Too unpopular to fail?


In 2008, financial services firm Lehman Brothers filed for Chapter 11 bankruptcy in the United States. With over $600 billion in assets, Lehman Brothers remains the largest bankruptcy filing in US history. Under-capitalised and enormously leveraged with significant holdings of risky mortgage-backed and residential property-related assets, despite weeks of intense negotiations with regulators and prospective buyers no viable solution could be found and Lehman was allowed to fail.

In the ensuing market chaos, and following a G20 meeting in London in early 2009, the Financial Stability Board was established to monitor the global financial system and coordinate financial regulation among the G20 nations. One of the Financial Stability Board’s key objectives was to end “too big to fail”, the idea that these huge, inter-connected financial institutions with balance sheets comparable to the GDP of small nations were too complex and not capable of failing without having adverse effects upon the broader global economy. As part of a package of measures, the G20 proposed and adopted rules that would ensure that all globally and systemically important financial institutions were required to hold more capital, to segregate riskier investment banking and trading businesses from retail banking operations and, significantly, that upon the failure of the institution, the bank’s creditors have their holdings written down or “bailed-in” in order to avoid future tax-payer funded bail-outs.

As an objective policy, this makes sense. Clearly those who seek to invest in firms so that they might share in the profits should also be expected to bear any losses should that firm fail. The existence an implied state guarantee of financial institutions, funded by the tax payers, is surely in direct contradiction to the free-market principles on which the economy is based. It creates ‘moral hazard’, as banks, encouraged by shareholders, may feel free to take more and more risk, safe in the knowledge that they will be bailed out should things go wrong. That such a system should apply as broadly and in as coordinated a way as possible is also obvious. Otherwise we end up with bifurcation of rules, state protectionism and concentration of risk in smaller, more economically vulnerable countries.

Unfortunately this is precisely what we are starting to see. For example in Italy, where the increasingly unpopular Matteo Renzi government is challenged by extreme parties from the left and right, macro-economic problems, simmering beneath the surface for so long, have begun to manifest. Italian banks in particular have been teetering on the precipice since the European sovereign debt crisis began in 2009. The choice for Renzi therefore is: (i) breaching EU law by adopting a policy of targeted fiscal injections into the worst affected financial institutions and (ii) writing down the holdings of bank creditors, of which a considerable number are Italian retail investors. The consequences of either course of action would raise serious questions over Italy’s continuing membership of the euro and/or the EU.

As evidenced by the recent European Banking Authority Stress Tests, southern European financial firms remain perilously under-capitalised. As local economies continue to stagnate, we will inevitably see more calls for these types of exemptions, fundamentally undermining the system of global, coordinated financial regulation that has become the legacy of the 2008 financial crisis.

Does recent experience demonstrate the weakness of harmonized, global regulation? Will pragmatism and the short-termism of increasingly populist governments mean that, in times of existential difficulty, nationalist and protectionist realpolitik will always take precedence?

As an internationalist party, how should the Liberal Democrats respond to those nations who resile themselves from such international commitments? In this example, does the overall policy objective of ensuring a broadly safer financial system justify the imposition of, arguably, punitive measures upon retail creditors?

I would be interested to read your views in the comment section below.

* Ciaran McGonagle is a Liberal Democrat member originally from Derry, Northern Ireland and based in Colchester. He is a solicitor working in financial services in the City of London.

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  • Richard Underhill 1st Aug '16 - 9:22pm

    Didn’t the Eurozone bank say it would “do what it takes”? QE at the Eurozone level?

  • `Does recent experience demonstrate the weakness of harmonized, global regulation? Will pragmatism and the short-termism of increasingly populist governments mean that, in times of existential difficulty, nationalist and protectionist realpolitik will always take precedence?`

    In that sentence you have the existential crisis of the current Farronite Liberal Democrat party. The EURO, Immigration from elsewhere to the EU, Schengen, banking problems in Italy etc – NOT OUR PROBLEMS. If there is fallout then it’s our job to protect ourselves. We did what we could in the 80s to change our economy while these countries didn’t. That’s their lookout.

    It’s about time the Lib Dems (of which thankfully I’m no longer a member) started putting Britain first instead of this outdated weird elitist mindset of thinking that everything is about the EU first.

    We will soon be out of it. We will have a BRITISH deal and thus normalise our arrangements with the EU friends from a position of strength when everything else is falling about the place.

    In time future generations will thank those that voted Leave. For the long-term we decided to sacrifice short-term gains for long-term global ambitions.

