Written evidence from nef (the new economics
foundation)
PROMOTING A DIVERSE AND RESILIENT BANKING
SYSTEM
1. EXECUTIVE
SUMMARY
1.1 Banking is unlike any other industry sector.
It has unique properties that require an approach that goes beyond
competition and choice to examine its broader social, economic
and environmental impacts. We argue that effective reform needs
to take as its starting point a re-statement of the function of
banking, and while acknowledging that there is a strong case for
reforms of the investment banking industry, we focus here on retail
banking.
1.2 The most important privilege of the banking
sector is the ability to create credit. This effectively hands
complete control over the allocation of credit and significant
control over the money supply, the means of exchange that underpins
the economy, to private banks. Closely connected to this is the
problem of moral hazard arising from the implicit and explicit
government guarantees of banks' solvency.
1.3 These features of banking make it more analogous
to public utilities, natural monopolies or merit goods1
such as health and education, than to ordinary free market industry
sectors. The incoherence caused by the privatisation and deregulation
of a public good creates inherent instability in the banking system.
1.4 Apart from these unusual features, the banking
market does not approach anywhere near conditions of perfect competition.
Therefore a laissez-faire deregulatory approach paradoxically
leads to less competition and choice. Other observed market failures
include:
— the
demise of relationship banking;
— distorted
incentives and short-termism;
— patchy
access to finance and poor customer service;
— withdrawal
of support from local economies, and;
— increasing
risks from increasing scale.
1.5 We argue that among the plethora of useful
reform initiatives, the watchword for transforming banking for
the better is "diversity"—of function, scale and
location, and ownership.
1.6 We further argue that to truly get at the
roots of systemic instability, the committee should consider convening
a separate inquiry into the case for and against monetary reform.
2. THE FUNCTION
OF BANKING
The banking system is, by its very nature, not subject
to the normal laws of market competition. Although competition
and choice merit careful examination, the Committee is well advised
to take a broad approach to reform. We believe it is necessary
and desirable to start any review of banking with the question
"What is the function of banking?" and we offer the
following definition:2
"To facilitate the allocation and deployment
of economic resources, both spatially and temporally, to ecological
sustainable activities that maximise long-term financial and social
returns under conditions of uncertainty"
We argue that a fundamental redesign of existing
market structures is required for banking to fulfil this function.
3. BANKING IS
SPECIAL
3.1 Banking is unlike any other industry; this
has been made abundantly clear in the current crisis. Banks enjoy
certain privileges that normal commercial businesses do not have.
The most important of these is the privilege of "credit creation",
and closely connected is the problem of moral hazard arising from
the implicit and explicit government guarantees of their solvency.
Credit Creation
3.2 In modern economies, through fractional reserve
banking, banks play a key macro-economic role in the creation
and allocation of virtually the entire money supply as credit.
This is accepted by the Federal Reserve and the European Central
Bank and by most monetary economists, although it does not feature
in most general equilibrium models of the economy used by orthodox
economists.3 Private-sector commercial banks can thus
be seen to provide a key public utility function as the originators
and allocators of the money supply.
Moral Hazard
3.3 This leads inevitably to the second privilege,
that risks are effectively underwritten by the taxpayer. This
happens in two ways: in order to prevent the sudden loss of confidence
that can lead to a run on the banks they are provided with a highly
valuable deposit guarantee scheme funded at taxpayers' expense.
This is compounded by the problem of institutions that are too
systemically important to fail. One estimate of the value of this
implicit guarantee in the UK, in terms of allowing banks access
to cheaper capital, is over £50 billion a year.4
This figure has swollen following the banking bailout, as these
banks would have faced significantly higher funding costs without
the government interventions, but the pre-crisis figure for 2007
was still £11 billion. Significantly, this value accrues
almost entirely to the largest five banks.
