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Banking on Change
July/August 2011


Willem Buiter, chief economist of Citigroup, is one of the liveliest contributors to current debates on economic policy. On May 23 he gave particularly stimulating evidence to the Treasury Committee of the House of Commons, in its inquiry into the powers of the Bank of England. As is well-known, the early phase of the financial crisis saw intense efforts to recapitalise Britain's banks. Because private shareholders were reluctant to participate, much of the new capital came from the state, and the government now has large stakes in RBS and Lloyds. The Bank of England and the Treasury worked together in the recapitalisation, but only the Treasury — acting on behalf of the taxpayer — could inject equity capital on a large scale.

According to Buiter, one clear lesson from these events is that in future a "recapitaliser" of last resort is needed, as well as the "lender of last resort". The recapitaliser must be the government, with the key decisions taken by the Treasury. In Buiter's view, the existing reform proposals "leave the Treasury out of the core" which is "a big mistake". Instead he would reduce the Bank of England's responsibilities. Buiter believes the Bank and the Treasury should share the task of maintaining financial stability (i.e., ensuring that bank deposits can always be paid out 100 per cent in cash). 

But, as the World Bank has shown in several studies, nationalised and semi-nationalised banks are less efficient than their wholly privately-owned competitors. By implication, constant Treasury involvement in banking supervision would be a mistake. 

Is there a way out? First, Buiter needs to remember a key feature of the existing structure of institutions in this field of public policy. Yes, the central bank is supposed only to extend loans that are to be repaid in full with interest. It is not meant to be a risk-taking equity investor. But — as Buiter  must be aware — central bank loans are meant to be available only to solvent, well-capitalised banks. The assessment of UK commercial banks' capital strength ought therefore to rest with the Bank of England. To involve the Treasury would complicate matters and lead to turf fights of the kind that were so embarrassing in 2007 and 2008.

Secondly, in the UK — as in most countries-an important state — backed institution is semi-autonomous from both the central bank and the finance ministry. This is the deposit insurance agency (known here as the Financial Services Compensation Scheme), which is another buffer to protect depositors from bank failure. If banks have heavy losses that wipe out their equity capital, the first line of defence for retail depositors is not capital injections from the state, but transfers from the FSCS. Further, if FSCS's own assets are depleted, it has the power to impose a levy on the banking industry to rebuild the fund.

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