The financial crisis that began in 2007 exposed fundamental weaknesses in the global financial system, and has had enormous economic costs in terms of lost output, higher unemployment and weakened public finances. In the build-up to the crisis, lenders and borrowers took on excessive and ill-understood risks, and banks operated with excessive leverage and inadequate liquidity. Regulation permitted the ratio of their assets to their capital base to grow far too high – to twice normal levels – and they could not access market funding when they needed it. When the crisis hit, bank balance sheets proved poor at absorbing losses, and the complexity of many failing institutions made it impossible efficiently to ‘resolve’ them – i.e. sort out which parts of them should fail and which should continue and how. To avert panic and ensure continuous provision of the basic banking services upon which the economy and society depends, governments and central banks injected vast amounts of capital and liquidity into the financial system. 

Reform options for stability

How to make the system safer for the future? An important part of the answer is better macroeconomic – including ‘macro-prudential’ – policy so that there are fewer and smaller shocks to the system. Work by others internationally and in the UK aims to address this. But these shocks cannot be eliminated, and the UK will always be subject to global events.

Making the banking system safer requires a combined approach that:

• makes banks better able to absorb losses;

• makes it easier and less costly to sort out banks that still get into trouble; and

• curbs incentives for excessive risk taking.

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