Still exposed

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It is now almost ten years since the onset of the global financial crisis, but its impacts are still being felt across the UK. Thanks to weaknesses and irresponsibility in the financial sector, millions of ordinary people were left to pay a huge price. And while measures were introduced – in the UK and other developed economies – to ensure that the tragic human cost of the crisis does not happen again, many believe these have not gone nearly far enough.

Now the UK’s vote to leave the European Union raises new uncertainties around the future of the financial sector. In this context, three questions become vitally important:

• How resilient is the UK’s financial system to potential future shocks?
• What might be the impact of different forms of Brexit on financial system resilience?
• How could different domestic policy choices improve or harm financial system resilience

This paper sets out to answer these three questions. We begin by updating our Financial System Resilience Index, first published in 2015, and find that:

• The UK’s financial system resilience has improved slightly since the financial crisis, but is still by far the worst performer among the G7 economies
• Despite seeing a reduction in intrafinancial lending, cross-border claims, leverage, non-performing loans and household debt, the UK still has among the largest, most concentrated, complex and interconnected financial systems in the developed world, and therefore remains vulnerable to shocks.
• Household debt is now on the rise again, and the proportion of real economy lending is strikingly low, creating further systemic risks.

Looking ahead, we find that Brexit raises new uncertainties – and poses new risks – to financial system resilience. The form that Brexit takes could have significant consequences for the size, composition and activities of the financial services sector – and, in turn, for financial system resilience. We consider the impact of three possible Brexit scenarios in the context of our financial system resilience framework, drawing on evidence from our expert interviews: a ​‘hard Brexit’ scenario, a bespoke agreement and a ​‘soft Brexit’ scenario.

Our analysis indicates that any outcome other than a ​‘soft Brexit’ will likely involve significant disruption to the financial sector, as financial institutions respond by shifting some wholesale activities overseas. This alone could pose risks to financial stability, but it also raises the possibility that the UK starts to roll back financial regulation and cut taxes in a bid to stem the outflow of business – a strategy that both the Prime Minister and the Chancellor of the Exchequer have hinted at. This would be the worst possible outcome.

While we were promised that Brexit would allow us to take back control, a move towards financial deregulation would do the opposite. It would lock us into a future of low regulatory standards designed to serve the interests of international finance, and would be a clear sign that lessons from the financial crisis have not been learned. It would create a much riskier and less resilient financial system, leaving people at the mercy of damaging forces over which they have no control.

But this is not inevitable. Our analysis suggests that the consequences of Brexit for UK financial system resilience will depend heavily on the domestic policy decisions that accompany them. Rather than seek to replace the lost business by lowering standards and attracting even riskier and more dangerous financial activity, we recommend the UK should instead seek to improve resilience by refocusing its financial system to better serve the domestic real economy and the needs of people now. The process of reshaping our financial system to better serve society can, and should, start now – regardless of the final outcome of the Brexit negotiations. To this end, we recommend that:

• A race to the bottom on financial regulation should be avoided at all costs. Far from being bad for the economy, measures to promote financial stability are pre-requisites for long-term sustainable growth. Slashing regulation in a bid to curry favour with the City of London will create a less resilient financial system and jeopardise the long-term social and economic health of the UK.
• The Bank of England should strengthen prudential and macroprudential regulation to mitigate risks posed by Brexit. This should involve increasing the levels of capital that big, systemically risky, banks are required to hold and looking more closely at other factors when assessing financial system resilience, such as: what is actually on banks’ balance sheets (asset and liability composition); the topography of the system as a whole (interconnectedness, transparency and complexity); and overall financial system size. Asset composition could be improved by developing forms of ​‘credit guidance’ to boost lending to non-financial firms, in coordination with the UK’s new industrial strategy.
• The Treasury should urgently review options for addressing the lack of diversity in the UK banking system, and for promoting a more vibrant banking sector focused on lending to the domestic real economy. This should include examination of the full range of options for the public’s majority stake in the Royal Bank of Scotland (RBS), including transforming it into a network of local or regional retail banks with a public interest mandate to serve their local area, lend to small businesses and provide universal access to banking services. The Treasury should also examine policy options for establishing new sources of patient, long-term finance for strategic investment, such as establishing a new national investment bank.
• In promoting competition in the banking sector the Competition and Markets Authority (CMA) should focus on diversity of provision, not just market share. Genuine competition and choice requires a diversity of providers for consumers to choose from, rather than simply a larger number of major players following the same business model.