by Anthony Painter

There is nothing more British than an establishment fudge. And as establishment fudges go, the interim report of the independent commission on banking (ICB) is an absolute belter. It lays out the case for a fundamental reassessment of the UK’s financial sector, but proposes nothing like that. It is like a flood risk report saying that only a twenty foot high concrete wall will protect a town from flooding but then actually only recommends the installation of sandbags. And given that George Osborne is in compromising mood, it will be watered down further. Get ready for the flood.

Don’t worry, the UK might get lucky. Maybe there won’t be a flood at all. We didn’t think floods happened – or we forgot. Then one did. But still, they are rare right? Well, The ICB doesn’t seem to think so:

“There is an inherent uncertainty about the nature of the next financial crisis”.

So we are not dealing with “ifs” here; we are dealing with “when”. This staggering statement, buried in section 4.173 comes after a long section on the need to protect the competitiveness of the UK financial sector. It provides jobs and £50 billion of tax revenues, after all (though £10 billion or so are from the retail operation, which presumably isn’t going to be off-shored any time soon). That is not insignificant. As we have discovered, that is not a cost and risk free income. In fact, it is highly risky and costly.

This graph helpfully provided on p.22 of the report tells us why:

In financial terms, the UK is more flood-exposed than any other nation. It may not feel this way given the massive output loss, fiscal disaster, and unemployment, but the UK was “lucky” this time. For Ireland, it was far worse:

“Had the asset quality of UK banks turned out to be as bad as that in Ireland, the hit to the UK’s fiscal position would have been significantly worse than it was”.

Oh, those Irish with their junk investments. How silly of them. Only it’s not quite like that. Financial crises don’t generally occur because people are buying junk. They occur because people are buying high quality assets that turn out to be junk. If people are buying junk then investors notice. If it’s AAA grade prime then they are relaxed. The global financial crisis occurred in no small part because AAA assets turned out to be useful only for composting.

At enormous cost, it’s all been quarantined, sanitised and disposed of now right? Perhaps. But there’s still lots of other risks that may be underpriced. An obvious example is the sovereign debt that banks hold. What happens if governments start to default on their debt just as owners of subprime mortgages started to default on their repayments?

Calamity is what happens. If Greece, Portugal, Spain, or Ireland were to default then suddenly the bonds held by German, Dutch, British banks et al are turned from prime to subprime in an instant. Mark Blyth on Crooked Timber has war gamed the shock that would be sent through the European economy. Fantasy? No actually, it’s a completely plausible scenario. The eurozone crumbles but, worse than that, the fiscal hit will be tremendous. What on earth will the Royal Bank of Scotland’s balance sheet look like if that happens and how will we keep a flow of credit to the real economy?

According to the ICB report, there are four functions of a banking system:

• providing payments systems;

• providing deposit-taking facilities and a store-of-value system;

• lending to households, businesses and governments; and

• helping households and businesses to manage their risks and financial needs

over time.

Its measures only aim to safeguard two of them: keeping the payments system going and providing deposit-taking facilities. In the event of another flood, it means that lives will be saved which is clearly a good thing. However, the damage and economic cost to the unprotected town will be enormous. If the flood is a eurozone flood, then governments will need to fiscally intervene once again if credit and lending are to be maintained (and we do have a £141billion deficit to finance as well a businesses and mortgages to finance). The question is – again one posed by the ICB – at what point does “too big to fail” become “too big to save”?

The harsh reality is that we have a financial system that would be too big to save if the flood were big enough. It is a bigger weight on our shoulders than that any on other country’s. We have broad shoulders, but they can’t take unlimited pressure.

And this is the real issue with the ICB interim report. It lays out the evidence that UK may face a financial catastrophe even greater than was experienced in 2008. And then it defaults to the traditional defence of the UK financial sector’s competitive position as an unarguable good. It has been criticised for not doing enough to promote further competition (and our banking sector is monocultured and uncompetitive), or to separate casino from utility banking. In a sense, these criticisms – though fair – miss the point also.

The UK economy and UK taxpayers may not be able to sustain the risk of a financial sector this large at all – even with better regulation. Actually, “competitiveness” may be economically calamitous. So the ICB should have been more honest with us. It should have said:

“We are recommending a 20-foot high concrete wall. This is expensive and it will cause much pain but that is our honest assessment of what it will take to protect us from the flood. It is not unreasonable if we do want to protect ourselves from what could be an adverse event that we see in the not too distant future. This needs a bigger debate than the one we are having. It is about the whole way we run our economy and requires real long-term vision, explanation, and courage. This is a choice but we don’t feel it is a choice that should be brushed under the carpet because of vocal interests or political compromise. We have experienced a calamity but it may only have been a warning. Next time we may not be able to cope at all”.

It didn’t say that. It said, it’s bad but let’s not overact. For that reason, the report is a failure. Meanwhile, Bank of England figures show lending to small and medium sized businesses falling again and the cost of finance increasing. And consumers are starting to borrow to consume more once more.

Here we go again. And did I mention the flood risk?

Anthony Painter is an author and economist.