An eventful week for banking...

Did you notice what an eventful week it has been for banking and finance?!

It began with Sir John Vickers' speech last Saturday at the London Business School, which outlined the current thinking of the Independent Commission on Banking (ICB). It was a level-headed review of the problems and possible solutions, which posed many questions. Sir John went further than most of the bodies currently addressing the problems in finance by being open to the idea of separating the activities of banks, in aim to protect the ordinary retail banker from risky investments. In response, some banks (big effort by Barclays) argued that there was no evidence that splitting up the banks would reduce risk. RBS estimated that such measures would cut their profits by up to £4.8bn a year. On the other hand, George Mathewson (ex- RBS CEO) told the ICB that they really should consider breaking up RBS and Lloyds to promote competition. Meanwhile, on Monday Project Merlin - negotiations designed to cut bankers bonuses - failed (thank goodness). Oh, and I interviewed Sir John!

I'm not allowed to share our conversation yet ... but let's consider what he said in his speech in London. You can read it in full here. (I can tell you that Vickers has the most adorable dog named Alfie and, as warden of All Soul's College, resides in a classic English home that reminded me of Jane's and Michael's in Mary Poppins.)  

There are three main tools that the ICB consider useful in increasing stability in the banking system: 1) Increasing capital requirements, 2) Creating resolution mechanisms, and 3) Separating or 'ring fencing' certain bank activities. There are many open questions as to how each would work, but I shan't go into that. 

The most significant insight for me has been that the ICB does not believe that, in our world and within the remit of UK-only regulation and reform, crises can or should be eliminated. This is because they believe that there is a trade-off between reducing risk and encouraging economic activity. For example, if you increased capital requirements a bank would not be able to lend as much, and so there would be fewer borrowers spending money in the economy. They also think that risk is an inherent part of the financial system: channelling savings into investment opportunities will always carry some risk (entrepreneurial projects, mortgages and pensions all involve some risk).  As a result the ICB only expects to reduce the impact and frequency of financial crises. I want to look into this trade off more... How do you measure the benefits and costs of reduced borrowing? Apparently Professor David Miles (one of the roundtable participants!) is doing work on this at the moment. I know there are many 'radicals' who believe both that the reduced economic activity is a price well worth paying to create financial stability because a lot of economic activity is in fact be harmful.

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Let me tell you about my impression of Project Merlin. It was an initiative set up by the coalition which aimed to 1) shrink banker's bonuses, 2) let the public know who were the highest paid bankers, and 3) increase lending from banks to businesses.  I say 'thank goodness' that negotiations broke down on Monday because in return for these short term sacrifices from the banking sector, the coalition was willing to reduce the future threat of taxes and regulation - long term actions that could actually make the financial system more resilient.

Specifically, the banks were asking for a "level playing field" with other big financial centres across the globe. After Sir John's speech on Saturday, however, it seems hopeful that the ICB will be considering much more than how well the banks can compete globally, which will affect their profits and bonuses.

The Great British Experiment

George Osborne and Tim Geithner's speeches, received yesterday at the World Economic Forum, remind us that the coalition's deficit reducing policy is not universally shared.

As Chancellor of the Exchequer and US Treasury Secretary, both Osborne and Geithner took their turn on the stand as an opportunity to defend their country's economic policy. Osborne was first up, declaring that "Those who argue that dealing with our deficit and promoting growth are somehow alternatives are wrong. You cannot put off the first in order to promote the second." After which, Geithner commented that rapid cuts in the US would jeopardise the US economic growth and long term financial health too. (The amount by which Obama recently committed to reduce the deficit is meager.) Although Geithner did not explicitly challenge Osborne - now that would have been interesting! - their different approaches are striking.

Is there any evidence to say which approach is better at achieving economic growth? Well, whilst both the US and UK have a deficit of about 10% of national income, the US grew by 0.8% in the final quarter of last year and the UK saw a dismal fall in growth of 0.5%.

Actually, a direct comparison like this is not informative. The US has the advantage that their currency holds position as the world currency, and so America can borrow more before confidence is undermined. Remember, this is what the conservatives are worried about - the market losing confidence in the pound because the government won't be able to pay back their deficit. So perhaps, if Geithner was in Osborne's shoes, he too would back the cuts.

What Osborne and Cameron must remember is that the imperative is to promote growth in the UK, not avoid the embarrassment of taking back policy should it turn out that what the UK needs is continued fiscal stimulus. The UK has not yet faced the impact of most of the cuts and considering its precarious position (consumer confidence, according to one measure, has suffered its sharpest decline since 1992) it is not clear that UK economic growth will recover any time soon.

Money Musing #3

As Mervyn King, governor of the Bank of England, described; "Of all the ways of organising banking, the worst is the one we have today". The system of finance and banking needs to change and the UK government are aware of this, which is why they set up the Independent Commission on Banking (ICB) that will make its recommendations in September. Despite this, I am worried that the status quo will prevail. My Uncle Harry told me today that in Holland they have already had banking reform, and that nothing has changed as a result.