An Incoherent System: Public Money, Private Banks
3.4 The government, via the Bank of England,
has a monopoly on the creation of legal tender. The means of exchange
that forms an essential building block of any modern economic
system is therefore limited to a single currency that allows no
legally enforceable competitors. There are alternatives to a monopoly
fiat currency, but discussion of these is outside the scope of
this paper. What is relevant to the reform of the banking system
is that the provision of a reliable and stable currency to fulfil
the function of a means of exchange is a public good. But the
advent of electronic banking and the demise of notes and coins
(which now make up less than 3% of the money supply) have resulted
in money now mostly existing in electronic form as credit created
by private banks. This could never have been envisaged by the
architects of the 1844 Bank of England Act that banned the private
creation of money by conferring a monopoly of issuance of notes
and coins on the central bank.
3.5 The means of money creation and its allocation
have significant economic, social and environmental impacts. The
Bank of England's attempts to control retail price inflation does
influence credit creation indirectly through interest rates and,
more recently, quantitative easing, but essentially the quantity
and allocation of money in the economy is determined by private
banks.
3.6 Thus an inherent contradiction exists: a
stable monetary system is a public good, money is backed by a
state guarantee in the public interest and in this respect nationalised,
but its creation and allocation is controlled by private banks
motivated only by profit. It should hardly come as a surprise
when private banks are bailed out by the taxpayer when the system
crashes.
3.7 These features of banking make it more analogous
to public utilities, natural monopolies or merit goods such as
health and education, than to ordinary free market industry sectors.
Retail banking underpins economic activity and has a related impact
on social inclusion. Access to basic transactional banking services
is increasingly important for full participation in the economy
and for social justice. The cost of not having a current account
and access to mainstream credit, borne by the most financially
disadvantaged, can reach £1,000 per year.5 Forcing
people into the arms of loan sharks and confining them to the
cash economy provides fertile ground for criminal operations and
tax evasion.
3.8 Although "public good" industries
often incorporate market mechanisms and competition to great benefit,
they are ultimately managed and regulated in the public interest
and subject to democratic control. Broader economic, social and
environmental goals take precedence over profit. We would argue
for this reason alone that the structure of the banking market,
the level of financial returns, the number of market participants
and their scale and scope, are all appropriate and indeed essential
subjects for regulation. There are further arguments for state
intervention based on observed market failures which we examine
next.
4. LAISSEZ-FAIRE
LEADS TO
MARKET FAILURE
4.1 The banking sector displays fundamental flaws
in approximating to anything close to conditions of perfect competition.
Indeed, the nature of banking as outlined above is such that a
laissez-faire approach will lead to less competition, not more,
and even improving competition cannot of itself address all forms
of market failure.
Deregulation destroys competition
4.2 Policy on banking regulation has been largely
based upon assumptions, derived from neo-classical economics,
of perfect competition and information that have no basis in reality.
A rigorous and objective review of competition in the banking
sector must start without making such deductive assumptions about
how economies and markets work based upon hypothetical models
of general equilibrium. It should take a more inductive approach
based upon empirical evidence of what is actually happening in
the sector.
4.3 Over the last three decades, regulators became
exceedingly relaxed about competition in the banking sector, relying
on the UK sector's international standing as proof of its competitiveness.
Policy permitted an ever more homogeneous and top-heavy sector
to develop. Consolidation, takeovers and aggressive acquisitions
left the UK economy with fewer banking institutions and the competitiveness
of UK banks in terms of their product offering to UK citizens
and businesses was neglected. They have been, to a greater or
lesser extent, doing the same things and offering customers the
same products.
4.4 The sheer profitability of the financial
sector makes it clear that the system is not competitive in the
usual meaning of the term. Competition is meant to ensure that
the lure of high profits will attract new entrants who will offer
products at a cheaper price. The fact that this has not occurred
suggests that there are major barriers to entry and that incumbent
institutions are operating in an oligopolistic6 rather
than in a competitive market. Over 85% of current accounts are
now concentrated in the hands of the big five banks.7
This destruction of diversity has had profound effects:
The demise of relationship banking
4.5 These few big banks operate at an ever-more
profitable distance from their customers, thanks to new, automated
techniques such as credit scoring. "Relationship-banking"
has gone in to decline, as employees with direct knowledge of
borrowers have been shed in favour of centralised IT systems able
to deliver more "efficient" computer ratings. However,
homogeneity in approach to credit scoring leaves some sections
of society underserved while decreasing system resilience as a
small number of institutions chase the same group of customers
and assess them in the same way.
