The governor of the Bank of England, Mervyn King, made an important speech in New York on 25th October. The Governor’s speech was a wide-ranging discussion of the banking system. At the heart of it was a fundamental economic concept: market failure. The market failure that King was referring to stems from the maturity transformation which occurs when banks borrow short, say through our savings or wholesale funds from other financial institutions, and then lend long as is the case with mortgages. Of course, the positive outcome of this maturity transformation is that it does allow for funds to be pooled and this, in turn, enables long-term finance, something which is incredibly important for business and households. However, King believes that banks have become too heavily reliant on short-term debt to finance lending. Indeed he went so far as to describe their levels of leverage as ‘extraordinary’ and ‘absurd’. He argued that such a system can only work with the ‘implicit support of the taxpayer’.
In elaborating on the market failure arising from maturity transformation in today’s financial system, King notes
…the scale of maturity transformation undertaken today produces private benefits and social costs. We have seen from the experience of first Iceland, and now Ireland, the results that can follow from allowing a banking system to become too large relative to national output without having first solved the “too important to fail” problem.
In the speech, King considers a range of remedies to reduce the risks to the financial system. These include: (i) imposing a tax on banks’ short-term borrowing which could, to use the economic terminology, help internalise the external cost arising from maturity transformation; (ii) placing limits on banks’ leverage and setting capital requirements as outlined in the recent Basel III framework (for a discussion on Basel III see Basel III – tough new regulations or letting the banks off lightly?; (iii) functional separation of bank activities to safeguard those activities critical to the economy. King argues that whatever remedies we choose they should be guided by one fundamental principle: “ensure that the costs of maturity transformation – the costs of periodic financial crises – fall on those who enjoy the benefits of maturity transformation – the reduced cost of financial intermediation”.
Mervyn King’s speech makes considerable reference to our banks’ balance sheets. So to conclude this piece we consider the latest numbers on the liabilities of British banks. At the end of each month, in its publication Monetary and Financial Statistics, the Bank of England publishes figures on the assets and liabilities of Britain’s banking institutions or ‘MFIs’ (monetary and financial institutions). The latest release showed that British banks had total liabilities of some £8.15 trillion at the end of September 2010. To put it into perspective that’s equivalent to around 5½ times the country’s annual Gross Domestic Product. Of this sum, £3.75 trillion was classified as Sterling-denominated liabilities, so largely reflecting operations here in the UK, while £4.39 trillion was foreign currency liabilities reflecting the extent of over-seas operations.
The Sterling liabilities of our financial institutions are dominated by two principal deposit types: sight deposits and time deposits. The former are deposits that can be withdrawn on demand without penalty whereas time deposits require notice of withdrawals. Sterling sight deposits at the end of September totalled £1.16 trillion (31% of Sterling liabilities and 80% of annual GDP) while time deposits totalled £1.52 trillion (40% of Sterling liabilities and 105% of annual GDP). The next largest group of deposits are known repos or, to give them their full title, sales and repurchase agreements. Repos are essentially loans, usually fairly short-term, where banks can sell some of their financial assets, such as government debt, to other banks and this can help to ease any shortages in funds. Sterling-denominated repos totalled £197.8 billion at the end of September (8% of Sterling liabilities and 21% of annual GDP).
To conclude, the growth in our banking system’s liabilities has been pretty staggering. Compared with today’s liabilities of nearly £8.15 trillion, liabilities 13 years ago totalled £2.35 trillion. So over this period the banks’ liabilities have risen from a little below 3 times Gross Domestic Product to over 5½ times GDP. That is certainly worthy of analysis.
Mervyn King’s speech
Banking: from Bagehot to Basel, and back again The second Bagehot lecture, New York City (25/10/10)
Articles
Mervyn King mobilises his tanks Independent, Ben Chu (26/10/10)
Get tougher on banks, says banking governor Mervyn King’ Daily Mail, Hugo Duncan (26/10/10)
Mervyn King attacks ‘absurd’ bank risk BBC News (26/10/10)
Mervyn King says banking must be reinvented BBC News blogs: Peston’s Picks, Robert Peston (26/10/10)
Data
Data on banks’ liabilities and assets are available from the Bank of England’s statistics publication, Monetary and Financial Statistics (Bankstats) (See Table B1.4.)
