Mervyn King – "Of all the many ways of organising banking, the worst is the one we have today."

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Mervyn King presented himself several times as broadly in favour of radical redesigns of the banking system.

In his speech in New York in October 2010, Banking: from Bagehot to Basel, and back again the Governor of the Bank of England asked “What lessons can we draw from recent and current experience to update Bagehot’s vision of finance and central banking?”

*Bagehot wrote in Lombard Street – 1873 on the world of finance and banking and focuses particularly on issues in the management of financial crises.

Banking has changed since Bagehot’s time, not least in it’s size relative to GDP. For instance, in Bagehot’s time, and for nearly 100 years following, the size of the UK banking sector was equivalent to roughly 50% of GDP. Today, RBS, Barclays, and HSBC each have assets in excess of GDP. The expansion and contractions of these balance sheets clearly have vastly more significant effects than they did in the past, and the associated risks to the economy of bank failure are significant.

King opened by stating that At the heart of this crisis was the expansion and subsequent contraction of the balance sheet of the banking system.  For those unfamiliar with bank balance sheets, this is another way of saying that the crisis was caused by a massive rise and fall in the amount of money in the economy. We couldn’t agree more.

King went on to explain that in the time of Bagehot, he would be used to seeing banks with roughly £1 of reserves to every £6 of liabilities (bank deposits – the numbers in your bank account), and that prior to the recent crisis, the ratio was closer to £1 in every £50.

King goes on to detail how banks are very highly “leveraged” in this way, and therefore risky, and explains how the various complexities in modern finance, designed to allow banks to earn more and more profit by “manufacturing assets without limit”. He then goes on to explain that these complexities, and the involvement of other non-bank institutions (the “shadow” banking system) have led to a highly interconnected financial system, this has the effect of making it very hard to regulate the system by regulating individual institutions. The second important consequence is that, “when the financial system is seen as a whole, gross balance sheets are not restricted by the scale of the real economy and so banks were able to expand at a remarkable pace.”

This situation should not arise, whereby the productive economy, which in a debt-based monetary system must rely on banks for credit, must effectively subsidise the finance industry – who instead of lending to them go about expanding their balance sheets, devaluing the currency and eventually causing a financial crisis.

Mr King goes on to explain the theory of banking, and to explain the recent crisis in terms of a solvency crisis, rather than a crisis of liquidity  (that banks were not able to meet long term debts and that lending them some short term money wouldn’t cover their losses, or your money, it wasn’t just a “blip”)

An interesting point he raises later in the article is that “modern financiers are now invoking other dubious claims to resist reforms that might limit the public subsidies they have enjoyed in the past”, that “Some claim that reducing leverage and holding more equity capital would be expensive.”. His response to this is that, regarding reform, “The benefits to society, most obviously through greater financial stability, but also through factors such as higher tax revenue, are likely to swamp any change in the private costs faced by banks”

King goes on to explain that we must find a long-term solution, and that “Whatever solution is adopted, the aim must be to align private and social costs.” In other words, end the system where banks can ‘privatise the profits and socialise the losses’.

The new banking regulations, known as Basel III, in King’s own words, will not prevent another crisis for a number of reasons.  He goes on to suggest a number of ways in which they could be improved, and then claims that small adjustments to the Basel III framework are “unlikely to do the job perfectly” and asks “So, if we cannot rely solely on these types of measures, are there more fundamental directions in which we could move that would align costs and benefits more effectively?”

He suggests a number of potential other options:

  • Much higher levels of capital requirements, “several orders of magnitude” higher.
  • Limited Purpose banking, to “ensure that each pool of investments made by a bank is turned into a mutual fund with no maturity mismatch”
  • Another, more fundamental, example [of reform] would be to divorce the payment system from risky lending activity, that is to prevent fractional reserve banking (for example, as proposed by Fisher, 1936, Friedman, 1960, Tobin, 1987 and more recently by Kay, 2009).”

The implied suggestion from Mervyn King is that sticking with broadly the same system of banking is no longer going to work. These “radical reforms” are presented as being capable of potentially greater benefits to those who would use them, that is, the public. Coming from the person who has the top job at one of the most important central banks on the planet, this is an important sign that there is a real chance that systemic change could be around the corner.

In closing, King states that

“Ultimately, we need a system whereby the suppliers of funds to risky activities, whether intermediated via banks or any other entity, must understand that they will not be protected from loss by taxpayer bailouts. Creditors should know that they will bear losses in the event of failure.”

“Of all the many ways of organising banking, the worst is the one we have today.”

“A market economy has proved to be the most reliable means for a society to expand its standard of living. But ever since the Industrial Revolution we have not cracked the problem of how to ensure a more stable banking system”

And that finally….

Change is, I believe, inevitable. The question is only whether we can think our way through to a better outcome before the next generation is damaged by a future and bigger crisis. This crisis has already left a legacy of debt to the next generation. We must not leave them the legacy of a fragile banking system too.”

King decides that it is not for him to suggest a solution (although the implication is that radical reforms present a better route to long term stability, and he’s left some pretty big hints about his own preferred solution) and that this is the job for the Independent Commission on Banking. They are one of our prime targets. It would certainly be worth familiarising yourself with the activities of this Commission, they are likely to prove instrumental in the reform of the financial sector, and by proxy, the direction we take as a society in the 21st Century. Crises often bring about radical changes in societies, and provoke ambitious reforms. We must see to it as concerned citizens that our crisis results in a system of banking that serves those who use it, and not only those who operate it.

Robert Peston’s analysis can be found here

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  • http://None Bill Clarke

    If commercial can create money to lend to borrowers why can’t they create enough to solve their liquidity problems? – by which I mean that they do not have enough reserves to meet their debts from borrowing.

