The UK’s Independent Commission on Banking (ICB) estimated the too big to fail subsidy that UK banks get as being worth well over £10bn a year. That is roughly £150 a year for each UK inhabitant. So why does this subsidy arise?
The answer lies partially in a piece of chicanery which suits banks and suits everyone who deposits money in banks – that’s you and me. This is that we want our money to be 100% secure: that is we want government (i.e. taxpayers) come to the rescue when a bank goes bust. While at the same time we want the benefits and interest that comes from engaging in commercial activity: i.e. letting banks lend on our money in a less than 100% safe manner. We want to have our cake and eat it.
Mervyn King described this process as “alchemy”. Quite right. “Chicanery” . . . “alchemy” . . . either word will do me.
He also said, “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”. Right again.
One solution to this problem is to make depositors come clean: that is, force them to be honest and say whether they want their money to be 100% safe, or whether they want it invested, in which case it will NOT BE entirely safe. In other words we need two basic types of account which for want of better words I’ll call “safe” accounts and “investment” accounts.
Safe account money would NOT BE invested, hence it would earn little or no interest, but it WOULD be “instant access”. Just to make sure this money is 100% safe, it could be deposited at the central bank. In contrast, investment account money WOULD earn significant interest, but it would not be instant access, plus there would be no taxpayer funded recompense if the relevant bank went bust.
As a result, there’d be little need for any bank subsidy. As regards safe money, that would be safe (absent blatant criminality). And as to investment account money, there’d be no government rescue if the bank went bust.
The above “two account” system would not of course ENTIRELY dispose of all the risks posed by banks: banks could still pose a systemic risk. But the two account system would certainly help. Moreover, the “too big to fail” problem can be mitigated by preventing any one bank growing too big.
The two account system might seem to constrain private banks’ freedom to lend (though of course under fractional reserve they have a large measure of freedom to create money out of thin air and lend it out when they see fit). Alternatively, under full reserve, the two account system would certainly seem to constrain banks’ freedom to lend. And indeed the ICB fell hook line and sinker for this “constraint” argument.
But any such constraint is not a problem, because the central bank can easily expand the monetary base to compensate for any such constraint.
The main solution advocated by the ICB was to increase banks’ capital. The problem with that is that shareholders are not saints: they want a commercial return on capital. So the cost of that extra capital is inevitably passed on to bank customers – depositors and those borrowing from banks.
So the ICB solution amounts to a game of pass the parcel, with the net result being not vastly different to the two account solution, in that the cost of the risk that investment inevitably involves is dumped onto depositors and those borrowing from banks. The weakness in the ICB solution is that depositors who are prepared to take a risk are not fully rewarded for doing so: part of the “reward” is donated to those who want to indulge in the above mentioned chicanery or “alchemy”.