Risky lending should not have state insurance

Andrew Lilico
The Vickers Commission issues paper floats a number of options for structural reform of the banking sector. As expected, one such option is a strict division between retail and investment banks, and another is an even more radical switch to “narrow” or “limited purpose” banking, in which fractional reserve banking is simply ended.

What problem are these proposals attempting to address? No politician wants to be Argentine President Fernando De la Rua, forced to flee by helicopter from the roof of the presidential palace to escape a baying mob after the collapse of the banking system left depositors unable to access their funds. When banks come under pressure, the natural political tendency will be for politicians to bail them out, sparing bondholders. Even if banks are allowed to go under, depositors are typically provided with state insurance.

Since bank deposits are thus implicitly or explicitly insured by the state, what the bank does with those deposits is of virtually no concern to the depositors themselves, and (insofar as regulation allows it) the banks can therefore use deposits to take large risks. If all turns out well, the bankers and shareholders receive high returns. If matters turn out badly, then the state bails out the bondholders and depositors.

The retail/investment split is intended to limit this gaming of government insurance. But it doesn’t really address the problem, because banks can still make commercial loans to businesses or personal loans to households, both of which are risky. A retail/investment split would thus encourage banks to make really risky business or personal loans at high interest rates. The basic problem isn’t solved, but in the meantime we destroy an industry in which Britain is strong internationally — universal banking.

“Narrow banking” and “limited purpose banking” do address the problem, but go too far. With “narrow banks”, for example, deposit-taking banks would have to back any deposits 100 per cent with government bonds, ending “fractional reserve” banking. But fractional reserve banking has been the main form of banking in the UK for about two hundred years, and has become enormously sophisticated and successful. Furthermore, it is economically efficient to use fractional reserves.

Many commentators suggest that we should do neither of these things, but instead just rely upon high capital and liquidity ratios to stop banks ever going bust and hence the issue of bailouts ever arising. But company failure is an essential part of a healthy capitalist economy. If there is no risk of failure, there is not enough risk.

There is a combination of solutions that addresses the real problem without destroying our banking system.

The most important component of these is a change to the structure of deposit-taking, whereby every bank licensed to accept retail deposits must offer a “storage deposit” account that is 100 per cent backed by government bonds.

These accounts would be legally insulated from the rest of the bank, akin to the nesting of an old-fashioned savings bank (like the “trustee savings banks”) inside every fractional reserve bank. Storage deposits would be insured by the government without limit.

In addition, banks could offer “investment deposit” accounts — standard fractional reserve deposits that the bank could use to invest in commercial loans, equities, derivatives, or whatever else its business model employed. Investment deposits would be completely uninsured by the state — and depositors would be warned before moving monies out of storage and into investment deposits that they could lose their money — but would be subject to standard prudential regulations on capital and liquidity. Some banks would attract investment deposits by being boring and safe; others by being risky and offering higher interest rates. This structural reform addresses the core of the issue, removing state insurance from risky lending, and yet leaves universal banking (and fractional reserve banking in general) intact. I think that’s the way to go.

Andrew Lilico is the Chief Economist of Policy Exchange, and the author of “What Killed Capitalism” and “Incentivising Boring Banking”.