A new volume from the free market, neoliberal think tank the Adam Smith Institute, What a Capital Idea!: How to make Britain’s banks more competitive, innovative, and safer, is calling for a radical rethink of banking regulation:

• UK banks that issue high levels of capital should be freed of other cumbersome prudential regulation, such as the mandatory deposit insurance scheme

• Banks are more leveraged now than in the lead-up to the Great Financial Crisis of 2008, when market-value leverage ratios were just over 7% — they now stand at just 4%

• The ‘Great Capital Rebuild’ that banks undertook in the past decade is ‘as real as the Wizard of Oz’ says Professor Kevin Dowd

• Higher capital requirements and less other prudential regulation would help restore public faith in banking, make banks safer and less prone to causing financial crashes, and reduce the barriers to entry of new banks that would increase competition and customer service

• This is similar to the regime in the United States’ CHOICE Act, which was passed by the Republican-controlled House of Representatives in the last Congress

Banks are not trusted. A poll last year found that two-thirds of the public do not trust banks to work in the interest of society and 63% are worried that banks may cause another financial crisis. They are broadly blamed for the global financial crisis, and prone to excessive risk.

The failure of the banking sector is not, however, a failure of the free market left to its worst impulses. Banking is highly regulated and directed by the state from the Bank of England’s control of interest rates to the Financial Services Act’s thousands of pages and the Financial Conduct Authority’s thousands of regulators.

The Adam Smith Institute report, written by Professors Kevin Dowd and John Cochrane, argues that the existing regulatory regime creates a moral hazard: the public deposit insurance scheme and expected taxpayer bailouts in a time of crisis encourage banks to take excessively risky behaviour and issue limited capital.

The growth of banking regulation does little to make banks less risky but it does increase compliance costs and create substantial barriers to entry for competitor banks. The lack of new entrants reduces customer service quality and innovation.

Professor Kevin Dowd argues that banks are considerably more leveraged now than they were going into the Great Financial Crisis. He says that the banks’ ‘Great Capital Rebuild’ in the wake of the crash is as real as the Wizard of Oz.

He argues that with banks more heavily leveraged that the next financial crisis will be bigger than the last, warning that there is a “good chance the next round of bailouts and stimulus will be beyond even our governments’ fiscal resources” and that “our fiscal firehouse is not infinite.”

Instead of following the same script of bailing out creditors to stop a run on a bank in any future crisis, and expanding asset and anti-competitive regulation, the free market think tank suggests that we should require banks to issue immense amounts of capital (and long-term debt) so that their remaining run-prone liabilities are not in question.

Banks should be required to issue immense amounts of capital, the free market think tank suggests, so much that their remaining run-prone liabilities are never in question. The issuing of more higher capital may mean banks can take fewer risks and are therefore less profitable, however current profits are dependent on an unfair taxpayer subsidy.

The United States’ CHOICE Act, passed by the US House of Representatives, offers banks a choice to either continue with the existing system that requires low levels of capital or if a bank operates with a higher level of capital it can be exempt from swaths of regulation. Britain should introduce a similar regulatory option for banks.

In the UK, the Adam Smith Institute argues that banks that issue more capital could be able to opt out of regulation stemming from Basel III and Solvency II (for insurance companies) and the Financial Services Compensation Scheme (i.e. deposit insurance).  Banks would be free to walk away from normal PRA supervision and new banks that wanted to set up on with high capital requirements (above 20%) would get automatic approval to do so.

Steve Baker MP, said about the report:

“Socialism for the banks — extensive regulation, state direction and taxpayer bailouts — is a disaster there as it is everywhere. In the public interest, it must be brought to an end. I congratulate Cochrane and Dowd on setting out how it might be done.”

John Cochrane, Senior Fellow at Hoover Institution at Stanford University and chapter author:

“We have the chance to end financial crises forever. If banks got most of the money they use to make risky investments by selling stock, as other companies do, we would not have crises when banks lose money. Modern financial, communications and computation technology allow such equity-financed banking to take over. This volume describes just how we can end financial crises forever in this way – and how the continuing effort to subsidize and regulate banks will not work.”

Kevin Dowd, Professor of Finance and Economics at Durham University and chapter author:

“Most people don’t realise that in market-value terms, banks are more leveraged now than they were before the crisis. This high leverage means that banks are vulnerable to a downturn and are being subsidised by the taxpayer to take excessive risks. It is therefore essential that minimum capital standards be much higher than they currently are.”

Matthew Lesh, the ASI’s Head of Research said:

“Banking as it stands is not the free market at work, but crony corporatism at its absolute worst. The time for tinkering around the edges is over. Taxpayers should not be on the line to pay the costs of excessive risk-taking from banks. It’s time to recreate an actual free market in banking, secured by proper capitalisation and limited prudential regulation that reduces risks while encouraging competition and innovation.”

-ENDS-

Notes to editors:  

For further comments or to arrange an interview, contact Matt Kilcoyne, Head of Communications, matt@adamsmith.org | 07904 099599.