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)
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 on banks’ liabilities and assets are available from the Bank of England’s statistics publication, Monetary and Financial Statistics (Bankstats) (See Table B1.4.)
- 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.