business economics

Are we asking the impossible from our banking system?

When the coalition government came to power, they set up an Independent Commission on Banking to analyse the financial crisis and make recommendations for reform. It’s a significant opportunity to undo some of the damage of de-regulation, and create a financial system that serves us, rather than the other way around. Or at least it should be. The commission released its interim report this week, and so far there have been very few protestations from the banks.

I’ve been browsing the report over the last couple of days. It’s a document that highlights, perhaps inadvertently, the paradox of our current financial situation. Here’s the challenge as the ICB sees it:

“Beyond the immediate task of repairing bank balance sheets while restoring the normal flow of credit to the economy at large, the challenge is to make the UK banking system more stable, and markets for banking services more competitive.”

Let’s break that down a little into the required steps:

  1. Restore bank balance sheets
  2. Restore flow of credit
  3. Make banks more stable
  4. Make banks more competitive

That sounds sensible at face value, but it all depends on how we define ‘normal’. If I understand the government’s definition, I’m pretty sure those are actually mutually exclusive aims. Let me illustrate with a graph.

This is the amount of ‘new money’ entering the economy over the last few years. That’s the made-up money that is written down by the banks and lent into existence, with the expectation that future growth will be sufficient to pay it back with interest. (See Positive Money) That drop between 2008 and 2009 is what we know as the ‘credit crunch’, the sudden unavailability of new money.

As the graph shows, the banks reached a frenzy of money creation in 2008. They lent too much, more than the economy could support. The level of lending in 2008 was great for the economy. Money was pouring out of the banks and into mortgages, powering a runaway property market. It wasn’t in any way sustainable, and when it emerged that those debts couldn’t be repaid, the banks were left with big holes on their balance sheets.

With that in mind, the Commission’s summary of what needs to be done looks rather different:

  1. The only way that banks can rebuild their balance sheets is to lend less, which is in direct conflict with the desire to ‘restart the flow of credit’.
  2. The only way that the flow of credit can be resumed is to return to the unsustainable levels of lending we saw before the crash, and that is in direct conflict with the desire to create a stable banking system.

It seems to me that the government has asked that the ICB go away and come back with a way for us to have our cake and eat it.

Our whole approach to the financial recovery is dogged by the persistent idea that we can get back to the ‘normal’ of the days before the crash. A return to ‘business as usual’ would see the money flowing again, house prices rising, and healthy, steady GDP growth – only stable this time, please. This is something of a fantasy, like trying to devise a diet in which we eat nothing but hamburgers and donuts and still lose weight.

The heady days of the last decade were not normal. They were a debt bubble. The sooner we get it into our heads that we cannot go back to it, the sooner we can get on with building an economy fit for purpose.

I don’t want to sound overly pessimistic about the ICB – their job is to create stability, not to restart lending. That’s happening elsewhere as part of project Merlin, and there are plenty of sounds suggestions in the report. I like the suggestion that switching between banks should be easier. 31% of us changed our energy supplier in the last two years, but only 7% changed our bank. Making it easier to switch would keep current account providers on their toes. Breaking up the Lloyds’ monopoly is important. The report’s starting question of ‘what is the financial system for?’ is vital.

In that sense, I’m not criticising the Commission or their specific part in reforming the system. But I do wonder  if we need to revise our expectations. Between the Vicker’s Commission and Project Merlin, we’re in danger of demanding something impossible.


  1. A very good analysis, IMO. It seems to me there are only a few options to try to minimise increasing levels of unemployment and consequent unrest: (a) banks lend more to the private sector (ie invent even more new money) to create more private sector jobs (b) govt borrows more in order to maintain higher levels of public sector jobs (c) everyone accepts a reduction in gross incomes &/0r higher taxation.

    If (a) and (b) are unsustainable, that only leaves (c) but that would be a vote losing policy for any party. I strongly suspect that most politicians favour (a), even if they are not willing to admit it. That will lead to higher inflation but, as usual, Govt (of whichever party) will see it as the lesser evil and blame it on ‘factors beyond our control’. As always, inflation will hit the poorest hardest but they tend to be the least politically active and party leaders know they only need the approval/support of less than half of voters in order to win the next election, regardless of the outcome of the referendum on AV.

    1. Yep, very few options left at this point that don’t involve a reduction in gross incomes, at least temporarily. That’s not the end of the world as far as I’m concerned, I don’t think rising incomes is something we should expect as a human right, year on year, but it’s not going to be popular!

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