Can Britain afford an investment banking sector?

One of the things that fascinates me about so many big debates in the mainstream media is how fact free they are, so you wind up having to decide what is going on in a did/did not yah boo slanging match. So, I decided to solve the issue of banker's bonusses over my afternoon tea break.

First question - how much did the UK taxpayer have to fork over in bailing them out?

The Independent broke it down - c £957bn - say a Trillion between friends:

(Update - that £957 is a typo, the Indy is actually c £857bn, and the typo was in my spreadsheet. But I'm going to stick with the overall "call it a Trillion" number I used in my calculations for this post, as estimates of the bailout range from this to £1.3 trillion, my calculations are high level anyway, and more has been paid in since then - so I do not believe the overall material thrust is invalidated. I just liked this one as it was broken down well)

£76bn To purchase shares in RBS and Lloyds Banking Group

£200bn Indemnify Bank of England against losses incurred in providing over £200bn of liquidity support

£250bn Guarantee wholesale borrowing by banks to strengthen liquidity in the banking system

£40bn Provide loans and other funding to Bradford & Bingley and the Financial Services Compensation Scheme

£280bn Agree in principle to provide insurance for selection of bank assets

£32.9m Slaughter & May - Commercial legal advice

£15.4m Credit Suisse - Financial advice on a range of measures, including Bank Recapitalisation and the Asset Protection Scheme

£11.3m PricewaterhouseCoopers - Advice on APS

£8.7m Ernst & Young - Due diligence on APS, Northern Rock

£7.7m KPMG - Due diligence on APS

£7.4m Blackrock - Valuation advice on APS

£5.3m Deutsche Bank - Financial advice on a range of measures

£5m Citi Financial - Advice on Aps

£4.9m BDO Stoy Hayward - Valuation of Northern Rock

£4.5m Goldman Sachs - Financial advice on Northern Rock

£1.5m Morgan Stanley - Financial advice on Bradford & Bingley

£2.5m Other advisers - Financial advice on a range of measures and proposals to revive Britain's ailing economy

Let us subtract the £200 + £250 + £280bn insurances and heroically assume we get our money back on all of those because the banks won't gamble away other people's captive money again, and that their declared assets are genuinely worth what they say they are.....ok, on second thoughts lets assume that lot run at a 20% loss overall (the very kind 20/80 rule) , so it costs us (c 20% of £730bn = say 150bn). That gives us a Total Cost of Bailout of c (1000 bn - 730bn + 150 bn = c 420bn, give or take afew tens of billions between bankers (er...thats' Take I think)


Second Question - what is the Investment Banking Sector really worth to the economy?

PWC did a report in December 2010, that stated that total returns to the UK in 2007, 2008 and 2009 were £67.8bn, £61.4, £53.4 bn respectively - a mean of c £ 60.9 per annum in total.

But from this you have to deduct the money we would have got anyway if those people had been employed in some alternative industry - so, let us subtract the National Insurance and Buildings rent and rates under the assumption that something would be there anyway (such as the retail banking sector, which employs most of the people and pays for most of the square footage in banking anyway). That is about 54% of that contribution, or c 33 bn. This leaves the net contribution (unrecoverable VAT, Corporate tax, Stamp Duty) at £28bn. Let us assume that this all goes to the heroic efforts of the investment banking sector, so that's a profit of £28bn to them (that is, of course, afer the c £7m bonusses they take off first for their herculean efforts.

(ie I shall assume in broad brushes that what I giveth and taketh away comes out in the wash, ie I assume the small costs* of investment bankers' NIC and rates are counterbalanced by the tiny amounts of heroic trading the retail banks do)

Update - The ever erudite Graeme Pieterz emailed me on this, arguing that I had wrongly attributed all the wrongdoing to the "Investment banks" - I admit I had separated "plain old banking " and "casino banking" sectors into "retail" and "investment" - Graeme's view:

All those numbers are for the whole sector, and the big costs are for bailing out retail banks. The root cause was surely lax mortgage lending on high house prices. Nothing to do with investment banks. I do not think that tax is an adequate measure of returns either: they measure payments to the government, not total benefits to the country less opportunity cost. The costs are also misleading: indemnities will probably never be paid, shares bought will eventually be sold. I am no fan of the bailout (I would have let them go bust and then bought cheap, as the government did with Bradford and Bingley), or of the regulatory regime which allowed it, but you need to prove your case by showing that the losses came from investment banking.