Today two things have come to my attention that made me feel positive that things CAN actually change. Two public figures, Robert Peston from the BBC and Sir John Vickers who is chairing the ICB both took action which promises that people in the 'right places' are thinking about regulation vigorously and boldly.


Robert Peston's documentary Britain's Banks: Too Big to Save? features both established bankers (e.g. Paul Tucker, deputy governor of the Bank of England, and likely to be the next governor) and less conventional critics damning the current system. One of the interviewees that struck me was Professor Robert May (who I have just invited to speak at the roundtable!), a zoologist who has been applying insights from his research into ecosystems to banking. Another participant, Tony Baxendale of the Cobden Centre, spoke at the Positive Money Conference at which I first became so interested in money and banking!


Secondly, the front page of todays FT reveals that Sir John Vickers is adamant to break big banks up despite the international difficulties. He'll be making a speech this weekend at the London Business School which will further reveal his opinions in anticipation of the ICB options paper that will be published in April.


I will be interviewing Sir John next week. Any questions? Let me know. £

Money Musing #2

My friend Al just sent me a link to this radio show about money. I recommend it! Find 'The invention of money' by This American Life here. Learn about the fiction of money, inflation and central banking.

The economics of my moldy molar

I should have suspected, given the grievous headaches and blueness of my molar, that something was amiss when the dentist told me that all I needed was a simple filling. It was unthinkable that she would mistreat me; surely dentists follow an ethical code and she couldn't be benefiting from carrying out a filling - one of the most basic and cheapest dental procedures.

Even when I went back because I was still suffering she said "sometimes fillings don't fit properly, we'll just have another go...". Alarm bells did then begin to ring and I decided to get a second opinion. It turned out that I needed root canal treatment, a much more involved and costly procedure. That dentist HAD MISTREATED ME. 

Perhaps she was inexperienced or lazy or...? I think the answer lies in the fact that she was an NHS dentist. Now, I don't think all NHS dentists would have behaved as she did, but on learning how the NHS system works it becomes apparent that there are strong incentives for dentists to avoid certain procedures. Under the system dentists are paid a flat rate for all fillings - about 40 quid - irrespective of the size or intensity. If my dentist had given me a root canal, she would not have been paid enough to cover the costs of the procedure. On the other hand, when she gives a standard filling, she will be paid more than the cost of the procedure (watch out for trigger happy dentists who keep finding new fillings in your mouth!). 

my rogue denticle

There are higher payment bands too, for more expensive treatments, but all of these bands group together several treatments that have very different costs. You would think that dentists should be paid the cost of the treatments they carry out. That was how the system worked until 2006 and it was misused. Dentists were over-influenced by the fact that more treatments meant more money. The result was very expensive, there were too many treatments and little emphasis on preventative care. 

At the root of the problem is the fact that dentists are experts who have more information than us. We have to trust what they recommend, and they might not always have the patient's best interest in mind. The fact that NHS dentistry is in short supply exacerbates the problem because the forces of competition and reputation building aren't able to keep dentists in check, and on top of this the NHS creates perverse incentives by distorting how dentists get paid. 

While my molar may no longer be rotten, the system of dentistry is. Economist John Maynard Keynes famously wished that economists would aspire to be “as humble, competent people on a level with dentists”. He wrote this at a time when moral judgement, in his opinion, was playing too large a role in economic policy. My own experience has made clear how, within the current system, a lack of moral servitude in the dental profession leads to malpractice. You don't need to make any normative judgements to see that the system requires change. 

Money Musing #1

"Money ranks with wheel and fire among ancient inventions without which the modern world could not have come into being. But it is much more mysterious. It is a unit of account that changes size like a rubber yardstick; a store of value that can swell or shrink over time; a medium of exchange that often never leaves the bank; an interest-bearing debt and a non-interest-bearing debt; a commodity (like gold) and a non-commodity token (paper money); easily transferable into real assets by individuals yet not at all transferable into real assets by the community; counterfeiters are sent to jail for making it, but the private banking system can create it out of nothing and lend it at interest; some economists think it merely a veil behind which real factors determine economic life, others consider it among the most important determinants; some think its quantity should be determined by a fixed rule, others that it should be manipulated by public authorities; and in addition, some people even claim that it inspires love that is the root of all evil. At least it is a rich source of bewilderment and danger. Probably in today's world more people are hurt by out-of-control money than by out-of-control wheels and fire."

-Herman E. Daly (Money, debt and wealth, in Ecological Economics and the Ecology of Economics)

This quote is quite dense but I like it because economist Herman E. Daly brings out the many dimensions to money. The final sentence is an example of the sort of observation that leads to the questions that are keeping me busy: Why is money out of control and can we design a monetary system such that money can be controlled?