All British banks are “too big to fail”

The media is alive with politicians, bankers and economic commentators saying British banks must be broken up so they are not “too big to fail”.  The Governor  of the bank of England  Mervyn  Kingof England Mervyn King was at it last week (htttp://www.thisislondon.co.uk/standard/article-23927727-well-let-banks-fail-says-mervyn-king.do) and the new chief executive of Barclays, Bob Diamond, has had his say today. (http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/8365101/Barclays-chief-Bob-Diamond-says-let-banks-fail.html)

The idea is a literal nonsense statement. To begin with the whole of economic history shows that a run on any bank above the size of a local bank with one or two branches is likely to spread the contagion to other banks. Indeed, even runs on small banks can have a snowball effect bringing ever larger banks to default as the nexus of borrowing and lending unravels. This is what happened in the USA during the Great Depression when their highly fragmented banking system saw the phenomenal number of approximately 9,000 banks fail before the America’s entry into the second World War in 1941 finally broke the economic spell with the sudden need for vast amounts of servicemen and war-related materials driving down unemployment.

Britain’s present position is different from that of the USA in 1929. None of her banks are really small for even the smallest building societies which converted to banks in the past twenty-five are far removed from a local bank with half a dozen or fewer branches. Not only that, but the ten largest banks control 90% of the UK banking market (http://www.economicshelp.org/blog/uk-economy/top-10-british-banks/). This produces two difficulties: the danger of a wholesale collapse of confidence in banks is greatly amplified because of their size and the damage done by a failure of any of them would be both great and immediate. For example, suppose Barclays was simply allowed to fail. It is inconceivable that the failure would not lead to a run on all the UK banks.

Those saying banks should be reduced in size so they are not “too big to fail” have a further hurdle to pass beyond that of the lessons of economic history. The internationalisation of banks makes the idea of governments forcing banks to become “small enough to fail” impractical. For example, how would a government force an international bank to split off its British banking from the international business? Unless this could be done, the contagion might well start overseas and spread to the British banking end. The same general objection applies to the idea of splitting retail from investment banking. If an international bank refuses to do it there would be little a British government could do because they could not afford to say do this or cease trading in Britain. But even if the international problem could be miraculously overcome, it is difficult to see how the UK parts of banks such as Barclays could be split into different parts small enough to be “allowed to fail”. Divide Barclays into ten separate companies and each part would still be large.

It is also difficult to envisage a situation whereby a British government would cease to guarantee deposits up to a sizeable or withdraw entirely from its position as lender of the last resort. The continuation of those two engagements would amount to a great deal of moral hazard remaining.

Most fundamentally, whatever system was put in place; whatever political commitments were given, if a run did begin on a British bank it is most improbable that a government faced with the reality of such a failure, with the threat of contagion spreading to other banks, would fail to step in. The only way to stop the bankers running riot again is to nationalise the banks. Fail to do that and we are likely to have a re-run of the present disaster in the not too far distant future because already the banks and their ilk are behaving , as far as present circumstances allow, much as they did before the failure of Lehman Bros in 2008, dreaming up new types of complicated derivatives, paying themselves grotesque amounts of money and laughing at those outside their magic insiders’ circle.