The world economy has been hit by a severe financial crisis, resulting in the worst global economic downturn for over 60 years. Triggered by difficulties in the US housing market that exposed the way that banks and other lenders had been underestimating real risks for too long, the crisis spread so quickly throughout global financial markets that banking systems around the world were severely destabilised. As a result, the impact has spread beyond the financial system,hitting economic growth, prosperity and jobs throughout the world.

First and foremost, the crisis has been caused by the failure across the world of many in the banking sector, including boards and investors, to understand the true risks created by the innovation and rapid growth of interconnected, globalised markets for financial services in recent years. The firms that have failed in the UK typically allowed their businesses to become
overextended through:

• excessive leverage and risk taking;
• over-reliance on wholesale funding;
• overdependence on particularly risky product streams, such as buy-to-let mortgages or derivatives; or
• poor management decisions in respect of acquisitions.

These failures of commercial judgement brought the world’s financial system to its knees in October 2008.

As a result, the Government had to intervene in unprecedented ways to protect depositors in UK banks and building societies, to enable banks to continue to lend to the UK economy during the recession, and to restore financial stability. At Budget 2009, the Treasury estimated that the cost of Government action could eventually be as high as £50bn. But the costs of Government inaction would have been far higher, as a modern economy cannot function without a stable banking system.

The way firms manage risk, the quality and quantity of capital they hold, and the way regulators monitor firms need to change. The Government will build on reforms already implemented to
improve the way banks are managed and regulated in the UK, to ensure that banks and financial markets will be more resilient to any global shocks that may in future threaten our financial system.

The Government is advocating similar changes across the world, in discussion with the EU, the G20 and international partners. Reform of how banks operate globally, and improving how
regulators across the world work together, will be key to preventing global financial crises from recurring in the future.

This document sets out the Government’s analysis of the causes of the financial crisis, the action already taken to restore financial stability and the regulatory reforms necessary to strengthen the financial system for the future, so that consumers, businesses of all sectors and the economy as a whole continue to have access to the stable credit that is so essential to building Britain’s future through growth, investment and innovation.

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