The process of financial intermediation responds to changes in the environment with product and service innovations, and in this manner have continually re-shaped the international financial landscape. Derivatives are among the most innovative sub-sectors of the financial industry. Specifically, the ‘over-the-counter’ (OTC) products are not derivatives on organized markets, but rather individually customized, often highly complex with combinations of standard financial instruments packaged together to meet the specific needs of clients. Such contracts involve very little direct lending by banks to clients, and generate little net interest income to the banks. Derivatives generate substantial fee and commission income without the need to commit any of the institution’s capital. This therefore involves a different risk management approach as there is a shift away from continuous risk assessment and risk monitoring of funded investment projects that usually produce recurring flows of interest payments over time to the identification of riskless ‘trades’ that produce large, single payments, with much of the residual risks carried by purchasers of such packages. This process has possibly been accelerated by the introduction of risk-weighted capital requirements. Market players and regulators both have a role to play in balancing potential risk with potential returns in order to promote a vibrant financial system, without compromising the stability and integrity or agility of the system. One of the Central Bank’s primary responsibilities is to maintain financial stability and confidence in the financial system and to ensure that the process of financial intermediation continues to function without disruptions.

It is whether they can convince investors that it is safe to provide them with funding at reasonable spreads over Bank Rate without central bank support. As the Financial Policy Committee (FPC) noted in its recent Review, UK banks are still some way from being able to convince the market in this respect. Regulators, who from 1 April will be in the Bank of England’s new Prudential Regulation Authority, are now working hard to ensure that banks are making adequate provisions for future losses, the likely costs of regulatory penalties and compensation to customers, and stating the riskiness of their assets in a more prudent way. A lesson from past crises, and also from this one, is that it is important to act now rather than hope that problems will go away of their own accord. As the FPC said last December, it is likely that banks will be required either to raise more capital or to restructure their businesses or exposures, and the FPC will review the position in March. There is no single remedy appropriate to all banks. With proper implementation, there is no reason why the two banks with significant state shareholdings could not largely be back in the private sector within a relatively short period. After all, in the United States banks that received state support are already back in private hands. Restoring our banking system to full – and transparent – health is only one of the structural changes that will be necessary to rebalance the economy.