ICB Interim Report – the wrong answer to the wrong question

The fundamental problem in the banking sector is that bank creditors are not exposed to risk of loss. Who are the bank creditors? There are two key sorts: bondholders and depositors. So any useful reform of the banking sector must aspire to increase the risk of loss for (decrease the temptation for the government to bail out) these two classes of bank creditors.

The ICB Interim Report solutions are focused in precisely the opposite direction. They make it more likely that depositors and bondholders in the retail divisions of banks be bailed out by the government. The concept of separating retail and investment banking activities is that the retail unit can be bailed out by the government without also having to bail out the investment banking unit. But we don’t want to bail out the retail unit! We want the retail unit to be able to go bust like other businesses!

Furthermore, by isolating the retail activities of banks we increase the damage incentives to excessive risk-taking by banks – incentives created by bailout promises – cause to the real economy. Retail banking is (like almost all business) an intrinsically risky activity. Banks make loans to businesses and for mortgages and for personal loans, some of which will go bad and some of which are riskier than others. If the creditors of retail divisions of banks are guaranteed by the state (which is made more certain by the ICB proposals) then the banks will seek to engage in riskier retail activities – they will want to lend to riskier businesses, for riskier mortgages, for riskier personal loans. That will all look rosy in the boom times when it means more rapid growth, but then busts will be larger – we increase macroeconomic volatility.

The ICB hopes to shield retail units of banks from the larger losses on retail activities implied by this by requiring them to hold very high levels of capital. But it simply isn’t feasible to make them hold so much capital that no retail unit of a bank will ever go bust, and if it were possible to do it would be a terrible idea. Raising capital requirements for retail units is an expensive illusion – a cosmetic exercise to pretend that retail banks are unable to go bust when it isn’t true, which will cost banks an enormous amount in terms of expensive capital-raising.

That’s not to say there is nothing in the report to be commended. Bail-ins, whereby bondholders have semi-automatic conversion of their debt into equity when a bank becomes distressed – precisely what I and others called for in late 2008 instead of taxpayer recapitalisations – are usefully (albeit sometimes confusedly) discussed. And the competition sections will bear further reflection.

But the central proposal is just the wrong answer to the wrong question.

Member of Advisory Council

Dr Andrew Lilico is a Fellow of the Institute of Economic Affairs and Chairman of the IEA/Sunday Times Monetary Policy Committee.  Andrew also acts as Executive Director and Principal of Europe Economics.  He is a frequent contributor in the UK and international media on economic and financial matters, appearing on programmes such as Newsnight, the Today Programme, Sky News, CNBC and Bloomberg. Andrew received his first degree from St. John’s College, Oxford, and his PhD from University College, London, where he also lectured in macroeconomics and in monetary theory.  

2 thoughts on “ICB Interim Report – the wrong answer to the wrong question”

  1. Posted 11/04/2011 at 10:19 | Permalink

    Very good points and their approach runs directly counter to the other objective of creating competition. Disappointing that, despite a big speech from Vickers, there was no proper mention of the tax bias against equity capital. I think that the best argument for subsidiarisation is probably only for those banks that cannot demonstrate how they can be wound up – in other words, subsidiarisation is to assist the process of winding up and not to prevent the failure of one or other bit of the bank.

  2. Posted 11/04/2011 at 12:10 | Permalink

    It’s a shame the Commission didn’t give more attention to the problems created by deposit insurance and how it could be phased out. Unfortunately EU legislation now mandates retail deposit insurance, which is further evidence of policy going in the wrong direction.

Comments are closed.