Here are six key structural reforms required for the banking sector.
- There must be two kinds of deposits offered by every bank licensed to accept retail deposits. One kind I call “storage deposits”. These are like deposits in an old savings bank (like the trustee savings banks). They must be 100% backed by gilts, and legally isolated from the other activities of the bank. These deposits are 100% guaranteed by the state, without limit, but pay only very modest (regulated) interest rates. The other kind of deposits are “investment deposits”. These can be used by the bank to invest in whatever its business model involves – commercial loans, mortgages, shares, derivatives, whatever. They are not (totally) insured by the state. They pay much higher interest rates. (You can read about this proposal in detail in the Policy Exchange research note Incentivising boring banking. Mervyn King is an advocate of this policy.)
- In the event a bank becomes distressed, and is placed into special administration, there must be quasi-automatic procedures whereby its bonds become converted into equity to recapitalise the bank. (You can read about this proposal in detail in the Policy Exchange report Bank Creditors, Moral Hazard and Systemic Risk Regulation. The European Commission is currently consulting on a version of this scheme.)
- Investment depositors must rank ahead of bondholders as claimants on the assets of a bank. (This point is explored in detail in both of the Policy Exchange reports referred to above.)
- Regulatory authorities and central banks must move away from guaranteeing the capital of investment depositors (i.e. from promising that depositors will not lose any money) to greater insurance of the liquidity of such depositors. Insurance of depositor capital achieves very little directly, for even in the US 1930s bank runs depositors typically recovered more than 80% of their money, but deposit insurance does not prevent bank runs (vide the run on RBS in late 2008, even though the British government clearly guaranteed 100% of all its deposits) because depositors are not primarily concerned with losing their money but, rather, with losing access to their money. In the 1930s many depositors did not have access to their deposit funds for more than two years whilst the firm was in administration, and by the time they recovered some money they had themselves defaulted on their mortgages on their homes and farms. It is access to money that is key. That is why I favour use of a deposit access fund – as explained, for example, in the Centre for Policy Studies pamphlet What killed capitalism? and also in both the Policy Exchange reports above.
- Central banks, regulatory authorities and treasuries must distinguish clearly in their minds and procedures between central bank liquidity provision to solvent institutions (which is not a form of bailout but, instead, an integral part of a system of banks and a central bank – which by nature have a symbiotic relationship) and treasury recapitalisation (which is nationalisation of the bank, and quite definitely is a bailout). As providers of liquidity, central banks must be prudential supervisors of the activities of banks – this justifies prudential oversight even of the activities of bank in respect of the use of investment deposits. (That point is explored in the Europe Economics report for the City of London, The Future of Banking Regulation.)
- There must be more competition in the bank sector, with greater ease of new entry. An integral part of new entry is that other players must be able to go bust. Otherwise a new entrant that is successful will tend undermine one of its competitors, that competitor will become distressed, the government will then bail it out, and so now the industry has one too many players for the long term, with the likely consequence being that the new entrant also becomes distressed – as a consequence of government support for its rival. No banking sector can be properly competitive without the possibility of firms going bust. It absolutely must not be the aspiration of policy that every bank should be so heavily capitalised that there is no chance it will ever go bust – the basic thrust of the banking regulation agenda of 2009-10. That is a deeply anti-competitive concept.