Lifeboats or deckchairs?
Civitas, 12 April 2011
For a reasonably large document (214 pages) the Independent Commission on Banking’s (ICB) Interim Report doesn’t really propose an awful lot. The report grasps the heart of the problem, yet does not embrace any reforms which it demands.
The problem as Vickers et al realise is the inevitable trade-off between safety and cheap, plentiful credit. The kernel of this truth is evident in the passage below on narrow and full reserve banking:
‘Like narrow banking, a complete move from fractional to full reserve banking would drastically curtail the lending capacity of the UK banking system, reducing the amount of credit available to households and businesses and destroying intermediation synergies’.
The ICB has grasped the relatively simple point that fractional reserve banking is inherently plagued by maturity mismatch where short-term deposits fund long-term credit extension. Furthermore banks build upon this shaky edifice through leverage and fiduciary media (money) creation, significantly adding to the problem. The downside is intermittent banking crises, which, contrary to public perception, are not rare events. The upside is high credit availability and ‘intermediation synergies’.
By dismissing full reserve or narrow banking the commission is in effect saying: ‘we know that banks fail, and will probably fail again in the future but we judge that the benefits of ‘intermediation synergies’ are greater than the costs of this’ – an empirically debateable point, but fair enough.
The problem is that having made this decision the Commission then goes on to make some tokenistic proposals to increase the stability of banks, in particular increasing the capital requirements for retail subsidiaries and systematically important banks to 10%. The ICB knows that 10% is not enough, and admits as such:
‘The Commission has examined these studies [those which look at capital requirements] and notes that they yield a range for the optimal ratio of Common Equity Tier 1 (CET1) to RWAs, on a Basel III basis, of 7% to 20%.’
10% is therefore a pretty arbitrary and low amount. The real question for the ICB is does it want seriously to address the issue of stability and ‘too-big to fail’ or does it instead want to ignore the issue and decide that bail-outs are an inherent feature of fractional reserve banking? If the former it should look at creating a variant on the ‘polluter-pays’ principle whereby large banks pay for the risk they pose to the system. This tax would cover (at least to a greater extent than at present, though it would be foolish to suggest that regulators can accurately assess the cost of future bail-outs) some of the risk to the tax payer in the event of another crisis. Such a principle would also help with the second issue examined by the Commission, that of competition. If large banks pay for the privilege of being large, then smaller entrants to the market do not face a situation where they suffer for being similarly risky, without any of the benefits which go with being large. Smaller banks would face fewer barriers to entry, yet would still pay for the (lesser) risk they pose to the system.
However, I do not believe the Commission will be so bold, for the simple reason that it has set out its stall already. It is in favour of the current system and acknowledges that banking is an inherently risky business. Furthermore it is a business where past risks are seldom a good indication of future risks and so the chance of another banking crisis is high and of a magnitude difficult to calculate.
After the Titanic disaster, maritime regulations were put in place to ensure that boats had the correct amount of lifeboats. The benefits of this were seen to outweigh to possible costs. In contrast the ICB has decide that the benefits of significantly improving the stability of banking are not greater than the costs this would entail; rather than order lifeboats it is proposing a rearranging of the deckchairs.