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Why Vickers Won’t Work

February 21, 2012

This post is a comment on the Government’s response to the final report of the Independent Commission on Banking (ICB), dated December 2011, found at,

I believe the government’s position is similar to that of the ICB and is a grossly inadequate response to the issue posed by the banking crisis and subsequent damage to the economy.

The fundamental mistake made by the ICB and the government is the failure to recognise that excessive debt in itself makes financial crises inevitable. None of the recommendations address this.

The principal stability recommendation is ‘ring fencing’. This evolved from Prof. John Kay’s conception of narrow banks. Kay (see his article in ‘The Future of Finance: the LSE report’, 2010) felt that moral hazard be reduced by allowing risky banks to fail provided that the payment system, current account balances and modest savings balances be protected. In Kay’s picture the only assets of a narrow bank (apart presumably from central bank money) would be government bonds. This would seem to deny to narrow banks the key role of any bank, that of credit creation. The government recognises that in addition non financial businesses require access to continuing sources of credit. The government’s model of a ring fenced bank looks rather like a 1960s bank would look like, with one exception. As pointed out by Adair Turner in the LSE report, in 1964 households were net savers and made a significant contribution to funding non financial corporate borrowing. By 2007 that was no longer the case. Household savings no longer quite funded household borrowing. Consequently there was a substantial ‘customer funding gap’ which was filled by wholesale funding. Even the surviving building societies now depend on it to some extent. The government model of a ring fenced bank recognises this. The ring fence seems riddled with holes.

Leaving aside the difficulties in deciding exactly what a ring fenced bank should look like, ring fencing cannot address the major threat that banks now pose to economies, that is simply their excessive creation of credit along with the associated debt. This goes on until debt levels become unsustainable, a crash occurs, and credit dries up.

If households, non financial businesses and governments, are all debtors, who are the creditors?

Some might claim that it is the fault of debtors; they should moderate their spending and not take on debt. That argument makes about as much sense as the claim that people are only unemployed because they are work shy. Some are of course but not the majority. Equally some borrowers are feckless but not the majority.

If before the crash you wanted to buy somewhere to live you could get a mortgage for as much as 5 times your annual earnings. You might have felt that was too much. The trouble is that others would extend themselves that far and so drove up house prices. If you wanted a decent car to get a good job you probably needed a bank loan. If you don’t take that loan you cannot compete with those who do have a car.

Likewise businesses have to grow and innovate to survive. If you did not accept loans in the good times you could not compete, so when credit dries up you are scuppered. If you go back to the 1960s you could raise equity funding (e.g. through rights issues). These days earnings per share is king so you cannot go that route.

In short, what with social pressures, excessive borrowing, when available is not optional. The only way of curbing excessive and unsustainable levels of debt is to limit the ability of all banks, ring fenced and others, to create credit in the ‘good times’, as was done in the UK before the 1970s and is done successfully in some Asian countries. The trouble is that by merely limiting banks’ credit creation, the government is likely to surrender to aggressive lobbying to increase the limits. The proper solution is to nationalise money. This would allow the state to create as much money as necessary to oil the wheels of the economy and spend it in the best way. Banks could not create money but would become financial intermediaries. As a by product customers’ current accounts would become in accounting and legal terms accounts with the Bank of England but administered by the commercial bank.

At present the banking system is a giant machine for funnelling wealth from the 99% to the 1%.

Since writing the above I have re-read John Kay’s 2009 paper [John Kay 2009] more carefully. I now believe that his Narrow Banking proposal would achieve his objectives but that Vickers fudged it.

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