A Diverse Banking System

9th January, 2013 6:15 pm

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.

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% of GDP, and 84% 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.

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 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% of the banking sector and their combined total assets were equal to 40% of GDP. By 2010 the top 10 banks represented 97.3% of the sector and their total assets stood at 459% 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% of GDP it is almost inconceivable that it could ever be allowed to fail – the implications for the wider economy 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.

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 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.

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. 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?

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.”

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.

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.

Duncan Weldon is an economist. This piece originally appeared in the Fabian Society’s new publication “The Great Rebalancing: How to fix the broken economy”

  • PeterBarnard

    Undoubtedly you are correct in your proposition of greater diversity in a country’s banking system, Duncan, but there are both a massive culture problem and massive vestive interests to overcome.
    Adam Smith in Wealth of Nations remarked : Though the principles of the banking trade may appear somewhat abstruse, the practice is capable of being reduced to strict rules. To depart on any occasion from those rules, in consequence of some flattering speculation of extraordinary gain, is almost always extremely dangerous, and frequently fatal, to the banking company which attempts it.
    Perhaps it should be a legal requirement that this should be posted in every office (in every bank) in which there is a “person of influence.”

  • JoeDM

    Don’t forget that it was those retail banks that issued the toxic sub-prime mortgages and other loans to people who couldn’t aford them, not the investment banks.

    If the traditional banking good practice had been encouraged by the authorities we would not have got into the mess in the firstplace.

  • MonkeyBot5000

    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

    If only we owned a bank which we could focus on SME lending and current/saving accounts. Oh wait, we do.

  • Pekka Taipale

    It is interesting that you give savings banks and co-ops as an explanation for why the German system is so successful. At the same time the banking system in Spain is in shambles. And which ones are breaking up? It’s the mutuals there that went crazy in the property bubble. Not the big commercial banks of Spain, which are relatively fine.

    Likewise, the 1990’s banking crises in Nordic countries were caused by co-op and mutual banks, not the commercial banks.

    In the US, the property bubble was particularly driven by government-sponsored enterprises Freddie Mac and Fannie Mae, until their collapse in 2008.

    Therefore, I don’t see that moving away from commercial banks would solve much of Britain’s problems.


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