Let's Be Clever - and Kill Off The Banks

It looks like the banks are about to be in the dock again - over ISDAFIX this time.

No doubt this will lead to renewed grandstanding from politicians about the perfidy of all banks and how we should cut them down to size. We can all agree there was bad behaviour, some of it illegal – which should be punished by law – and some of it bad judgement driven by greed and ignorance. However it only applied to a minority of banks and those banks it did apply to were operating in a political and regulatory environment which allowed it to happen. Banks and businesses in general do not exist in isolation, but as part of wider society whose values and objectives they reflect. Moreover tremendous steps have been and continue to be made to address past weaknesses. The danger now is going too far the other way, blaming the banks for everything and concluding we would be better off without a large and vibrant banking industry.

The Labour party’s response to accusations it presided over a collapse of our public sector finances and an out of control public sector deficit, appears largely to consist of pointing to the global nature of the crisis and then blaming the cost of bailing out the banks. Politicians in general often now appear to go along with the notion that the banks created this mess and should be punished in some way by being cut down to size. Few if any are brave enough to acknowledge the wider causes of the crisis nor the benefits this country enjoys from its large and successful financial sector.

It is true that the banking crisis of 2008 was the result of incompetence and irresponsibility, but it was a crisis of leadership in a relatively small number of banks, in particular in this country, at RBS and HBOS which endangered the whole system. Many of those responsible have suffered only minimal financial pain as a result – an unfortunate, but unavoidable consequence of the much greater good of our being under the rule of law not the mob: Personally I’d like to see them strung up, but am glad it is the law which prevails and not me. In fact Northern Rock, bailed out unnecessarily by Gordon Brown to protect jobs in a particular area, was the canary in the coal mine, but the message was ignored, while RBS, HBOS, Lehman, Bear Stearns et al were only half of the crisis.

The other half was the over-indebtedness of public sectors in many of the world’s most advanced economies and which was the next shoe to drop. Politicians must take responsibility for that catastrophe and in this country, Gordon Brown whether in No11 or No10, was high priest, architect in chief and driving force behind our over-indebtedness, pumping up the public sector with borrowing to be paid for by future generations. Now the coalition government is taking the necessary steps to address it, we see the full extent of the earlier profligacy - and are paying for it.

The banking sector, by financing industry in general, can be an enormous engine for growth. Moreover it generates tremendous revenues for the treasury. It must form a key element in efforts to rebuild our economy and not forever be traduced as a convenient scapegoat for much wider problems.

It was a political decision to part nationalise RBS and HBOS. There were alternatives. On the other hand there was probably no alternative to the massive guarantees issued by governments in this country, the United States and others to underwrite the liabilities of the banks. It was that underwriting which avoided a systemic default and prevented contagion spreading from the few “bad” banks to the whole system. So what did it all cost in this country?

Precise figures as to the true costs will only be known once all is resolved and the publically owned banks returned to private ownership. However we can attempt a rough estimate.

Part nationalisation was a political call. Its cost will be the £68bn invested, less the proceeds of disposal of Northern Rock and eventual disposal of the holdings in RBS and Lloyds, plus the interest paid by the government on the funds invested until they are repaid, whether from the disposal or from revenues raised elsewhere (ie tax). At current UK government borrowing rates, the servicing costs will be between £1bn and 2bn p.a. So, even if the whole lot is written off and only after 10 years (improbably far off), the total cost to the UK taxpayer will not exceed £90bn. More likely the banks are re-privatised and we recover at least 1/3rd of the investment, so lets say the cost is £55bn (45 equity + 10 interest).

Now let’s look at the loans. According to the NAO, peak cash outlay by the government was £133bn (HM Treasury Resource Accounts, Parliamentary supply estimates and NAO reports to Parliament), deducting the equity investments in RBS, Lloyds and Northern Rock of £68bn, leaves £65bn in cash loans. The total cash outlay by 31st March 2012 was £119bn and the equity investment had fallen to £67bn with the sale of Northern Rock to Virgin Money, so the net outstanding lending was then £52bn. It should be lower now. No loan has had to be written off. It is increasingly likely all will be repaid. The banks receiving the loans are charged varying levels of interest on them. Initially this was set at what they could afford. By now they should be able to pay at least the cost to the government, so the loans should be self-funding. However let’s be cautious and allow £1bn p.a. in interest for say 7 years. Absolute maximum cost to the taxpayer £7bn.

