In exercising its authority, following its published approaches, the PRA also makes judgements around a broad set of firm-specific factors that the FPC would not be involved in: risks not captured in the formal capital definitions, senior appointments, approving specific transactions, risk and governance controls etc. In short the FPC makes decisions to ensure financial stability in the system as a whole and the PRA acts to support the safety and soundness of individual firms. But the PRA approach to supervision also involves other considerations. I have already mentioned that we must not operate a “zero failure” regime. That was in the context of not taking extreme decisions in over-zealous pursuit of our objectives. But if investors and other market participants believe that supervisory effectiveness leads to a situation in which a firm cannot fail, then they will likely take inappropriate exposures to those firms and the market will become distorted. In particular if a firm is likely to be bailed out by the public sector then that reduction in risk means that firms will have to pay less for their liabilities – giving them an implicit subsidy. That has been discussed at length in a number of Bank publications, but a key point for today is the Bank’s continuing commitment to end the “Too Big to Fail” problem and, specifically, to seek to establish realistic recovery and resolution plans for the firms it authorises. That consideration also affects supervisory decisions on legal entity structures, transactions, senior persons and so on.
This vicious circle also works in the opposite direction: problems in the banking sector spill over into lending and growth, which weakens public finances and the state’s ability to back up the banking system when necessary. Incidentally, this pattern of interaction between problems in the financial, real and public economies recurs throughout history. Reinhart and Rogoff have described how economic problems and bursting speculation bubbles have led to financial crises and subsequent sovereign debt crises time and again over the last 800 years. Developments in the banking system, 2007 and on So far, the European banks have not regained their credibility in the same way as the US banks did in 2009 and the Swedish banks did in 1992 and 1993. A great deal of uncertainty still prevails over which European banks are robust in the long-term. According to one estimate, the total decline in the value of assets on the European credit markets amounted to EUR 184 billion by the summer of 2011. The same publication made the assessment that losses over the years to come could amount to over EUR 200 billion, of which EUR 125 billion would derive from losses linked to government securities.6 The IMF has calculated that the effects of the sovereign debt crisis may amount to EUR 300 billion.7 Even so, the European banking sector was reported to have a larger balance sheet total in 2010 than in 2008. This reflects the fact that the problem assets have still not been addressed.