Opinion: Banks are bloated subsidy junkies playing financial Jenga

As bankers continue to scandalise the country with the scale of their pay and bonuses while the real economy struggles and youth unemployment soars, we should take a long hard look at the role of banking in the wider economy.

For years the received wisdom has been that they make huge profits so they must be simply wonderful, Masters of the Universe, the jewel in the crown of the British economy and so unlike the broken-backed manufacturing sector. But how do they do it? I can see why top footballers are paid a fortune and why Apple’s brilliant innovations are so profitable. But banking?

The suspicion is that, far from creating wealth, they redistribute existing wealth to themselves – and that, like polluters, they do so by avoiding part of their costs. They book the profits, others pay for the cleanup.

This is what Andrew Haldane, Executive Director for Financial Stability at the Bank of England argues in a paper published last year [PDF] with systemic risk cast in the role of pollutant. He is not alone in this view; the New Economics Foundation (NEF) recently concluded that banks are getting hidden subsidies.

Even before the crisis, the ‘Too Big To Fail’ (TBTF) banks were benefiting from a market perception (correct as it turned out!) that the government would rescue them in a crisis enabling them to raise funds more cheaply than would otherwise have been the case. Haldane calculates that this covert subsidy averaged over £50 billion between 2007 and 2009 – a roughly equal to their annual profits prior to the crisis.

As for the bailout itself, Haldane argues that its direct cost may be less than £20 billion, or a little more than 1% of GDP, depending on the eventual losses. If a crisis comes along, say, every 20 years this is (sort of) affordable given that the UK banks had 2009 pre-tax profits of around £23 billion.

This would be bad enough if it ended there – but it doesn’t. The really big cost is the damage to the wider economy. Haldane estimates that UK output was around 10% lower than it would have been absent the crisis. In money terms this is equivalent to a loss of £140 billion for the UK just for 2009.

And it gets worse. Experience from past financial crises shows that the output loss is likely to persist for years – in other words the resulting recession is more likely to be L-shaped than V-shaped; it’s a step change, not a transient glitch. Haldane calculates that the Present Value of the persistent loss is between £1.8 and £7.4 trillion – roughly 1 to 5 times GDP. (It’s a big range because the assumptions are necessarily approximate; the important point is that it’s BIG relative to the economy.)

In addition to the TBTF subsidy, the NEF identifies other subsidies enjoyed by the banks, in particular ‘Quantitative Easing’ and ‘Make the Customer pay’ subsidies. NEF couldn’t get enough information to estimate the first but for the second they used mortgage data and certain investment banking fees to estimate “at least another £2.5 billion per year”.

However, these figures do not appear to include the cost to retail savers of ultra-low interest rates that the banks are not passing on to their borrowers. Channel 4 News recently put this at £20 billion per year.

NEF highlights the profit from ‘debt seignorage’. It’s hugely profitable for banks to create debt because they earn a percentage and laissez-faire regulation hasn’t constrained their behaviour. This has driven the excessive growth of the banking sector. Until about 50 years ago its size relative to UK GDP was relatively stable at around 50%. Since then it has grown so fast that it is around five times annual GDP while leverage has gone from 6:1 to 50:1 or more. It’s financial Jenga.

The effect has been to ‘financialise’ the economy, creating economic rent for the banks in the form of excessive mortgage payments etc. NEF doesn’t quantify it but it must be massive – roughly in proportion to their bloated size. Basically it’s a complex Ponzi scheme which, like all Ponzi schemes, enriches its sponsors while impoverishing the rest. Inequality is a by-product.

But perhaps the biggest distortion of all is the diversion of talent away from the real economy. As a nephew who recently graduated in engineering from Cambridge put it, “Why would I go into industry when I can earn many times more in the City?” We cannot run a successful economy staffed only by the B team. No wonder there is so much unemployment.

The inescapable conclusion is that, far from being paragons of economic virtue, the banks are subsidy junkies that badly distort the economy. Without the hidden subsidies their profitability would be more like the rest of the economy – as would their salaries.

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21 Comments

  • Keith Browning 20th Feb '11 - 10:43am

    The desperation of the banks to cover up their self centred, greedy attitude to the rest of us is no better demonstrated when the Barclays head claimed that the £2billion of PAYE and Natational Insurance paid by its employees out of their salaries was in fact taxes paid by Barclays to the government. Why he was not held to account for this statement is beyond me. I expect his enormous salary is well sorted in the tax avoidance scheme of things.

