17 September 2008

The Banking Crisis

Earlier today, Lloyds and HBOS formally announced that they are in merger talks. There is a lot of comment in the media suggesting that this move has been motivated by the credit crunch. I think that is true, but not in the way the media is implying. In the banking market, where bigger is generally better, merging is always going to be an attractive option. The problem for the banks is that, when times are good, competition rules make merging difficult. When the economy turns messy, it's a completely different story. The government becomes so scared of banks going bust that they throw competition rules out of the window. That presents the banks with a golden opportunity.

I've seen plenty of comment on message boards claiming that the current crisis in the financial sector is a sign that the free market doesn't work, because institutions are being bailed out by the state. As an argument, I think that's pretty poor. The banking sector is not even a vague approximation of a free market. It has high statutory barriers to entry and the state intervenes in a way that encourages reckless behaviour, such as, ironically, by bailing out institutions when they hit problems.

In the UK, the three state interventions in the banking sector which I think cause the most distortion are:

1. The government guarantees bank deposits (to certain levels), which reduces the risk to the depositor and therefore reduces the need for banks to prove to customers that they are well managed.

2. The Bank of England acts as lender of last resort for the banks, which allows them to make riskier liquidity decisions. If banks were at the mercy of their competitors when seeking out liquidity, they'd have to be more prudent.

3. The government implies that some banks are “too big to fail,” which sends out the message that the bigger players will be kept safe no matter how bad the situation gets, which encourages risky behaviour all round. This is one of the major reasons that "bigger is better." The current arrangement offers an implicit guarantee that, if a bank gets big enough, the government will make it immune to some market forces and prevent it from ever failing. The potential for failure is an essential part of a free market; it's what gets the bad practices out of the market. It's not a perfectly smooth system, but like evolution, it pushes things in the right direction. Take failure out of the system and bad practices can build up, until what might have been an individual failure becomes a wider catastrophe.

Add in the fact that the FSA has the statutory objective of "maintaining confidence in the financial system," which is a bit like telling a road safety officer that part of their job is to convince people that the roads are completely safe and risk free and you have a recipe for disaster.

If the current situation shows anything, it's that government intervention has a tendency to solve problems by creating bigger ones.

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Mark Wadsworth said...

Just dropping in to say thanks for the fine efforts over at Samizdata. I don't think we made any converts, but hey. There are none so blind as those that don't want to see!

Re your comment on my rents post. I don't think house prices go up because people anticipate future rents going up (they aren't that sophisticated - if they were, they wouldn't expect rents to rise faster than wages!!), it is pure bubble mentality, once the bubble is underway, people just look at the 'capital' value.

Paul Lockett said...

Thanks Mark.

I don't think we got any converts, but I got the feeling we were sowing a few seeds of doubt at the end, which is probably as much as you can hope for!

I think you are right about the thought process with rents. I don't think it is necessarily an explicit belief about the pattern of rents that drives it, just an irrational underlying belief that wages, rents and prices will keep heading constantly upwards.