  • Eddie Sammon 2nd Aug '16 - 1:59am

    Interesting article. There’s nothing wrong with retail creditors losing some money, but of course too much would be a problem.

    It’s not just banks that are too big to fail, we’ve seen similar with steel, although maybe this industry is “too loved to fail” as much of the left can’t wait to bail this industry out, but heaven forbid that banks should.

    To avoid the moral hazard there needs to be punishment when banks go bust. I’m not saying imprisonment, but if there is another bank bailout then we need to cut bank wages at the top in the ones that receive the bailout.

  • David Evershed 2nd Aug '16 - 2:05am

    Equity investors in public banks do suffer losses when the bank is in difficulty. Shareholders in Northern Rock or Alliance and Leicesterfor example lost 100% of their investment and shareholders in HBOS and Lloyds lost about 95% and 90% of their investment.

    Bond holders in banks however have not lost out this millennium as far as I recall. Under the latest rules the bond holders in Italian banks could see their loans converted into equity shares and I see this as the best solution. Existing shareholders in Italian banks have already seen big falls in the value of their investment of course.

  • Ciarán McGonagle 2nd Aug '16 - 6:19am

    @ David – you are absolutely right, thanks for offering that correction

  • @Jane “position of strength” – really??? Aren’t we about to scrounge a loan from China and France to build Hinkley C Power Station? Has Jane noticed our roads and other public services?

  • David Evans 2nd Aug '16 - 7:56am

    David, Ciaran,

    I’m afraid you are both wrong. Alliance & Leicester shareholders did not lose all of their money. It did not go bust, but was actually surviving when it was taken over by Santander. Indeed to my mind the biggest mistake made by A&L directors was that after making it through the main crisis, they started the process of the sell off just as the funding squeeze eased and so sold out at the bottom of the market. But that’s a different matter.

  • Ciarán McGonagle 2nd Aug '16 - 8:24am

    Hi David Evans,

    I wasnt commenting on specific events or precedents, rather agreeing with David Evershed that the rules actually require that, upon the resolution of a bank, bond holders and other creditors are “bailed in” and their debt holding converted to equity which is then marked down in line with other shareholders.

    This is factually correct and my article is slightly misleading in this regard.


  • Steve Trevthan 2nd Aug '16 - 10:47am

    An excellent combination of a thoughtful article and thoughtful responses!
    Can a “financial system” which has and does rely on stiffing small depositors/retail creditors and taxpayers be considered safe for the most of us?
    Following the inauguration of the US “dollar-debt standard based on dollar inconvertibility” in 1971, is the currency basis of international banking inequitably beneficial to the USA? [See “Super Imperialism” by M. Hudson]
    What does “harmonized, global regulation mean? Does it mean a single system imposed upon all? Does it mean a form of non-zero-sum form of financial organisation with different currencies and money creation, storage and distribution systems which gives choice, encourages initiatives and brings the discipline of “competitive-collaborative innovation” and reliability? [See”Against Intellectual Monopoly” by Baldrin and Levine]

  • Ciaran McGonagle 2nd Aug '16 - 11:33am

    Thanks Steve

    One point I neglected to mention is the existing regulatory arbitrage between the US and EU/UK.

    US regulators are, perhaps surprisingly, much more protectionist than their EU counterparts and impose much tougher sanctions on EU banks which break the rules vs their American counterparts. Arguably an abuse of their dominant position and will inevitably lead to the investment banking being dominated by US firms.

    I would suggest lighter touch regulation in the EU to compensate but there doesn’t appear to be any appetite for that just yet.

  • Ciaran asks important questions. Getting to good answers is of immense political importance to the Lib Dems as political responses have been limp in the extreme due in part to lack of leadership but mainly because of ‘regulatory capture’ of politicians by the finance sector. I think that voters perfectly understand they are being short changed big-time even though very, very few understand the technicalities.

    With retail depositors there are, as I understand it two issues. Firstly, that in Italy (also Spain) huge numbers of ordinary people have been miss-sold bonds thinking they were just getting a type of deposit account and for many it’s their life savings. The politics of taking these savings to bail out a bank is explosive to say the least.

    Secondly, if you have an ordinary bank account you are in fact an unsecured creditor of the bank so if it fails you loose some or all of your money along with its trade suppliers. The EU recently legislated that ordinary depositors must be ‘bailed-in’ (i.e. take a loss this way) before any taxpayers’ money is used to support a failing bank. (Translation: Germany thinks Italians, Spaniards etc. should take a loss before German taxpayers).

