Speech by Mr Mervyn King, Governor of the Bank of England, to Scottish business organisations, Edinburgh, October 20 2009

Mervyn King: Monetary policy developments

Two years ago Scotland was home to two of the largest and most respected international
banks. Both are now largely state-owned. Sir Walter Scott would have been mortified by these events. Writing in 1826, under the pseudonym of Malachi Malagrowther, he observed that:
“Not only did the Banks dispersed throughout Scotland afford the means of bringing the country to an unexpected and almost marvellous degree of prosperity, but in no considerable instance, save one [the Ayr Bank], have their own over-speculating undertakings been the means of interrupting that prosperity”.
Banking has not been good for the wealth of the Scottish – and, it should be said, almost any other – nation recently. Over the past year, almost six million jobs have been lost in the United States, over 2½ million in the euro area, and over half a million in the United Kingdom. Our national debt is rising rapidly, not least as the consequence of support to the banking system. We shall all be paying for the impact of this crisis on the public finances for a generation.

The United Kingdom faces two fundamental long-run challenges. First, to rebalance the economy, with more resources allocated to business investment and net exports and fewer to consumption. That is consistent with the need – now widely accepted – to eliminate the large structural fiscal deficit and to raise the national saving rate. It is part of a need for a wider rebalancing of domestic demand in the world economy away from those countries that borrowed and ran current account deficits towards those that lent and ran surpluses.
Second, both the structure and regulation of banking in the UK need reform. Banks increased both the size and leverage of their balance sheets to levels that threatened stability of the system as a whole. They remain extraordinarily dependent on the public sector for support. That was necessary in the immediate crisis, but is not sustainable in the medium term.

These two challenges are interrelated. In creating the crisis, imbalances in the world economy led to unusually low real interest rates and large net capital flows from the emerging market economies to the developed world. That provided the fuel which an inadequately designed regulatory system ignited to produce the financial firestorm that engulfed us all. If our response to the crisis focuses only on the symptoms rather than the underlying causes of the crisis, then we shall bequeath to future generations a serious risk of another crisis even worse than the one we have experienced.

Tonight I want to focus on the second of those challenges – reform of the structure and regulation of the banking system. Why were banks willing to take risks that proved so damaging both to themselves and the rest of the economy? One of the key reasons – mentioned by market participants in conversations before the crisis hit – is that the incentives to manage risk and to increase leverage were distorted by the implicit support or guarantee provided by government to creditors of banks that were seen as “too important to fail”. Such banks could raise funding more cheaply and expand faster than other institutions. They had less incentive than others to guard against tail risk. Banks and their creditors knew that if they were sufficiently important to the economy or the rest of the financial system, and things went wrong, the government would always stand behind them. And they were right.

Download the PDF file with the full transcript of the speech.

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