Breaking the banks

The separation of the banking industry into utility and other services is moving up the agenda. Could it help prevent the next crisis, and is the political will there to take on the banks?
Peter Johnson
22 October 2009

The gamekeepers have turned poacher. Both Alan Greenspan and now Mervyn King have called for the composite banks to be split up, separating the ‘routine’ business of taking customer deposits and executing payments from everything else that banks currently do, from mortgage, commercial and credit card lending to investment banking and proprietary trading.

Both men focused on the moral hazard that pervades the banking system today and that has so far not been addressed by the G20 or any individual government: when an institution becomes so important that it cannot be allowed to fail, that implicit state guarantee removes any incentive – other than a purely moral one – to behave prudently. If the banks didn’t already know that the taxpayer would insure their losses, they do now. None of the new regulations proposed to require banks to hold more capital, change their remuneration packages and so on get anywhere near tackling this issue. And unless it is tackled the banks will simply carry on as before and we’ll all end up insuring them as before.

Now the reason to separate deposit taking and payment systems from the rest of banking is that these two activities are broadly speaking the things we need banks to do for our economies to keep functioning. These were not the areas of the banks that failed, but they would have disappeared along with everything else if major banking groups had been allowed to collapse. So we bailed out a whole load of speculative proprietary and frankly dodgy trading activities that should have gone to the wall in order to keep the cheques flowing and people’s savings in tact. Monumentally expensive and entirely avoidable. We literally can’t afford this to happen again.

This argument is also the burden of John Kay’s paper, published in September and titled Narrow Banking: the reform of banking regulation, for the Centre for the Study of Financial Innovation. In his view, the deposit taking and payment systems are so fundamental that they can be thought of as public utilities. This, and this alone, justifies the existence of state guarantees, which may be expressed as deposit protection or whole-company support. He further argues, persuasively in my view, that the Basel capital adequacy régime encouraged banks to find inventive techniques that in fact made them riskier. Capital margin rules are part of the problem rather than the route to safer institutions.

Kay’s proposal in essence is this: utility banking should be performed only by specially licensed entities – narrow banks – that would be required to match all their depositor obligations with secure and liquid assets such as government bonds. A run on the bank could then always be met. Narrow banks would still be free to lend money using funds obtained from the money markets. In return for accepting these restrictions, banks would receive a back-up state guarantee and in effect protected cartel status.

The rest of banking would be carried out by other institutions that Kay argues should operate in a largely unregulated market and after explicit removal of the implicit state guarantee we have today. This side of Kay’s argument relies on a happy optimism that markets will drive out bad trading and under-capitalised institutions. But even without cheap market-bashing, the evidence isn’t good. Kay overlooks the self-fulfilling character of bubbles and forgets that markets don’t inherently do good things. The morals of the market are those of its participants.

Martin Wolf’s reaction in the FT got to the core of the issue. The quasi-banks that would house ‘non-utility’ banking would, it is true, not be able to play with depositors’ money or count on state bail-outs, but they might have even greater incentive than now to use financial engineering to crank up returns and manipulate risk. Could one really say that this would make the system less fragile? The narrow banking advocated by Greenspan, King, and Kay may not harm, but would it really help 

Wolf provocatively concludes that we should make banking illegal. By this he means that all banking liabilities should be subject to reserve requirements in assets of similar maturity and value – so abolishing the short-long and leverage tricks that banks traditionally play and that are the core contributors to risk. The implication is that all banking should be considered in light of the public interest.

Whether you believe that regulation is there to restrain or to facilitate what goes on in markets, and whatever your view of specific regulatory measures, behind this emerging debate is a simple and familiar idea: the economy should serve the polity, and the polity may mould the economy into whatever shape it chooses.

It is most encouraging that the likes of Alan Greenspan and Mervyn King are now engaging seriously on this ground. What of our politicians? The UK’s Alistair Darling was reported to have said, in effect, that (a) fundamental change was difficult, (b) there would always be banking failures, and (c) the banking sector needed more competition. These are shameful platitudes. If certain kinds of commercial activity have the character of public utilities that should be publicly guaranteed, then the public deserves a serious exposition of the issues and the political world must be ready to act.

On this last point Kay is entirely right. The idea that any action must be internationally co-ordinated is stupidly, stubbornly short-term. If something is worth doing, then it is worth doing alone. It would be a shot in the arm for the whole of society if the authorities for once stood up for something. It really matters what individual countries do, but somehow governments have come to believe that in this diplomatic game they can only act if all the others act too.

The argument that banks would simply relocate in the face of unilateral action is no doubt top of the banking lobbyist’s checklist, but it is nonsense. If a major institution were told to restructure in order to trade in the UK, the US, Germany, Japan, or China, do we really think that it would just pull out and leave the field to its competitors? And if it’s the kind of bank that would do that, would we care if it went?

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