Our 2017 Fiscal risks report noted the historical and international evidence that financial crises have been a major source of risk to the public finances. Since the crisis of the late 2000s, the UK Government has reformed its regulation of the financial system. In this box we outlined key elements of those reforms, which aim to ensure that should a bank fail it can be managed in a way that protects the wider economy and financial system.
Since the financial crisis, the UK has reformed its regulation of the financial system. One aspect has been the creation of the Financial Policy Committee (FPC). This has primary responsibility for identifying, monitoring and mitigating risks to financial stability, with the aim of ensuring that regulators take a holistic approach to safeguarding financial stability. UK banks have continued to build up capital resources since the financial crisis, more than doubling their risk-weighted capital ratios. At an aggregate level, these are now in line with the levels judged appropriate by the FPC for the UK banking system to withstand potential losses.
The Bank of England also conducts annual stress tests of the banking system to ensure that banks can withstand periods of severe stress. In 2016, the FPC judged that “the banking system is in aggregate capitalised to support the real economy in a severe, broad and synchronised stress scenario”.a This scenario included a severe, synchronised UK and global recession with associated shocks to financial market prices and an independent stress of misconduct costs. This year will be the first that the Bank also runs an ‘exploratory’ scenario to complement the annual cyclical scenario. The aim of the biennial exploratory scenario will be to probe the resilience of the system to risks that may not be neatly linked to the financial cycle.
The UK has carried out reforms aiming to ensure that, in the event that a bank does fail, it can be managed in a way that protects the wider economy and financial sector. Resolution is the process by which the authorities can intervene to manage the failure of a firm in a manner other than allowing it to fall into a disorderly insolvency. In particular, the UK has:
- Implemented a comprehensive bank resolution regime: The UK’s ‘special resolution regime’ provides the authorities with tools to manage the failure of financial sector firms. This includes powers for the Bank of England to ‘bail-in’ shareholders and creditors of failed banks. The bail-in tool can be used to absorb the losses of a failed firm and to recapitalise the firm using the firm’s own resources. In recent years, UK banks have issued substantial amounts of loss-absorbing debt instruments suitable for this purpose.
- Passed the Financial Services (Banking Reform) Act 2013: this requires the largest UK banks to separate core retail banking services from their investment banking activities by 2019 (known as ring-fencing). These reforms enable the resolution authority to resolve retail and investment banking activities separately if required, ensuring that core retail banking services can be treated separately from the large balance sheets that support investment banking activities.