The costs of returning to 'business as usual' in the banking sector
The recently published report A Bank for the Future by James Leaton and myself recommends that the government should reform RBS into a Green Investment Bank to provide financial support for the UK's transition to a low carbon economy. In the report we argue that the alternative to a Green Investment Bank – carrying on with 'business as usual' – risks imposing huge costs on the UK economy, in terms of making it more vulnerable to future systemic financial crises of the type that almost brought down the entire banking system.
But just how large are the potential costs of returning to business as usual? It's impossible to know for sure. But, as the FT's John Kay (for example) argues, since the mid-1990s each financial crisis – the Asian crisis, the “dot com” collapse and now the credit crunch – has been worse than the previous one. Therefore, it seems reasonable to take the overall costs of the 2008 crisis as an estimate of the minimum costs of the next crisis in the absence of doing anything to make the UK economy less likely to encounter such crises in the future.
But just how much has the 2008 crisis cost the UK? There are three main elements to the cost, which this post looks at in turn, using figures from the National Audit Office's December 2009 report Maintaining financial stability across the UK's banking system.
First, there was the the cost of bailing out UK banks. This comprises the following elements of the various bail-outs to RBS, Lloyds Banking Group and Northern Rock carried out during 2008 and 2009:
- The nationalisation of Northern Rock after the provision of £50 billion of public support (February 2008);
- An initial purchase of £37 billion of shares in these banks, resulting in Lloyds Group becoming 43% taxpayer-owned and RBS becoming 70% taxpayer-owned (October 2008);
- Agreement to purchase up to an additional £39 billion of shares to provide additional capital for the part-nationalised banks, increasing the public stake in RBS to 84% (November 2009);
- Indemnification of the Bank of England against losses incurred in providing over £200 billion of liquidity support;
- A guarantee of up to £250 billion of wholesale borrowing by banks to strengthen liquidity in the banking system;
- Provision of up to £40 billion of loans and other funding to Bradford & Bingley and the Financial Services Compensation Scheme;
- Agreement in principle to provide insurance covering nearly £600 billion of bank assets, reduced to just over £280 billion in November 2009.
The Treasury’s total net cash outlay for purchases of shares in banks and lending to the banking sector, including Northern Rock, amounted to around £117 billion by 2010. The Treasury’s additional potential exposure to banking losses totals (through insurance of bank assets and Bank of England lending) totals over £1 trillion.
However, these losses would only be realised in the worst case scenario of total banking system failure, which looks to have been averted by the scale of the 2008 bailouts. Therefore the overall expected losses to the taxpayer from these operations is much smaller.
The Treasury estimated in April 2009 that there may be an overall loss to the taxpayer of between £20 and £50 billion. Taking a midrange point of this estimate - £35 billion – implies a loss per household of around £1,500 (based on an estimate of 23.5 million UK households from the Office for National Statistics). This would be a one-off loss rather than an ongoing annual loss per year. There is a high degree of uncertainty attached to this estimate as the loss to the taxpayer depends on the performance of banking shares on the FTSE index.
Second, there was the cost of lost productive capacity. When the business cycle is relatively mild, recessions are assumed not to have an impact on the economy's long-run growth rate. However, particularly severe recessions can have longer lasting impacts because they lead to reductions in the level of potential output – not just the level of actual output.
This occurs for example because business failures on a large scale reduce the potential output level of the economy, even after the economy emerges from recession. Both HM Treasury and independent forecasters agree that the 2008-09 recession (which was the worst, in terms of lost output, since the 1930s) resulted in a permanent reduction in output. The Office of Budget Responsibility's estimates from the June 2010 Emergency Budget suggests that the financial crisis permanently reduced UK output by just under 9 percent.
How much is this in cash terms? The latest ONS projections suggest that in the current tax year, GDP will be valued at £1.476 trillion. 8¾ percent of this figure equals around £129 billion. Given that there are about 23.5 million households in the UK, this equates to a loss of around £5,500 per year – or about £106 per week - for every household at current prices. This is an ongoing annual loss rather than a one-off loss.
Finally, there is the impact on the public finances. The Office for Budget Responsibility also publishes forecasts of the structural deficit in the public finances (also known as the “cylically adjusted deficit”). This is defined as the amount by which the public finances would be in deficit if the economy were operating at full capacity. Because the economic crisis had a permanent impact on productive capacity, there was a knock-on impact on the public finances. This is particularly severe given that some of the activities that took a large hit (e.g. financial services) were large contributors to tax revenue.
In the 2007-08 tax year (before the main financial crisis blew up in autumn 2008) HM Treasury calculated the structural deficit to be 2.5% of GDP. The recent forecasts from the OBR estimate that the structural deficit increased to 8.8% of GDP in the year 2009-10. The correct measure of the effect that the financial crisis has had on the structural deficit can be arrived at by subtracting the 2007-08 deficit (pre-crisis) from the 2009-10 deficit (post-crisis). This gives a figure of (8.8 – 2.5) = 6.3 percent of GDP.
This suggests that the financial crisis had an overall impact on the public finances equal to around £93 billion, or about £3,900 per year for every household. Taxes will have to rise, or spending be cut, by an average of £3,900 per household to balance the books.
Overall, it seems unarguable that the 2008-09 financial crisis has had a devestating impact on the UK’s productive capacity. The best current estimates suggest that by 2015, when the full impact of the crisis has worked through, output will be almost £130 billion per year lower (at 2010 price levels) than it would have been if the crisis had not happened. This equates to about £5,500 per year for every person in the UK. For comparison, average household disposable income for a family with no children in the UK in 2008/09 (the latest year for which detailed figures are available) was just over £26,000 per year.
The crisis has also had a huge impact on the public finances. Based on estimates of the deterioration in the structural deficit which occurred following the crisis, UK households will have to pay around £3,900 per year more in taxes – or public spending per household will have to be reduced by £3,900 per year, or some combination – to balance the books. Households are also likely to face a one-off cost of £1,500 each (on average) for the banking bailout itself.
It is important to note that, on current trends, a future economic crisis resulting from the collapse of the banking sector under ‘business-as-usual’ will probably be worse than the previous crisis. In the very worst case scenario, given that the public finances of many countries are already severely stretched, another crisis could stretch them beyond breaking point – leading to the complete collapse of the global financial system.
The consequences of such a collapse are difficult to estimate but could involve substantial declines in global output, huge increases in the extent of poverty and deprivation, massive social unrest, and in the extreme case the complete breakdown of society as we know it. Thus the estimates presented here, although substantial, should be viewed very much as lower bounds on the cost of returning to ‘business as usual’.
It follows that if the transformation of RBS into a Green Investment Bank makes future systemic financial crises much less likely, its net positive impact on UK (and global) output is likely to be enormous.