Banking and Finance in the UK Made Easy: How can we make people make banking safer?

The finance industry can make us much better off. Insurance, payment systems, mortgages, lending to businesses, funding entrepreneurs, futures markets, risk management, the list goes on with the many ways in which finance makes our lives better. But, and it is a big but, finance also carries with it large risks and the risks our current system of finance pose are greater than the benefits. Reform is vital. This calculus will be at the heart of the Banking Commission‘s report published in April and has been the driving force behind the posts I have written over the last few days.

Finance has benefits, but also produces damaging byproducts. Pollutants can be taxed, to embed the cost of the pollutant in the price of the product, for example a banking levy. On the other hand, pollutants can be banned, like we have with certain uses of DDT. The losses from the financial crisis dwarf anything which a banking levy could raise and this leads me to argue that finance must be reformed. The graph from my first post illustrates the losses suffered by the UK as a whole. The red line is trend economic growth from the start of the past decade, the blue line is actual economic growth. I think it speaks for itself. Worse still, evidence cited by Andrew Haldane (pdf) suggests anywhere from around £1.8 and £7.4 trillion of wealth may have been permanently forgone as a result of the financial crisis.

Reform of the banking sector should not be an issue which splits the left and the right. Massive government intervention in finance is now a certainty - no large bank will be allowed to fail – all that is left to discuss is whether we want intervention on the banks terms or on our terms. The US have plans to somewhat restrict the trading activities of deposit taking banks to insulate them from systemic crises. These reforms will not go far enough and will be too easily gamed by the financial sector – it is sadly, where many of the best minds end up. Only a more comprehensive reform, in which the big banks are broken up and the activities of commercial and investment banking split up, will be enough to stop the recurrent financial crises which are the pollutant produced by finance.

Despite the massive long run societal wide benefits from a better financial system, reform will not come easily. People like Jamie Dimon of JPMorgan Chase are arguing that any regulation would make the financial industry less efficient, and the Treasury are already offering pre-emptive compromises to placate the financial sector. These sorts of events will continue to build and financial reform will slowly be moved from the back burner to washing-up bowl of abandoned policy initiatives without popular protest. The banking industry will viciously resist attempts to make it better behaved.

Spending cuts will hit, are hitting, some people incredibly hard, but unless the horizon of action for anti-cuts groups shifts to include financial reform their actions could come to ought in the long run. UK Uncut and other organisations need to take up the baton of boring boring boring financial reform or it will fail. Well-meaning technocrats will always lose when up against the unrelenting power and cunning of the financial sector, so they need our back up. My preference for smaller less powerful financial institutions is not necessarily the right solution, but it almost certainly points in the right direction.

This movement shouldn’t be restricted to the left, both those who are aghast at the Tory’s treatment of the welfare state and those angry with their paltry pittance of a pay packet need to unite against a common enemy. A financial system which serves itself more than it serves households, small businesses and entrepreneurs and which poses a massive risk to the whole economy once a generation. Until that beast is tamed, wrenching crises will continue.

Filed under: Blogging, Economics, Politics, Society

Banking and Finance in the UK Made Easy: How can we make banking safer?

One way of recovering the cost from a slightly dysfunctional financial system is a levy to gradually recoup the cost of any occasional crises. This is something like the system which is currently in place, in part to insure against future crises and in part to fill the fiscal hole from the last one. But, given that the upper limit on the total wealth destroyed by the crisis could be up to £7.4 trillion for the UK economy alone, no bank tax can possibly be large enough. Plus there is no way of knowing that the levy will be paid by bank owners rather than in inflated credit card charges and deflated saving account rates.

Therefore, I would argue there is simply no way large banks can be permitted to continue to exist in their current form. I would further argue again that this is not a particularly left-wing point, I want the right onboard with this too. The logic goes like this. Further intervention in the financial system is a certainty and to pretend otherwise is foolish. Investors long ago guessed that no large institution will be allowed to fail and the current crisis and bail-out has confirmed this intuition and cemented this subsidy for the financial system. There is no longer any “non-interventionist” policy on the table, the only question is what form intervention should take.

As discussed in the last post on this topic, when all banks are widely diversified the banking system as a whole becomes vulnerable to systemic shocks. The current arrangement allows for massive private gains in good years and massive public losses in bad. This system remains largely intact and only robust action to reduce the risks of the system will be adequate in the long run.

I would also argue that reducing the size of banks would not necessarily result in a reduction in their efficiency – we may be able to reduce the severity of crises in the bad times and improve the functioning of finance in the good times with the right intervention. Banks are now massive institutions, even the biggest firms have enjoyed fast growth in the last decades. In the UK, 85% of personal accounts are held with one of the five biggest banks, financing small businesses and the mortgage market are even more concentrated.

There is little evidence however, that massive banks operating in a multitude of different markets offer economies of scale or scope (pdf). In fact, there is evidence that larger banks suffer from managerial overstretch and thus diseconomies of scale. A bank which operates in many markets, as you would expect, gains useful knowledge which spills over into its other operations and this is a net plus for the economy at large as capital and production is better allocated. But even in this way, larger banks are not necessarily worthwhile creatures as the extra knowledge gained is at the cost of increased exposure to the risks which we have already discussed. The optimum size of a bank may well be under $100 billion, and may possibly be as low as $5 billion, significantly below the level of concentration in the modern financial sector.

There are a number of options for shrinking banks, and for how banks should be run post-reform. The Dodd-Frank Act in the US contains a provision, the so-called Volcker Rule, reminiscent of the Glass-Steagall Act which separated commercial and investment banking. The Volcker Rule seeks to limit the trading of stocks, bonds and derivatives with the firm’s own money for profit, to limit a deposit taking bank’s exposure to risk. Although along the right lines this is too convoluted a process to form part of a robust system of banking regulations, as banks can more items around on their balance sheets to appear to be engaged in legitimate activity when they, in fact, are not. This isn’t a conspiracy theory it’s a history lesson.

Only with a more comprehensive approach, in which banks are split and cross investment between commercial and investment banned, will finance become more stable. In fact, it may be better to go further and completely insulate the core “utility” services of banking – transaction services and retail deposit-taking – from the riskier activities of banks through a restrictive system of limited purpose banking, something which the lamentably blogless Luis Enrique has often mooted. Reform of the banking system will not be straightforward, the complexity of finance and the interconnectedness of the modern world both makes reform difficult and vital to get right. The next post will sum up and look at what needs to be done to maintain what momentum banking reform has.

Filed under: Politics