    You can fool some of the people some of the time, but surely the whole banking scam of self-centred back slapping has been rumbled. Trouble is no-one is prepared to pull the rug because too many parliamentarians are also ‘friends of the banking sector’ and have their fingers in the pie.

  • gramscis eyes 20th Feb '11 - 10:50am

    How do the banks get away with it? Obviously vested interests, but collectively it is because we allow them to get away with it.

    You dont need a conspiracy when everyone thinks the same way.

  • cynicalHighlander 20th Feb '11 - 10:50am

    How the Guardian was gagged from revealing Barclays tax secrets while bankers and big corporations use elected (puppet) politicians to do there bidding then it will only get worse.

  • Not only does this overgrowth of the financial sector lead to the problems above, it is also highly active in actually destabilising and destroying industry in this country. There is such a hunger for deals among these banks that they have facilitated the sell-off of major productive assets and sabotage management of industrial companies by championing ideas of short term shareholder value. If that can be maximised in the very short run by selling the company off to the highest foreign bidder, so much the better in their eyes. They have championed the “quick buck” mentality within management, with short three to (at the very maximum) five year time horizons, whereas companies in other countries like Germany are focused on 10 years or more, time enough to build up worldwide brands and product ranges and develop export markets.

    Psychological studies have shown that individuals who are able to defer gratification in the interests of long term gain are much more likely to succeed in life overall. I believe this principle also operates as far as nations are concerned. Our current business culture is the exact antithesis of this, and unless we can make a radical cultural change, we will carry on suffering as a result.

    The trouble is that anyone who tries to make changes that would tackle this problem is systematically sabotaged and howled down by “business leaders”. These “business leaders” turn out to be the chief execs of financially driven companies with no interests in the long term wellbeing of the country – only in lining their pockets as quickly as possible and then high tailing it to Switzerland, Monaco or the Virgin Islands.

  • Andrew Duffield 20th Feb '11 - 11:47am

    Good article – and spot on, apart from the fact that the real extent of seignorage subsidies is in excess of £100bn.

    Question is – what are we going to do about it?

    http://www.positivemoney.org.uk/

  • cynicalHighlander 20th Feb '11 - 12:51pm

    Question is – what are we going to do about it?

    The North African countries are doing something about !

  • Has the author of this piece seen that brilliant film ‘Inside Job’, just released in the UK, I wonder?
    Perhaps lifting the curtain, so that the mass of an otherwise largely compliant public can be let into the asylum is one way of doing something about it. You wouldn’t need to go on an anger management course after reading a Bank of England report so when are we going to move on to Act 2 of this tragedy?
    If anyone reading this article knows somebody in denial about the scale of the world banking crisis, please tell them to go and see ‘Inside Job’ – if they can bear to!

  • greg Tattersall 20th Feb '11 - 3:22pm

    Bankers love socialism as long it bails them out but hate it when it tries to tax the profits.When the banking sector went up in turmoil the bankers came begging with their bowls in their hands walking on their knees.Now when things look good they want to keep the profits and let the foolish taxpayers keep them in the lifestyle they have got used to.
    Well Mr Clegg your party and country needs you to do something and stop the bankers from sucking the country dry.

  • Simon McGrath 20th Feb '11 - 3:57pm

    Oh dear, another nonsensical report from the NEF. But this time with lots and lots of very big numbers. Hands up anyone who wouldn’t like an extra £1.8trillion or possible even better an extra £7.4 trillion. If it wasn’t for the wicked banks we would be rolling in money . even Gordon Brown would have trouble spending an extra £7.4trillion.

    The fundemntal idea that big banks are bad because they are too big to fail was shown to be utterly wrong during the crisis. The Government did not differentiate between size of banks in who they rescued, even decided that those who had foolishly lent to the Icelandic banks would get all their money back courtesy of the British taxpayer.

    is there any evidence that the rest of the economy has suffered because some clever people chose to go into financial services?

  • @ Simon McGrath

    “is there any evidence that the rest of the economy has suffered because some clever people chose to go into financial services?”

    Looking at their complicity in conducting the auction to sell off our manufacturing sector to the highest foreign bidder, then yes, there is.

    Just look at glass maker Pilkington: bought in 2006 by Japanese company Nippon Sheet Glass, using £1.5bn of money raised by BRITISH banks. Or Cadbury’s acquisition by Kraft, with money raised by HSBC and Barclays.

    Basically, the banks have been raking off vast fees from conducting a fire-sale of our best industrial assets. And now they tell us the time for apologies is over.