Questions
- What do you understand by the terms: (i) market failure; and (ii) maturity transformation?
- What is the external cost identified by Mervyn King arising out of maturity transformation?
- What does it mean to internalise an external cost? Can you think of examples from everyday life where attempts are made to do this?
- Consider the various ‘remedies’ identified by Mervyn King to reduce the riskiness of our financial system. (You may wish to download the speech using the web link above).
- Distinguish between the following deposits: (i) time deposit; (ii) sight deposit; and (iii) repos.
Governments and businesses across the world have been trying to become more environmentally friendly, as everyone becomes more concerned with climate change and emissions. In the UK, incentives had been put in place to encourage large-scale organisations to reduce their consumption of gas and electricity. The Carbon Reduction Commitment Scheme began in April 2010, with companies and public-sector orgainisations required to record their energy consumption. Then in April 2011 it was planned that those consuming over 6000 MWh of electricity per year (about £500,000 worth) would be required to purchase ‘allowances’ of £12 for each tonne of carbon dioxide that is emitted by their use of fuel: electricity, gas, coal and other fuels. This would require the organisations working out their ‘carbon footprint’, using guidance from the Department of Energy and Climate Change. In the case of coal and gas, the emissions would be largely from burning the fuel. In the case of electricity it would be largely from generating it.
The government had intended to use the revenue received from the sale of allowances to pay subsidies to those firms which were the most successful in cutting their emissions.
By raising money from the largest emitters via a levy and giving it back as a ‘refund’ to those who cut their usage the most, the government would not have been able to raise any revenue, but it did tackle the core of the problem – reducing emissions. However, following the Spending Review, this scheme will now actually generate revenue for the government. Paragraph 2.108 on page 62 of the Spending Review states the following:
The CRC Energy Efficiency scheme will be simplified to reduce the burden on businesses,
with the first allowance sales for 2011-12 emissions now taking place in 2012 rather than 2011. Revenues from allowance sales totalling £1 billion a year by 2014-15 will be used to support the public finances, including spending on the environment, rather than recycled to participants. Further decisions on allowance sales are a matter for the Budget process.
Over 5000 firms and other organisations will now find that their hard work in cutting usage and being more environmentally friendly will give them much less reward, as the revenue raised from the levy will remain in the Treasury. All that firms will now gain from cutting emissions is a reduction their levy bill. The extra £1bn or more raised each year from the scheme will undoubtedly be beneficial for tackling the budget deficit, but it will no longer provide subsidies to firms which reduce their emissions. Furthermore, PriceWaterhouseCooper estimates that it will cost businesses with an average gas and electricity bill of £1 million an extra £76,000 in the first year and this may increase to an additional cost of £114,000 per year by 2015.
It’s hardly surprising that businesses are angry, especially when this withdrawal of subsidy, which some have dubbed a ‘stealth tax’, was not mentioned in the Chancellor’s speech, but was left to the small print of the Spending Review announcement. The following articles look at this highly controversial plan.
Articles
Spending Review: Large firms ‘face green stealth tax’ BBC News (21/910/10)
Business lose out via £1bn-a-year green ‘stealth tax’ Management Today, Emma Haslett (21/10/10)
Fury over £1bn green stealth tax in spending review Telegraph, Rowena Mason (20/10/10)
Is ‘stealth’ tax a threat to UK economy going green? BBC News, Roger Harrabin (20/10/10)
Green spending review – it could have been a whole lot worse Business Green, James Murray (20/10/10)
Coalition hits big business with stealth carbon tax Business Green, James Murray (20/10/10)
UK government hits big businesses with stealth carbon tax Reuters, James Murray (20/10/10)
UK’s carbon tax bombshell takes business by surprise Reuters, Will Nichols and James Murray (21/10/10)
CRC allowances sting in UK Spending Review The Engineer, M&C Energy Group (22/10/10)
The CRC scheme
CRC Energy Efficiency Scheme Department of Energy and Climate Change
Questions
- How does a tax affect the supply curve and what would be the impact on the equilibrium price and quantity?
- To what extent might this “stealth tax” (i.e. withdrawal of subsidy) adversely affect (a) businesses in the UK; (b) the economy more generally?
- Why will firms have to re-look at their cash flow, costs and revenue following this change? How might this affect business strategy?
- By taxing firms using more gas and electricity, what problem is the government trying to solve? (Think about market failure.)
