Neither one thing nor the other


The FT reports that Sir John Vickers, the chairman of the Independent Commission on Banking, has admitted to the Treasury select committee that the commission’s proposed reforms “might not prevent more failures or free the taxpayer from providing support to the sector.” He is absolutely right, and that’s why the commission’s proposals are somewhat deficient.

As I’ve written before, by far the most pressing task facing financial reformers is to reintroduce proper market discipline into the banking. Bank executives need to know, beyond any doubt, that they won’t be bailed out if they make bad business decisions. Bondholders – that is, people or institutions who lend money to banks – need to know that their investment isn’t risk free. Even savers and depositors need to realise that their money is only as safe as the bank holding it is sensible.

Such market discipline would do far more for financial stability than any amount of regulation and enlightened ‘supervision’ – with all the information and incentive problems that brings with it – ever could.

But some people say this is just pie-in-the-sky stuff. They argue that while – yes – a real free market in banking might work, that’s just not something we’re ever going to have. Democracy, they say, means that banks are always inevitably going to be bailed out. At the very least depositors (and probably bondholders too) are going to receive full or partial government protection. In other words, they say that you just can’t possibly eliminate the risk subsidy that government gives the banks, and which inclines the financial system towards instability.

I hope this isn’t the case, but if it is, it probably suggests a far more radical regulatory approach than the Independent Commission on Banking has considered. It might even point in the direction of ‘narrow’ or ‘limited purpose’ banking, which would involve imposing strict structural divisions in the finance industry, and require banks to hold dramatically higher levels of liquid reserves. Bank of England governor Mervyn King has nodded in this direction.

Of course, I’d much prefer the free market option, but the trouble with the Independent Commission on Banking’s proposals is – arguably – that they do neither one thing nor the other. They don’t eliminate moral hazard and risk subsidies or restore real market discipline to the financial sector. But they don’t offer a particularly strong regulatory response either. As such, the banking sector is liable to cause more problems in future.