The Governor of the Bank of England has called for a "radical" overhaul of the banking system in Britain, which could include a break-up of the banks, and praised President Barack Obama's controversial plan to take on Wall Street.
Mervyn King told MPs yesterday that "we have to reform the financial system" and warned that if anything less than extreme measures were taken "we are doomed to make the same mistakes on a bigger scale".
MPs on the influential Treasury Select Committee are looking at whether financial institutions should be too important to fail, and whether they should be split up. Mr King said while it was not up to the central bank to decide, he would "like to see a world in which there are more, probably smaller, banks which specialise in different activities". He added: "It might well be that the right method of getting the firewalls is indeed to break them up, I don't rule that out."
The Financial Stability Board, the body set up by the G20 to identify problems in the global financial system, is investigating the risk of banks being too big to fail and will make recommendations to G20 leaders in October.
The board backed the plan tabled last week by President Obama to limit the size of the banks in the US and their trading activities.
Mr King also welcomed President Obama's recent plan because it meant that "radical reform is on the table". He added the move was a "serious proposal because it does go to the heart of the 'too big to fail' issue".
The Governor said he advocated a "three-legged stool" approach to shake up the industry. This would consist of raising capital requirements, the creation of living wills for winding up banks if they fail, and an overhaul of the industry's structure.
He said there was no "silver bullet" proposal that would sort out the issues facing the banks, and that governments, regulators and the industry needed to take their time to make sure they came up with appropriate plans.
Changes would not occur overnight, he warned. "Whatever the pros and cons of various alternatives, the system that has the least going for it is the present system. That's the one that has brought us financial crisis of ever-growing severity. That's why asking radical questions about the structure is the right way to conduct the debate."
The structure was crucial because "from time to time things will happen that we can't prevent or imagine or calibrate the risk of in advance", Mr King said. "When it happens, the right thing is not to pretend in advance you can stop it from happening but to design a system that is resilient enough, so that when it still happens one part of the sector doesn't bring down the other."
The Bank believes the implicit guarantee of support from the government has to be removed, saying that when banks find themselves in distress, they, and their wholesale creditors, should not assume the government will bail them out, despite its actions with Northern Rock, RBS and Lloyds.
"To have a small number of big institutions dominating your banking is not a healthy position to be in and I think the implicit subsidy is, in part, responsible for that," Mr King said.
As an alternative to breaking up the banks, Mr King said groups with global operations could be split into national divisions, to simplify the job for regulators if they needed to be wound up.
"The first step is to have a simple, clear, broad-brush approach to how we break up an international institution that failed and different parts of the globe would take responsibility for different bits of it," he said.
The Bank expects movement towards subsidiaries rather than branches "because that makes it a whole lot easier for the national regulators to do their job", the Governer said.
Mr King ruled out the prospect of a so-called Tobin Tax, a move to cut speculative trades, despite claims from Gordon Brown that the policy was gaining traction.
A radical approach: The Kotlikoff plan
We've just had a financial crisis that bankers believed was impossible, whose economic damage has been incalculable. In response, we must think the unthinkable.
Mervyn King sent MPs, journalists and City thinkers scurrying for their internet search engines yesterday when he name-checked a relatively low-profile Boston University economist, whose proposals to reform banking would turn the clock back on the industry by two hundred years.
Mr King, an academic economist himself, wants the ideas of Laurence Kotlikoff brought in from the fringes and debated in Parliament.
So far, it is Barack Obama who has floated the most radical proposals to reform banking, accepting arguments from his adviser Paul Volcker that banks should be shorn of their speculative activities, such as investing in hedge funds and gambling with shareholders' money, and limited to a set size as a proportion of the credit markets.
Professor Kotlikoff, who advised President Ronald Reagan, has been pushing something far more radical: an end to fractional reserve banking, something that would change the face of finance as we know it.
For 200 years, banks have had to keep only a fraction of their deposits in reserve to cover repayment demands, allowing them to effectively create credit. Under an alternative system, the economist calls Limited Purpose Banking, banks, hedge funds and all the other paraphernalia of modern finance would be converted into mutual funds, investing customer deposits across the world economy on a one-for-one basis. These financial intermediaries would take no financial risk, and as a consequence there would be no more financial panics. But what it would do to economic growth would also be worth debating.
"I hope when your committee takes evidence from people in the US you will talk to people that come up with pretty radical proposals," Mr King told members of the Treasury Select Committee yesterday. "All of these things should be on the table for debate and discussion."