Regular readers know that the simple solution for ending the too big to fail problem and addressing instability in the financial system is to require banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.
Market participants will use this information to exert market discipline and shrink the banks.
For example, by requiring the banks to disclose their trading positions, the banks will have an incentive to eliminate all their proprietary trades rather than risk having the market trade against them. This shrinks the banks.
Market participants will also use this information to adjust the amount and pricing of their exposure to the banks consistent with what the market participant can afford to lose knowing that they will not be bailed out. This eliminates the too big to fail problem because the market participants have already adjust their exposures for the possibility of failure.
The chancellor, George Osborne, responding to the Vickers report, seems to think it's "mission accomplished" on banking. But the report's proposed reforms don't address the inherent instability of the banking system.
The main lesson of the financial crisis, illustrated in spectacular fashion, was that banks had been given too much regulatory freedom, profiting at the expense of taxpayers and customers alike.
Politicians, economists and journalists lined up to agree that robust regulation was necessary to stabilise the economy and ensure the mistakes of the past could not be repeated. Three years and after pledging approximately £1tn in support of the sector, we are no closer to stabilising the financial system.That is a direct result of not requiring the banks to provide ultra transparency. Without ultra transparency, the losses on the banks' balance sheets remain hidden, but continue to undermine the financial system.
The Independent Commission on Banking was launched last year with the promise it would address systemic risk in the banking sector. However, all that was proposed in the final Vickers report was the ringfencing of retail banking away from investment banking activities, and banks being asked to hold more capital aside in case of trouble. While both of these initiatives should be welcomed, they do not address what caused the scale of the banking crisis.
The problem remains the same as it did in 2008, a banking industry that is too big to fail. It is a problem that was acknowledged by Vince Cable before he became the business secretary.
In the last 25 years we have allowed banks to balloon in size. Until the 1970s, banks' assets as a percentage of UK GDP remained steady at approximately 50%. By 2006, after decades of deregulation, banks' assets as a percentage of UK GDP were more than 500%.
These large interconnected institutions dwarf the rest of the UK's economic activity, and when they are threatened we have no option but to bail them out.That is why ultra transparency is needed. It directly addresses the interconnected institution problem.
Given this reality, even outright separation between retail and investment banking – which is not what the government has proposed – would not address the inherent instability in the financial system.
Lehman Brothers didn't have a single retail bank, but its collapse sent shockwaves through the global economy because of the size and reach of its operations.
So Britain's bloated mega-banks will remain fundamentally unaltered despite the continued threat they pose to the economy. And taxpayers will continue to subsidise them, as government guarantees enable them to access finance at a significantly lower rate than would otherwise be possible....
The media is unhelpfully reporting that the commission's proposals are the most radical reforms the banking sector has seen in the past century. But this is only a reflection of the excessive freedoms we have granted banks in the past; it does not mean that our problems are now solved.Actually, it is a reflection of the fact that the last crisis of this magnitude that required major reform of the financial system was the Great Depression.
The commission's recommendations, welcomed by the government, opposition and the banking industry, make plenty of political sense but very little economic sense. It is time to bring an end to the bankers' private welfare state.