Financial firms should be allowed to fail, said the official, adding that having firms that are either too big or too important to fail is bad for competition in the industries that the FSA regulates. An industry where exit is too difficult is one where entry is likewise inhibited. In his view, embedding resolution into the public policy objectives of financial regulation matters for two reasons relevant to competition: first, because exit enables entry; and, second, because if new entrants must satisfy the regulator on their resolvability in order to be authorized, the regulator can lower the barriers and costs of opening for business.
Mr. Bailey, who in 2013 will become the Deputy Chief Executive of the new Prudential Regulatory Authority, pledged that it will not be the PRA’s role to ensure that no financial firm fails. Rather, the PRA will ensure that any firm it regulates that does fail should do so in a way that avoids significant disruption to the supply of critical financial services.
In this regard, and more generally, he supports the Vickers Commission proposal to ring-fence commercial from investment banking and, in so doing, define the scope of commercial banking that can be inside the ring-fence. This will be a major structural change for the banking system, he predicted, and will have important implications for regulators.
The UK Independent Commission on Banking, the Vickers Commission, recently proposed a sweeping structural change for organizations engaged in commercial banking. In essence, within a single organization the range of ordinary banking operations, such as deposit taking, lending, and payments, would be segregated in a retail bank, which would be overseen by its own independent board of directors and ring fenced to greatly reduce relations with the rest of the organization. While proprietary trading and investments in hedge funds would not be prohibited, these activities would be outside the ring-fence and thus isolated from retail banking.
According to Mr. Bailey, there are two key points in the Vickers reforms. First, in the last ten years or more, the nature of investment banking has changed to include a much larger element of proprietary trading and position taking. The incentives and risks of this activity are quite different from commercial banking, he said, and he does not believe that the two should be mixed in the same legal entity. Regulators around the world have struggled to regulate this mixture, said the FSA Director, and will continue to do so even though the cost of doing investment banking business has been raised through changes to the regulatory regime.
Second, in a world where the authorities will not accept banks being too big or complicated to fail, it is sensible to be able to resolve commercial and investment banks separately, he emphasized, and to achieve this the ring-fence approach is needed to support the continuity of provision of financial services.