Writing for FT.com’s “The Exchange” blog, economists Diane Coyle and Jonathan Haskel suggest that Britain’s regulators — namely, the Competition and Markets Authority and the Bank of England — have got it wrong on competition in banking. The authors argue that “the CMA and the BoE” have overlooked “the ruinous effect on competition of the ‘too big to fail’ subsidy” in their recent reports and policy announcements, and that, if anything, it is becoming “harder than ever for new entrants to gain a foothold” in the banking market.
In my view, Coyle and Haskel are right, but their argument doesn’t go far enough.
Let’s start with the basics: what is the too-big-to-fail subsidy, and how does it affect competition in banking? The fundamental idea is that the bigger a bank is, the more likely it is to be bailed out if it runs into trouble. The events of the 2008 financial crisis seem to confirm this, as do the assumptions of government assistance that some rating agencies build into their “support” ratings. And as the 2011 report of Britain’s Independent Commission on Banking points out:
If one bank is seen as more likely to receive government support than another this will give it an unwarranted competitive advantage. As creditors are assumed to be less likely to take losses, the bank will be able to fund itself more cheaply and so will have a lower cost base than its rival for a reason nothing to do with superior underlying efficiency.
The result is that small banks struggle to compete against larger rivals, while market entrants have difficulty establishing themselves against privileged incumbents. All of this makes the banking sector less dynamic — and more comprehensively dominated by large, established firms — than it might otherwise be.
As Coyle and Haskel see it, however, Britain’s CMA thinks the problem has already been solved: that the competitive playing field has been leveled by the Bank of England’s proposed “systemic risk buffer,” according to which larger banks must hold more equity capital against their risk-weighted assets than smaller competitors. In consequence, the CMA’s October 2015 provisional report on Britain’s retail banking market mostly ignored the too-big-to-fail problem, focusing instead on the rather more mundane question of how consumers can be encouraged to switch bank accounts more often.
Yet the CMA’s position is mistaken, say Coyle and Haskel, for three reasons. First, switching bank accounts doesn’t always make sense for consumers: in the UK, at least, one bank account is pretty much the same as another, so consumers’ status quo bias is often quite rational. Second, the level of additional capital big banks must hold as a systemic risk buffer is not high enough to outweigh the funding benefits that accrue from being too-big-to-fail. Third, the stepped schedule of systemic risk buffer requirements outlined by the Bank of England might make big banks less likely to compete with each other, by effectively creating high marginal tax rates when banks move from one “systemic risk buffer” tier to another. As Coyle and Haskel say, “This might restrain the emergence of gargantuan banks, but the purpose of competition is to promote rivalry, not hold up expansion at arbitrary regulator-determined thresholds.”
So far, so good. But there’s a bigger picture here that Coyle and Haskel don’t see, or at least fail to mention. For one thing, it isn’t just lower funding costs that make too-big-to-fail such an anti-competitive doctrine. In fact, the very act of bailing out a failing institution itself constitutes a powerful strike against market competition. As Europe Economics’ Andrew Lilico has put it, “company failure is an essential and ineliminable part of the competition process. One of the most important obstacles to new entry in the banking sector, impeding competition, is that failing banks are saved by the government.” If you want smaller banks to grow, and new banks to prosper, in other words, you can’t keep saving their bigger rivals from the consequences of bad investments.
More important still are the grounds upon which banks compete. And it’s here that our financial regulatory authorities have the most to answer for. Yes—of course—banks should compete with one another to provide the best possible service at the best possible price. In an ideal world, however, banks would compete on something else as well: namely, their safety, stability, and reliability. That banks do not tend to compete on these grounds today is testament to the fact that their depositors, bondholders, and shareholders do not see the need to pay attention to such things. “Regulatory badging,” that illusory sense that banks must be safe because they are subject to regulators’ oversight, means that people seldom ask how highly-leveraged their banks really are. Deposit insurance means they might not care about the answer, even if they ask the question. And too-big-to-fail compounds the problem: if your bank is going to be bailed out, why worry about its risk profile? No amount of regulatory oversight can compensate for this loss of competitive market discipline.
Ultimately, then, Coyle and Haskel are right to stress the importance of competition: if financial stability is the goal, then competition must be central to any banking reform agenda worthy of the name. But before regulators can be part of the solution, they must understand the ways in which they are part of the problem. And that, alas, has yet to happen.