British banks are still too big to fail

This week could see Ed Miliband’s first big test on banking reform. The parliamentary commission into banking standards is due to report on Friday and is likely to reopen debate about whether retail and investment banking should be fully separated.

We already know the Chancellor isn’t keen on a full separation. But the reality is even a full split of retail banks from their riskier investment arms will leave us with a lingering problem – banks that are too big to fail.

Today the new economics foundation has found that Barclays, Lloyds, RBS, and HSBC enjoyed implicit subsidies of £10bn, £9bn, £11bn and £5bn respectively last year because markets believe they are too big to fail.

All the large banks (not just those that received a bail out) benefit from this subsidy because assume the government will step in and bail-out these very large and highly-interconnected institutions if they ever get into trouble. This translates into lower interest rates for big banks, which saves them enormous sums of money when they borrow.

The size of the subsidy and the fact it’s still so large (it peaked at £54 billion in 2009) present major challenges to delivering a fair and productive banking system.

New and smaller banks do not benefit from the subsidy, and so they find it extremely difficult to compete with the big four. It encourages banks to take on more risk, and increases their reliance on short-term funding instead of customer deposits. Moreover there is no evidence that banks pass this benefit to their customers, it simply inflates their profits.

But most importantly, the ‘too-big-to-fail’ subsidy is a key barometer of whether taxpayers have been taken off the hook for the failures of bankers, and the judgement of the financial markets is that nothing has changed. This year Ed Miliband took a bold stance on banking reform. If he’s serious he needs to tackle the issue of institutions that have become too big to fail.

This week’s parliamentary commission offers a great opportunity for him to push the government to examine more ambitious proposals they are already considering in America, such as capping the size of banks that have grown bigger than our economy can bear.

Lydia Prieg is a senior finance researcher at the New Economics Foundation