The Safety Trap

A hindsight view of the right and wrong lessons from 2008

Keir Starmer has been on the ropes for weeks. Labour MPs are restless, the polls are ugly, and Westminster has started doing what Westminster does best: pretending the next man will solve all the problems created by the last man.

So Labour now looks as if it may drift from Starmerism to Manchesterism.

Starmerism claims to offer stability, seriousness, fiscal discipline and competent administration. Manchesterism is the Andy Burnham alternative: public control of buses, visible mayoral activism, local pride, housebuilding promises, and the idea that the state should be more muscular, more rooted, and less embarrassed about intervening.

There are real differences between the two. Starmer is a cautious lawyer managing decline. Burnham is a mayor who has spent years learning that people like buses that turn up.

But the central problem remains the same: Britain is not growing fast enough.

In The Great Stagnation, I discussed how US GDP per capita grew by around 1.2% annually from 2008 to 2024, while the UK managed less than half of that, at around 0.48%. Over sixteen years, that small difference compounds to a huge one.

Americans got richer. Brits got excuses.

Since 2008, Britain has spent a lot of time asking how to stop banks failing again. That was understandable. But a financial system has more than one job. It has to avoid blowing up the economy. It also has to help finance the economy.

Britain may have remembered the first part and neglected the second.

How we got here

After the dot-com crash and 9/11, America cut interest rates and tried to keep growth moving. Housing became the obvious outlet.

American governments had spent years encouraging wider home ownership, including for poorer households and historically excluded communities. It helped expand the social and political permission structure around mortgage credit. The dangerous part came when weak loans could be mass-produced, bundled, rated, sold, insured and borrowed against.

Subprime (ie bad) mortgages rose from 8% of US mortgage originations in 2003 to 20% in 2005. Among subprime borrowers, the share using ARMs rose from around 60% in 2001 to 76% in 2004.

Thousands of mortgages were put into a pool for investors. The top tranches were paid first, so rating agencies could label them AAA even when the underlying mortgages were much weaker.

By the end of 2008, more than 90% of CDO tranches had been downgraded. More than 80% of AAA CDO bonds were eventually downgraded to junk. The system had built an industrial process for turning fragile credit into apparently pristine paper.

Then there were the extreme leverage levels: by November 2007, Bear Stearns had reached nearly 38:1 leverage. The major US investment banks were around 30:1. Fannie Mae and Freddie Mac, including loans owned and guaranteed, had combined leverage of around 75:1 by the end of 2007.

In June 2007, national house prices were already down 4.5%, and around 16% of subprime adjustable-rate mortgages were delinquent. In July 2007, two Bear Stearns hedge funds heavily exposed to mortgage securities collapsed. Fannie Mae and Freddie Mac were taken into conservatorship in September 2008. Lehman Brothers filed for bankruptcy on 15 September 2008. AIG was rescued the next day.

Britain had built its own fragile banking system.

Northern Rock was the first warning. It had grown aggressively and relied heavily on wholesale funding rather than ordinary deposits. In June 1998, its assets were £17.4bn. By June 2007, they were £113.5bn. When wholesale funding froze, the model cracked. In September 2007, savers queued outside branches in the first major British bank run for around 150 years. Northern Rock was taken into public ownership in February 2008.

Then came the bigger banks.

The government injected £45.5bn of equity into RBS. It put £20.3bn into Lloyds Banking Group. Across the crisis interventions, the UK state provided £137bn of public money in loans and capital to stabilise the financial system.

The wider economy paid for it. UK GDP fell by more than 6% between the first quarter of 2008 and the second quarter of 2009. It took five years for the economy to regain its pre-recession size. Unemployment rose from 5.2% in 2008 to 8.4% in 2011.

The pre-2008 system had failed. It had too much leverage, too little capital, fragile short-term funding, bad mortgage risk, rating-agency failure, opaque derivatives and regulators who did not see the whole machine until it was already breaking.

So the question is not whether Britain needed financial reform. It did.

The question is whether it chose the right reforms, stopped at the right point, and remembered that a financial system has to do more than survive. It also has to finance growth.

The sensible reforms

Before 2008, banks could run with tiny cushions of real equity and huge piles of borrowed money. Bear Stearns reached nearly 38:1 leverage by November 2007. The major US investment banks were around 30:1. Fannie Mae and Freddie Mac, including loans owned and guaranteed, were around 75:1 by the end of 2007. At those levels, an asset does not need to collapse. A small fall is enough.

