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Home > Blogs > Anthony Harrington > Banking futures: Smaller and safer? Maybe, maybe not…

Banking futures: Smaller and safer? Maybe, maybe not…

Finance Blogger: Anthony Harrington Anthony Harrington

The notion that banks have learned the lessons of the great crash of 2008/2009 is starting to look a little shaky. US players like Morgan Stanley and Goldman Sachs are once again racking up the numbers on the profit front. Plus some commentators are now expressing considerable skepticism that the Banking Bill put forward by the US Congress actually does much to reign in the banks (no mention, for example, of “too big to fail” as an issue).

However, addressing a Bloomberg event recently (December 16) on the theme of “The Future Financial Landscape,” David Miles, a member of the Bank of England’s Monetary Policy Committee, said there were several reasons why banks are likely to become less important financial intermediaries going forward, and that there was a good chance that we would in fact wind up with smaller, more restrained banks in future.

One of the key reasons for this is that prior to the crash it was all too easy for banks to roll the dice largely. If you have to increase your capital reserves for each piece of loan business you write, then you quickly run into real capital constraints in expanding your book. Miles showed his audience a chart which showed that in the run up to the crisis, by 2007 UK banking capital relative to assets was about half the level that pertained a half century earlier, and only a third of the level of a hundred years earlier. At that rate, if there had been no smash, one hesitates to think just how leveraged they would have been in another 20 years!

Miles then points out that this bald ratio of capital to assets takes no account of risk, and that if the loans being written were actually riskier, the adequacy of the ratio would actually be a lot worse. (Excuse me? There is room for doubt on this? With RBS and HBOS each losing how much?)

Then there is the matter of really liquid assets, the kind of asset that can be cashed even in stressed circumstances, which means government and central bank debt. Banks used to hold a good deal of this. Today they don’t, but Miles thinks that position could well be reversed once again. Indeed, quantitative easing is already doing this in spades.

So how did banks get to hold such slight capital reserves and so few really liquid assets? Because of the “implicit and explicit insurance given by the state,” Miles says. We are back with “too big to fail.” If people know that the government will back the banks, then borrowing by banks becomes cheaper (since there is a diminished need for the lender to add a risk premium, as they might to other borrowers). This makes it easier for banks to grow and swells the size of the banking sector. For example, Miles points out that banking sector assets, relative to the size of the economy, were stable at around 50% of GDP in the hundred years from 1875 to 1975, but rocketed in the last 40 years to about 500% of GDP.

How will this change going forward? Banks are now under a cloud, so borrowing is more expensive again. Capital ratios are sure to rise, and there will probably be regulatory pressure for banks to hold more liquid assets. Will this shrink the sector? Miles thinks so, others are not so sure.

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Tags: banking , capital adequacy , David Miles , regulation
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