The Chancellor warned that “aggressively” breaking up banks would do little to benefit the UK and insisted the Government’s plans to put in place a so-called “ring fence” to force banks to isolate their riskier, investment banking businesses from their retail arm was the right way to make the financial system safer. “If we aggressively broke up all of our big banks, I am not sure that, as a society, we would benefit from it,” he said. “We don’t have a huge number of banks, sadly, large banks. I would like to see more.” His comments came as he gave evidence to the parliamentary commission on banking standards where he was accused of attempting to pressure members into supporting his ring-fencing reforms. “That work has been accepted, as far as I’m aware, by all the major political parties. We are now on the verge of getting on with it,” he said. Several members of the Commission have argued in favour of breaking up large banks, including former Chancellor, Lord Lawson.
This is really disappointing. Why would Osborne want to see more of something which requires government bailouts to subsist? Because that is the reality of a large, interconnective banking system filled with large, powerful interconnected banks. The 2008 crisis illustrates the problem with a large interconnective banking system. Big banks develop large, diversified and interconnected balance sheets as a sort of shock absorber. Under ordinary circumstances, if a negative shock (say, the failure of a hedge fund) happens, and the losses incurred are shared throughout the system by multiple creditors, then those smaller losses can be more easily absorbed than if the losses were absorbed by a single creditor, who then may be forced to default to other creditors. However, in the case of a very large shock (say, the failure of a megabank like Lehman Brothers or — heaven forbid! — Goldman Sachs) an interconnective network can simply amplify the shock and set the entire system on fire. As Andrew Haldane wrote in 2009:
Interconnected networks exhibit a knife-edge, or tipping point, property. Within a certain range, connections serve as a shock-absorber. The system acts as a mutual insurance device with disturbances dispersed and dissipated. But beyond a certain range, the system can tip the wrong side of the knife-edge. Interconnections serve as shock-ampli ers, not dampeners, as losses cascade. The system acts not as a mutual insurance device but as a mutual incendiary device.
Daron Acemoglu (et al)formalised this earlier this year:
The presence of dense connections imply that large negative shocks propagate to the entire fi nancial system. In contrast, with weak connections, shocks remain con fined to where they originate.
What this means (and what Osborne seems to miss) is that large banks are a systemic risk to a dense and interconnective financial system. Under a free market system (i.e. no bailouts) the brutal liquidation resulting from the crash of a too-big-to-fail megabank would serve as a warning sign. Large interconnective banks would be tarnished as a risky counterparty. The banking system would either have to self-regulate — prevent banks from getting too interconnected, and provide its own (non-taxpayer funded) liquidity insurance in the case of systemic risk — or accept the reality of large-scale liquidationary crashes. In the system we have (and the system Japan has lived with for the last twenty years) bailouts prevent liquidation, there are no real disincentives (after all capitalism without failure is like religion without sin — it doesn’t work), and the bailed-out too-big-to-fail banks become liquidity sucking zombies hooked on bailouts and injections. Wonderful, right George?