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Mervyn King’s uncomfortable sermon for the City

June 18, 2009

Did Mervyn King miss his true vocation? Last night he compared the Bank of England to a church – with the Governor as the priest – as he took to the Mansion House pulpit to pour a rhetorical bucket of cold water over guests at the Lord Mayor’s banquet.

Headline writers predictably seized on King’s disagreement with Alistair Darling over Britain’s regulatory structure. But the more interesting section of his speech dealt with banks that pose a threat to the stability of the financial system.

If some banks are thought to be too big to fail, then, in the words of a distinguished American economist, they are too big. It is not sensible to allow large banks to combine high street retail banking with risky investment banking or funding strategies, and then provide an implicit state guarantee against failure. Something must give. Either those guarantees to retail depositors should be limited to banks that make a narrower range of investments, or banks which pose greater risks to taxpayers and the economy in the event of failure should face higher capital requirements, or we must develop resolution powers such that large and complex financial institutions can be wound down in an orderly manner. Or, perhaps, an element of all three.

If King knows the answer, he is not saying so publicly. However, the policy implications of what he is saying are profound. During the credit bubble, banks had an incentive to become big because the market assumed – rightly, it turned out – that large banks would not be allowed to fail. Removing that implicit guarantee, or charging for it properly, is probably the thorniest problem facing policymakers today. It will take more than prayer to come up with an answer.

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