The Future of Banking

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SUMMARYThe global financial crisis is the most important economic event in the West for two generations. The challenge this presents to our thinking in economics and finance is only just beginning to be understood. The foundations of much of our current theory, efficient markets and rational expectations, have been shown to be inappropriate. Even behavioural finance was poor in signalling the locus of crisis. This matters because how we think about finance determines how we approach regulating institutions and markets. This in turn impacts on the ability of the financial system to perform its key functions of intermediating between borrowers and lenders and best managing the associated risks. We contend that performance was undermined before, during and after the crisis due to failures of regulation rooted in an inadequate understanding of the nature of finance.Governments have been active in responding to the crisis with both prudential and structural regulatory initiatives but in our view do not show enough understanding of the underlying issues. Too many initiatives take banks to be the same institutions as in the past, rather than how they operate today. In this context, the main policy document which this study will address is the Independent Commission on Banking (ICB) study on stability and competition in the UK banking sector, which has counterparts in the US (Volcker Rule) and EU (Liikanen High Level report on banking separation).NIESR has repeatedly challenged the ICB approach as partial and incomplete.[1] The ICB fails to recognise: (a) the information problems inherent in the complexity of new universal banks (e.g. HSBC has over two thousand entities), (b) that reputation matters to banks and so competition and stability may not always be complements, and (c) bank stability cannot be assured without a robust infrastructure in key funding markets. Our concerns have sadly been vindicated by the stream of governance failures coming to light in banks since the report was published.We aim to undertake three separate studies which address the shortcomings in current thinking regarding financial regulation. First, we consider whether there is empirical evidence to support the combination or separation of retail banking and investment banking in a single firm. Second, we examine the relationship between competition and stability in the financial sector, including the potential impact of reputation of an individual firm. Finally, we will look anew at the infrastructure of finance (including the regulatory environment, legal and accounting procedures and key trading markets) and consider its appropriateness in the light of recent experience and the efficiency with which the key functions of the financial system are performed.[1] See National Institute Economic Reviews, issues 218,219 and 220 for articles.