In Defence of Big Banks

In Defence of Big Banks

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My comment on the BBC's Newsnight programme that failures of big banks are very rare and that RBS was an "aberration" caused something of a storm. Some people said that they were "shocked and horrified" that I was "defending TBTF". Others complained about the behaviour of big banks in recent years. But I did not defend TBTF, and I did not defend the behaviour of banks. My comment was simply a statement of fact. Big banks fail very rarely. RBS's failure was the first failure of a big bank in the UK for over 100 years.

The UK has had large banks for a very long time. The mainstay of the UK banking system for over 100 years has been five (now four) large English banks and three Scottish banks. They are known as the "clearing banks", because they clear cheques and other payments. Other credit intermediaries rely on them for payment services. These banks have been directly supervised by the Bank of England for most of their history, with a brief interlude prior to the 2008 financial crisis when they were supervised by the FSA. Most people now regard that interlude as less than glorious.

Smaller banks in the UK tend to occupy several distinct niches. Building societies are mutually-owned banks that used to specialise in prime residential mortgage lending, although in recent years they have diversified into commercial lending, commercial real estate lending and subprime mortgage lending, with less than happy results. Merchant banks specialise in providing trade finance for exporters (hence the name). And savings banks are pure deposit-takers that invest only in safe assets. Only one independent savings bank now exists, and even that is not like the savings banks of old, since it now offers lending services to households and businesses. Very few independent merchant banks exist now either: most have been absorbed into investment banks or universal banks. And the building society sector is also far smaller than it was fifty years ago, due to demutualisation and consolidation. Consequently, it is perhaps fair to say that the clearing banks are more dominant in the UK's financial landscape than they used to be, and this may be to the detriment of customers who want a more personalised, local service. But the growing credit union sector is beginning to provide a realistic alternative for those who like small local banks, and the middle-tier banking sector, which had all but vanished after the financial crisis and the ensuing building society consolidation, looks set to expand with the entry of challengers into the market, notably (though not limited to) banks owned by large retailers. 

However, these small and medium-size banks depend on larger banks to provide essential payment services, deposit facilities and liquidity. When you open an account in a credit union, you are really banking with the large bank that underpins it.  "Move your money" doesn't actually move your money at all.

The UK also has a history of unregulated intermediaries doing bank-like things - and this has not always turned out well. During the 1960s, the absence of an effective system of bank licensing in the UK coupled with tight controls on credit creation by clearing banks and building societies encouraged the growth of unlicensed lenders. These "secondary" banks borrowed on the money markets, which were just developing, to fund residential mortgage lending at higher risk than building societies could offer at that time. By the time of the 1973 oil crisis, their balance sheets were highly leveraged and very risky. When the Treasury raised interest rates, sparking a swathe of mortgage defaults, the money markets, worried about potential losses, refused to roll over short-term lending. There was, in other words, a wholesale bank run on unregulated lenders due to a property market crash. Does this sound familiar? It should - it is exactly what happened in the US in 2007-8. We now call unregulated lenders "shadow banks".

Thirty of these "secondary banks" went belly up and a further thirty or so experienced severe funding distress. And the ensuing collapse of asset prices threatened the solvency of the clearing banks on which the secondary banks depended for payment services and liquidity. Note that although credit controls were lifted in 1971, the clearing banks themselves had not taken excessive risks: the excessive risks had built up over the best part of a decade in the secondary banks, which were never subject to credit controls. It is therefore simply incorrect to blame the 1973-5 Secondary Banking Crisis on the lifting of credit controls, as some do. The ultimate cause was the inadequate coverage of prudential regulation and supervision, and the proximate cause was the sudden tightening of monetary policy to control inflation after the 1973 oil price shock.

