The Vickers report came out in Britain identifying areas where Britain’s banking system needed to alter its regulatory structure. Simon Johnson talked to Bloomberg about this report and banking regulation in general. His view is that first and foremost large globe-spanning banks are too large. Using Goldman Sachs as an example, he notes that Goldman had a $1 trillion balance sheet when the panic hit in 2008, 4 times as many assets as it did just a decade earlier. Meanwhile most studies show no significant economies of scale or scope above the $300 billion range.
On the UK in particular, Johnson notes that the UK has the Icelandic problem, meaning that its financial sector is very large relative to the size of its economy – five or six times the size of GDP. In Iceland, this was catastrophic, resulting in the failure of its three largest banks and an economic depression. In Ireland, the result was equally disastrous as the four largest banks were rescued by the federal government at great cost to taxpayers. National bankruptcy is an unfortunate possibility. This issue was very talked about in late 2008 and early 2009 (see Iceland: a cautionary tale for small nations and Too big to rescue). However, since then, people have acted as if these concerns are irrelevant. But, Johnson argues that herding by banks means that a nation’s big banks all face similar risks such that when one gets into trouble they all feel the same stress to their balance sheet.
Johnson believes a 25% equity financing level is the right amount. That would give banks four-to-one leverage (discounting the embedded leverage of derivatives, of course). He also believes this ratio should be pro-cyclical, meaning equity capital should increase as the economy improves to provide a buffer against the pro-cyclicality of the credit cycle in which dodgier loans are made at the top of the cycle.