    This is insane; at the first whiff of trouble people will take their money out of a troubled bank (aka start a bank run) with those best connected getting out first. This is what happened in Cyprus a few years ago which the EU used as a pilot case (not an important country so experimental open heart surgery was deemed acceptable).

    Italy (and later others) are truly in a bad place.

  • Better and more effective regulation is clearly crucial – but what?

    First up a Glass-Steagall type separation of commercial (High Street) banking and investment banking. Recent governments have danced around this issue and not come up with a serious answer and that is costing us dearly. Also we should recognise that the Basle lll rules in their current version are not up to the job. They are simply too complex and won’t work.

    A brutally simple way of achieving much more and doing so more quickly would be to rule that main board directors of an institution that accepts deposits from the public
    are jointly and severally liable for its debts before any government bailout, this to extend to anyone who has been a director in the ten years before a bailout. If that were in place they would drop the profitable but risky casino business of investment banking like a hot potato. The (newly separated) investment banks, now without access to essentially free money from depositors in high street banks or government bailouts, would have to be much more cautious – as they should be. Something like this was the rule until 1868 or thereabout AFAIK.

    Of course, bank directors would scream blue murder. I would simply ask, “So what where you planning to do that would risk the nations savings?”

    Commercial banks should be seen as utilities, boring but safe. Also, because of the necessary government backstop, they are quasi public sector, as important to the economy as roads. Hence their directors should be incentivised to run them prudently. If they don’t want to others can surely be found who will.

  • Rebecca Taylor 2nd Aug '16 - 1:40pm

    @Ciaran – very interesting well thought out article thanks. I strongly recommend you speak with Sharon Bowles (former Chair of EP ECON committee) about these issues.

    @Gordon – In your comments about Italy and Spain you hint at the fact that one of the main reasons we bailed our banks out was to avoid Mr & Mrs ordinary investor losing their life savings/pension etc, which would have caused social unrest and personal financial pain. That’s not to say the bailouts couldn’t have been handled in a way less kind to those responsible BTW. I also like your idea of joint liability for bank directors : )

    @Jane – “changing our economy in the 80s” did not prevent the UK banking system being badly hit by the financial crisis. The government used public funds to rescue our banking system and two banks are still partly owned by the UK taxpayer.

    What happens in the EU and the Eurozone (UK doesn’t contribute to Eurozone bailouts BTW) affects the UK whether we’re in or out of the EU, if nothing else because it’s our biggest export area (45% of exports, 12% of GDP) . It is in our interest that problems get fixed.

    I am sure as Leaver you will now argue that the UK should “sell more to the rest of the world”, but this ignores that:
    (a) The UK has been increasing our global exports. The fact that other EU countries do this better than us indicates EU membership isn’t the problem.
    (b) The UK exports mainly services (79% of our economy) and they are more difficult to sell outside the EU due to lack of international trade in services framework. Hoping to replace EU trade for global trade in this respect is unrealistic even in the medium term.

    We don’t insulate ourselves from any of the problems you highlight by leaving the EU, we just lose the right to influence policies that will ultimately affect us come what may.

  • One of the worst and most off putting aspects of the Lib Dems being in the Coalition Government was the dishonest echoing and parroting of the Tories that the economic crisis of 2008 was the fault of the Labour Party.

    The crisis was clearly triggered by such as the Lehmans and it originated in the USA.

  • Ciaran McGonagle 2nd Aug '16 - 2:29pm


    You raise some interesting points.

    The separation of retail and investment banking is an interesting topic. European investment banks in particular have always seen deposits as a form of easy capital against their trading book, allowing excessive leverage. Splitting the functions would be an interesting exercise in ensuring that pure investment banking business model is run in a way which ensures that capital is raised organically. Of course, this would massively impair profitability. How much capital is needed before it becomes counterproductive?

    On joint and several liability, I think this will be largely addressed by the new senior managers regime which imposes criminal liability on senior managers of firms who do not do their job properly. I recall a previous iteration of the legislation reversed the burden of proof so that directors were assumed to be criminally liable unless they could prove otherwise! That was shot down quite quickly following objections from the legal community. Im sure liberal democrats would have a view on that…

  • Ciaran (reply to Steve at 11:33 am)

    Yes, regulatory arbitrage is a very important feature of the global financial system as it now is. What it means is that if X is not allowed in, say, the USA then the bank that wants to do X just does it in the Cayman Islands or some such location where it is allowed. One popular place for this is, ahem, London which has remarkably (and intentionally) loose rules (naturally, concealed behind a veil of pretend propriety) and also acts as the ‘mother ship’ for a global network of offshore islands like the Caymans, British Virgin Islands and other fragments of empire traditionally described as “tax havens” but better described as “secrecy jurisdictions” since secrecy is what they mainly offer. Much of the actual work can be done in London but put through the books elsewhere.

