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.