Mega-banks

These mega-banks exist so that different parts of the business can leverage on other parts of the business. So, there are riskier parts of the business that are kind of protected by the safe deposits. Then the bank will be willing to take some risks because it knows that it has this stable other side. This, of course, can lead to moral hazard problems.

Answered by: a German Bank Official

Since 2013, when the Bank of England took over the Prudential Regulation System, we have been working with banks to completely overhaul the financial system and to end the “too big to fail” situation. We have restructured the financial system using ring fencing.

When we ring fence, we asks these big banks to separate the retail and the investment sides of banks. The retail side of the bank provides services to the economy, where people get mortgages, put their savings and have accounts – this is the side of the bank that serves the real economy. The investment side is the one that takes risks – the side that is often known as casino banking. This side of the bank invests in very complex products, for example derivatives.

What happened before, and in the 2008 crash, is that when banks became too big, and their investment side failed, it would drag with it the retail side too. This is why since 2013 we have been asking banks to separate these two sides and this will come into effect from January 2019. So if there is another crisis from then on, and one of the big banks, for example RBS, had made very risky investments and was about to fail, we would let them fail.

This has been done to remove the “moral hazard problem”. (Moral Hazard = If banks know they will just get bailed out then they will make risky investments because they know that it will have no consequence, they will just get saved when they’re in trouble.) Now banks know that if they take too many risks then we will let them fail and this will have no effect on the real economy and the retail side of the banks.

The investment side of the banks must use investors money, not the money coming from the retail side. So if the banks fails in the investment side, the investors are now the ones that would be the ones baring the brunt of a bank going bankrupt, it would not be the British taxpayers. If the shareholders didn’t have the money to save that side of the bank then the bank would fail and we would let that happen. That bank would no longer pose a systemic risk because of the ring fencing, if the investment side fails, the retail side would continue to operate as normal.

Answered by: Bank of England