    This is all legal but only because successive governments have been careful to keep it so since it’s so immensely profitable. However, it’s thoroughly immoral; many of those who need secrecy are those who want to conceal their assets and evade tax or have proceeds of crime to launder. In short it’s highly destructive of legitimate enterprise so one practical difficulty is that it’s very difficult to run an economy outside the City when many there see successful firms as opportunities for asset stripping.

    The point about US regulators is interesting. In the US financial interests have captured politicians. From his record it’s clear that, despite the rhetoric, Obama has always represented the vested interests of bankers and the like, not the public so much enforcement is only for show. Crimes including embezzlement of client accounts, money laundering for drug cartels (both for multi-million sums) and presenting transparently forged documents as evidence in courts are routinely ignored or ‘punished’ with nominal fines with no-one going to jail.

    Regulation of non-US banks is largely to enforce US hegemony – hence financial sanctions on Iran, Russia and others that don’t fall into line. Hence also Russia and China are cooperating to develop an alternative clearing system for international payments.

  • Robert Wootton 2nd Aug '16 - 3:38pm

    What is needed is an ultrastable economic system. Use the science that now exists to design and build/construct one.

  • Robert Wootton 2nd Aug '16 - 3:52pm

    “The crisis was clearly triggered by such as the Lehmans and it originated in the USA.”

    Perhaps it was but the economic conditions for it to arise is due to the successful fulfilment of its mission statement to propagate the neoliberal economic ideology; De regulation of the financial system, Liberalisation of the markets and Privatisation of public services; D.L.P. of the Centre for Policy Studies. A think tank founded by Margaret Thatcher and Sir Keith Joseph.

  • Ciaran (comment at 2:29 pm)

    On investment banking: when any private business is given ‘easy capital’, subsidised and backstopped by the government so it’s not necessary to worry about risk, then of course that business is going to be super-profitable – which is exactly what we see with investment banking. A smaller investment banking sector, more mindful of risks, would be much healthier for itself but especially for the country. I would count that a desired outcome (although not one likely to be popular in the City!!!).

    On joint and several liability I disagree that the new senior managers regime is likely to work. We already know that (probably all) major markets have been ‘fixed’ by insiders for years. In each case that’s eventually come to court it was widely (universally?) believed they were ‘fixed’ for years before the authorities took action. The difficulty I suggest is that conflicts of interest abound right up to government that is conflicted by (a) the enticing prospect of juicy directorships for retiring ministers, to (b) a reluctance to interfere with the cash (and tax-paying) machine that is the City. It’s wilful blindness leading for a desire for ‘light touch’ (meaning ‘negligible’) regulation, a curious contrast with the Tories traditional emphasis on strong enforcement for blue collar crimes.

    The key to making anything work is therefore to make it very simple, very stark, with strict separation of parts. (NB: The government has no qualms about enforcing such a regime on the railways where it isn’t appropriate because it impairs important network benefits.)

    Complexity is the enemy since it provides the nooks and crannies for all sorts of creepy-crawlies to inhabit. Of course, if the real intention is to provide a new coat of whitewash (which can’t be admitted politically) then the new senior manager’s regime is just the ticket with the advantage that it can provide a steady stream of fall guys to show that everything is just peachy while nothing material changes.

  • Ciarán McGonagle 2nd Aug '16 - 6:34pm

    For anyone interested, this article was a bit of an offshoot for an article I wrote for another site which concentrated specially on Italy:

  • @ Robert Wootton

    Quite right, the roots go far deeper than 2008. Lehan’s was simply the trigger to a deeper malaise.

    I still make the point about leading Liberal Democrat Ministers parroting the Osborne/Cameron mantra that was not only incorrect but downright embarrassing. I certainly lost respect for them.

  • David Raw 2nd Aug ’16 – 6:49pm…….I still make the point about leading Liberal Democrat Ministers parroting the Osborne/Cameron mantra that was not only incorrect but downright embarrassing. I certainly lost respect for them…..

    Well the chief offender got a knighthood so not too much embarrassment on his part…

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