$8 billion – this is the likely cost of the BP oil leak, which spilled 206 million gallons of oil into the Gulf of Mexico. Whilst the oil leak has been stopped for some time, there were ongoing concerns that the leak would re-appear due to the underwater pressure. The cost of stopping the leak has been substantial, but BP will face further costs, as the company begins to pay out compensation.
$20 billion is the compensation that residents of the Gulf of Mexico will receive. Further to this, BP has said that it will invest more money in promoting the tourism industry there, which has suffered from the oil spill. However, what about the fishing industry? Although compensation will be paid for the losses incurred, will this continue in the long term? The oil may cause a loss in productivity in certain populations of sea-life. How will this impact us? If certain fish became scarcer, then their price will rise accordingly, whether you purchase the fish at a shop or have it as a meal in a restaurant. To make matters worse, the hurricane season has arrived in the affected areas, which will make the clean-up effort even harder.
As BP’s share price has fallen, individuals have suffered from lower dividends. Jupiter Income Trust had almost 10% of their portfolio invested in BP, which largely explains the 9 per cent drop in their payout.
Articles
BP oil well ‘poses no further risk’, says Allen BBC News (5/9/10)
BP oil spill fallout hits Jupiter dividend Mail Online, Richard Dyson (4/9/10)
Gulf Oil leak: biggest ever, but how bad? BBC News, Richard Black (3/8/10)
BP oil spill didn’t hit tourism too hard Jabber Lounge, Gloria Rand (5/9/10)
BP oil victims face strings on $20 billion oil fund Telegraph, Rowena Mason (20/8/10)
BP share price data
BP historical share prices Yahoo Finance
BP share price chart Interactive Investor
Questions
- Which industries have been affected by the oil leak? Don’t think too close to home – look at the wider picture.
- Is the oil spill an example of a negative externality? Can it be illustrated on a diagram and, if so, how?
- What has happened to BP’s share price since the beginning of the oil spill? Put this on to a graph to trace the trend. Try to explain the changes in the share price using a demand and supply diagram.
- How would BP have calculated the compensation to be paid to residents of the Gulf of Mexico? Would cost–benefit analysis have been involved?
On April 20 2010, there was an explosion on one of BP’s drilling rigs approximately 50 km offshore and over 1000 metres underwater in the Gulf of Mexico. This has led to more than 5000 barrels of oil leaking into the sea every day. The slick now covers an area the size of Luxembourg. Attempts have, at this time, failed to stop the leaks and the massive sheet of oil is edging closer and closer to the coast.
A giant dome was the original idea to stop the oil leak, however, this proved ineffective, due to a buildup of crystallised gas in the dome. The next step is to shoot debris underwater, including golf balls, tyres and human hair, under intensely high pressure and try to clog the leak. However, every time a new idea to stop the leak is tested, costs for BP mount. Furthermore, every time an idea fails, costs for the environment and the affected industries increase. Costs to BP are currently estimated to be $350 million, but other businesses are also suffering. Oil has now started to appear at costal resorts, yet even before it did, the tourism industry was suffering. Captain Louis Skmetta from Ship Islands Excursions said:
“Yesterday was beautiful. School are letting out, and we were hoping for about 500 passengers yesterday. We had a total of 166. So we are definitely seeing a little bit of an impact”.
Another industry that is concerned about the effects is the restaurant trade, in particular those who specialise in sea-foods. With the oil killing off marine life, prices of seafood for businesses and customers have already begun to rise in New York and London. The impact on this industry cannot be accurately estimated at present, but costs are continuing to rise every day this environmental crisis continues. These price rises are on top of already rising commodity prices: Wholesale food prices rose 7 percent in the 12-month period that ended March 31 2010. There is great uncertainty about the overall economic impact of this crisis, but what is certain is that every day oil continues to leak, costs will continue to rise.
