In a June address before the British Bankers’ Association Annual International Banking Conference in London, Paul Tucker, Deputy Governor for Financial Stability at the Bank of England, explained his thoughts on redrawing the social contract between banking and society in light of the contract’s failure leading up to and during the financial crisis. According to Mr. Tucker, the traditional social contract wherein bank regulation is balanced against insulation from certain market risks through industry-wide deposit-insurance programs and state sponsored measures to reduce the probability of unwarranted failure is now deeply fractured.
According to Mr. Tucker, the framework of the social contract was ill prepared to handle the realities of shadow banking and financial innovation. Regulations were poorly designed, and at the onset of the financial crisis, bank regulators and finance ministers found their priorities muddled, emphasizing short term consumer protection measures, rather than focusing on the more pressing need to assure the soundness of the banking system as a whole. Further, central banks' liquidity-insurance facilities found themselves initially ill equipped to address the economic realities of practices going on outside of traditional banking, like shadow banking. (e.g., the US Federal Reserve was temporarily permitted to extend liquidity to non-banks).
Tucker warns that hasty reregulation without first reexamining the social contract would be foolish. Therefore, he recommends the social contract be reexamined with an emphasis on resolvability and on the health of the system as a whole, ultimately leading to a financial system that is able to keep lending even during periods of extreme market stress.
In reassessing the social contract, Mr. Tucker insists that two flaws in the traditional contract be addressed:
1. The absence of a regime for resolving distressed banks in a way that avoids both taxpayer support and systemic disorder.
Traditionally, bank supervisors worked to reduce the probability of firm failure. They did so, of course, because of the costs of failure. Yet they did not spend much time working out how to handle a firm’s failure in the event of prophylactic supervision proving insufficient. That was a major problem in the very conception of prudential regulation and supervision, going back decades.
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A central element of the new Social Contract for banking is that firms must be fit to fail in an orderly way. Working backwards from that ultimate objective will necessarily change the dialogue between banks and their supervisors.
2. The issues raised by interconnected banking and shadow banking activities.
The prevalence of non-bank banks as they used to be called, or shadow banks as they are now known, was a deep faultline in the international financial system. Things cannot be left where they are. The status quo was deeply unsatisfactory, and if we do nothing it will be made worse by the re-regulation of the banking system, which creates powerful incentives to reinvent the economic substance of banking beyond the perimeter of prudential regulation and supervision.
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In another return to the distant past, the supervisor cannot treat firms as islands. They are part of a system. So, at the very least, supervisors will need to look laterally across peer groups of firms for oddities, and stress test firms’ resilience against short-term and longer-fuse threats from the environment. They will, therefore, need to draw on market intelligence on industry trends from the Bank’s Markets area; insights from the operators and overseers of the clearing, settlement and payment systems; and analysis from the finance and monetary researchers in the Bank.
Ensuring a healthy, stable, and orderly global financial system, even in times of extreme market conditions requires more than remedial reregulation and prudential oversight, but rather, a fundamental reexamination of the realities of modern banking activities, and how the risks of those activities are shared or socialized fairly and effectively. Though it is difficult to keep supervisors and policy makers focused on the stability of the system as a whole, rethinking the frayed social contract between banking and society may act as a lens through which they may view the mechanics of securing the financial system.