Next the guarantees: Here the UK government in effect used its own balance sheet to underwrite the banks and indeed the Bank of England in its efforts to support the system. This was a significant risk which peaked at £1,029bn (net of the peak cash outlay described above). However, the risks never turned into loss and the nominal is now down to £109bn. The government charged for the guarantees, but for simplicity we can overlook that income. Similarly we can overlook any increase to the government’s cost of borrowing from taking on this additional risk as it will have been short-lived. In terms of government borrowing then, we can assume the guarantees are neutral.

So what cost does all this add up to? It depends on how events unfold, but part recovering the equity, recovering the loans and paying out nothing on the guarantees looks realistic. This would equate to £62bn including interest (45+10+7). Best case would be around £15bn (if the holdings of RBS and Lloyds shares are sold at cost, all loans are repaid in full and no guarantees are called) and worst case £255bn (if nothing is recovered re RBS and Lloyds, the remaining outstanding loans go bad and the outstanding guarantees are all called - all highly unlikely). £62bn is a lot of money. Something everyone becomes very angry about.

So let’s kill off the financial services sector or reengineer it into a shadow of its former self and instead let’s focus all our efforts on manufacturing and non-financial services. It is not clear how other these other industries would be efficiently funded without a vibrant and creative financial services sector, but it is the logical conclusion of the rhetoric we continue to hear from many a politician and commentator.

Well if we were to kill off financial services, we would forego an average of £60bn p.a. in tax revenues. This is the figure estimated by PWC in a report prepared for the City of London Corporation and published in December 2012, taking into account Corporation Tax, the bank levy, payroll taxes, VAT and other taxes. It is over 11% of the total tax take and has been maintained, more or less, throughout the crisis: Getting on for £800bn over the life of the last 3 Labour governments alone. We would also forego jobs for 1.1 million people.

Or perhaps we should just get rid of, or neuter, the banks which the report estimates are responsible for between 50% and 70% of these revenues? Look at Cyprus to see what happens when you kill off your banks. Let’s be serious. £62bn is just about a year’s worth of the annual tax take from financial services. Against this we have enjoyed years, decades of tax receipts from the financial services sector, along with jobs and wealth creation: Taxes which pay for health, social security, education, defence, transport infrastructure etc. Set against the long years of these injections into the public coffers, £62bn is a relatively small price to pay.

If the cost ends up at only £15bn it is, relatively speaking, a very small price indeed. Even if it were £255bn, the benefits would still far outweigh the cost. So it is time politicians and the media stopped beating up our banks and started championing them. Yes ensure proper management, provide intelligent regulation (which the FSA failed to do – too much box-ticking and not enough rigorous analysis of systemic risks) and foster an ethos in which ethics and responsibility play a central role. But stop bashing them for political ends and stop talking about punishing them.

Instead the debate should be about how to help and encourage the banks to start lending again by opening up opportunity. The funding for lending scheme and its recent further expansion is a positive step, but much more is needed. Creating certainty around the capital and tax regime they operate under would be good.

The debate should also be about how sensibly to ensure against nationalising future losses – for failures are inevitable in any vibrant system: Living wills appear to be a very sensible initiative here if properly crafted. It is essential that shareholders and bond holders recognise their stakes are fully on the line in the event of a failure. Thought should be given too to the systemic risks created by the use of government bonds as a “risk free” asset throughout the system when it has been demonstrated they are anything but risk free – and just wait until Japan’s public sector debt begins to go south as it inevitably will, and/or one of the regulatory-mandated derivatives central counterparties gets into trouble.

Review of the tax system is also long over-due, encouraging as it does companies to use debt finance and banks to supply it, in preference to equity. The legitimate topics for debate around banking are almost limitless, but let’s be clear, banks have a vital and valid role to play role to play in our economy. They are key to industrial and service growth, not a distraction from it or an alternative to it. Let’s focus on how to encourage them to get on with business, contributing to wealth creation, jobs and tax revenues, rather than constantly sniping at them for cheap populist ends.

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