A diverse banking system

Ever since the failure of Northern Rock in 2007, it has been clear that the UK’s banking system is not working. A crisis in the banking system led to a collapse in GDP, a large rise in unemployment and the ballooning of the government’s deficit. The recovery is being held back by tight bank credit with the existing system seemingly unable to provide enough finance to small and medium sized enterprises (SMEs) or long-term finance to fund infrastructure projects. But the problems in the UK banking sector did not suddenly emerge five years ago and they are not just a reflection of the weak state of the economy; instead the UK is faced with a deep structural problem in how its banking system operates.

There are three distinct issues facing policymakers dealing with the UK’s broken banking model: the challenge of making it safer to avoid a repeat of the crash; the problem of excessive remuneration, which is highlighted with each passing bonus season; and the underlying question of how the banking system can be made to support the real economy.

Much of the policy discussion since the crisis has been focussed on the first of these issues, indeed the Independent Commission on Banking (ICB) looked at little else. The ICB’s recommendations (primarily around the need for a firewall between retail and investment banking) go some way towards making the system safer but they do little to ensure we have the banking system that the wider economy needs.

The scale of the challenge is best seen by looking at lending figures. £1.3 trillion of loans were extended to British residents by UK banks in the 10 years before 2007, around 100 per cent of GDP, and 84 per cent of this went into either property or to financial companies. The banking system’s focus on property and finance contributed to regional inequalities, to the UK’s low level of investment and to the asset price boom, which sowed the seeds of the crisis.

This is an old debate in the UK. The failure of banks to support growth businesses was identified by the Macmillan Committee in 1931 (the so-called ‘Macmillan gap’) but complaints that the UK’s banks were not supporting industry can be found as early as the 1890s when industrialists glanced longingly across the Channel at the German Reichsbank.

Whilst the failure of banks to lend enough has featured heavily in the news in recent years, the deeper issue has been debated for over a century.

The fact that UK banks have been so poor at supporting the real economy may seem somewhat paradoxical given the UK’s global reputation as a centre for financial services. However, the globally focused international wholesale market, based around the City and Canary Wharf, actually has very little to do with real the UK economy. The UK’s domestically-focused financial markets – the actual business of extending finance to companies that need it – is both bizarrely underdeveloped and oddly concentrated.

There are many ways that a company can access the finance it needs to invest and grow, the most straightforward being the reinvestment of retained profits. In terms of equity finance the UK has large and well-developed equity markets but access to the stock market is only really an option for larger firms. The UK’s venture capital markets are small by international standards and, whilst the UK has a large private equity sector, this is not effective in supporting growing companies – indeed it often seems more preoccupied with buying out existing companies and selling off many of the assets.

As a result of the lack of equity finance, UK companies that need external finance (i.e. that cannot finance themselves from their existing resources and profits) are reliant on debt finance. The UK’s bond markets (only really an option for larger companies anyway) are the smallest in the G7, meaning that it is traditional loans from banks that many companies rely on.

The banks therefore play a very important role in the UK economy: if a company wants to expand and cannot fund itself through retained profits then, in the absence of a larger venture capital sector or bond market, it is to the banks that a company has to turn.

The UK’s banking sector is not only of vital importance to growth but is also highly concentrated and very large. The top 10 British banks in 1960 represented 69 per cent of the banking sector and their combined total assets were equal to 40 per cent of GDP. By 2010 the top 10 banks represented 97.3 per cent of the sector and their total assets stood at 459 per cent of GDP.

The UK then has an unusual triple cocktail of banks that are very large, very concentrated and are central to firm finance.

The concentration of the sector causes a multitude of problems, the first of which is the ‘too big to fail’ problem. When Barclays assets have reached 110 per cent of GDP it is almost inconceivable that it could ever be allowed to fail – the implications for the wider economy (and the rest of the financial system) would be catastrophic. The markets, knowing this, sense that Barclays will never be allowed to fail and hence the perceived credit risk of lending to it falls. In effect the implicit public backing lowers a large bank’s borrowing costs and gives it a competitive advantage over smaller competitors.

The size of this implicit public subsidy is disputed but recent work by the Bank of England puts the figure in the UK somewhere between £6bn and over £100bn annually – with the strong suggestion that is likely to be towards the higher end of this scale. As the paper concludes, “all measures point to significant transfers of resources from the government to the banking system.”

