THE ECONOMIC CONSEQUENCES OF THE VICKERS COMMISSION
By Laurence J. Kotlikoff
Civitas. 98 pages. £8.00
ISBN 978 1 906 837 426
Laurence Kotlikoff is Professor of Economics at Boston University and has a PhD in Economics from Harvard University. He is the author of several books on economic subjects.
Professor Kotlikoff’s book has two purposes:
1. To critique the report produced by the Independent Commission on Banking, chaired by Sir John Vickers, which was commissioned to provide recommendations for reforming the banking system in Britain in order to prevent another financial crisis and reduce the need for taxpayer bailouts of failing banks to protect the financial system.
2. To promote an alternative solution he developed and proposed to the Vickers Commission, so-called ‘Limited Purpose Banking’ (LPB).
Kotlikoff’s idea has some interesting elements which deserve consideration in the debate over financial reform. Nevertheless, the proposal makes some naive assumptions about human behaviour that call into question many aspects of his proposal. (Full disclosure: the writer is a banker.)
Critique of the Vickers Report
Kotlikoff’s criticism of the Vickers Report seems overly strident, until he reveals that the Vickers Report devoted only a few lines to LPB, dismissing it as an unrealistic solution. As a result, Kotlikoff’s arguments start sounding at times like sour grapes.
Kotlikoff traces the source of the financial crisis to three fatal flaws in the modern banking system: opacity, complexity and leverage. The nature and quality of banks’ assets are unknown to the public at large. When a bank fails, depositors and other creditors in other banks panic and run as they wonder if their bank is next. The problem is exacerbated by leverage: banks hold only a small amount of capital in comparison to their assets. When losses occur, creditors are spooked because they are afraid that the banks will have insufficient capital to absorb the losses. Kotlikoff argues rightly that banks have a special role, similar to utilities, of supplying an essential service to the public: the financial market, which provides a mechanism for channelling savers’ money into home loans, business loans, trade finance and the like. The so-called opacity of banks’ assets causes a loss of trust, which can spread to otherwise healthy and well-managed banks.
Kotlikoff then argues that the Vickers Commission’s proposed solution does nothing to correct these problems. Its principal proposal is to separate banks into ring-fenced retail banks, which provide traditional financing of individuals and small businesses, and corporate and investment banks, which engage in ‘complex’ and potentially ‘risky’ derivatives and other esoteric services. Failures of the latter would then theoretically not endanger the financial system and lead to the perceived need for a taxpayer bailout. But this proposed separation will do nothing to address the opacity and leverage of the banking system that contributed to the crisis.
Limited Purpose Banking
Kotlikoff then sketches out his proposed solution, which is to convert banks into mutual funds with no leverage. For example, instead of workers depositing their wages and savings in a bank, which promises to return the money with interest to the customer either on demand or at a fixed future date, workers would invest their money in a mutual fund, which in turn would invest the money in home mortgages, car loans and other traditional banking activities. By their nature, mutual funds cannot ‘go bust’, since they would not be allowed to borrow money; instead the bank’s depositors and other customers would be the owners of 100% of the bank’s assets.
The FSA (the current bank regulator, soon to be subsumed into the Bank of England) would assume the responsibility of analysing and reporting detailed information on the banks’ assets, so that supposedly bank depositors would know precisely what the banks are investing in. As if the scope of this responsibility is not staggering enough to consider, Kotlikoff also proposes to make the FSA responsible to act as a type of central giant trading system through which all bank investments would have to be distributed via an auction process. Presumably this would reduce the financial system’s reliance on ‘discredited’ rating agencies and ‘corrupt’ bank traders.
What about the banks’ roles in providing payment services, such as demand deposits, cheques and electronic transfers? Simple, says Kotlikoff. Create LPBs which specialise in these services. These banks would invest in short term Treasury bills, so that 100% of depositors’ funds would be ‘safe’. Depositors would have the assurance that all their money was available to them, although they would have to pay potentially higher bank fees.
Conclusion
While Kotlikoff rightly pinpoints the unique nature of banking, which relies on the trust and confidence of bank depositors and creditors, which can easily be shaken, because creditors are not in a position to assess the quality of their bank’s assets, panicky withdrawals can ensue, causing serial collapses of otherwise healthy banks, thus raising the spectre of taxpayer bailouts to prevent the collapse of the financial system.
Nevertheless, Kotlikoff relies on a flawed and naive belief in fallen human nature. First, he assumes that the average person on the street, by simply having detailed information on a bank’s assets, would have the time, inclination or capacity to make an informed decision about where to invest his money. The amount of financial information that currently circulates in the City is staggering. How would he expect the average Joe Bloggs to derive any meaning from such information? Second, he makes another naive assumption, that replacing the services of thousands of analysts, rating agencies, banks and research firms with one giant bureaucracy would somehow remove any potential for conflict of interests, manipulation, or a new opacity caused by potential political pressure to suppress inconveniently bad news. Third, he misjudges people’s willingness to accept losses on their investments, which would inevitably ensue if bank customers were converted to equity owners in mutual funds.
Even his proposal for payment banks is flawed, when he states that customers would have the assurance of safety because all their money would be invested in Treasury bills. Earlier on, he made the correct observation that no investment is ‘bullet proof’; European sovereign bonds were once considered safe as houses. So, in addition to committing the cardinal sin in finance of putting all your eggs in one basket, he also does not consider the reaction among depositors when told they would have to pay much higher fees for the privilege of maintaining a bank account!
While many of Kotlikoff’s observations about the nature of the banking system and the danger of leverage are spot on, he undermines his otherwise interesting idea by not recognising the problems mentioned above.
Steve Gandy,
Managing Director and Head of Securitisation at Santander UK
