use of risk-weighted assets as the basis of capital, liquidity, and accounting ratios. This has been set out before in a number of reports (see for example Brunnermeier et al. 2009). To make matters worse, political pressures led the risk weights for housing lending and all Eurozone government bonds to be fixed at artificially low levels. Proposals for constraining property bubbles financed by excessive leverage should therefore be central to this report. But they receive scant attention, muscled out of the way by a focus on increasing competition, ring-fencing retail from wholesale banking and introducing instruments to bail in creditors. These are solutions to a different set of problems than financial instability.

The financial crisis had little to do with the structure of banking. Where unsustainable housing and property finance was provided by pure retail banks like Northern Rock and the Irish banks, they were the weak points. When provided by investment banks like Lehman Bros and Bear Sterns, or by universal banks like UBS and RBS, or even quasi-government agencies like America’s “Fannie” and “Freddie”, they too were the weak points. Moreover, the notion that we can limit the exposure of taxpayers to the financial system by saving the retail part of the banks and letting the wholesale part go to the wolves seems, stunningly, to ignore the example of the failure of Lehman Bros, a modestly sized wholesale bank, whose failure seized up the whole banking system. In the credit economy confidence is everything and is not easily divisible. Waterproofing individual compartments did not save the Titanic from a sinking either. In hindsight, saving Lehman Bros might have been the cheaper route for taxpayers. It would have been cheaper still if Lehman’s leverage were limited more effectively than the risk-weighted capital ratios the report keeps faith with.

The report promotes “challenger” banks to prise open a cosy banking oligopoly. But it was precisely those “challenger” banks like Northern Rock, HBOS, and Anglo Irish that introduced ‘dodgy products” and took most risks to build market share. Recall Northern Rock’s “Together” 125% loan-to-value mortgages. The Icelandic banks were archetypical challengers; “Icesave” offered better returns to depositors. Their success leads normally more prudent, incumbent banks, to emulate them. The main purpose of US regulatory laws after 1933 was to reduce competition in the name of stability. There is a long-standing tension between competition and stability and the report does not tell us how to solve it.

The Commission flirts with bail-ins and co-co bonds. These are clever products that make their protagonists seem cleverer still, but they will lead to an even quicker and more complete shutdown of the credit markets were we once more to be in the breach of systemic failure, where asset prices have dropped out of the sky, and as a result, every bank is about to bail in their creditors – who are invariably also taxpayers and pensioners. These instruments are better suited to the failure of a single bank. But we are reasonably good at managing single-bank failures without them – as evidenced by the contained failures of JMB, BCCI and Barings.

Without a framework of systemic risk control it is easy to think that the solution to protecting tax payers lies in saving “Captain Mainwaring” style domestic retail banking from “Gordon Gekko” style international investment banking. But systemic risks are caused by a previous, collective, underestimation of risk by the Mainwarings and Gekkos and all others in between that promote excessive lending and leverage. It follows from this that the way to make our financial system safe is to make it less vulnerable to the mispricing of risk and pro-cyclical valuation. There are two ways to do this:

  • First, by limiting leverage in ways that are divorced from perceptions of risk. A simple leverage ratio (assets to equity) and counter-cyclical loan-to-value ratios for housing should be key components.
  • Second, we need to increase the capacity of the financial system to absorb risks for a given amount of leverage. This requires common capital adequacy requirements across the financial system that incentivise transfers of credit and liquidity risks so that when risks do blow up, credit risks in the system as a whole are diversified and maturity mismatches (liquidity risk) are minimised.

The report’s main recommendations – slightly higher risk-weighted capital ratios, more competition, and ring fencing retail from wholesale banking – do not do either of the above.


Brunnermeier, Markus K, Andrew Crockett , Charles A Goodhart, Avinash Persaud, Hyun Song Shin (2009), The Fundamental Principles of Financial Regulation, Geneva Reports on the World Economy 11, CEPR.



Topics:  Financial markets Global governance International finance

Tags:  UK, financial regulation, UK Independent Commission on Banking

Emeritus Professor in the Financial Markets Group, London School of Economics

Emeritus Professor of Gresham College


CEPR Policy Research