By Charles Goodhart
It is remarkable how powerful a well-turned phrase can be. There have been many such phrases generated in the course of this crisis, not all of them helpful, indeed in some cases misleading. Examples are: ‘Toxic assets’; ‘If a bank is too big to fail, it is too big’; and particularly relevant here: ‘Banks have become a combination of a casino and a utility.’ While I congratulate John Kay on his authorship of this last, arresting phrase, I am afraid that it is both misleading and wrong-headed.
To begin with, it is generally accepted that the greatest error of recent policy was to allow Lehman Brothers to fail. If ever there was a bank that would be characterised, under John’s category, as a casino rather than a utility, it would be Lehman. Presumably John would also have been keen to have Bear Stearns, Fannie Mae and Freddie Mac, and also AIG, declared bankrupt. None held retail deposits or was much involved in the standard payment system. That, of course, would have been a blood bath.
The proponents of narrow banking focus, almost entirely, on the liability side of banks’ balance sheets, and their concern relates to the need to protect retail depositors and the payments system. While this concern is entirely valid, it has been notable in the recent crisis that virtually no retail depositors lost anything, and the payment systems continued at all times to work perfectly. The crisis was not much about that, and policies served to protect these key elements satisfactorily.
The key problem that developed, and to some large extent remains, is that the fragility was experienced in the availability of credit to the real economy, companies and households. The modern economy cannot do without credit, and the need to maintain credit flows has been uppermost in the minds of the authorities. The narrow banking proposal would shift virtually all such credit flows out of narrow banking into those parts of the financial system outside the narrow banking boundary, because the narrow banks would be required to invest in safe assets. So had a narrow banking system been in place, the crisis would have been even worse, with a virtually complete cessation of credit flows to the real economy.
This consideration leads on to the generic failure of the narrow banking proposal. The tougher regulations involved, and the greater regulatory burdens, will mean that the narrow banks inside the protected boundary will only be able to provide a lower return on deposits and worse financial services than those outside the boundary. So, during normal economic conditions there will be an incentive for savers and depositors to put their money with the unprotected, but higher yielding, institutions beyond the boundary. The narrow banks will, for the most part, wither on the vine, just as the narrow banks that were once established in the UK, such as the Post Office Savings Bank and the Trustee Savings Banks, your archetypal narrow banks, withered in comparison with commercial banks.
Of course, when there is a crisis the savers and depositors who shifted towards the higher-yielding institutions will come rushing back either to cash or to the protected sector. But that will just worsen the pro-cyclicality of the whole system by encouraging pro-cyclical fluctuations across the boundary as the economy moves from good times to bad. All this was set out, I hope clearly, in my paper on ‘The Boundary Problem‘, which was published in the National Institute Economic Review last year, and again as an Appendix to the Geneva Report on ‘The Fundamental Principles of Financial Regulation‘.
There are at least two major problems that John Kay, and the other proponents of narrow banking, have failed to consider. The first is that the maintenance of credit flows is as central to a well-functioning modern economy as the protection of depositors and the payments system. The second is that the existence of the boundary problem will mean that the narrow banking proposal generates more pro-cyclical crises rather than fewer.
Charles Goodhart is Professor Emeritus of Banking and Finance at the London School of Economics.
