Banks are still too big to fail

December 19, 2012 // By: Lydia Prieg

Banks occupy a unique position in our economy and enjoy privileges that other industries can never hope for. This is most obvious in the way that major banks - Northern Rock, RBS, and Lloyds TSB - were bailed out by the government during the financial crisis. But these bail-outs were just the tip of the iceberg.

Today we have published figures that show Barclays, Lloyds, RBS, and HSBC enjoyed subsidies of £10bn, £9bn, £11bn and £5bn respectively. They’re an update of our report on the special privileges of the banking industry which was first published last year.

Calculating the Too Big to Fail Subsidy

All the large banks (not just those that received a bail out) benefit from an implicit subsidy from UK taxpayers. This subsidy exists because investors consider them ‘too-big-to-fail’ (TBTF): they assume the government will step in and bail-out these very large and highly-interconnected institutions if they ever get into trouble.

This translates into lower interest rates for big banks, which saves them enormous sums of money when they borrow. The Bank of England calls these savings a ‘TBTF subsidy’ and developed a method to calculate it. Using this methodology and market data, nef has calculated the total size of too big to fail subsidies for the last few years, and then by individual bank.

How much is the Too Big to Fail Subsidy?

The table below outlines the size of TBTF subsidies for big banks over the last few years:

Although the ‘too-big-to-fail’ subsidy has fallen from its mid-2009 peak, big UK banks still enjoyed a combined subsidy of £34 billion in 2011, with Barclays, Lloyds, RBS, and HSBC enjoying subsidies of £10bn, £9bn, £11bn and £5bn respectively. No other industry enjoys such a subsidy.

What’s wrong with the subsidy?

Banks do not pass on this benefit to their customers, it simply inflates their profits. In addition to being highly unfair, it’s also anti-competitive, as new or smaller challenger banks do not benefit from such a subsidy, and so find it extremely difficult to challenge the big four institutions. Moreover, the subsidy reflects the fact that taxpayers may once again be called upon to bail out the banks – exactly what we were promised wouldn’t happen. It also encourages banks to take on more risk, as they get to pocket any upside from risky trades but know that taxpayers will be there to pick up the tab if everything goes wrong. Finally, the TBTF subsidy also encourages further expansion and concentration within the banking sector, thus creating even larger too-big-to-fail institutions that enjoy even higher subsidies and further weakening competition.

It is also important to recognise that whilst the TBTF subsidy does not involve the direct transfer of funds from the Treasury to the banks, it may involve an indirect transfer, as the interest rate at which investors will lend to the government may increase to reflect the additional risk the government is taking on board in effectively underwriting banks.

Tackling TBTF

The government’s primary prescription for tackling the TBTF problem is to ring-fence retail banking away from investment banking activities. Yet ring-fencing is widely anticipated to only reduce and not eliminate the TBTF subsidy. For example, Lehman Brothers was an investment bank that had no retail banking component - yet its collapse sent shockwaves around the globe. In the UK we have individual banks with assets greater than UK GDP and, given this reality, even outright separation between retail and investment banking – which is not what we are getting – would still leave lingering too-big-to-fail problems. We have to acknowledge the fact that we have banks that are quite simply too big for our economy.

The Parliamentary Commission on Banking Standards is releasing its recommendations to the government on Friday 21st December, and has been looking at the ring-fencing proposals in depth. Let us hope that the Commission acknowledges the short-comings of the current plans, and pushes the government to at least examine more radical proposals, such as capping the size of banks, as has already been discussed in the US.


Banking & Finance

Banks are still too big to fail

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