Once again, Compass and the nef don\’t get it

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.

4 thoughts on “Once again, Compass and the nef don\’t get it”

  1. >>Installing a firewall between retail and investment banking is welcome<<

    Hmm…. but in the UK I thought it was the retail, commercial and mortgage banks which failed – Northern Rock, B&B, HBOS plus the commercial part of RBS – not the investment banks. And the Icelandic banks were taking retail and commercial deposits rather than trading?

    Can somebody explain how splitting off the investment banking parts of Barclays and HSBC would have helped?

  2. We’ve done something about this problem, but it’s the wrong solution because it introduces yet more moral hazard into the system.

    Which means we either need to do away with wholesale deposits or we need to have some deposit insurance.

    No, we just need everyone, including retail savers, to accept that money that is put to use by the banks is at risk. The solution is to recognise that risk, plan for that risk and most importantly to price that risk properly by demanding higher interest rates or not lending the money in the first place[1]. The banks in the wholesale market obviously failed to do that. The question is whether that failure was due to their belief in an implicit government guarantee or if it was simply incompetence on their part.

    [1] Alternatively, for those who really don’t want to be subject to any credit and liquidity risk, the solution is a parallel, non-FRB system where you pay the bank to securely hold your money on deposit.

  3. Alternatively, for those who really don’t want to be subject to any credit and liquidity risk, the solution is a parallel, non-FRB system where you pay the bank to securely hold your money on deposit.

    With interest rates as they have been for the past 5 years, that’s pretty much what I’ve been doing anyway.

  4. I suspect the nef’s acid test is more along the lines of “do I get to throw bankers into a vat of acid?” than anything to do with the actual problem.

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