"Voice from the City" rebuffs Labour’s claim as economically competent in respect of Northern Rock, banking supervision and deposit insurance.

Following the Conservative Party’s very successful conference, and the Thursday opinion polls, the spin in yesterday’s press was that Labour may delay the election so as to give it time to "undermine" the Conservative Party’s economic plans, in particular the pledge to fund a rise in the inheritance tax threshold by imposing a flat charge on those registered as "non-domicile" for tax purposes.

Doubtless Labour will do as it must. Two kinds of strategies Conservatives might adopt in response may seem obvious — (1) detailed defence of the plans; (2) focusing on presenting our case positively, largely setting aside the (somewhat boring) Labour critique. But I suggest a third, somewhat belligerent alternative — rather than allowing the focus of economic discussion to revolve around a critique of our own plans, we take the opportunity of political interest in economic issues to divert the focus instead onto a critique of Labour’s own record for economic competence.

In electoral terms, Labour’s reputation for economic competence has probably been its single greatest positive asset. Conservatives have looked foolish predicting (or insinuating) a number of disasters that never came to fruition, and our own economic plans have often looked timid or amateurish. But all that can be made to have changed with the Northern Rock affair and with Labour’s ill-judged response. We should be attacking Labour over this — not in the way we have been doing so far (which has rebounded on us, because our attacks were mis-directed and populist and seen as such by journalists and experts), but in a way I shall explain now.

Before I set out my critique, I want to emphasize that what I shall say is not just a matter of political advantage and opportunity. Labour has got some things seriously wrong, and is about to make matters much worse — with the potential consequence of undermining Britain’s status as the premier global financial centre. This is a matter of the first economic importance, not merely a matter of political opportunism.

As has been widely discussed, the Northern Rock affair saw the first bank run in the UK since the nineteenth century. The government’s response has been to guarantee the deposits of Northern Rock savers and to propose a much more extensive system of deposit insurance — in particular a scheme to guarantee the first £100,000 of deposits. There has been extensive criticism of the Bank of England’s role in the affair, and there is now speculation as to whether Mervyn King will continue as governor when his current term ends next year.

I want to argue the following: (a) The bank run occurred because of, not despite, Gordon Brown’s economic reforms, and unless they are changed (in essence, unless a key element is reversed) there will be more such runs in the future; (b) Deposit insurance, far from being the remedy to bank runs, is a disastrous concept that is well-known to require vast additional regulation to make it work properly — regulation which could seriously damage Britain’s role as a global financial centre.

A solvent bank has enough assets to pay its debts, including what it owes to its depositors. But because banks lend out many times the amount of money they take in in deposits and because those loans are typically longer-term than the deposits (people can often withdraw their deposits immediately, whilst they sometimes have 25 years to pay back a loan), if all of a bank’s depositors try to take out their money at once, then even if the value of assets (including the loans made — e.g. to people taking out mortgages to buy houses) exceeds liabilities, the bank may have a cash-flow problem. Unless it can get hold of cash, even a solvent bank can fail.

One place to get hold of extra cash is by borrowing it from other banks. Unfortunately, this summer, the markets in which one would borrow money from other banks seized up. Another place to get hold of extra cash is from the Bank of England. From the middle of the nineteenth century until 1997, the Bank of England adopted a broadly two-part approach to dealing with banking crises. If a bank were solvent, the Bank of England would lend it cash so that even if all of its depositors turned up at once it would never run out. Since the Bank of England was the supervisor of banks, it had intimate knowledge of whether they were solvent, and so could agree almost instantly to lend cash if it was necessary (the jargon for this is the "lender of last resort" function). On the other hand, if a bank were insolvent, or if though solvent its solvency might soon come into doubt, the Bank of England would organize a takeover, which would be presented as a fait accompli.

