Where do we stand, five years on from the start of the crisis, on progress towards banking reform? Major advances have been made, but a lot of unfinished business remains, notably on structural reform of banks. Following a stock-take of current reform initiatives, the paper reviews some economics of public policy towards banks, starting with the rationale for deposit guarantees and lender-of-last-resort support but concentrating on why governments feel compelled to provide solvency support in crisis. It then covers the economics of capital requirements – and loss-absorbency more generally – and examines why such regulation is a better approach than taxation to address systemic risk externalities, and why the public interest requires much more capital than banks would choose. The role of structural regulation in making banking systems safer is then analysed, in particular forms of separation between retail and investment banking such as ring-fencing (as in current UK reforms) and complete separation (as in the US before the repeal of Glass-Steagall). The paper concludes with some reflections on the wider European policy debate in the light of the Liikanen Report on structural reform. A central theme of the analysis is that banking reform needs a well-designed combination of policies towards loss-absorbency and structural reform.
