The Bank is barking up the wrong tree

It is difficult to argue against the view that with assets about thirty times their capital in 2007, UK banks were under capitalised, but papers written at the Bank of England go far beyond making this point. David Miles, a member of the monetary policy committee, claims to have shown ‘that the amounts of equity capital that is …desirable for banks to hold is very much larger than banks have held in recent years…’. Mr Haldane, an executive director, sums up his paper: ‘the maximum efficient scale of banking could be relatively modest’.

Historically, the concentrated structure of the UK banking industry has served the country well. Reinhart and Rogoff in their study of banking crises report no UK banking crises at all between 1890 and 1974. During this period the US had four crises. It is important note that the UK economy encountered economic recessions, despite the absence of banking crises and UK banks having much higher levels of equity finance. Between 1974 and 1976 the secondary banking crises occurred in the UK and the Johnson Matthey Bank failed in 1984, the BCCI failed in 1991 and Barings in 1995. Only the secondary banking crisis was serious. An interesting feature of that crisis was the failure of small banks. Again in 2007/9 it was the demutualised building societies that collapsed and, in the case of Halifax, caused the failure of Lloyds.

Mr Miles assumes that banking crises are related to permanent falls in real national output. He then uses data on falls in national income for a sample of countries over the past 200 years to assess the chances of UK banking crises. Only the inclusion of countries such as Peru and Argentina, and data for the pre-1945 period, lead to forecasts of any major future UK banking crises.

The costs of crises are measured by the losses of output. For example, UK GDP fell by 3.3% between 2007 and 2010. Allowing for trend growth of the potential output of the economy, GDP was about 10% below trend in 2010. Miles assumes that some of the diminution in output will persist forever and so the aggregate losses of output are astronomic.

Effectively, Mr Miles still believes the expansion would have continued in the absence of the banking crisis. Another implicit assumption made by Mr Miles is that raising the equity capital of banks will remove the risks of recessions and the losses they cause. UK experience between 1890 and 1974 shows this is implausible. Increased equity capital will not convert banks to charities.

Mr Haldane shows the relationships between the size of banks and the volatility of their income. We are not told which banks are included or the countries in which they are based. Banks operate in different countries and specialise, and they cannot rapidly change the countries and businesses in which they operate. Without detailed information about the characteristics of the banks the analysis is arguably meaningless.

Mr Haldane believes that insights for the future organisation of UK banks can be drawn from Al Qaeda’s ‘systemicresilience’. Mr Haldane also quotes Austin Robinson’s statement: ‘Every increase in size beyond a point must involve a lengthening of the chain of authority… at some point increasing costs of co-ordination must exceed the declining economies.’ Edith Penrose changed the focus of debate to the rate of growth of firms. This is particularly important for banks. Johnson Matthey, the BCCI and RBS all failed after a period of explosive growth. Existing banks growing at moderate rates have balanced loan books and they also have the pick of customers.

Eliasson’s theories of experimentally organised economies provide further insights, from industrial organisation theory, on the structure of banking. UK banks experimented with high gearing and reliance on the wholesale money markets. The managers of banks have realised their mistakes and will avoid the same mistakes in the future.

The Bank’s proposals for substantial restructuring of the UK banking sector are based on flimsy evidence, questionable assumptions and without estimating the costs of transition. Financial services are for the UK economy the equivalent of Germany’s motor and machine tools industries. The top brass of the Bank should impose a check on their plans. Would German policy makers impose similar plans on their motor and machine tool industries in equivalent circumstances?