Dome fails to stop Louisiana oil leak Independent (10/5/10)
Aerial view of oil leak in Gulf of Mexico BBC News (9/5/10)
BP plans to use debris to staunch Louisiana oil leak Financial Times (10/5/10)
Cost of oil leak spills into valley Dayton Daily News, Mark Fisher and Steve Bennish (9/5/10)
BP: oil leak will be stopped but can’t say when Associated Press (7/5/10)
BP shares down; Says Deepwater cost $350m so far Wall Street Journal (10/5/10)
BP misses out on FTSE rally as oil spill costs reach $350m so far Guardian, Nick Fletcher (10/5/10)
Conn. restaurants fear spike in costs of crabs, shrimps, oysters following Gulf oil-spill The Middletown Press, Cara Baruzzi (10/5/10)
BP examining oil leak options ABC News (10/5/10)
Oil-soaked crab threatens sea-food prices at top-ranked eateries Bloomberg BusinessWeek (10/5/10)
Tourism operators say oil threat hurting their pocketbooks WLOX, Danielle Thomas (10/5/10)
Coastal businesses feel the pain of Gulf oil leak NPR, Debbie Elliott (7/5/10)
Questions
- Try to carry out a cost-benefit analysis of the two attempts to stop the oil leak.
- Which industries are likely to be affected by the oil rig explosion? Explain your answers.
- Who should have to pay for the clean-up? Could the oil spill be seen as a negative externality?
- Why are restaurants in London seeing rising food prices, when the oil leak is located in the Gulf of Mexico?
- What has happened to BP share prices? How do you think they will change when the oil leak is stopped?
- What will be the impact on BP in the long term? Think about the role of corporate social responsibility.
The Labour government’s investment in education has been widely publicised since its rise to power in 1997 and there has been a significant increase in funding to match its ‘50% participation in higher education’ target. However, at the university level, this looks set to change. More than 100 universities face a drop in their government grants as a consequence of £450 million worth of cuts. 69 universities face cuts in cash terms and another 37 have rises below 2 per cent. Furthermore, increased funding is now going to those departments where research is of the highest quality, which means that whilst some universities will not see a cut in funding, they will see a reallocation of their funds.
Sir Alan Langlands, Chief Executive of Hefce, said: “These are very modest reductions. I think it is quite likely that universities will be able to cope with these without in any way undermining the student experience.” Despite this reassurance, there are concerns that, with these spending cuts and growing student numbers, class sizes will have to increase, the quality of the education may fall and ultimately, it may mean a reduction in the number of places offered. The Conservatives have estimated that 275,000 students will miss out on a place. UCAS applications have grown by 23% – or 106,389 – so far this year, but the number of places has been reduced by 6000. This policy of cutting places is clearly contrary to the government’s target of 50% participation.
With the average degree costing students over £9000, it is hardly surprising that students are unhappy with these spending cuts and the fact that it could lead to a lower quality education. With the possibility of rising fees (in particular, as advocated by Lord Patten, who has called for the abolition of a “preposterous” £3,200 cap on student tuition fees) and a lower quality degree, this means that students could end up paying a very high price for a university education.
Articles
Universities fear research funding cuts Financial Times (18/3/10)
More students but who will pay? BBC News, Sean Coughlan (18/3/10)
University cuts announced as recession bites Reuters (18/3/10)
How about $200,000 dollars for a degree? BBC News, Sean Coughlan (18/3/10)
Liberate our universities Telegraph (17/3/10)
Universities should set own fees, say Oxford Chancellor Patten Independent, Richard Garner (17/3/10)
University budgets to be slashed by up to 14% Guardian, Jessica Shepherd (18/3/10)
Universities face cuts as Hefce deals with first funding drop in years RSC, Chemistry World (17/3/10)
University cuts spell campus turmoil BBC News, Hannah Richardson (18/3/10)
Universities told of funding cuts Press Association (18/3/10)
100 universities suffer as government announces £450 million of cuts Times Online, Greg Hurst (18/3/10)
Data
HEFCE announces funding of £7.3 billion for universities and colleges in England HEFCE News (18/3/10)
Questions
- Why is there justification for government intervention in higher education? Think about the issues of efficiency and equity and why the market for education fails.
- What are the arguments (a) for and (b) against allowing universities to set their own tuition fees?
- Why is the government planning these substantial cuts to university funding, when it is still trying to increase the number of students getting places at university?
- Is the ‘50% participation in higher education’ a good policy?
- What are the benefits of education? Think about those accruing to the individual and those gained by society. Can you use this to explain why the government has role in intervening in the market for higher education?
- Is it right that more spending should go to those departments with higher quality research? What are the arguments for and against this policy?
- What are the costs to a student of a university education and how will they change with funding cuts and possibly higher tuition fees?