One big problem with this report is that it puts both risky and non-risky bank activities inside the much vaunted “ring-fence”, when the whole object of the exercise is to separate the two.
For example, retail depositors like you or me have a right to 100% safety (though I’ll come back to this point below). And these deposits are inside the fence. But so too are loans to small and medium size enterprises: clearly not an entirely safe activity! But it gets worse. The report is not even clear on whether deposits from and loans to large companies should be inside or outside the fence. (1st paragraph on p.12).
Or as the Guardian’s City editor, Jill Treanor put it, “The commission is vague about whether banking to large companies should be in or outside the ring-fence.”
How different are loans and equity?
Next, there is a problem with the idea that investment banking has been separated from other bank activity. The distinction between “investing” in a company and “lending” to a company is actually blurred. To illustrate, a loan which is last in line for reimbursement in the event of bankruptcy and/or where the so called interest is related to profits is very close to “investing” i.e. taking an equity stake. Lawyers will have a field day here.
So it’s no surprise that there is an article on the Legal Recruitment site entitled, “Vickers review puts lawyers centre stage”.
Or as Martin Jacomb, former chancellor of the University of Buckingham put it in the Financial Times, “The ring-fencing proposal involves much detailed regulation.”
Why did Vickers get in this muddle?
Why, if the object of the exercise is to separate the safe and risky, does Vickers mix them up inside their famous ring fence? The explanation lies in a piece of economics which the Vickers commission clearly did not grasp. And this revolves round what they call “trapped deposits” (e.g. see p.277). I’ll explain.
Deposits, or at least some of them, need to be safe. At the same time, lending out money is clearly not 100% safe. Thus there is an absolutely fundamental conflict between safe deposits and lending.
If one solves this problem with excessive restrictions on the types of loan that banks can make with “safe deposit money”, the relevant money is liable to become what Vickers calls “trapped”. And this, according to Vickers, would reduce the supply of credit (paragraph A3.29).
Well obviously it WOULD reduce the supply of credit, all else equal. But if restrictions are put on the way money can be used, there is nothing to stop a central bank / government expanding the money supply to compensate for this. So the “trapped” problem is a non-problem.
Positive Money’s proposals.
In contrast, the ideas set out by Positive Money, Prof R.A.Werner and the New Economics Foundation on bank reform are a breath of fresh air and “lawyer free” simplicity. Plus it’s pretty obvious, that these ideas have the support of Mervyn King, though it’s more than his job is worth to actually say so.
The basic idea proposed by Positive Money & Co is to give depositors a simple choice: have their money invested by their bank or not have it invested.
Depositors wanting to invest would have to accept the inherent advantages and disadvantages of this option. Since the money is locked up in, for example a loan to a business, depositors would not have instant access to their money, but they WOULD earn interest – reflecting the fact the money had been put to work. In fact they’d get a better rate of interest than under current arrangements. But also, there is an inherent risk here. That is, if the bank goes bust, depositors would lose some or all their money.
The second option for depositors is 100% safety. In this case the money could be deposited at the Bank of England. Depositors can have instant access, but they’d get no interest.
As Mervyn King put it, “If there is a need for genuinely safe deposits, the only way they can be provided . . . is to insist such deposits do not coexist with risky assets”.
A big merit of the “two options” system is that it largely dispenses with the too big to fail subsidy that banks get, (paid for by taxpayers). This subsidy is worth well over £10bn a year, according to Vickers (though there are other and bigger estimates).
That is, currently, depositors have 100% safety while reaping the benefits of having their money invested: a free lunch. Well, there is no such thing as a free lunch – someone pays. Or as Vickers puts it, “The risks inevitably associated with banking have to sit somewhere” (p.8). And the risks “sit with” the taxpayer under the current system.
Vickers in contrast allegedly makes banks safe, but does so by expanding banks’ capital. But there is problem here: shareholders are not saints. They’ll want a commercial return. And that means that the cost of carrying the risk will be passed onto depositors and those borrowing from banks.
So the Vickers’s proposals amount to a game of “pass the parcel”: with the parcel ending up, after paying exorbitant fees to lawyers, in about the same place as under Positive Money & Co’s proposals. Except that under Vicker & Co’s proposals, no distinction is made between depositors willing to take a risk and those who want safety. The result is that the former cross subsidise the latter.
Positive Money & Co get rid of this cross subsidisation. Vickers & Co don’t.
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