Banking Reform – Is That It?
By Greg Fisher
I recently had cause to look at the Draft Financial Services (Banking Reform) Bill, which was published a few weeks ago. It made for depressing reading because, in my opinion, the proposed reforms will do little to protect the UK from a future banking crisis. Furthermore, it will not address two fundamental problems in the UK banking industry, namely the problem of concentration and banks’ insensitivity to local conditions and individuals’ needs. In this article I will use the new field of dynamic networks to evaluate the draft proposals.
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The financial crisis of 2007-8 was a truly momentous event. In the years preceding the crisis, many economists and experts in finance were stating with high degrees of confidence that a broadly liberal financial system with light touch regulation was the answer. The global market boom, which lasted from around 2003 until 2007, and the development of complex derivatives that supposedly re-allocated risk to those more able to handle them, were seen as strong evidence of this state of excellence. And, with the financial system being close to a state of perfection, regulators were petitioned to dilute regulations further and further. I was in the thick of it at the time, working for the Bank of England and then in a hedge fund.
So what happened? And how can we stop it happening again? This is an acutely important question for the UK, which has a disproportionately large banking system.
The British Government asked John Vickers to look at this question. He reported in September 2011 and in October 2012 the Government published its Draft Financial Services (Banking Reform) Bill. That Bill focuses on three broad reforms: (1) “ring-fencing” commercial & retail banking from wholesale and investment banking; (2) clarifying the ranking of depositors upon a bank default; and (3) increasing the capital held by banks, notably those viewed as systemically risky.
Will these work? Interestingly, a framework of understanding complex systems like finance has been bubbling away under the surface of academia for a few decades. The field of dynamic networks has matured a great deal, to the point where we can use it to make sense of things like the financial crisis, and to contemplate a way forward. It also helps us to evaluate the policy ideas contained in the draft Bill. Unfortunately, the Vickers’ Commission hardly used this material. (I wrote a submission for Vickers when I was the Chief Economist at ResPublica, which shined a light on this new thinking and its relationship with banking. I heard nothing more.)
Importantly, the financial system is a dynamic network of interacting agents who adapt to each other over time. Orthodox economics and finance typically under-emphasises the integrated and dynamic nature of this system and if laws and regulations are based on this type of thinking, they will generate inappropriate conclusions. For example, the Banking Reform Bill’s first proposal of ring-fencing retail and “casino” banking is very unlikely to significantly reduce the risk of financial crises, which are more about relationships than institutions.
Half a Dam
For dynamic, networked systems like the financial system, ring-fencing different types of banks from each other is like putting half a dam across a river: the river will obviously find its way around the dam, carrying on regardless. Ultimately, the nature of how crises cascade across complex networks like the financial system, including by word-of-mouth narratives, means that this ring-fencing is unlikely to do very much. For example, it will not prevent institutions like Northern Rock – which was substantially funded through the interbank market – from running in to trouble.
Orthodox thinking also leads us to think of the banking system as a collection of broadly independent organisations. The whole system is viewed as the sum of its parts. This type of thinking tends to lead us to believe that the best protection against a systemic crisis is to make each institution safer by, in the case of banks, raising their equity “buffers”. This is the third theme in the Banking Reform Bill. Importantly, this will probably help to some degree but it smacks of “doing what we used to do… but better”.
The financial crisis of 2007-8 dwarfed the equity buffers available to many banks – a number of banks saw their capital ratios disappear in a matter of days and it is highly questionable that higher buffers would have made much of a difference. Plus, governments intervened aggressively before we could see just which banks would have been insolvent. What is required is different thinking and different approaches, not more of the old. These equity buffers are contingent on asset prices, and orthodox thinking has no serious explanation for why financial asset prices are so volatile: the new field of dynamic networks and some recent work in the area of psychoanalysis indicates that bubbles and busts are an inherent part of free market financial systems. We need to base policy on this thinking, not on frameworks of reference that have already failed us.
Perhaps the biggest gap between what we need to do with banking system and the proposals of the Banking Reform Bill is in the area of localism versus centralism. The UK’s retail banking system is enormously over-centralised – even the CEO of RBS said recently that banking in the UK needs to get closer to the real world, adding value to people and businesses on the street. And the Bank of England’s own analysis suggests that the UK’s big banks are about 30 times larger than they ought to be. Thirty times! And yet the draft Bill contains nothing about creating or encouraging a more localised banking system. It mentions that the government is pursuing a more competitive banking market in the UK but their measures seem trivial in face of the ability of large banks to maintain centralised and impersonal banking systems.
It would be preferable to impose some form of “insurance premium tax” which increases progressively with size in order to fund future bail outs, and in order to incentive banks to remain small and local. This matches the economics of banking in any case: the tax payer insures banks, whether they want to or not and this is more true of larger banks, so let’s force them tp ay a fair insurance premium. Moreover, such measures would not damage London’s comparative advantage in finance, which derives from its investment banking operations and wholesale markets.
Hi Greg, I think your ideas about looking at relationships and size are very useful here. One question might be about looking at ‘systemic mass’ or something – how does each bank impact the others, and tax/insure/regulate on that basis – the bigger the mass, the harsher/firmer/more expensive the impact on the bank. Which could drive banks to splinter into workable and more local units?
Another related approach is to build new bottom-up alternatives to provide the services currently provided by central and retail banks. For example, peer-to-peer (P2P) lending systems like zopa.com allow for borrowers and lenders to bypass banks. Also Bitcoin.org provides sophisticated software that supports a completely new form of base money (bitcoins) that is not under the control of any state or other entity but rather relies on cryptography and smart distributed algorithms. Ripple-project.org provides an experimental platform for creating credit (out of thin air) like banks in a P2P way based on networks of trust established between individuals.
It would be wrong to over state the current ability of these new experimental approaches to support the financial needs currently supplied by banks but from small acorns great oaks may grow.
Indeed a recent ECB report focuses explicitly on the Bitcoin.org system as a potential threat to central banks and states in the future. Rather than scare stories and fear perhaps a more progressive engagement by central banks with these new technologies could payoff in the longer term.
I’m sure your analysis is entirely correct, unfortunately.
“The Bank of England’s own analysis suggests that the UK’s big banks are about 30 times larger than they ought to be.”
Wow, that is an interesting and scary number, Greg.
Have you seen Gareth Morgan’s “Images of Organisation”?
http://en.wikipedia.org/wiki/Gareth_Morgan_(author)
He has a system map of the mad cow crisis, I made a PDF of it for my teaching – I’ve emailed it to you.
I think it speaks for itself. Perhaps you could produce one for UK banking?