Basel III raised the floor. Banks had to hold more common equity, more liquid assets, and more capital against risky exposures. The ordinary minimum Common Equity Tier 1 requirement became 4.5%, plus a 2.5% conservation buffer, before extra buffers for larger or riskier banks. By the mid-2020s, major UK banks had CET1 ratios around 15%, while large US banks were closer to 12% to 13%.

Stress testing also made sense. Before the crash, regulators looked too much at individual firms and too little at the system. A bank could look fine by itself while half the sector was exposed to the same property assumptions, the same short-term funding markets, and the same ratings models.

The US moved first. In 2009, the Federal Reserve stress-tested 19 major bank holding companies and found that 10 needed extra capital, with a combined shortfall of about $75bn. That forced banks to raise money and helped restore trust. Britain later built its own Bank of England stress tests. The 2022/23 UK test used a scenario with GDP down 5%, unemployment at 8.5%, house prices down 31%, and Bank Rate at 6%. Banks were expected to survive that without immediately becoming a taxpayer problem.

Resolution reform addressed the other obvious failure. In 2008, governments could either let a major bank fail and risk chaos, or rescue it and prove that large banks had a state guarantee. That was the “too big to fail” problem. Shareholders kept the upside. Taxpayers got summoned after the fire had already started.

Britain and America both tried to make large banks fail-able. Banks had to prepare living wills. Regulators gained stronger powers to restructure failing firms. Bail-in rules meant some creditors could absorb losses before taxpayers. The UK built its MREL regime, requiring large banks to hold layers of debt and equity that could be written down or converted in a crisis. The US used Dodd-Frank, living wills, orderly liquidation powers, and loss-absorbing capacity rules for the biggest banking groups.

These reforms attacked real weaknesses: too little capital, too much leverage, fragile funding, weak system-wide supervision, and no credible way to let large banks fail safely.

The fork in the path

Britain and America both made banks safer. Britain and Europe then went further.

Some of this was not direct 2008 banking reform. MiFID II, Solvency II and pension regulation belong to the wider post-crisis culture of financial caution. But that is part of the story. After 2008, risk became something to separate, document, capitalise, stress-test and avoid.

British ring-fencing applied to banks with more than £35bn of core deposits and material investment banking activity. Retail deposits, payments and basic lending were placed inside a protected bank. Trading, underwriting and investment banking sat outside it. If the riskier parts of the group failed, the ordinary bank was meant to keep working.

America used the Volcker Rule instead. It restricted proprietary trading and limited banks’ involvement with certain funds. It did not recreate Glass-Steagall. The largest US banks remained universal banks, combining retail banking, corporate lending, investment banking, underwriting, trading and advisory work inside large financial groups.

MiFID II did something similar to the equity market. From 2018, investment managers had to separate payments for trading from payments for research. The aim was transparency. Fund managers should not hide research costs inside trading commissions.

The side effect was weaker coverage. Large companies still attracted analysts. Small and mid-cap companies became easier to ignore. Research budgets as a share of assets under management reportedly fell by more than 50% after MiFID II.

Insurers and pension funds moved in the same direction. Solvency II-style rules pushed insurers towards capital discipline and caution. Pension schemes moved heavily towards liability matching. Trustees and advisers focused on reducing volatility, matching promises and avoiding regret.

Britain now has vast pools of long-term savings and very little domestic risk appetite. UK pension funds once held more than half their assets in UK equities. That figure has fallen to 4.4%. Corporate defined benefit schemes are even lower, at around 1.4%.

The call from inside the house

The most useful evidence comes from the Bank of England itself: in ‘Staff Working Paper No. 892, Side effects of separating retail and investment banking: evidence from the UK’, Matthieu Chavaz and David Elliott studied what ring-fencing did to banks before it came into force in 2019.

Before ring-fencing, a universal bank could use cheap retail deposits across the group. After ring-fencing, those deposits had to sit inside the protected retail bank. That made some activities cheaper to fund and others more expensive.

Banks responded by shifting towards domestic mortgage lending. They cut mortgage rates, gained market share, and expanded retail lending. Chavaz and Elliott estimate that ring-fencing explains around 10% of the fall in mortgage spreads between 2013 and 2019, making them cheaper.

