Why the UK has the least resilient financial system in the G7

Photo credit:   Aleem Yousaf

June 2, 2015 // By: Josh Ryan-Collins

Since the financial crisis of 2008, financial sector regulators have spoken frequently about ‘resilience’ of the financial system. The Bank of England’s June 2014 Financial Stability Report, for example, uses the word 56 times – but there is little agreement as to what the term actually means.

Often it seems to be implicitly assumed that, by making individual banks hold more capital we can stop them from ever going bust - ‘resilient’ banks will equal a resilient system. This is a dangerous assumption that ignores our growing understanding that complex systems are about much more than the sum of their individual parts.

Today NEF launches a new Index that sets out how we can measure financial system resilience and why efforts to redesign and regulate the system are necessary to ensure economic stability, both here in the UK and globally.

Drawing on academic and policy literature and a series of consultations with experts, we set out six fundamental factors that should be taken in to account when measuring and assessing system resilience. These include: diversity, interconnectedness and network structure, financial system size, asset composition, liability composition, complexity and transparency.

We add to this the regulators’ favourite, the ratio of bank’s capital to assets, to form a composite Index and examined the results across the Group of 7 advanced economies since 2000 (see figure below).

Figure 1: Financial systems resilience index - Composite Index

For the UK, the news is not good. According to the latest available data (2012), the NEF Financial Resilience Index gives the UK a resilience rating of just 27, lagging behind the US (56), Canada (62), Italy (63), France (66), Japan (71) and Germany (73).

As shown in the graph above, the resilience of our financial system resilience took a nosedive in the early 2000s and, despite a small improvement since 2008, is still nowhere near bridging the gap with its nearest competitors.  Why is this?

Firstly, the UK banking system is the largest financial system of the major advanced economies, relative to GDP. As a historical global financial centre, this is not surprising. But it is only in the last 10 years that the size of the UK financial system – in terms of total bank assets as a percentage to GDP – has expanded notably faster than other advanced economies.  The UK also now has some of the highest levels of private household debt among the G7, making it vulnerable to monetary shocks such as shifting interest rates.

UK banks are also more interconnected with other parts of the financial sector, including the so called ‘shadow banking sector’, than our G7 competitors. UK banks both lend to and receive funding from other financial corporations to a greater extent than other advanced economies. We are also more exposed to international shocks since our banks hold many more foreign assets than our competitors. Yet academic research suggests that, beyond a certain point, intra-financial system connectivity enhances vulnerability to system-wide shocks. 

Our financial system is also lacking in diversity.  Whilst our G7 competitors have a significant number of cooperative, mutual and public savings banks, the UK is dominated (82%) by shareholder owned and large banks.

How can the UK improve its resilience?

Finance received little attention in the election campaign – if politicians talk about it at all, it is to reassure us that banking reform is done and dusted. But our analysis shows that post-crisis reforms have in fact been woefully inadequate to address the structural problems with our financial system. If we are to weather the next financial storm, we need a new approach.

Our analysis shows the importance of diversity within our financial system. Efforts to increase competition within the UK financial sector must not simply mean more ‘lookalike’ challenger banks. 

Equally, policy-makers cannot rely on complex new capital requirements to ensure system resilience: structural reforms, such as separating retail from investment banking, will be more effective.

Innovations in finance, such as the rise of peer-to-peer lending, could also significantly improve system resilience, but this depends on how the industry evolves – if P2P platforms are simply bought up by existing banks or their loans securitized, this could actually increase financial fragility.

The Bank of England has made a good start in thinking about the financial system in a more holistic way with the creation of the Financial Policy Committee and increased focus on macroprudential policy.  We hope this report helps regulators go further and explicitly define system resilience and measure and publish resilience indicators on a regular basis. 

Only then can we talk more seriously about a stronger UK financial system that will ensure our economic stability in the face of any future crises.

Issues

Banking & Finance, Innovating Finance, Monetary Policy

How can the UK improve the resilience of its financial system?

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