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

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