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Work and prosperity
31 July 2013

Banks would behave better if more of their own money was at risk

Two weeks ago the Deep End featured John Lancaster on the PPI mis-selling scandal. In a new article for the London Review of Books, he adds a twist to the tale:

  • “In their response to last year’s budget, the OBR included a modest boost to ‘household consumption growth’, i.e. people spending money, thanks to the effect of PPI repayments. The OBR’s assessment of Osborne’s other policies showed no effect on household consumption growth. So the OBR reckons that the PPI repayments have done more to help the economy than all the other stuff the chancellor is trying to do put together!”

Things have moved on since, as demonstrated by the latest GDP figures. Still it is extraordinary that  before the start of this recovery (if that is what it proves to be), PPI fines were a significant source of growth –  “a boost of 0.2 per cent to GDP” according to one estimate. Lancaster notes the irony:

  • “That’s really amazing. The banks are so bad at their primary function, lending money, that it’s better for the economy if they pay billions of pounds in fines to the customers they ripped off.”

This Government, unlike its predecessor, has not been slow in reforming our deeply dysfunctional banks; but, while acknowledging what has been done so far, Lancaster argues that the culture of banking is so rotten that the very fundamentals of the system have to change: 

  • “One of the four biggest UK banks literally had a priest in charge… [Yet] it was while the Anglican minister was running things that HSBC undertook criminal actions which led to a fine of $1.9 billion… There’s no reason to think that an emphasis on ethical banking, from the head of the company down to the troops, is likely to have any effect.”

The argument here is that banks are just too big and complicated to allow top-down management – however saintly – ensure good practice. Something more pervasive is therefore required:

  • “What would be the simplest, crudest and most reliable way of making the banks safe?”

Drawing upon the work of Anat Admati and Martin Hellwegg, Lancaster’s answer is that the banks should carry more equity – meaning that their assets should exceed their liabilities by a greater margin than is currently the case. This would have an obvious cushioning effect against insolvency, but even more importantly it would bring about cultural change:

  • “There are a number of reasons why banks dislike the focus on equity, but the main one is that it reduces their ability to gamble with other people’s money. It is much more efficient, in financial terms, to borrow money on the liability side of the balance sheet, and bet it on the asset side, and keep the profits for yourself. If the bets go wrong, most of the money you lose is somebody else’s and then – if you’re a bank – you get a bailout and are back in business. If you have higher levels of equity, however, more of your own money is at risk. You can lend as much: it’s just that you’re lending it at your own risk.” 

Would higher equity requirements mean less lending – for instance, to small businesses? Lancaster believes not, because loans to customers are on the asset side of a bank’s balance sheet. However, the banks still need to find the money they lend out. So, if they can’t borrow as much (loans to banks being on the liability side) then they need to attract more equity investment and/or reduce their running costs. The most obvious way of achieving the latter is to cut salaries and bonuses.

No wonder the bankers aren’t so keen.


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