Last week, Mark Carney, governor of the Bank of England, brought cheer to the City of London. His robust defence of finance and declaration that "we are open for business" mark an abrupt change from the regime of Lord King, his predecessor. The financial sector will certainly love him. His views are refreshingly clear. But they are also a gamble.

In the speech celebrating the 125th anniversary of the Financial Times, Carney's central point was that "organised properly, a vibrant financial sector brings substantial benefits".

Carney pointed to the scale of the London markets, with almost four times as many foreign banks as in 1913. The assets of UK banks have grown from 40 per cent of gross domestic product to more than 400 per cent. But, he added, suppose: “UK-owned banks’ share of global financial activity remains the same and that financial deepening in foreign economies increases in line with historical norms. By 2050, UK banks’ assets could exceed nine times GDP, and that is to say nothing of the potentially rapid growth of foreign banking and shadow banking based in London.” He continued: “Some would react to this prospect with horror.”

He was right, since this would turn the UK into the Iceland of 2007. He responded that “a vibrant financial sector brings substantial benefits”. This is true, he asserted, not only for the UK, but for the world: “The UK’s financial sector can be both a global and a national asset – if it is resilient.”

Carney outlined the measures taken, and soon to be taken, to make banking more resilient. These include rules on bank capital and liquidity and, above all, procedures for the “resolution” of failing cross-border banks without need for taxpayer-funded bailouts. He noted that “the UK state cannot stand behind a banking system that is already many times the size of the economy”. In addition, he discussed new rules for markets, stressing the way changes in the value of collateral generate instability. But he insisted these weaknesses, which caused the markets to freeze in 2008, are being rectified.

Raw loans
Carney stressed the supportive role of the Bank of England while arguing that "our job is to ensure that [the financial sector] is safe". He emphasised the forthcoming approach of the central bank to supplying money and high-quality collateral to banks: "The range of assets we will accept in exchange will be wider, extending to raw loans and, in fact, any asset of which we are capable of assessing the risks. And using our facilities will be cheaper. In some cases, the fees are being more than halved."

This then is a new Bank of England. Is it also a sensible one? First, are the new liquidity rules wise? A central bank can, in principle, create domestic money without limit. But if it uses that power more freely, it will encourage banks and markets to generate more maturity transformation, making themselves and the economy more vulnerable to panic. The Victorian commentator Walter Bagehot thought central bank lending at a penalty rate would curb the danger. The lower the penalties, the more important are the new regulations on liquidity management. Will these work? We do not yet know.

Second, will new rules for banking and markets make them sufficiently resilient? Scepticism is in order. The idea the UK could become Iceland makes the ringfencing of retail banking proposed by the Independent Commission on Banking even more important. Beyond this, continued reliance on risk weighting of capital is disturbing. A leverage ratio of more than 30 to one is excessive. Far more equity is required.

Carney’s response to this is largely that the ability to “resolve” banks, by converting debt into equity, would solve the problem. Resolution might take taxpayers off the hook. But it would not take the economy off the hook. Once debt is converted into equity, in a crisis, the banks’ ability to expand credit would be curbed. That is what matters.

Is the future Carney outlines good for the UK? Here, he is right: the financial sector has become a crucial source of incomes and jobs. But this industry also generates instability and rising income inequality. At least, the UK needs to understand the implications of becoming a greater Hong Kong.

But the biggest question is whether ever-increasing financial deepening and cross-border integration are good things. The evidence is against these beliefs. In a recent paper, two economists from the Bank for International Settlements argued that there is a “negative relationship between the rate of growth of finance and the rate of growth of total factor productivity”. Part of the reason for this is that finance disproportionately benefits “high-collateral/low-productivity projects”.

Interconnected machine
As of August 2013, loans outstanding to UK residents from banks were £2.4 trillion (160 per cent of GDP). Of this, 34 per cent went to financial institutions, 42.7 per cent went to households, secured on dwellings, and another 10.1 per cent went to real estate and construction. Manufacturing received 1.4 per cent of the total. UK banking is a highly interconnected machine whose principal activity is leveraging up existing property assets.

Why should its expansion promote growth, other than its own? It may instead mainly exacerbate the British economy’s debt-induced fragility. Financial deepening does promote prosperity – up to a point. Many high-income countries are beyond it. The huge expansion in finance since 1980 has not brought commensurate economic gains. Many developing countries do have room to grow finance, to their benefit; India is an example. Yet some may already have enough.

It is also far from clear that arguments for cross-border financial integration carry over from those for trade in goods. Financial integration carries with it risks of crises, as emerging countries have learnt. The costs of self-insurance against crises are steep. A desire to protect domestic financial stability, by insisting that foreign banks create subsidiaries, not branches, is wise.

The governor has defined a new vision. I admire its bravura. Of its wisdom, I have doubts. The idea that a huge expansion even of a reformed financial system would bring great global benefit is doubtful. Not too much zeal, Mr Carney. – Copyright The Financial Times Limited 2013
martin.wolf@ft.com