Why was competition and credit control introduced? And what were the consequences? Charles Goodhart, Emeritus Professor of Banking and Finance at the London School of Economics, reflects on the politics and economics of the 1970s.
The Great Depression in the 1930s was ascribed at the time largely to excessive competition. And the response that the authorities applied was to encourage large companies in each sector to form cartels.
Montagu Norman – then the Governor of the Bank of England – played a particularly large role in this exercise, encouraging cartels in a variety of industries, as described in Sayers’ History of The Bank of England: 1891-1944.
The same analysis – and supposed remedy – was applied to the UK financial system.
Various sectors – such as the London clearing banks, the building societies, and the London discount market – were encouraged to form cartels whereby prices were set communally, and individual members of each cartel strongly discouraged from competitive price setting.
Such constraints on competitive behaviour were, of course, reinforced by World War II, whereby exchange controls on capital movements were introduced, alongside direct controls over the amount and allocation of credit.
These continued, with direct controls over bank lending being in operation often for many years at a time, until the reform of Competition and Credit Control was introduced in 1971.
Competition and credit control (CCC), 1971
Suddenly the main banks, ie the London clearing banks, were allowed – even initially encouraged – to compete with each other for business.
There had been no such freedom in living memory, and, with the benefit of hindsight, the authorities – notably at the Bank of England, and including myself then working as a monetary economist there – failed to anticipate what would happen.
The only previous experience of such deregulation had been a few years previously in Canada. Bill White, who subsequently had an illustrious career at the Bank of Canada and the Bank for International Settlements, was then working at the Bank. He wrote a note describing what had happened to the Canadian monetary aggregates on the event of their deregulation.
The outcome there did not seem too worrying, though both the severity and length of control and cartel had been much greater in the UK than there. Formerly, UK banking competition had been largely restricted to branch expansion and various kinds of non-price service.
I cannot recall exactly what form we thought that the unleashed competition might now take.
What we were not fully prepared for was the willingness of the main banks both to raise deposit rates and lower lending rates, thereby sharply reducing the spread between the two, in order to gain more business.
I imagine that we thought that the desire for profit maximisation would limit the extent to which the spread might be cut. If so, we were wrong, since at that time the banks appeared to use their new-found freedom to engage in competitive expansion, rather than profit maximisation.
Spreads were so sharply reduced that at times good credit borrowers could borrow from one bank at a lower rate of return than they could find on certain deposits with another bank.
This was termed ‘round-tripping’ and was a major factor leading to the surge, indeed explosion, of the monetary aggregates.
The intuition is quite simple. If the spread is huge, an agent facing a cash payment would benefit by running down their monetary deposits, rather than borrowing at much higher rates. If the spread falls to zero, any agent ought to meet any outward cash payment by borrowing – thereby retaining liquidity – until any liquidity premium disappears.
And if the spread becomes negative – as occurred from time to time during the immediate aftermath of CCC – then each agent facing that ought to borrow and expand their deposit base ad infinitum.
Perhaps it was a failure of imagination, but we had not fully anticipated this. But even with hindsight it is not at all obvious what we might have done in advance to limit this response.
Supplementary Special Deposit scheme
Then, towards the end of 1973, Prime Minister Heath and Chancellor Barber told the Bank to introduce some new method of bringing monetary growth under control, without involving any further increase in interest rates.
Heath had continuously opposed increases in nominal interest rates, even though the level of such interest rates had fallen below the rate of inflation, resulting in negative real interest rates. It was at that time that I was asked how it might be possible to meet the wishes of the politicians.
The resulting Supplementary Special Deposit scheme, later known as the ‘Corset’, was my idea. In one important sense the purpose of the exercise was to make the punishment fit the crime.
The crime had been to cut the spread in pursuit of expansion so far that it led to a surge in both bank lending and bank deposits. Under the Corset, if banks tried to expand by raising interest-nearing eligible liabilities (IBELs), they would be forced to hold non-interest bearing supplementary special deposits (SSDs) with the Bank – to an extent that made such price competitive action strictly loss-making.
The Corset worked, in that it stopped the banks competing so aggressively, and led them to restore normal, even perhaps somewhat higher spreads than before. Monetary growth subsided rapidly.
Moreover, although this was a, somewhat disguised, direct control again, it was sufficiently complicated that most commentators did not immediately treat it as a straight reversion to the previous system of direct controls. It certainly served to save face for the Bank.
On the other hand, it was of course a direct control, and as such it led to a number of distortions.
In particular, the complete unwind of the Corset in 1981 – after exchange controls had been abolished in the previous year – led to such an immediate surge in £M3 that it caused huge problems for the recently adopted ‘Medium-Term Financial Strategy (MTFS)’, embarrassment to the new Conservative government, and a severe deterioration of relationships between the Bank and the Prime Minister. But that is another story.
Charles Goodhart is Emeritus Professor of Banking and Finance at the London School of Economics (LSE). He was a member of the Bank of England’s Monetary Policy Committee from 1997 to 2000 and has worked as a monetary economist at LSE and the Bank of England for the last 60 years.
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