Financial World, 7th July 2010
There are separate issues which often get confused. The first is how to regulate banks so as to prevent the next financial crisis. The second is whether we should continue to subsidise banks and the third is how to make the banking industry competitive.
The data show that UK* and US** banking is an uncompetitive industry with returns on equity about three times greater than they would be if the industry was competitive. The lack of competition also shows in the industry’s concentration. The size of the average US commercial bank was stable, relative to GDP, from 1934 to 1994 but has since tripled, as has the proportion of bank assets held by the three largest banks. A similar concentration has occurred in the UK banking sector, with the largest bank having had assets equal to 50% of GDP in 2000 and 140% in 2007. ***
The size of banks impedes competition by restricting new entrants to the industry. The IMF has suggested that large financial institutions should be required to have higher equity to asset ratios. This would cancel out the advantage of size. Their equity ratios should be steadily raised over time, until banks split themselves up of their own accord.
As we have seen with the collapse of Lehman Brothers, large financial institutions are also a threat to economic stability and this threat would be greatly reduced if they were split up. Furthermore, a host of small businesses would be less likely to take excessive risk, because lenders would fear that they were no longer too big to fail and be less willing to lend to risky firms.
Taxpayers are currently providing huge subsidies to financial institutions. This is partly explicit, through the guarantees made to depositors. But there is also an implicit guarantee to other creditors who know they are too big to fail. We have at the moment the absurd situation that taxpayers are subsidising the activities of large banks, and thus aggravating the damage to the public interest that comes from the lack of competition in the industry and the consequent excessive returns. Breaking up banks will therefore have three benefits with regard to each of the three issues: (i) reducing “rent extraction” by an uncompetitive industry, (ii) reducing the way this is aggravated by the subsidy and (iii) reducing the risks that large financial institutions pose to the stability of the economy.
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* See Chart 4 of “Banking on The State.” by Piergiogio Alessandri & Andrew G. Haldane, Bank of England, November 2009.
** FDIC data.
*** The data on the concentration in UK banks are taken from The $100 Billion Question by Andrew G. Haldane, published by the Bank of England, March 2010.
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