We'll pay for banks to be virtuous

I've talked before about the fallacy of composition arising from all banks discovering virtue and prudence at the same time.

If all banks increase their holdings of liquid assets, shrink their reliance on wholesale finance and lend less relative to their capital resources in one fell swoop, well there would be a collapse in lending to the real economy and we'd be in a fair old depression in no time at all - and the banks themselves would soon find themselves bust.

Even so it's to the benefit of the economy over the longer term and in the interest of the banks individually for the banks collectively to strengthen their finances in just that way (though we should be under no illusion that in the first phase of the credit crunch, in the year before the collapse of Lehman, the knee-jerk evasive action taken by banks to shrink their balance sheets relative to their capital and liquidity - which was encouraged by regulators - did tremendous damage to the economy, in curtailing the supply of credit).

But even if the banks are given long enough to reinvent themselves as more cautious, well capitalised, better balanced institutions, it would be very foolish to believe there won't be costs - and most of those costs will probably fall on us, their customers, rather than on the banks themselves and their shareholders.

The point is that safe liquid assets, such as high quality government bonds, have a lower yield - they pay out less income - than other kinds of riskier loans. So when banks have to hold more cash and government bonds, their revenues fall.

Also, capital - which is vital for banks as insulation against potential losses - is expensive. Banks have to reward the providers of capital with fat dividends.

So safe, sturdy banks are intrinsically less profitable banks. And safe, sturdy banks have a huge incentive to endeavour to recoup their lost profit by pushing up what they charge households and businesses for loans and also by reducing what they pay for deposits (although that is harder, when deposits are in short supply).

How big a price will we have to pay for a fit banking system?

Well, in spelling out the new liquidity rules for banks yesterday, the City watchdog, the Financial Services Authority, gave some estimates of the profits that banks will forego.

It is impossible to be precise at this stage, because the FSA has yet to determine quite how much stress it wants banks to be able to withstand.

But on the basis that banks are also forced to reduce their dependence on unreliable short-term wholesale funding by up to 40%, well they would be forced to hold between £310bn and £450bn of additional top quality liquid assets.

And, according to the FSA, that would lead to a reduction in their profits of between £5.7bn and £7.8bn.

Which is not trivial. Especially since the FSA says that "we expect these costs to be absorbed by the wider economy [rather] than by the banks themselves."

In other words, merely making sure that banks have enough cash to meet demand from creditors in a panic would take up to £7.8bn every year from households and businesses in the form of higher interest charges or lower deposit rates.

If you translated that into an equivalent tax rise, there would be uproar.

But, funnily enough, there hasn't been any debate about how much we are prepared to pay to make our banks safe.

Some would say the FSA - and other regulators around the world - are imposing taxation without any kind of representation.

What's more, the cost to us of forcing the banks to hold more capital could be just as high, if not higher.

In the case of capital, banks were previously obliged to hold 2% of their assets in the form of what's called core tier one capital (or more-or-less pure equity, genuine risk capital). Right now - at the urging of regulators - that's risen to between 6.5% and 9%. And the FSA has signalled that it wants banks to hold even more, probably 10%.

So the amount of core tier one capital that'll be held by banks will have quintupled.

Which will increase the banks' costs of doing business very significantly.

So they'll levy another de facto tax on all of us running to many billions of pounds in the form of higher interest charges and lower deposit rates.

To be fair to the FSA, it seems to recognise that in imposing these costs on banks and us without actually asking us, there is something of a democratic deficit (to put it mildly).

It is therefore working on an assessment of the impact of the economy of these separate measures to strengthen banks.

Which - let's hope - should spark a debate.

Because it's all very well to say that we want a safe banking system, one that isn't vulnerable to the kind of meltdown we experienced last autumn.

But if we wanted to eliminate all risk from the banking system, that would be very expensive indeed: a zero-risk banking system would be one which supplied very little and very expensive credit; and it would probably be associated with a sclerotic, stagnating economy.

It's very much like safety on the railways.

We need to decide the maximum price we're prepared to pay to avoid crashes. And we should recognise that the cost of eliminating all risk of crashes is prohibitive.

PS. In a world where capital requirements have gone through the roof, shouldn't we all just club together to form mutuals - so that the price of servicing all that additional capital is distributed between lenders and borrowers, rather than transferred to outside shareholders? Just a thought.