Distorted incentives and short-termism
4.6 The recent problems in the system have been
compounded by the way in which traders are remunerated on a very
short-term basis, creating incentives to maximise short-term returns.
Similarly, the financial "engineers" creating new products
for the derivatives market are often paid immediately for the
returns forecast over the whole term of the product. This creates
potentially destructive incentives to develop products with a
long "tail" of risk.
4.7 Institutions have converged on those activities
that offer the highest returns, particularly over the short time
horizons against which performance is generally judged in listed
companies.8 There is little to be gained from accepting
lower returns now to move into sustainable long-term sectors that
may ultimately produce higher returns, if all your shareholders
have left in the meantime for rivals posting better quarterly
results.
Choice for whom? The lack of access to finance
4.8 As institutions stopped specialising, either
geographically or by market sectors, less profitable activities
- such as maintaining a branch network and providing financial
services for low-income people9 - became ever more
marginalised. The spatial and social dynamics of branch closure
are important. Academic research shows that branch reductions
have generally been greatest in more deprived and ethnically diverse
areas, and lowest in more affluent ones.10 This means
that where finance is available, it is often on exorbitant terms
- a typical APR from the legal end of the home credit market,
is 272%.11
4.9 According to the Campaign for Community Banking,
the number of bank branches in the UK is now just 9,094 - 43%
fewer than just 20 years ago.12 The UK has 197 bank
branches per million inhabitants (including building societies).
This compares with over 500 and 1,010 branches per million inhabitants
respectively in Germany and Spain.13 Not only does
Spain have more banks per head of population, they are also far
better disbursed than they are in the UK. The UK has 162 banks14
compared with France's 450 banks15 and Germany's 2,000
banks.16 Both countries have a variety of banking forms,
such as savings banks, co-operative banks, private banks, municipal
banks and post banks that are firmly anchored in local communities.
This helps explain the superior performance of these economies
is providing access to finance.17
4.10 And, when we find a branch that is still
open, there are fewer people to deal with any queries we have.
Figures from the British Bankers Association (BBA) show that in
the five years from 2003, Abbey reduced its staff numbers by 12,897,
Lloyds TSB cut 15,058 staff, and the Royal Bank of Scotland, 11,200.
Since the BBA data was compiled, Lloyds TSB announced plans to
make 11,000 more staff redundant and RBS announced plans for a
similar number of cuts.18
Withdrawal of support from local economies
4.11 Nor is it just a question of access for
individuals. Access to banking is vital to the survival of retail
and other services in many medium-sized rural communities and
in less well-off suburbs, estates, and inner cities. If active
people and small businesses go to bank elsewhere, they are likely
to spend elsewhere, too. Those that suffer most from the loss
of local amenities are the most vulnerable: older and disabled
people, those with mobility difficulties, and carers.
Economies vs diseconomies of scale: Increasing
returns means increasing risks
4.12 While economies of scale are important,
they also bring dangers. The concept of "too big to fail"
is well-documented and tends to allow returns to be increased
by increasing the risk to the taxpayer. Crucially, the theory
of diversification of risk through universal banking has shown
to not hold true when a small number of very large banks all converge
on similar portfolios. Shareholders should have control over their
own risk diversification and have a broad range of divergent institutions
in which to invest.
4.13 As financial institutions grow they move
further and further from their customers, and the knowledge of
the products they are buying, selling or trading inevitably suffers.
The fact that the crisis was sparked by an international market
in subprime mortgages in the United States, about which very few
had any real knowledge or great understanding, underlines this
point.
5. STRENGTH IN
DIVERSITY
5.1 With others, nef has been advocating
a series of reform proposals which are documented in previous
publications,19 and for brevity we do not reproduce
them here. Instead we focus below on one key theme: diversity.
