Getting ready for Vickers

Roger Alford 12 September 2011

a

A

The proposal that each of Britain’s large universal banks should be separated into a deposit bank and an investment bank arose from the crisis of October 2008. At the time, two of these banks – Royal Bank of Scotland and Lloyds TSB – faced failure and public money was thrown in to save them.

There was widespread anger at the incompetence of the bankers concerned and at this use of public money by the government. It was the public outcry that gave political weight to the argument for separation which would create stand-alone and ring-fenced deposit banks. These would be immune to failure in any circumstances and never again would large banks have to be saved using public money in order to safeguard bank deposits. Such separation would represent a major structural change in the British banking system and the government took the political decision to hand over to the newly created Independent Banking Commission the task of passing judgement on the proposal. In its Interim Report the Commission looked with favour upon separation and the Chancellor seemed to agree with this (see for example Véron 2011 on this site).

There were five main factors that, in varying degrees, contributed to Britain’s banking crisis:

  • The incompetence of the bankers concerned, which was the main focus of the public outcry;
  • Light touch supervision of the banking sector by the Financial Services Authority (FSA) as outlined by then Chancellor Gordon Brown;
  • The passive acceptance of this remit by the FSA, whose management was apparently unaware of the risks being taken by the banks and failed utterly to curb them;
  • Britain’s blatant and unsustainable property boom added to the debacle, but neither the Bank of England nor the Treasury did anything to restrain it;
  • Under Basel II the capital requirements of banks were set at an unduly low level determined by political convenience rather than any assessment of risk.

It was the malign coincidence of these five factors that was responsible for the crisis.

However, the public did not spread the blame across these five. It was incompetent bankers who were singled out and anger at the use of public money by the government to save them became transmuted into the more general demand that never again should public money be used to save banks. But in the crisis government used public money to save banks from insolvency and to safeguard their deposits in order to prevent a damaging shock to the whole economy. This would not have been money which could be used for other expenditure, however worthwhile. It was money created to provide temporary loans of capital to make good that lost by the banks, with the aim that when the banks were restored to viability the money would be recovered by the government and cancelled. This use of public money had a negligible real resource cost compared with the massive real resource loss it prevented.

The use of public money to save banks was much more extensive than is generally appreciated. Government provision of temporary equity capital to save banks from insolvency was dwarfed by the Bank of England’s massive creation and use of public money to save virtually all the banks from failure through illiquidity. Such (profitable) liquidity support was an extension of the Bank’s long-standing role as lender of last resort. It was hardly noticed by the public and led to none of the outcry that arose from the government’s capital support. Such is the background to the now entrenched dogma that public money must never again be used to save failing banks.

There are now powerful safeguards against a re-run of anything like the last crisis. That experience has led to greatly improved competence at all levels:

  • The bankers held responsible for the debacle have been replaced, leaving with their reputations heavily damaged;
  • Light touch supervision has been discarded; there is now effective bank supervision and the FSA is to be replaced by the Prudential Regulatory Authority under the Bank of England;
  • A new Financial Policy Committee is to have general responsibility for financial stability; and
  • The banks have greatly strengthened their capital ratios in line with those now introduced under Basel III.

But no system is perfect and there is always the possibility of an extreme shock – unforecastable and unimaginable – which could cause even well-managed universal banks to fail. With their pervasive role across the whole economy, this would cause enormous economic damage and it would be cost-effective to use public money to save these banks. But this compelling rationality would be ruled out by the dogma that never again should public money be used to save the banks, which is in direct conflict with the core competence of government to act freely in the public interest.

The alternatives

We seem to face the alternatives of: 

  • A banking system which is competently managed at all the levels identified above, where only an extreme event would endanger the banks and this would lead to the rational and desirable use of public money to give them temporary support; and 
  • A system based on dogma and separation, where such problems as demarcation, inflexibility, commercial viability and many others would all have to be solved, to allow each deposit bank to become a secure financial fortress.

No government or Bank of England public money could ever be used to save other non-deposit/investment banks, no matter how well managed or how important their role in financing the economy.

The final report of the Independent Banking Commission will appear on 12 September. If it recommends a policy of separation – radical surgery on the banking system, going far beyond anything contemplated in any other advanced banking system – we shall see its solution to the many problems involved and the trade-offs it has applied. If its recommendations were to be accepted by the Chancellor we should then begin to see the wider implications and costs of conforming to the hollow dogma that public money must never be used to save the banks. Such a redesigned system would have to be set up so that those responsible for its future management have full power to adjust and reform it as the inevitable problems and unintended consequences emerge.

Editor’s Note: This was initially published on the website centralbanking.com.

References

Alford, Roger (2010). “Some help in understanding Britain's banking crisis 2007-09”, LSE Financial Markets Group Special Paper 193, October.

Véron, Nicolas (2011), “Some progress in the banking reform debate”, VoxEU.org, 26 April.

a

A

Topics:  International finance

Tags:  UK, financial regulation, too-big-to-fail

Roger Alford

Emeritus Reader in Economics, LSE

Events