Wednesday, March 16, 2011

What is the optimum size of the banking sector?

Those concerned with Basle III seem to be under the illusion that the optimum size is the maximum size that is consistent with a low chance of systemic collapse. Those holding this view have forgotten their basic economics.

The optimum size is actually the size that maximises GDP. And that will be obtained when there is fair competition between banks and the other sources of funding for borrowers. Plus there needs to be fair competition between commercial banks, when they seek capital, and other firms (in the non-bank sector) when THEY seek capital.

Walter Bagehot.

Surprising as it may seem, Walter Bagehot’s dictum that central banks should in emergencies lend on the basis of good collateral and at penalty rates does not meet the above criteria. Reasons are as follows.

First, the criterion “good collateral” is ridiculously vague, which makes it open to corruption. That is, thanks to the desire by politicians to kick cans down roads, and (at least in the US) to have bankers fund politician’s election campaigns, what “good collateral” and “penalty rates” actually translates into is “toxic collateral” and “near zero interest rates”. In effect this equals subsidies for commercial banks.
Moreover, even if commercial banks offer good collateral, my response, if I were a central bank governor, would be “OK, if the collateral is so good, why don’t you just sell it, and raise the cash you need that way?”

And the latter question is particularly apt, given that commercial banks, certainly during recessions, normally do not lend other than on the basis of collateral that can actually be sold for an amount that raises enough cash to cover the loan. For example about two thirds of mortgage deals in the UK currently require a deposit of at least 20% or so.

In short, if banks can borrow on the basis of so called “good” collateral which can’t, er, actually be sold for the amount it is supposedly worth, whey can’t everyone else? To repeat the point made above, unless there is a level playing field as between banks and everyone else, GDP will not be maximised.

Outlaw 100% mortgages?

It is clear from NINJA mortgages and the credit crunch in general that banks are incapable of fulfilling one of their central functions: distinguishing between credit worthy and non credit worthy customers. Either that, or they cannot be bothered making the distinction because they know the state will rescue them when they go belly up: an implicit subsidy.

We thus need some sort of simple rule which prevents banks making use of the latter subsidy. One possibility is to disallow money used from state backed deposit protected accounts for anything more than say 80% mortgages. Those wanting mortgages would still be free to seek 100% mortgages, but they’d have to get the remaining 20% from non state backed sources.

Reduced bank lending does no mean reduced GDP.

The objection raised ad nausiam by banks to any constraints on their activities is that this will reduce the amounts they lend and hence reduce “economic growth” or GDP. Politicians fall for this nonsense hook, line and sinker every time.
Clearly requiring banks compete on a level playing field with other firms WILL constrain bank’s activities, lending in particular. And without any compensatory measure, this WOULD reduce GDP.

However, what is to stop the government / central bank machine implementing stimulatory measures to make up for the reduced lending? Absolutely nothing!

The net effect would be more economic activity that had absolutely nothing to do with banks. For example more businesses would be funded by their owners, owners’ family and friends than by banks. Plus more firms would be funded by share issues than by bank loans. That is, the world can manage very nicely, thank you very much, with a much reduced banking sector.

Indeed bank assets and liabilities in the US and UK have expanded by a factor of about ten over the last fourty five years or so relative to GDP (see Haldane, Chart 1, p. 24). Yes, you read that right: TEN! And to what benefit? Economic growth has not improved as a result.

In fact economic growth (at least in the form of improved living standards in the UK over the last five years or so) has been next to non existent: that is, worse over the last five years or so than at any time since WWII.

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