By Natasha Brereton

LONDON -(Dow Jones)- Bank of England Governor Mervyn King said Tuesday that heightened regulation can’t prevent the financial speculation that results in bank failures, and called for a serious review of the structure of the banking sector whose goal would be to eliminate institutions that are too important to fail.

In a speech to business people in Scotland, King championed the idea of separating banks’ utility functions as a means of minimizing the government’s effective subsidy of risky activities and reducing the U.K.’s reliance on a small number of very big banks.

Turning briefly to the economy, he noted that there was likely to be “significant” fiscal tightening in the years ahead, and stressed the need to boost broad money growth, but gave no clear indication on whether he would favor extending the bank’s bond buying policy.

“The sheer creative imagination of the financial sector to think up new ways of taking risk will in the end, I believe, force us to confront the ‘too important to fail’ question,” King said. “The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.”

King said it was hard to see how the existence of banks that are too important to fail was consistent with them being private entities.
One way to address the problem would be to reduce the likelihood of such institutions failing as much as possible, but the capital requirements that regulators can impose to achieve such an aim will always be arbitrary, he said.

Imposing a ratio for contingent capital – which automatically converts to common equity before a bank becomes insolvent – is “worth a try,” but the government would still have to provide some crisis insurance, giving banks the incentive to keep taking big risks.

The unpredictability of crises also makes it hard to know how much capital would be appropriate, and allowing too-important-to-fail institutions to exist would probably necessitate a special resolution regime for all banks that could fall into this category, he said.

The other option, King said, would be to draw a clear distinction between utility banking and other activities that can be left to the control of market discipline, restricting government guarantees to banks’ socially necessary functions.

“There are those who claim that such proposals are impractical. It is hard to see why,” King said, noting that prudential regulation already distinguishes between different types of banking activities.

While he welcomed growing global support for banks to write living wills, “without separation of the utility from other components of banking it will be necessary to develop detailed resolution procedures for a very wide class of financial institutions,” he said.

King said there was a strong case for a “serious review” of the structure and regulation of the banking industry. He pointed out the high concentration of the U.K. financial sector by international standards, and expressed the hope that greater competition would result in “less rigidity” in the composition of the top four banks.

He also said those banks that are being supported by the government mustn’t be encouraged to try to “earn their way out” of that support through the type of practices that got them into trouble.

On the economy, King said he expected to see “modest” growth in activity in the second half of this year, but that output was likely to stay “well below” levels seen last year for some time to come.

The weakness of the banking sector and the likelihood of “significant” fiscal tightening over the coming few years will make the setting of policy particularly difficult, he said.

The bank has said that inflation could rise sharply in the near term as a temporary cut in the sales tax is reversed. But the weakness of money spending is dragging down on prices, and a pick up in broad money growth would likely be necessary to help it to recover, King said.

“That is precisely what our asset purchase program, by injecting more money directly into the economy, aims to achieve,” he added.

Other MPC members – including David Miles, who backed King in his call to boost the program by GBP75 billion instead of GBP50 billion in August – have recently downplayed the reliability of money supply data as a means of judging whether the policy is working.

Economists are divided on whether the Monetary Policy Committee will extend its GBP175 billion quantitative easing policy of buying bonds with freshly created central bank money when it meets next month.
King also said that BOE Deputy Governor Paul Tucker would set out the bank’s views on macroprudential regulation in a speech later this week.

Last 5 posts by Alex Stanczyk

• Smoke = Fire ? Why have a 7 day restriction on withdrawals if the bank never intends to use it? Citibank - February 23rd, 2010
• City Controller Miller: Bankruptcy is inevitable - February 22nd, 2010
• Gold shoots as high as $1125.77 in early trading, Bank Lending Still Sliding - February 22nd, 2010
• Simple Math: If your gains do not surpass the rate of money creation, you will forever be losing buying power. - February 19th, 2010
• Branson: Peak Oil is Real, Act now or face the consequences - February 12th, 2010