Free market fairy tale

The other day, I had a debate with various people on Twitter as to whether there was any such thing as a free market.  I think we agreed to disagree, and personally I still question whether a really free market can exist at all in an advanced economy. But one thing we do agree on is that the banking "market" is anything but free.

Yesterday I wrote a post pointing out that the banks actually set saving and borrowing interest rates according to market demands and the needs of their business, not according to the base rate - despite what people think and the media say.  And I identified the real cause of the increased spread between borrowing and savings rates as being the introduction of higher capital and liquidity requirements to make banks "safer".  Safety comes at a price, and that price is less lending, higher rates to borrowers and lower rates to savers.

Having capital requirements for banks at all is direct government interference in the market, which creates distortions and gives certain categories of customer a raw deal.  The question we have to ask ourselves is whether additional regulation is needed to protect the customers disadvantaged by the regulations we have already introduced.  Regulation tends to beget regulation, as each time another regulation is added the commercial organisations react to it in ways that disadvantage other consumer groups.  The "red tape strangles business" we hear from politicians of right-wing persuasion arises from this tussle between regulator and regulated. These politicians tend to try to persuade rather than regulate, but the effect is still the same.

Here are some of the current distortions in the retail banking market.  Note how many are "sacred cows"!

  • Unlimited taxpayer guarantee of retail deposits
  • Capital reserve requirements
  • Liquidity requirements
  • Bank of England funding support for payments
  • Interbank lending rate (why is there only one LIBOR rate?)
  • Bank of England base rate (why doesn't the BoE charge different rates according to institutional risk?)
  • Single fiat currency issued only by the Bank of England
  • The Bank of England (why do we have a "lender of last resort" at all?)
  • Project Merlin (why should the banks lend more to SMEs just to "get the economy growing"?)
And how about these distortions in investment banking (a much larger savings market):

  • Tax relief on pension savings
  • Tax relief on other forms of savings such as ISAs
  • Requirements for pension funds to invest highly in "safe" securities such as government debt
  • Bans on short selling of CDS and government debt in EU, US and other countries
These are not exhaustive lists.  No doubt there are many more examples.

A free market in banking would look very different from what we currently have:

  • No government guarantee of retail deposits, or anything else for that matter.  A bank that failed would not be bailed out by taxpayers, however large and important it was.  Savers would lose all money not covered by voluntary bank insurance schemes
  • Savers would be charged by banks for insurance to protect their savings in the event of bank failure. They would of course be free to refuse this insurance and take the risk.  There would be a growth of private-sector insurance schemes protecting savers - and of course an attendent risk of mis-selling (nobody ever said that a free market couldn't be corrupt!) 
  • No free banking. Banks would charge for every bank transaction
  • Banks could lend unlimited amounts of fictional money. They would have no need to hold reserves except for funding.  But they actually might increase their reserves - read on.....
  • All bank funding would come from the interbank market. There would be no lender of last resort. If the markets stop lending banks would fail.  Banks would be forced to put in place longer-term funding strategies: their current practice of lending long and borrowing VERY short would have to end. Because of this, banks would be likely to hold reserves voluntarily because of the risk of losing short-term funding. There would be a greater need for them to attract retail deposits, particularly longer-term notice deposits, and savings rates would rise due to the increased competition.
  • Banks of varying sizes would face different funding rates depending on the interbank market's view of their risk. Smaller banks would either charge more for borrowing or suffer margin reduction.  They would be likely to become niche players - offering very high savings rates to sophisticated investors who don't mind risk, or focusing lending on high risk individuals and businesses at very high rates.  We are seeing some of this developing already (companies specialising in payday lending, for example).
  • There might be more differentiation in the market - more players specialising in different things.
Oh, and there would be no IMF, of course. The very existence of a supra-national body whose sole purpose is to "maintain the stability of the international financial system" creates the largest distortion in the banking market and disadvantages the greatest number of customers.

It's an interesting model, isn't it? Note that savers would be likely to do VERY much better under such a model, but borrowers would have to pay more.  So it is fair to say that the present regulated banking system systematically discriminates against savers in favour of borrowers.  If the government prefers to maintain a regulated system, then this is an area that needs addressing through additional regulation. It is not reasonable to expect banks to offer a better deal to savers voluntarily. There is no reason for them to do so.


  1. Frances - this is perhaps slightly at a tangent but aren't schemes such as ISAs a complete rip off for the government? My impression is that virtually 100% of the tax foregone accrues to the banks since ISA rates are typically miserably low. So effectively the government pays the banks lots of money in order to give them a marketing ploy for people who wouldn't otherwise save and don't notice that they may not be getting a much better deal within the confines of their tax-free ISA than they might have obtained outside it. Is this a way too prejudiced view of things or does it have a reasonable element of truth?

  2. Frank, I agree. I discussed this in relation to pensions, which behave similarly, in a previous blogpost (Vampire City, see list). The return on an ISA is effectively generated ENTIRELY from taxation. Savers pay part of the return on an ISA because the tax they pay on the rest of their income is used to pay the interest on gilts, which form part of ISA investment. The rest is paid by government in the form of tax foregone. The tax relief is beneficial to savers but it is an additional incentive to the banks to pay peanuts. It's a scam, really.

  3. I'm no expert in banking history but isn't this effectively what we had up until a century or so ago?

    Didn't we get more bank failures when the banks were unregulated?

  4. No, we didn't get more bank failures. The last financial crisis has seen more banks go to the wall than in any previous crisis, and they are still failing. Financial crises are also getting more frequent, and their effects on the global economy are getting worse. Every time there is a financial crisis we pile more regulation on the financial sector in the hopes of preventing another crisis. You'd think we would have realised by now that everything we have historically done to protect ourselves hasn't worked, and therefore it is unlikely that what we are doing now will work either, since it is simply more of the same.

    I think I could make a case for excessive regulation actually CAUSING financial crises. And it definitely makes them worse. I don't expect my model above to be taken seriously - I did call this a fairy tale, after all. But I do want to challenge accepted thinking on the financial system and its regulation. We have to do something fundamentally different or eventually the system will implode.

  5. Frances, this would be a great start.

    But incomplete, until legal tender laws are revoked and banks allowed to issue their own paper, which would be of two varieties. The first would be 100% reserve notes, issued only as evidence of receipt of physical amounts of hard currency from depositors (essentially, warehouse receipts). For such depositors, the banks would be providing a safekeeping function and would charge a fee.

    The second type of paper would be fractional reserve notes, issued against hard currency of those depositors who want to allow the bank to lend out their hard currency, in return for interest.

    Depositors would thus deliberately choose whether they want a safekeeping function or an investment function, or a mix.


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