But the catastrophic risk, of dealers withdrawing from market making altogether because balance sheets have become dangerously overstretched, should be much reduced. Managing the impact of failure With a zero-failure regime neither feasible nor desirable, reform is also underway to reduce the impact of failure as well as its probability. And specifically to allow even the largest banking groups to fail and be resolved in a safe way without recourse to taxpayer funds. The key is to be able to recapitalise a failed group safely, quickly and credibly by bailing in the group’s uninsured, unsecured creditors, such as debt-holders. To be clear, the aim is not to resurrect every failed business, though that may be the outcome in some cases. The aim is to enable the critical parts of the group – the parts vital to the real economy and the parts that financial stability depends upon – to keep operating so the group can be safely resolved over time. The ultimate solution could involve a mixture of sales, administrations and run-off. The bail-in provides the time and the loss absorbing capacity to allow that to happen. The required legal framework is well progressed. In both the UK and US, it will in future be possible to bail-in debt holders. An EU framework has been agreed with the Banking Recovery and Resolution Directive, which will come into effect in January next year. This not only provides the powers for bail in.
Which of the two ratios binds first depends on the kind of risks that banks are running. The leverage ratio automatically places tighter limits on expansions in the balance sheet through supposedly low-risk assets. The international community has made progress on the leverage ratio. The definition guiding how it should be calculated was agreed at the start of this year. This will provide the basis for banks to disclose the ratio over the next 3 years in the light of which the international community will decide in 2017 on the calculation of a minimum standard. A number of authorities, including the US, the Netherlands, and the Swiss, have already introduced or are considering a leverage ratio in advance of the international standard. In the UK, the Prudential Regulation Authority has already asked the eight major UK banks and building societies to take steps to achieve a leverage ratio above 3%. The Financial Policy Committee has been asked by the Chancellor to review whether a leverage ratio framework should be introduced in advance of the international framework. This could include a power for the FPC to vary the ratio to counter macro-prudential risks. The FPC will consult on the review and expects to publish its conclusions towards the end of the year. There is also important work underway to ensure the risk-weighted framework is robust. Reviews are underway to build a credible standardised approach to calculating risk-weights for banks’ trading activities and their loan books; this too should help reduce the system’s exposure to model risk.