    Is it that in the case of lending to the general public they secure collateral in the case of default but there is no collateral if they create money to fund themselves?


  • Simon Dixon

    This is such a key speech for Monetary Reform.

    Thanks for a great summary Ben.

    It seems that more and more people are starting to see the need for monetary reform.

    Keep up the good work.


  • Conrad Jones

    “Moral Hazard”

    If The Bank of England continues to guarantee a Bank’s losses with tax payers money (or purchasing power from savings), then the next crisis will be upon us sooner than we might expect.

    There is only incentive for a Bank to take greater risks with this kind of environment.

    Imagine Car Insurance issued at a flat rate to everbody and that didn’t change even if a person had several accidents a week.
    We could take as many risks as we like and somebody else would end up paying for the damage. The roads would be very dangerous.

    We need to protect the responsible Banks and Building Societies by not bailing out the irresponsible risk takers. We also seem to have a lack of competition in the Banking sector which is reducing the number of players on an almost yearly basis. Why?

    I envisage a World where you will be walking down the High Street and instead of seeing: Barclays, HSBC, Nationwide, Halifax, Santander etc, there will only be ONE Bank that everyone will have to have an account with. ONE option, the name will be just “The Bank”.

    This “Crisis” has accelerated the process of bigger Banks taking over smaller ones. It was a tactic used by JP Morgan in the early 1900’s.

    How can we have any faith in a Central Bank that provides solutions that will accelerate a centralist form of Banking. A banking system that was “too big to fail” before the Crisis is now even more “Too big to fail” with the smaller Building Societies being swallowed up by a few bigger Banks. Their losses now Guaranteed by tax payers and reduced choice with savings rates below even the rate of the CPI-Lie, unless putting our savings into a 5 year Bond.

    When Deflation arrives – savers will be attacked again for taking their money out of the system and stimulating a Depression which will instigate more Quatitative Easing.

    I do not believe we need to reform the Banks – we just need to stop having our purchasing power stolen by bailing them out. And pass a law that states that Fractional Reserve Banking is equivalent to counterfeiting.

  • Conrad Jones

    Mervyn King (Bank of England) has said “Of all the many ways of organising banking, the worst is the one we have today.”

    He also said – reported in the Telegraph:
    “I think that banks themselves have come to realise in the recent crisis that they are paying the price themselves for having designed compensation packages which provide incentives that are not, in the long run, in the interests of the banks themselves and I would like to think that would change.”

    Point 1: The Banks are not paying the price – taxpayers are, as “Quantitative Easing” (printing money) will cause Inflation which will steal purchasing power
    from peoples savings and their children’s and grandchildren’s savings.
    Point 2: If Mervyn King doesn’t like Fractional Reserve Banking (which is especially inflationary during the “Good” times), why doesn’t he and the Government pass laws against it.
    Point 3: By handing over £200 billion to failed Banks, they are encouraging the existing system to be even more unstable through Moral Hazard.

    “Moral hazard occurs when a party insulated from risk behaves differently than it would behave if it were fully exposed to the risk.”

    [I don’t believe that Private Banks should be held responsible for the Government (with the Bank of England) giving them taxpayers money. A private bank is just like a business and shouldn’t be bailed out – this is the only way to be fair to the Banks that do operate responsibly.]

    If there was a way of voting against this policy I would. Some democracy we have.

  • Conrad Jones


    A Driving Analogy …

    What we have: is a Driver who’s steering column has a massive Air Bag (A big cosy soft one) – so that when he hits anything on the road – the Air Bag will immediately blow out and protect him – however reckless his driving is.

    What we need: is a Large stainless steel spike bolted at 90 degrees to the surface of the steering wheel and aimed directly at the Driver’s face. This would reduce reckless activity.

    The “Stainless Steel Spike” is equivalent to the Bank of England refusing to Bail out ANY Financial Institution – no matter what.

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  • stojan nenadovic

    Noncredit money is proposed by Biagio Bosossone, former executive director of World Bank and IMF. Noncredit money is positive money in fact. Noncredit money as a gift is the only real money. Noncredit money as a gift whose cost is zero can measure and buy real costs and real prices. Credit money whose cost is debt cannot measure and buy real costs and real prices. Credit money as a debt transforms real costs and real prices in nominal costs and nominal prices.
    Nominal cost (price) = real cost (price) + debt.
    Credit money as a debt is never sufficient. Therefore inflation and economic crisis. Noncredit money as a gift is ever sufficient. Without inflation and economic crisis.
    Noncredit money is the necessary additional quantity of money in circulation (currency = dM) as a percentage (k) of existing quantity of money in circulation (currency = M).
    dM = kM ; k = (supply – demand)/demand ; k = 5% e.g.
    If noncredit money is emitted according to the cited formula, inflation cannot exist. Taxes and debts are annulled for the amount of noncredit money. The consumers pay less and producers get more than today, in the order of credit money. All get the gift from noncredit money. The source of noncredit money is the growth of economic rationality. Noncredit money monetizes progress of mankind. There is both national and world noncredit money. We must create both national and world order of noncredit money.
    Noncredit money demands new system of national accounts. They are:
    (P/C)P = I ; P = GDP ; C = COST ; I = INCOME ;
    INCOME = income from costs + income from noncredit money ;

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  • Jim Miller

    The Banksters lied to us (at least once), Sham on them. The Banksters are lying to us now, sham on us if we believe them.

    When the Banksters cancel all of the sovereign debt against all nations, then I’ll give some credence to what they say.
    Jim Miller

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