Banking regulation upside down


In her speech to a Banking Summit on 25th May, 2011, convened by the new economics foundation and Compass, Professor Chick reviewed the report of the Independent Banking Commission. She noted that "the state's responsibility to provide the country's money has been franchised out to private sector institutions.. bank-created money is a franchised product... It is this that gives the state the right, indeed the obligation, to regulate banks. In the era of well-regulated banks, their performing loans were the foundation of our money. Those loans performed because they supported productive activity and investment and could be paid back out of profits. It is quite impossible to say what the foundation of our money is now, except that we know that, for the most part, it is not based on the real economy.

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Reading the Interim Report of the Independent Banking Commission (IBC), I felt I was in a topsy-turvy world. Traditional analysis of bank regulation looks first at the smaller problems - those which are earliest to appear and lead to the more serious problems - and then moves on to the more catastrophic situations. And it privileges prevention over cure. Thus liquidity is addressed before solvency, and discussions of bankruptcy and ‘resolution’ rarely appear. The whole idea is to construct a banking system sufficiently robust to avoid failure and resolution. By contrast, the Report emphasises the avoidance of government bail-outs and constructing rules to deal with bank failures in an orderly fashion. Capital adequacy also receives considerable attention and would have received more if it were not for the Basle Committee on Banking Supervision having done most of the work already. Liquidity is given half a page.


Even more depressing than the Report’s orientation towards regulation for failure is the fact that the orientation might be explained by the evolution of banking itself. The last major positive change in bank regulation, Basel I, in 1988, concentrated on capital adequacy and said nothing about liquidity. I argued (Chick 2008) that one reason for this was that banks in the advanced countries had, where regulation allowed, reduced their holdings of liquid assets to virtually nothing. (Britain led the way in this.) Thus solvency became the front-line problem; liquidity was ignored because there was nothing left to regulate. If the same logic applied here, the IBC’s concentration on resolution suggests a pessimistic view of long-term bank solvency.

Basel I proposed adequate capital against risky assets as the way to prevent insolvency. Unfortunately, the law of unintended consequences kicked in, big-time: rather than encouraging the banks to keep a greater proportion of less-risky assets, as was the intention, the banks took up an innovation already in use in the USA and got their risky assets off their balance sheets by securitisation. This was the worst thing that could possibly befall our banks, for they moved from being institutions which evaluated potential borrowers’ ability to repay and monitored their debt service to ‘originating’ institutions which, because the loan would be securitised and sold off, had no responsibility for the quality of their loans. No wonder they made ‘ninja’ loans and all the other horrors that the world at large only learned about when it all fell apart. These loans were sold to ‘the market’ in the form of securities so complex that the original collateral was almost impossible to trace, and no one seemed to care, relying on the ratings instead.

Perhaps the most striking thing about the Report is that the words used to describe this new business model, ‘originate and distribute’, do not appear at all. Securitisation is discussed only in the context of improving the transparency of the markets on which CDOs and their like are traded. Nor is there any mention of the herd behaviour which made all banks adopt the originate and distribute model and expand aggressively on the basis of leverage. Surely the first criterion of ‘good banking’ is that bankers take responsibility for what they do. This will require not only a split between retail and investment banking (I would favour something stronger than the ‘Chinese walls’ Vickers advocates) but a return to the retail banks keeping their loans on their books – an end, that is, to securitisation, at least on the part of retail banks. This will entail a massive change in banking culture and a shrinking of their balance sheets, and I have no idea how they can be persuaded to do it, but I think that unless it can be done, our banks will remain unsafe beyond their traditional structural fragility.

The stability of banks is important beyond their role as businesses and employers. Their liabilities are money. It is an oddity of monetary theory in this country that the question of who is responsible for the money supply has never been debated, not even by the Banking and Currency Schools (they debated whether deposits should be acknowledged as money, rather than who should be responsible for the supply of money). At one time, money was unquestionably the responsibility of the State, but very gradually the success of many banks in maintaining their promise to convert deposits into cash on demand at par led to cash and deposits being seen as interchangeable. This process was not without failures. But in the early days, deposits mainly represented the savings of the well-off. Depositors in failed banks were viewed simply as losing an investment; it was a private matter. Once the Bank of England undertook a protective role, however, the relation between the banks and the monetary authorities altered: all monetary policy – regulation, supervision, interest rate policy, deposit insurance, lender-of-last-resort operations, the lot – all have the purpose of maintaining the banks’ ability to meet their promise to convert from deposits to cash on demand and at par. What this means is that the state’s responsibility to provide the country’s money has been franchised out to private sector institutions. (Until 1946, the Bank of England was also private.) But now, deposits are not a rich person’s investment: nearly all incomes are paid through the banking system, and deposits are held by almost everyone. They are the bulk of the country’s money, and they are created when banks expand their balance sheets by lending and by acquiring assets (a fundamental point of banking theory which the IBC (see p. 16) does not understand; they should read Keynes, Treatise on Money Vol. 1, Ch. 2).

But as long as everything is done to maintain par value between cash and deposits, bank-created money is a franchised product. It is this that gives the state the right, indeed the obligation, to regulate banks, and this includes bailing them out when they have not monitored their franchisees effectively. In the era of well-regulated banks, their performing loans were the foundation of our money. Those loans performed because they supported productive activity and investment and could be paid back out of profits. It is quite impossible to say what the foundation of our money is now, except that we know that, for the most part, it is not based on the real economy.

If this present government really believes its free-market rhetoric, it should make it plain that bank deposits are a risky investment like any other and dismantle all monetary policy. Cheques and transfers would soon start trading at varying discounts, as in the so-called wildcat banking period in the USA. As long as the authorities act to protect par value, bank money is a franchise and the responsibility of the franchisor, shirked in this country in stages since Competition and Credit Control in 1971, must now be accepted.

The IBC proposes relying on competition and potential failure as market disciplines, with capital adequacy controls being the only non-market regulation taken seriously. The fundamental questions of a banking system’s role in the economy and of its position as creators of our money are never addressed. A depressing document!



Chick, V. (2008) Could the crisis at Northern Rock have been predicted?: An evolutionary approach, Contributions to Political Economy, July; 27: 115-24. doi: 10.1093/cpe/bzn007. ijkey=mxBAH3yM45yVzel&keytype=ref