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Bankers Holding Uk Economy to Ransom

Vickers Commission’s banking reforms fail to protect the public from future financial crises

As the City reels from the revelations of the interest-rate fixing scandal, a new Civitas report shows that the Government’s reforms of UK banks leave the public exposed to the mis-selling and risk-taking of bankers.

The Government has promised to implement the proposals of the Vickers Commission, which are meant to safeguard the banks and the taxpayer from another financial collapse. But in The Economic Consequences of the Vickers Commission, Laurence Kotlikoff shows that the reforms will not prevent the next crisis, nor make it any less harmful for the general public.

Kotlikoff, Professor of Economics at Boston University, challenges the proposals of the Independent Commission on Banking, known as the Vickers Report. He argues that they do little to protect either the real economy or taxpayers from risks created in the financial market. Indeed, he says that in some important ways the Commission has made the UK banking system even more risky. Kotlikoff proposes Limited Purpose Banking as an alternative solution to make banking safe for the British public.

The banker always wins

Last month, the City reportedly ‘breathed a sigh of relief’ when the Government launched its banking reforms, which represent only a watered down version of the original Vickers proposals. Despite causing a financial crisis that required huge taxpayer bailouts, the City was already back to ‘business as usual’.

Now the City has been rocked by more corruption scandals, involving collusion to set interbank interest rates and mis-sold interest-rate hedging products. Kotlikoff shows that bankers are able to get away with this recklessly self-serving behaviour because of the stranglehold that they have on the political system and the real economy, as well as their perverse secrecy. He shows that the existing financial system is built to fail due to its interdependent nature and lack of transparency.

Besides facilitating corrupt practices, lack of transparency means that even rumours of failure can lead to catastrophic bank runs. The collapse of a big bank can freeze the entire payment system. The potential of individual bank failures to bring down the entire financial system means that they are almost untouchable:

Their threat of failure and high average profitability gives them leverage over the public and politicians – in bad times, to extract bailouts, and in good times, to operate with minimal transparency and disclosure, to produce extremely complex products that can be sold at inflated prices to unsuspecting investors, and to take on extreme amounts of leverage. (p. 15)

Kotlikoff argues that the Vickers Commission fails to address this inherent instability of leveraged, ‘trust-me banking’. Under the current system, banks are encouraged to make promises they can’t keep, knowing that they will make a profit in the best case scenario, but can still rely on the taxpayer to foot the bill when things go wrong. In the event of a crisis, bankers can hold the rest of the country to ransom, forcing the government to step in to support them:

Banks have leverage over taxpayers because they are caretakers of a public good, namely the financial market. When they go under, they take down financial intermediation with them. (p. 15)

Bad things can happen to ‘good’ banks

The Vickers Report proposes ring-fencing banks in the hope of reducing this risk to taxpayers. By preventing ‘good’ retail banks from engaging in ‘bad’ activities, the Commission intends to insulate them from the dangers of financial crises. But Kotlikoff points out:

Keeping the ‘good part’ of the financial system safe is not the central goal of financial reform. The central goal of financial reform is keeping the non-financial system safe – safe from crises in both the ‘good’ and ‘bad’ parts of the financial system. (p. 9)

Kotlikoff explains that even good, ring-fenced banks could readily go bad, as ‘safe’ assets are never truly risk-free. Moreover, restricting good banks to investing in only ‘safe’ assets violates economics’ basic lesson of risk mitigation, namely, ‘Don’t put all your eggs in one basket.’ According to Kotlikoff, neither good banks nor bad banks are safe as a result of the Commission’s proposals. By breaking-up existing banks into retail and investment arms, the Government does not address the fundamental problem of systemic risk.

Ultimately, neither ‘good’ banks nor ‘bad’ banks can be allowed to fail without putting the economy-wide payment system at risk. If the financial exchange collapses, the real economy grinds to a halt as consumers and businesses are unable to pay for goods and services. Even the spectre of financial collapse can change the economy’s ‘animal spirits’, inducing a major recession or depression. This means that neither consumers nor government can ever credibly punish the banks’ bad behaviour.

Show me the money

Kotlikoff proposes Limited Purpose Banking as a more thorough solution. LPB has received very strong interest and support from, among others, Mervyn King, Governor of the Bank of England, who castigated the recent behaviour of bankers last week, seven Nobel Laureates in Economics and two former Chief Economists at the IMF.

LPB replaces faith-based ‘trust-me’ banking with transparent, ‘show-me’ banking. Banks are only able to hold mutual funds, which themselves hold no debt. While investment mutual funds can rise or fall in value, they cannot systematically fail in the way that leveraged financial instruments have done. The payment system would use exclusively cash mutual funds: deposit accounts that are backed pound-for-pound by cash. Cash mutual funds can neither rise nor fall in value and can also never fail.

While current regulations allow banks to keep their assets private, under LPB all bank mutual fund holdings are made public and transparent via on-going, real-time disclosure on the internet. This prevents banks from either holding or marketing leveraged products that can create systemic risk.

Crucially, LPB does not prevent individual investors from taking any risks that they choose with their own money. However, LPB does prevent bankers from taking risks with other people’s money without their permission, which the current system both allows and encourages. The result of LPB would be a resilient financial system where large private losses could be absorbed without imposing any costs on the general public or the taxpayer:

Limited Purpose Banking is extremely safe compared to our extremely risky and, indeed, radical status quo. Indeed, it’s hard to think of LPB as being anything but highly conservative in terms of maintaining the safety of the financial system, requiring disclosure to preclude fraud in financial markets, and keeping bankers from imposing unaffordable costs on taxpayers. (p. 48)

Gambling with High Street to placate Lombard Street

Kotlikoff concludes that the Vickers Commission missed a unique opportunity to call time on the casino practices of the current financial system. The public has been left exposed while bankers can still ‘make the money and run’:

A banking system that was terribly risky will, on balance, end up riskier, a regulatory system that was dysfunctional will now have many more things to get wrong, and a population that was praying for a sure economic future will be left on its knees. (p. 71)

For more information contact:

Laurence J. Kotlikoff, 020 7799 6677

Civitas 020 7799 6677

Notes for Editors

i. Laurence J. Kotlikoff is Professor of Economics at Boston University and a Research Associate of the National Bureau of Economic Research. He was a Senior Economist with the President’s Council of Economic Advisers.

ii. The Economic Consequences of the Vickers Commission (RRP: £8.00) is available from the Civitas shop, by calling 020 7799 6677, and on Amazon Kindle. A PDF copy (for press and media) is available on request.

iii. Civitas is an independent social policy think tank. It has no links to any political party and its research programme receives no state funding.

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