This system worked spectacularly well. Whilst banks in the US and in Europe often faced runs or solvency problems through the late nineteenth and twentieth centuries, UK banks never faced runs and only very rarely had solvency issues. There were two key reasons for this that we should emphasize: (1) Britain had a clear institution responsible and competent to provide lender of last resort, solvency, and takeover broking functions. This contrasted with, for example, the US case, in which prior to the creation of the Federal Reserve there was no clear central banking function at all, whilst in many other countries the presence of State-owned banks meant that the processes of solvency designation and takeover faced considerable political obstacles. (2) Next, in contrast to most other countries, the UK had virtually no deposit insurance. It is vital to understand why this was a positive gain for the UK. Because of the factors set out in (1), other countries found that they faced bank collapses whilst Britain never did. Because there was the possibility of bank collapse in these other countries (essentially impossible in Britain), they found it necessary to have a process of protecting depositors when banks did collapse. But matters could not stop there. If one does have deposit insurance, but does not have considerable additional invasive regulation, then the following happens (as was found in the US in the late 1970s):

  • Since depositors are insured by the deposit insurance scheme, they are clearly better to place their money where deposit rates (interest rates to savers) are higher, regardless of the business model of the bank concerned;
  • Banks with business models which offer potentially higher returns but also greater risk, can offer higher deposit rates than banks with lower risk business models;
  • Hence banks with risky business models will attract savings away from banks with lower-risk business models.
  • Consequently, banks with lower-risk models will face solvency problems (they will become unprofitable if they match the market deposit rate, but will find it hard to raise cash by attracting deposits if they do not match the market rate), and banking models will in general become riskier, leading to more risk of bank failure.

To alleviate these problems, countries with deposit insurance have two options. They can either impose caps on deposit rates — price regulation of saver interest rates. Or they can have invasive regulation of the lending activities of banks, to prevent them from engaging in risky activities.

The UK, with its superior lender-of-last-resort arrangements, has never needed deposit insurance, and hence has had limited use for limits on saver interest rates or highly intrusive regulation on the activities of banks, whilst at the same time has had a stable banking environment. This superior regulatory environment has been a key factor in maintaining the UK’s global role in financial services. The US model, for example, has long been regarded as markedly inferior — often people think of US regulation as less invasive than that in the UK, but in the case of banking this has not been so.

Gordon Brown chose to seriously undermine the first great strength of the UK approach. He divided up the supervision of banking solvency from the provision of lender-of-last-resort cash. This meant that there needed to be a protracted negotiation and checking process — checking with the FSA whether the institution was, in fact, solvent (and this is non-trivial, for of course the regulator has a considerable incentive to say that insolvent institutions are actually solvent, so as not to cause financial instability). Because of EU market abuse rules, this process needed to be disclosed to the market, in the name of "transparency" (something that was not required under the old and successful UK system). The Bank was also unable to broker a quick and secret takeover of a troubled bank, because of EU takeover rules. All of these changes were introduced by Gordon Brown and lauded as part of his economic reforms — for which he was very happy to take political credit when matters went well. It was well-known at the time that this was a potentially dangerous set of reforms (indeed, the then Governor of the Bank of England is believed to have considered resignation). But Gordon Brown did it nonetheless, and then boasted about it.

This system was then not allowed to work (as was easily predictable given its greater complexity and the greater political obstacles — another of the flaws in other countries’ arrangements that have been well-known). Even though the Bank of England could have leant cash to solvent institutions to guarantee that depositors would not suffer (the same applying to Alliance & Leicester and Bradford & Bingley as to Northern Rock), in practice politicians found it impossible not to become involved once a bank run was seen.

The Labour Party’s proposed response is now to introduce deposit insurance. But as we have seen, unless it is accompanied by intrusive additional regulation, this will increase banking instability (creating more insolvency) rather than reducing it.

So Labour’s reforms have already damaged our position as a global financial centre, potentially undermining one of the UK’s most important growth industries. And Labour’s response to its regulatory errors is to introduce more regulation, which will have the consequence of necessitating even more regulation after that. If this counts as economic competence, it’s hard to know what would count as incompetence.

So, Gordon, if you want to play "Whose economic competence is under question?", I say: Bring it on!

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