This public subsidy would be almost defensible if it was passed on to consumers in the form of lowering borrowing costs but there is little evidence that this is the case. Instead the subsidy seems to find its way into higher pay packages and larger bonuses.

Another problem with excessive concentration is that it makes the whole system less resilient. If a country has dozens of banks and several run into problems, there will still be healthy banks capable of lending to support the real economy. Whereas, if a country has only a handful of large lenders and they all run into trouble, then that country will experience very weak credit growth, holding back any recovery.

Finally there is a powerful argument that a finance sector which becomes too large has a negative impact on the rest of the economy. As the Bank of England’s Andy Haldane has argued, this is “because human and financial resources are drained from elsewhere in the economy. The sectors hardest-hit by this financial vacuum-cleaner effect are research and development-intensive businesses (who might otherwise have attracted the scarce, skilled labour that flowed into finance) and businesses reliant on external funds (whose financial cake was instead being eaten by the banking system). These are the very businesses that today we are seeking to re-nurture.” Haldane goes on to argue that this changed the nature of the offer banks made to customers: “The humble, regional loan officer was pensioned-off, replaced by a centralised credit risk model which neither answered back nor required a pension …Banking became a transactional business, underpinned by a sales-driven, commission-focused culture.”

There is no question that the UK’s banking system requires serious reform, as politicians from all the major parties appear to be realising. Two such reforms can be identified, the first of which is now seemingly supported by all the major parties, the second of which has yet to enter mainstream political debate.

The first reform is the vital need for some kind of state-backed credit provider, focused on making sure credit gets to SMEs and infrastructure projects. As Nick Tott’s report for the Labour party noted, the UK is only G7 economy without such a body.

In Germany the development bank KfW, established in 1948, has long been an important driver of Germany’s industrial success. In 2010 it extended a record €28.5bn in loans to SMEs as well as supporting infrastructure, housing, energy efficiency and new environmental technologies. By using the government’s AAA rating to raise funds, KfW can borrow at a lower rate than many other banks and passes these savings onto customers. In addition the bank can act counter-cyclically, extending its lending when other banks are pulling back and helping to smooth some of the volatility out of the credit cycle.

Successful state-owned credit providers such as the KfW, the Nordic and European investment banks and the US Small Business Administration provide a model that the UK should seek to emulate. All three major parties now back some form of state-owned lender.

But there is a bigger debate to be had. The question becomes: would a state-owned investment bank alone be enough to make a serious difference to the UK’s banking structure? As the IPPR’s recent report on the case for a British investment bank (BIB) noted:“The BIB should also offer long-term loans and should seek to adopt an on-lending model[i], though a key challenge would be how to tailor the KfW’s on-lending model to fit within the context of the UK’s commercial banking structure.”

This touches on an important issue – one reason that KfW works so well in the German context is the existence of a very different banking system, one that is markedly different to the UK’s highly concentrated structure.

Whilst the UK relies on a handful of big commercial banks, Germany has a ‘three pillar system’ with over 400 municipally-owned savings banks (Sparkassen) and 1,100 co-operatives operating alongside the commercial sector. These banks have weathered the crisis in much in better shape.

Most of these banks are constrained to lend within a certain geographic area – something which astonishes many Anglo-Saxon bankers.

The IMF, in their most recent assessment of the German banking sector explained that in Germany “the contraction of bank lending during the financial crisis was mostly demand-driven and was significantly explained by real economic variables. In particular, the decline in bank lending was more evident for large banks, whereas Sparkassen and co-operative banks typically lending to SMEs have provided stable supply of loans, and they managed to expand their retail lending throughout the crisis.”

The IMF concludes that as a result“German intermediaries may be able to increase social welfare through the provision of services and intertemporal smoothing of returns that a more short-term oriented market has limited incentive to provide.”

Germany’s diverse banking ecology has allowed a more long-term focus by industry, has supported a higher level of investment and, perhaps crucially, has allowed Germany to avoid many of the stark regional inequalities that mark the UK economy.

The primary problem facing the German banking sector according to ratings agency Moody’s is a “lack of profitability”. If only the UK had such problems with its banking system.

Establishing a state investment bank is a necessary but insufficient step to ensuring the banking system supports the real economy. What is really required is a more diverse banking system in the UK. More mutually-owned banks, for example, would help address some of the issues around short-termism and corporate governance.

A diverse banking system with many more players focused on different geographies, different sectors and different types of banking would be more supportive of the real economy, less at risk from the failure of any one institution and would likely be marked by less excessive remuneration.