8 April 2024

How to fix British banking


Wherever one sits on the political spectrum, a priority since the bank bailouts of 2007-2009 has been to try to prevent that situation from arising again. One kind of approach to achieving that has revolved around restriction and oversight. Tough capital and liquidity requirements, combined with strong regulatory oversight of lending on bank balance sheets, seeks to minimise the risk of banks failing.

One obvious drawback of this approach is that it will inevitably limit growth. The size and complexity of a large bank’s balance sheet is not dissimilar to that of a small to medium-sized country’s economy. Quite literally, if regulatory oversight and prudential restrictions could produce capital allocations from banks that would optimise the balance between growth and economic stability, then central planning would be an ideal economic system.

This is, of course, recognised. So along with additional oversight and tougher prudential requirements, a number of specific structural regulations have also been introduced, to try to make it more feasible for banks to fail safely, without triggering bailouts. The most important of these include much higher levels of depositor insurance (up from £2,000 prior to 2007 to £85,000 today), deposit preference in respect of insured deposits (ranking them ahead of other bank debts in the event the bank fails) and the convertibility of bank debt into equity.

Some of these measures are improvements. Some, such as increased deposit insurance, are mistakes. But, either way, none of them addresses the ultimate issue, the basic contradiction at the heart of the financial system. And hence none can ultimately prevent a future widespread bailouts scenario.

The fundamental problem is this. A deposit in a modern bank is, by its nature (as in, this is what a ‘deposit’ is) a form of loan to the bank. The bank uses that loan to engage in fundamentally risk-taking activities (as in, that is what a ‘bank’ is). Regulators might limit the risks banks take, but that can only ever be a matter of degree. They cannot eliminate all risk (and neither should they try) without stopping them from being banks at all.

Yet a significant portion of deposits – probably upwards of 20%, maybe a much higher share – are not handed over to banks with the ambition of securing a return (least of all by taking some risk). Instead, the money is deposited into the bank in order to have somewhere to store it and in order to access the payments system. A classic example, frequently quoted, is the monies someone climbing the housing ladder receives when selling one house as part of a chain to purchase another. That money probably enters a bank account, but the receiver has no interest in receiving any return on it for the brief period it is there.

Similarly, imagine a company receiving payments from its customers and then paying the wages of its workers. It probably uses a bank account to manage that process. But it is unlikely that the firm has any real interest in receiving any return on those customer monies in the period between when they are received and when the wages are paid.

There are many such cases where the economic purpose of a bank deposit is not the making of a risk-taking loan in order to receive a return as a reward for that risk. Yet, ineluctably, that is what a deposit in a modern bank is. So when a bank fails – as, in any remotely efficient financial system, must happen from time to time – there is a sense of injustice for depositors that might lose out. (And note: the sums involved for the depositors we have mentioned will typically be far in excess of the £85,000 deposit insurance limit.) Governments respond to that sense of injustice by bailing the banks out to protect depositors. And so the disastrous cycle continues.

However, modern bank deposits are not the only kind of bank deposit there could be. Until the 1970s, there were two kinds of banks in operation in the UK. There were the banks we have now, which operate via ‘fractional reserves’, only ‘backing’ their deposits with matching cash or cash-equivalents such as short-term government bonds at a small fraction of those deposits’ total value (the vast majority of their assets instead being loans for houses, personal credit, business loans etc). These are, unsurprisingly, called ‘fractional reserve’ banks. But until the 1970s, there was also a second kind of bank, called a ‘savings bank’.

Savings bank deposits were 100% backed by cash, government bonds or gold (recall that historically sterling was tied to the gold standard, so gold would in that period have provided a certain amount of pounds). A deposit in a savings bank was thus not risk-taking. It was simply a matter of storage and access to whatever payment services that savings bank offered. Interest rates on deposits were of course very low (even less than government bond yields).

We could remove the current contradiction at the heart of the financial system by restoring savings bank deposits in the following form. We would still have fractional reserve banks as we do now (I am not proposing, as some people do, to ban all forms of deposit-taking other than in savings banks). But any bank licensed to receive deposits would have to have, nested and ring-fenced within itself, a savings bank. And whenever customers sought to make a deposit they would have to turn down making it in that savings bank in order to make it in the fractional reserve deposits.

That way, anyone that wanted simply to store funds could do so with complete safety and without any limit – in savings deposits. And all deposits in the fractional reserve part of banks would be deposits specifically chosen in order to secure a higher return at the expense of taking a little risk. So if the bank failed there would be no need of any material deposit insurance for those deposits at all, nor any particular public sense of injustice that would support bailing them out.

The banking reforms since 2008 have gone some way towards addressing the issue of bailouts, in some dimensions, though in other ways things have got worse (eg the big rise in deposit insurance thresholds). Yet the fundamental problem still remains and will not be resolved until we have a means by which depositors that just want to store money can do so, without limit, without risk, without insurance and without bailouts. At the same time, depositors that do want to take some risk can be permitted to do so, and get a commensurate return, without regulation curtailing that and without bailouts saving those depositors when their risk-taking turns bad. The system I propose would achieve both of those things.

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Andrew Lilico is Executive Director and Principal of Europe Economics

Columns are the author's own opinion and do not necessarily reflect the views of CapX.