When bigger isn't better : bailouts and bank reform

Taking retail deposits and lending to SMEs and households were the traditional role of commercial banks: but banking in Britain has been transformed by increasing consolidation and by the lure of high returns available from investment banking. With appropriate changes to the Diamond and Dybvig model of commercial banking, we show how market concentration enables banks to collect ‘seigniorage’ profits; and how ‘tail risk’ investments which escape regulatory notice allow losses to be shifted onto the taxpayer. In principle, the franchise values associated with market power might assist regulatory capital requirements to check risk-taking. But when big banks act strategically, bailout expectations can undermine these disciplining devices: and the taxpayer ends up ‘on the hook’ - as in the recent crisis. Structural change is needed to prevent a repeat; and we discuss how the Vickers report proposes to protect the taxpayer by a ‘ring fence’ separating commercial and investment banking