  • And don’t start telling me that it doesn’t matter where a company’s headquarters is or that we would be “blocking vital inward investment” in not allowing such deals, because that is just such BS.

    Other countries only sell off companies that are failing and in need of cash or new management. We sell off whatever the banks want to flog because they can make a quick buck out of it.

  • Liberal Neil 20th Feb '11 - 6:35pm

    If everyone who moans about ‘the banks’ chose to switch their personal account, mortgage and penion to mutuals it might have some impact.

  • Simon McGrath 20th Feb '11 - 7:11pm

    @Robert C – oh dear. First of all if you want to blame anyone you should blame the shareholders for selling to forgeign companies. and the alternative to the british banks would have been the US , German , japansese banks etc. For example the takeover of EMI was financed largely bu US banks.
    @Liberal neil – I agree, although since the Coop bank only paid 1.9% tax in 2009 …..

  • Simon McGrath 20th Feb '11 - 8:33pm

    @ olly – why is pointing out that the NEF talk nonsense Tory?

  • @ Simon McGrath

    “Oh dear”, so you still don’t get it that the financial services sector – wherever it is based – is being allowed to destroy the rest of our economy.

    “the alternative to the british banks would have been the US , German , japansese banks etc. For example the takeover of EMI was financed largely bu US banks.”

    Yes, they target the UK because they know that only the British would be stupid enough to sell off all their productive assets.

    And try leaving out the patronising “oh dears” in future.

  • @ Simon McGrath

    If you had bothered to read my posts above, you would notice that *I HAVE* given you some facts. The fact you chose to ignore them is up to you.

    The whole reason – as your correctly observed – why we don’t have many other productive or profitable sectors is that our economic policy has been run for the convenience of the financial sector.

    To give you one example: the “light touch” financial regulation about which Brown boasted led to excessive creation of credit. This in turn created inflationary pressure. The only way to respond to that pressure was to raise interest rates, pushing the value of the pound higher leading to higher imports, lower exports and stagnant manufacturing production. This was the consistent pattern from the late 1990s onwards.

    The financial services sector may pay a lot of tax (not as much as it should, if you look at the example of Barclays for instance), but that does not mean it should be allowed to distort our economic priorities and dictate government policy at the expense of the longer term prosperity of the UK.

    Of course financial services do have a role to play in a mixed economy, but they are now no longer a valuable adjunct to the rest of the economy and instead have become a destructive force within it. They are the tail wagging the dog. If you cannot see that, then you must be fairly blinkered in your analysis – I can only assume you work in financial services and so can’t view matters objectively.

  • Thanks for the comments. As expected, the great majority of Lib Dems understand that banking should not be given special treatment – for instance via subsidies etc. I wish I could same the same of senior Conservatives who seem to be very attached to the notion of crony capitalism. Specific responses:

    @Sean

    I have not yet seen ‘Inside Job’ although I did see an interview with its maker. There is a lot of similar material about if you look for it.

    @ Simon McGrath

    You appear to be confusing the Bank of England with NEF. Haldane’s PV estimate does not mean that this amount would have available for spending.

    Also how world class is the financial service sector in reality? Panorama last year made the point that much of financial services’ income arises from high prices for indifferent products (the killer for me was the factoid that a Dutch person with the same age and contributions record would retire with a 50% bigger pension pot that his British counterpart). This sounds alarmingly like the high cost/poor product world of British Leyland circa 1980.

    @ Steve Horgan

    Did you actually read the post? The first line should have made it perfectly clear that I was not talking of those working in High Street branches for modest salaries.

    Direct support for hte banks was, as I stated modest in the scheme of things. However, the Bank of England work that you gloss over makes it abundantly clear that the banks were and are are getting massive and continuing covert subsidies from the public. I am surprised that, as a Tory, you are content with that.

    As you say the key question is where we should go from here; ending subsidies would be a good start. They have enabled the banking sector to bloat beyond what is reasonable so diverting resources from other parts of the economy. Hence right-sizing banking is a necessary start to rebalancing the economy.

  • Gordon F
    Posted 21st February 2011 at 8:23 pm | Permalink
    Thanks for the comments. As expected, the great majority of Lib Dems understand that banking should not be given special treatment – for instance via subsidies etc. I wish I could same the same of senior Conservatives who seem to be very attached to the notion of crony capitalism…..

    …..
    I am sure tht you are right on this . it is such a shame that teh majority of Lib Dems does not extend to the neo -con infitrators who have taken over most of the goverment posts.

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