From the TUC

Too Big to Fail Banks – The case for a Progressive Bank Levy

02 Jul 2012, by Guest in Economics

Last week I wrote about the case for a public inquiry into the banking sector (something the TUC has been calling for for three years now). The ideal model would be the US Pecora Commission of the 1930s which led to a system of financial regulation which, as Paul Krugman has argued, resulted in 50 years without a major US financial crisis.

It’s worth noting that a public inquiry isn’t a substitute for criminal prosecutions in the short to medium term, as in the case of Leveson criminal investigations can precede alongside a wide ranging inquiry.

Inspired by a weekend of rereading Sorkin’s ‘Too Big to Fail’, I’ve been thinking about the issue of Too Big to Fail (TBTF) banks – an area that any inquiry would have to look into and that got a load of attention around 2009/2010 but now seems to have faded from the world of day to day mainstream public policy debate.

One way to address the TBTF question would be to build on the Government’s existing Bank Levy by making it progressive.

As I see it, there are three primary challenges facing policy makers with regards to the banking sector.

  1.  How do we make sure banks support the real economy and the recovery?
  2. How we can we the banking system safer so that public money is not put at risk?
  3. How do we deal with excessive remuneration and bonuses?

There isn’t sadly a simple fix that deals with all three problems – although the TUC (and many others) are convinced of the need for a stronger Green Investment Bank and some form of State backed lending institution focussed on SME and infrastructure lending to address the first question.

The Vickers report was really mainly aimed at dealing with the second question and came out with some reasonable solutions, solutions that the government is now delaying implementation of.

The question of TBTF banks impacts on all three issues.

First though, some context. The Governor of the Bank of England set out the important facts about the growth of banks in a speech in October 2010. The top ten British banks in 1960 represented 69.0% of the banking sector and their combined total assets were equal to 40.0% of GDP. By 2010 the top ten banks represented 97.3% of the sector and their total assets stood at 459.0% of GDP. During those 5 decades Barclays’ assets, for example, grew from 10.0% of GDP to 110.0%.

The banking sector has become much bigger and it has become much more concentrated.

When Barclays assets have reached 110% of GDP it is almost inconceivable that it could ever be allowed to fail – the implications for the wider economy (and the rest of the financial system) would be catastrophic . The markets, knowing this, sense that Barclays will never be allowed to fail and hence the perceived credit risk of lending to it falls. In effect the implicit public backing lowers a large bank’s borrowing costs and gives it a competitive advantage over smaller competitors.

The size of this implicit public subsidy is disputed but recent work by the Bank of England puts the figure in the UK somewhere between £6bn and over £100bn annually – with the strong suggestion that is likely to be towards the higher end of this scale. As the paper concludes, “all measures point to significant transfers of resources from the government to the banking system.”     

Of course there may be other reasons why the banking system has become more contrasted over time – it may that larger banks are simply more efficient and hence in the language of economists enjoy economies of scale.

This can be disputed. And even if larger banks do ‘enjoy’ economies of scales there are still two important questions: 

  1. To what extent do the economies of scale come from lower borrowing costs through the public subsidy rather than through operational reasons?
  2. Who ‘enjoys’ the benefits of these return to scales? Customers, bank investors or bank employees? To what extent do we simply see ‘rent seeking’ behaviour from bankers?

Quite a bit of recent work has attempted to answer these questions. A study from the Wharton Business School (one of the top US business schools) noted that:

Market concentration results in slightly less favorable prices for customers, but has little effect on profitability.

A recent LSE paper found that: 

Applying this approach to annual data of US bank holding companies since 1990, we find much stronger evidence of economies of scale in returns to bankers as compared to returns to investors. The scale economies appear to be particularly strong in the top size decile of banks measured by total assets.

A paper from the St Louis Fed, despite being reasonable supportive of TBTF banks, argued that: 

Thus, our results indicate that while regulatory limits on the size of banks may be justified to ensure competitive markets or to limit the number of institutions deemed too-big-to-fail, such limits could impose significant resource costs on the industry.

Whilst former IMF chief economist Simon Johnson (who is very critical of the St Louis paper’s methodology)  has written that:

The central issue with regard to size that should be before the Financial Stability Oversight Council is not the presence or absence of economies of scale in banking generally – that is, whether a bank becomes more efficient as it increases from, say, $100 million to $100 billion in total assets. Rather, the pressing policy priority is how to assess what has happened to efficiency within our very largest banks (which now have assets of $1 trillion to $2.5 trillion) and the precise way that has benefited the broader economy (or not).

Taken together we have a picture of large banks that benefit from an implicit public subsidy and yet do not pass the benefits on to consumers, instead capturing the excess profits in the form of higher pay or profits.

The business lobby is certainly supportive of more competition in banking and see it as something which would boost lending. Hence the recent calls for this from the British Chambers of Commerce, the Federation of Small Businesses and the EEF (the manufacturers’ trade body).

Addressing the TBTF issue could therefore be seen as helping to answer all three key challenges for banks – it could improve the flow of credit, reduce the risk to taxpayers and it could reduce the ability of banks to extract excessive profits from the rest of the economy and therefore the problem of excessive pay in the sector.

One way to achieve some of these ends could be start with the government’s existing Bank Levy. This is currently charged on all bank liabilities over £2bn for each bank in the UK. The levy is already set at two different rates, with short term liabilities attracting a rate of 0.078% and long term liabilities charged at 0.039%. In effect the government is already using the tax system to incentivise banks to manage their balance sheets in a more desirable way – in this case by favouring long-term liabilities over short term ones.

To encourage banks to be smaller the levy could be made progressive with a lower rate for balance sheets of say, up to £100bn, a higher rate for balance sheets over £100bn, a further rate for balance sheets over £200bn, etc, etc.

This would firstly be a way of clawing back some of the public subsidy the sector already enjoys: the larger a bank is the greater the chance that is seen as TBTF and hence benefits from lower interest rates, therefore a higher Bank Levy be one way of recouping an existing subsidy.

In the medium term one impact of such a differentiated levy would be to encourage smaller banks. If this was combined with measures designed to encourage new entrants to the sector the overall impact could be a more competitive banking sector. A banking sector that would make fewer excessive profits, which would be more supportive of the real economy and would entail a lot less risk to taxpayers’ money in the future.

3 Responses to Too Big to Fail Banks – The case for a Progressive Bank Levy

  1. Per Kurowski
    Jul 8th 2012, 4:29 pm

    How to break up a too big to fail and too big to capitalize bank in hours!

  2. Miliband’s Banking Speech | ToUChstone blog: A public policy blog from the TUC
    Jul 9th 2012, 4:03 pm

    […] need for more competition, and related issue of ‘too big to fail banks’ (a topic I wrote about last week), is directly related to both the need to make banks safer and the need to ensure they do more to […]

  3. Why I welcome Ed Miliband’s speech on banking today | Liberal Conspiracy
    Jul 9th 2012, 5:42 pm

    […] need for more competition, and related issue of ‘too big to fail banks’ (a topic I wrote about last week), is directly related to both the need to make banks safer and the need to ensure they do more to […]