Diversity of function
5.2 We need financial institutions to focus on
specific functions and to do a good job, not to chase the latest
bandwagon. Retail banking is a very different business from investment
banking, but universal institutions that devote large resources
to speculative activity put at risk their ability to provide core
functions for their customers - payments, settlements, savings
and loans. Government must see through its commitment to the creation
of a Post Bank, Green Investment Bank, and Big Society Bank, which
we suggest should be based closely on the recommendations of the
Social Investment Task Force for a Social Investment Bank.20
However, we would also benefit from banks that focus on particular
industries, customers and products.
Diversity of scale and location
5.3 Large banks, or rather banks that can service
large customers, have their place in the ecology of finance, but
we need many more smaller and medium sized banks that are not
too big to fail. We need regional and local banks with the particular
knowledge, experience and culture of the areas they serve. This
notion is not fanciful as comparisons with competitor economies
demonstrate. A vibrant Community Development Finance Institution
sector should be encouraged by introducing a UK version of the
US Community Reinvestment Act which would provide greater transparency
over where banks deploy their capital - or more to the point where
they choose not to.
Diversity of ownership
5.4 Britain has a long and proud heritage of
mutually owned financial institutions. The sector was demolished
in the 1990's to little good effect according to an All-Party
Parliamentary Group inquiry.21 The government should
seriously consider re-mutualisation as part of any forced demergers
or sales by large banking groups. They should also remove the
harsh and artificial constraints on the credit union sector, which
is puny compared with competitor nations. While only about 0.5%
of the adult population in the UK is member of a credit union,
the equivalent figures for Ireland, the US, Australia and Canada
are 45%, 30%, 20% and 16%, respectively.22
Key benefits of diversity
5.5 Greater diversity in the banking sector would:
— help
ensure that less profitable activities are not left behind;
— provide
greater clarity to savers about the use of their deposits and
the potential risks and returns associated with a bank;
— allow
greater management focus at Board level on areas of banking that
are considered overtly or covertly to be poor relations within
large universal banks, and help reconnect senior management with
high-street customers;
— allow
more focussed micro-prudential oversight, and
— assist
macro-prudential oversight and promote greater system resilience
by creating "fire-walls" between different parts of
the system.
We need a financial system that channels finance
to ecologically sustainable activities that maximise long-term
financial and social returns. We need to explicitly promote diversity
and resilience as much as competition and choice, not least because
the latter will be harder to achieve without the former.
6. EXAMINING
THE ROOTS
OF INSTABILITY
- AN INQUIRY
INTO MONETARY
REFORM
For the reasons outlined above, we believe that a
system that allows private control over a public good creates
incoherence and instability in the banking system. We recommend
that the Select Committee convenes a separate inquiry on the case
for and against monetary reform, including the nature and operation
of credit creation under our existing current system of fractional
reserve banking, and allowing a thorough review of all alternative
variations on creation and control of the nation's money supply.
September 2010
REFERENCES
1 Merit goods confer
positive externalities on the economy and society as a whole that
are not enjoyed directly by the customer. This leads to too few
of such goods and services being supplied in a free market, hence
they tend to be subsidised or provided directly by the state.
2 Nissan S and Spratt
S (2009) The Ecology of Finance (London: nef).
3 "…the
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7 Vickers et al (2010)
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http://fsa.gov.uk/pubs/list_banks/june10.pdf
15 Accessed at
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/$File/Chiffres_cles_des_banques_francaises_2007.pdf, p 10
16 Accessed at
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17 Thiel V (2009)
op cit.
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http://www.thisismoney.co.uk/savings-and-banking/article.html?in_article_id=498645&in_page_id=7
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& Greenham T (2010) Where did our money go? (London:
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report to HM Treasury, October 2000 (London: Social Investment
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Ten Years On, report to HM Treasury, April 2010 (London: Social
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21 Welch I (2006)
Windfalls or shortfalls: The true cost of Demutualisation
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22 Werner R (2009)
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