The other side moved in the opposite direction. Banks reduced their provision of credit lines and underwriting services to large corporates, i.e. the reform made banks better placed to lend against houses and less active in parts of corporate finance.

On the corporate side, Chavaz and Elliott found that when banks lost access to cheap deposit funding, the size of syndicated loans they offered fell: an 11% fall in deposit funding was associated with a 7% fall in loan size, with larger effects for credit lines and ordinary corporate loans. Simply put, ring-fencing helped make mortgages cheaper, but made some banks less willing or able to support business finance.

This isn’t a complete explanation of British stagnation - it would be absurd to blame weak growth mainly on ring-fencing when Britain also has NIMBYism, expensive energy, slow infrastructure, weak public investment, tax complexity and poor state capacity. But it is a useful piece of the puzzle.

Britain already had a problem with property-heavy growth. Too much capital flowed into land, houses and existing assets. Too little flowed into new firms, productivity, technology, infrastructure and scale-up finance. Ring-fencing appears to have nudged the banking system further in the same direction.

Protecting ordinary deposits after 2008 was a reasonable aim. But the trade-off is now visible. Britain made retail banking safer and cheaper. It may also have made the financial system even more biased towards mortgages over productive risk.

Moderate fixes

Five reforms could help keep what is working, while opening up finance for growth:

1. Loosen ring-fencing where resolution now does the same job.

Ring-fencing currently applies to banks with more than £35bn of core deposits. That threshold should rise, and the separation rules should be loosened where banks already have strong capital, liquidity, stress tests, bail-in debt and credible resolution plans. Ordinary deposits and payments still need protection. But the UK does not need two separate systems doing the same job while cutting retail banking off from useful corporate finance.

2. Stop making property lending the easy option.

Capital rules should be reviewed against a simple test: do they make it easier to lend against existing houses than to finance productive business investment? A diversified pool of loans to real firms should not automatically be treated as more suspect than another pile of mortgage lending. The goal here is fewer hidden incentives pushing credit into property.

3. Rebuild SME and mid-market securitisation.

Britain should create a standardised market for SME and mid-market loan pools. Not the opaque pre-2008 version, where weak loans were chopped up, blessed and sold as magic paper. The new version should be dull by design: standard contracts, public loan-level reporting, simple structures, and originators keeping at least 10% first-loss exposure. That would let pension funds and insurers buy diversified productive-credit assets without pretending they can assess every individual company loan themselves.

4. Undo the worst effects of MiFID II for small and mid-cap equities.

Research unbundling was meant to make costs clearer. It also made research easier to cut. Large companies still get analyst coverage. Smaller listed firms become invisible. The UK should make it easier for brokers, exchanges and fund managers to fund research on small and mid-cap companies, with clear disclosure rather than rigid separation.

5. Let pensions and insurers take more productive risk when the return justifies it.

UK pension funds now hold only around 4.4% of their assets in UK equities. Corporate defined benefit schemes are even lower, at around 1.4%. That is not a healthy sign for a country that claims to want more domestic investment. Pension and insurance rules should make it easier to hold infrastructure debt, growth equity, venture funds, productive credit and scale-up finance where the risk and return are credible. The goal is to stop treating all long-term risk as a regulatory embarrassment.

A step farther

One more radical option would be a National Growth Credit Auction.

The government could set a target each year: for example, £20bn of long-term finance for productive UK firms, infrastructure suppliers, advanced manufacturing, energy projects and scale-ups. Banks, insurers, pension funds and private-credit funds would then bid to provide that finance.

The bid would not be “give us money”. It would be “this is the smallest tax or regulatory adjustment we would need to provide this amount of long-term credit”.

One bank might ask for lower capital charges on a tightly defined pool of mid-market loans. One insurer might ask for a specific Solvency II adjustment for infrastructure debt. One pension fund might ask for a tax change on long-term productive-credit vehicles. The Treasury would choose the cheapest credible bids.

The private institution would take the first losses. The eligible assets would be tightly defined. The terms would be public. The performance would be reviewed each year. Firms that gamed the scheme would be excluded from future auctions.

This would be very different from the usual “buy British” nonsense. The real problem is that too little capital reaches useful firms on workable terms.

A British ISA says: please buy British assets because flag.

A National Growth Credit Auction says: show us the cheapest way to make productive lending happen.

That is the right question. Do not force capital to chase weak returns. Make financial institutions compete to provide useful risk at the lowest public cost.