Monday, 19 December 2011

Vickers does not separate safe from unsafe bank activities.

Roll of drums, fanfare, etc. It’s just been announced that the Vickers proposals on banking are to be implemented in the UK. And everyone thinks that safe banking activities will be separated from unsafe activities. Well people believe whatever they’re told, I suppose.

Vickers actually puts both risky and non-risky activities inside the much vaunted “ring-fence”, when the whole object of the exercise is to separate the two.

For example, it is generally thought that money deposited in banks by small depositors like you and me should be 100% safe (though that idea is flawed, as I’ll explain below). So 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 Jill Treanor, the Guardian’s City editor put it, “The commission is vague about whether banking to large companies should be in or outside the ring-fence.”

If Vickers & Co could not make up their mind on that basic and simple point, why did they even publish their report?

Loans and equity: how different are they?

As regards separating so called investment banking from other bank activities, there is another problem, which is that the line between “investing” in a company and “lending” to a company is very 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 & Co 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 (and this is the point that Vickers does not get) 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.

Indeed, central banks have massively increased the supply of central bank created money (monetary base) in response to the crunch. Perhaps Vickers & Co weren’t aware of this.

But that all raises a question, namely what is the point of expanding the money supply and then putting restrictions on how money can be used? Answer is that it enables us to get a clear distinction between money that is supposed to be 100% safe and money which the possessor of said money wants to have invested, and which in consequence is not 100% safe: exactly what Vickers & Co aim to do but fail to do.

Or in the words of Mervyn King, “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”.

Quite right. I.e. what we need is a system under which those who deposit money in banks have a choice. If they want 100% safety, that’s fine: but they cannot at the same time reap the benefits of having their money invested in a less than 100% safe manner. That involves a free lunch, and someone somewhere pays for that free lunch: cross subsidisation is involved.

Alternatively, if depositors want their bank to lend out their money, nothing wrong there. The money is being put to good use, so depositors can get a decent rate of interest. But they cannot at the same time ask for 100% safety. And since their money has been locked up in some business or a mortgage, they cannot ask for instant access to their money either.

We have a choice. Face reality, which will dispense with cross-subsidisation. Or second, we can live in la-la land where we indulge in the belief that we can have our cake and eat it. But the result is cross-subsidisation.



  1. "100% safe" should mean "I get my money back worth at least as much as before, after inflation and taxes".

    If that happened, I suspect that much of the ordinary population would (a) choose that option and (b) save more than they do now.

    End of economy. Which is why the State made NS&I index-linked savings certificates available for 4 months this year and - peep-bo! - hid them again.

  2. The 100% safe option should be delegated to National Savings.

    "End of economy."

    Nope. The state just has to spend the money 'saved' instead.

  3. Sackerson;

    "I get my money back" and "worth at least as much as before after inflation and taxes" are goals that directly compete with each other.

    "I get my money back" (with 100% certainty) can only be achieved by holding onto that money. Lend it to anyone, ANYONE, ad you run the risk of them not being able to pay you back. That risk can get small, but it can't be eliminated.

    "Worth at least as much as before..." clearly demands that a loan be made. Money held on to does not multiply, and inflation will eat away at your capital. But, loans mean accepting some default risk.

    In a world in which there is uncertainty about the future, you cannot square the circle. You just can't.


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