Smaller banks, more competition


An editorial in the FT this week stated that:

The UK needs to set out a plan for selling off publicly owned shares, rolling back guarantees and reintroducing a competition regime under which banks get cut back if they are overdominant, and can be allowed to fail. During the panic, stability was the key aim of policy. For a time, banks had to be cosseted. But, as calm returns, so too must competition.

The need for more competition in the UK banking sector is one of the dominant themes which has emerged from my talking and listening to financial experts over the last few months. The primary motivation behind it is that banks should not be allowed to become 'too big to fail' in future, with all the moral hazard and systemic risk that carries with it. A more competitive market might also improve deals for consumers and encourage higher industry standards.

Of course, it might strike some people as not being very free-market to suggest that government policy should try to prevent businesses from growing too large. In many sectors, that might be the true: as long as it is possible for new competitors to enter the market, monopolies or oligopolies will not be able to get away with abusing their market position and offering consumers a bad deal. As such, government intervention would be unnecessary.

This argument may not apply to the banking sector, however. For starters, the regulatory barriers to market entry are extremely high, and make it hard for competitive forces to operate. It's also worth making the point that many big businesses would probably never emerge with a very basic legislative intervention in the market – limited liability incorporation laws. This means that supporters of the free market should not dismiss measures to promote competition out of hand.

The question remains though, how best to encourage smaller banks? This merits a more in-depth study, but the obvious place to start would be with the banks now majority-owned by the government. They should be broken up before being returned to the private sector. In the rest of the financial system, it might make sense to impose higher capital requirements and lower leverage ratios the larger a bank gets.