Whining about the banking system report they say:
– The reforms set out by Vickers fail the acid-test, they are not sufficient to prevent further collapse. Radical reform is not optional, it is necessary. Installing a firewall between retail and investment banking is welcome, but banks must be broken up to a size where their failure doesn’t threaten the rest of the economy.
Well, no, you see. It\’s not that the individual banks are too large. It\’s that all of the banks are interconnected.
Now, if we had a banking system in which all banks only lent out the money they get from their retail depositors, then if a run happens upon one bank then it doesn\’t really matter all that much in the grander scheme. We have deposit insurance for retail depositors and that\’ll kick in. How big the bank is suffering the run doesn\’t make all that much difference.
However, that\’s not the banking system we have. What we have is one where there are large wholesale deposits floating around the system. Spare cash that companies have, excess balances on the books of this or that bank and so on. This money did not have deposit insurance. And when a run did start (on Northern Rock) those wholesale depositors, quite rationally given that they didn\’t have deposit insurance, fled. Making Northern Rock both illiquid and insolvent.
This could equally easily happen whether we\’ve 5 or 500* banks. Sure, if there are 500 then a run on one of them, as long as it is contained, is just fine. But if they\’re all interconnected, so that if one fails then the next finds itself £4 billion short, which leads to the failure of the third and so on…..then it\’s not the size of the banks which is the problem. And of course the failure of one will lead to people wondering about the possible failure of the next and thus cause a wholesale run anyway.
The problem is that the wholesale depositors have no deposit insurance. Which means we either need to do away with wholesale deposits or we need to have some deposit insurance.
Fortunately, we\’ve already addressed this. The banking levy is an explicit charge for the wholesale deposit insurance that we all knew the Government was implicitly providing anyway.
It just isn\’t the size of the banks: it\’s that they\’re all connected. And we\’ve already solved that problem anyway.
* Actually we do have 500 banks. Something like 450 banking licences in The City.