Graeme felt that I underestimated potential benefits (eg earning foreign currency) and I was possibly over estimating the benefits back to the taxpayer from the various guarantees, that I had been too kind to Retail banks and too cruel to Investment Banks, and that the losses and benefits will probably be larger than I assumed.

With that in mind, I am going to change the argument below to look at a "Big Banking Black Box" ie sum up all the losses over the whole sector vs the benefits, rather than separate it out, so will subsume this original calculation....

So, what is the ROI of the Investment banking Sector?

A simple measure is payback time - To pay back the £420bn on £28bn a year return will take about 15 years, which as a payback is pretty cruddy in anyone's language. And if I put a 5% interest per annum on that, it will take a generation to pay it back.

Now, if they were to forego their bonusses for all that time, at about a £7bn a year sum (because they have taken consideration of Messrs Clegg and Cameron's finger wagging), we could get payback in about 12 years - see, hardly a difference really, so we may as well pay the bonusses anyway, right?

Erm...actually, wrong - at a 12 to 20 year payback can the UK actually afford an invextment banking sector? One whoopsy every generation and it cancels out all the benefits.

.....within the bigger calculation here. I will assume that Graeme's increased good news is cancelled out by his increased bad news, so we are now left with an overall sector that will lose c £420m, and returns c £61m per annum, of which c £33m is mainly jobs and space rentals of Plain Old Banking businesses. I will also assume that I can run the basic retail banking safely without the casino superstructure (re-mutualisation anyone?), and employ most of the bodies in the industry in said retail structure, as before. I am also going to assume that the much vaunted "invisible earnings" from the sector are either being taxed already in the PWC figures above - or are being evaded/avoided, so the supposed benefit is invisible too.

This means in essence that the whole sector has to pay back its £420bn on a £28bn return - about 15 years, or 12 years if I remove bonusses, and 18 years + if I add in interest as above. So it doesn't change my overall thrus except to say "a pox on all their houses". And it certainly doesn't change my original overall conclusion.

Now, if I was running UK PLC as a "business", the obvious thing to do is keep the bit that is at least not loss making (the retail banks that deal with basic accounts and loans to small businesses etc) and divest myself of an asset so risky it can nearly bring my entire UK PLC down, or ensure that it is run in a far less risky way. Which I don't see happening. In fact, what I see happening is possibly the largest case of "regulatory capture" ever in the UK, where the sector has captured not just the regulator but the government. The Glass Steagal act (which forced separation of retail and investment banks in the US after the Depression for exactly this reason) would never get passed today. And as for paying the money back in a generation, its clearly a great idea, its just that its my kids' generation that are currently doing the paying, not the banks'.

To continue the update, Graeme Pieterz' summarised his view as follows:

Banks should be smaller so that they would not be too big to fail. Once reason more were not treated like Northern Rock was a fear of panic if the same happened to a big bank. Building societies should be encouraged if it is not too late - demutualisation encouraged consolidation and risk taking (savers are likely to be much more cautious than shareholders). Breaking up the big (giant!) banks would provide a clear message that shareholders can expect to lose more next time. Banking mergers should not be permitted if either party is above a certain size.

Regulation should also be better. The use of opaque and easily tweaked complex risk models was a huge mistake, as was the reliance on market driven measures of risk. Unconventional business models like Northern Rock's should not really have a place in retail banking.

I do favour a separation of investment banking and retail banking. I also wonder if it is necessary for banks to do some high risk activities such as proprietary trading at all - that can be left to hedge funds.

Which I heartily agree with, and I think so do most people who fdo not have an interest to vest. But it isn't happening, which means that what happened can easily happen again.

*They can't have it both ways - either the top "casino" bankers earnings are insignificant as a proportion of the total, and thus no discrete "banker tax" is deserved, or they are significant in which case Mr Milliband has a case, given the N year payback calculated above....)