The wholesale bank run threatened to bring down the clearing banks because of the impact on the clearing system and the collapse of asset prices. The Bank of England therefore launched what it called the "Lifeboat", which provided liquidity support both to the clearing banks AND the secondary banks. I've explained elsewhere why providing liquidity support to clearing banks alone may not be sufficient to end a bank run: clearly in this case the Bank of England felt it was insufficient, just as the Fed did in 2008. The 1973-5 crisis was on a much smaller scale, but it played out in much the same way as the 2007-8 financial crisis. Interestingly, the principal clearing bank recipient of the Bank of England's exceptional liquidity support at that time was the National Westminster Bank....a portent of things to come, maybe?

There is a popular view - expressed, among others, by Iain Martin on Newsnight - that systemic crises are caused by big banks. Many people argue that if banks were smaller, they could be allowed to die without causing a systemic crisis. Individually, this is indeed the case: the death of a small bank such as Southsea causes barely a ripple, whereas the failure of a big bank such as RBS threatens the entire economy. By far the greatest number of bank failures in the financial crisis were among small US banks, hundreds of which failed between 2008-2011. However, these by themselves did not cause systemic problems, not least because the US's considerable experience of small bank failure means that it is very experienced at resolving them fast and efficiently. Small banks fail ALL THE TIME. The bank failure rate even in normal times is about 4% per annum, and the vast majority of these are small banks. In the UK, credit unions fail at about the rate of 1 per month.

But a number of small banks all failing together can do as much systemic damage as one large bank, and a "domino effect" failure of multiple small banks in the same market sector is actually much more common than a large bank failure. The Secondary Banking Crisis was the UK's first systemic banking crisis for over 100 years and it was caused by small unregulated banks, not by the large clearing banks. And it had serious economic effects. It caused a stock market crash in 1974 and was a contributory factor in the UK's poor economic performance for the rest of the 1970s.

The US has not been without its problems, either. The US has a long tradition of very small banks. Until relatively recently banks were prevented from growing by regulations outlawing branch and inter-state banking. The giant universal banks the US now has are a recent phenomenon, and cordially hated by much of the US population, which is - like much of the UK population - convinced that very large banks are the source of all problems in the financial system. But the facts do not support this view. Persistent runs on small banks in the Depression caused widespread failures that were a major contributory factor in the US's economic collapse: they were only stopped by FDR's famous "bank holiday" and the (re-)introduction of deposit insurance. But the US's love affair with small banks continued, despite the fact that over the border in Canada, where larger universal banks and branch banking prevailed, there had been no such problems with bank runs. To this day, many in the US believe that the bank runs were due to lack of deposit insurance, not the inherent riskiness of very small banks with no liquidity backstop - despite the fact that in New Zealand, which still has no deposit insurance scheme, bank runs are virtually unheard of. In the popular imagination, small banks are wholesome and good, and if they fail it is someone else's fault (usually the Fed or the Government).

But the US's problems with small banks didn't end with the introduction of deposit insurance. Far from it. The Savings & Loan crisis of the 1980s and 1990s was a crisis of small and medium-size deposit-takers and lenders - the equivalent of the UK's building societies - not of big banks. And although the US's disintermediated financial system now makes it more difficult to identify "banks", except the very large universal ones, arguably the financial crisis of 2008 was also a crisis of multiple small deposit-takers (money market funds) and lenders (mortgage originators and securitizers), which rippled out to bring down specialist banks such as Lehman and even a couple of badly-managed giant universal banks (RBS and UBS). Small financial institutions that do bank-like things but aren't regulated or supported like banks threaten the stability of the financial system far more than any big bank.

This brings me neatly to the current situation. Calls for the big banks to be broken up are, frankly, perverse. There is no evidence that systemic crises are caused by big banks, nor that big banks are more vulnerable to failure than other banks. On the contrary, the evidence appears to be that small unregulated lenders all failing together do more damage than anything else. But we aren't doing anything to ensure that small lenders are adequately regulated and diversified. Indeed, in the UK we seem to be intent on repeating the mistakes of the past.

Historically, the UK has always had a two-tier system of bank regulation: large banks regulated and supervised by the Bank of England, surrounded by a "shanty town" of smaller financial firms that are more lightly supervised and possibly not subject to prudential regulation at all. The 1987 Banking Act attempted to reduce it to a single tier, but unfortunately the result was proliferation of regulators by market sector instead. The FSA brought the regulatory smorgasbord back together, but unfortunately failed to regulate anything very effectively, partly due to the sheer extent of its remit and chronic understaffing, but also because of a prevalent view at the time that regulation wasn't really that important. Now, it seems we are busy re-creating the two-tier regulatory system. "Real" banks are regulated and supervised by the Prudential Regulatory Authority, which has a mandate to ensure that they do not put the financial system at risk. But things such as payday lenders and peer-to-peer lenders, that do bank-like things but aren't "real banks", are supervised by the FCA to ensure they don't rip off customers (!) but not by the PRA. This is presumably because it hasn't yet dawned on anyone that a lot of these things failing in a disorderly fashion could endanger the financial system just as much as the failure of a large PRA-regulated bank, because of the risks they pose for the large banks whose customers they are - and it is far more likely.

I repeat, small financial firms that are lightly regulated and supervised because they are thought not to be a danger are more often the cause of systemic crises than anything else. Particularly if they are involved in property lending, as they were in the UK's Secondary Banking Crisis, the US's Savings & Loan Crisis and the 2008 financial crisis. From Faisal Islam's book "The Default Line":

"What is the most dangerous toxic financial asset in the world?" This was the question put to me by the chief executive of a leading European bank. Anxious to display my superior knowledge of the darkest corners of the shadow banking system, I replied: "Credit default swaps on super-senior tranches of asset-backed, security-collateralised debt obligations". I thought I had come up with a pretty pithy answer. 

"No," he gently chided me. "The most dangerous financial product in the world," he paused a moment for effect, "is the mortgage". 

Charles Goodhart observed that of four financial crises in his lifetime, three were caused by property market collapses. I would add to that, that not one was caused by big banks. All of them were primarily caused by over-leveraged small lenders, unregulated, unsupervised and cut off from central bank support.

So yes, I defend big banks. They are more resilient and less likely to fail than other banks, because their balance sheets are sufficiently big and diversified to absorb shocks. As the Bank of England noted in 1996:

"....smaller less-diversified banks do appear — not surprisingly — to be generally more vulnerable to changes in market conditions than large banks which are diversified across a number of sectors and income sources."  

Yes, many big banks have behaved badly. But so have many smaller banks. In fact the 2008 crisis was arguably at least as much caused by bad behaviour in small firms than large ones. Size is not a predictor of behaviour.

I emphatically do NOT defend "too big to fail". I want to see bank resolution regimes put in place that will allow even the largest banks to fail safely. And I have suggested ways of protecting the most important parts of the financial system - the payments system, the central bank and the funding network - from the consequences of large bank failure. I accept completely that the presence in a country of banks whose balance sheets dwarf GDP can present a considerable risk to its economy, as Iceland and Cyprus have amply demonstrated. But let's not forget that the history of financial crises is generally one of SMALL bank failure, and bailouts of small banks for systemic reasons are far more common than bailouts of large banks. We have become so mesmerised by the possibility of meltdown from giant bank failure that we do not see the real danger, which is that once again we allow the growth of an unregulated, unsupervised small bank sector which will in due course cause yet another "unforeseeable" financial crisis.

Related reading:

The genesis of regulation - Bank of England

The Bank and the banks - Andrew Haldane, Bank of England (speech)

Deposit protection and bank failures in the UK - Bank of England (1996)

Why do we never learn? - Coppola Comment

Anatomy of a bank run - Coppola Comment

Why did FDR's bank holiday succeed? - NY Fed

Cleaning up the mess - Coppola Comment

The Default Line - Faisal Islam 

Making it Happen: Fred Goodwin, RBS and the Men who Blew Up the UK Economy - Iain Martin


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