In These New Times

A new paradigm for a post-imperial world

History’s lesson is that investment and retail banking must be separate

Posted by seumasach on March 13, 2011

Given that the banks are again running into bad debt problems and are essentially bankrupt the issues here  would apply to a post-bankruptcy environment. In the meantime “too big to fail” is the governing principle. That means , one way or another, bailout.

Liam Halligan


13th March, 2011

The mighty PIMCO slashed its holdings of US Treasuries to zero – causing an awful lot of soul-searching among global investors that still insist American sovereign IOUs are a “safe haven”.

A massive and tragic Japanese earthquake then sent financial shockwaves, as well as actual tsunamis, across the eastern hemisphere. This coincided with Saudi Arabia’s “day of rage”, which saw the desert kingdom’s rattled authorities unleash percussion bombs and rubber bullets.

Amidst momentous events, though, I’m determined to focus on an issue that to some may seem arcane and even staid
– UK bank reform. Despite appearances, this is also a hugely important subject, with implications that go way beyond the UK and which could do a great deal to determine the future shape of the global economy.

Just over a week ago, the Bank of England Governor, Mervyn King, was interviewed byThe Daily Telegraph on the banking sector. Anything King says on banks is important – given that the institution he runs will, later this year, take charge of UK bank regulation once the Financial Services Authority, after less than a decade and a half in existence, is disbanded.

What was interesting about King’s interview, though, wasn’t so much what he said, but the reaction it provoked. After months of shadow boxing, the crucial battle over the future of the UK banking industry is now finally on.


King argued that unscrupulous bankers are keen “to make money out of gullible or unsuspecting customers”. To anyone who has a British bank account, and has been hit with extortionate charges for minor transgressions while waiting days for an incoming cheque to clear, this is a statement of the obvious. But senior bankers were still seriously miffed by this comment.

What really got the banking lobby’s goat, though, was King’s insistence on fundamental bank restructuring. Banks have acted like “casinos” in recent years, the Governor argued, “making bets with other people’s money” while “not understanding the nature of the risks they were taking”.

King expressed “surprise” there wasn’t more public anger at the banks, given the disastrous impact of their excesses on the broader economy. Pointing to a previous lack of regulatory oversight, he also stated that “we allowed a banking system to build up which contained the seeds of its own destruction”, while raising the prospect of yet another deeply-damaging bank collapse. “We’ve not yet solved the ‘too big to fail’ problem,” he observed. “Or, as I prefer to call it, the ‘too important to fail’ problem”.

The City shouldn’t be surprised at these words. King has aimed strong language in the banks’ direction before. He has also previously made clear he favours breaking up the big “universal” banks.

During the summer of 2009, the Governor said it “isn’t sensible to allow large banks to combine High Street retail banking and risky investment banking strategies, and then provide an implicit state guarantee”.

The reason is that bonus-fuelled bankers then “lever up” the deposits of firms and businesses and make “heads I win, tails the taxpayer loses” bets – precisely because the deposits of ordinary firms and households are involved.

King left no doubt this was his view when, in the autumn of 2009, he said that the “breath-taking” scale of the bank bail-outs due to sub prime had created “the biggest moral hazard in history”. And just a few months ago, he added that “of all the ways of organising banking, the worst is the one we have today”.

In the aftermath of King’s previous “radical outbursts”, the big banks have remained tight-lipped. In recent days, though, the Governor has been the subject of some nasty press briefings. Anonymous City sources have dubbed King “bitter”, “deeply scarred” and “out of touch”. The banks’ spin doctors have been working overtime to undermine his authority.

King’s views are irrelevant, we’re told, as he didn’t see the sub-prime crisis coming. In fact, he did. Of the many occasions I heard King speak about the dangers of mortgage-backed derivatives and too much borrowing, the one that sticks in my mind is the Lord Mayor’s Banquet in Central London in June 2007.

“It may say champagne – AAA – on the label of an increasing number of structured credit instruments,” King boomed almost four years ago. “But by the time investors get to what’s left in the bottle, it could taste rather flat. Excessive leverage is the common theme of many previous financial crises. Are we really so much cleverer than the financiers of the past?”

King gave repeated, public warnings about the dangers brewing in the UK and international banking sector – going as far as a Bank of England governor could, without risking accusations of spreading panic. He didn’t have the detailed knowledge he should have had about the specifics of each bank’s balance sheet. But that’s because the bank supervisory role was with the (Treasury-controlled) FSA – which knew Gordon Brown wanted the lending boom to continue, in the misguided hope that the resulting “feel good” factor would make him the UK’s most popular politician.

Getting down to the fundamentals, the big banks say King’s preferred “Glass-Steagall” banking split – named after the legislation introduced in the US after the 1929 Wall Street crash – is a “red herring” seeing as Lehman wasn’t a universal bank.

But the Lehman collapse was only as devastating as it was because the UK’s core commercial banking system was so riddled with bad bets and leverage foisted on it by its investing banking masters. Had that not been the case, the failure of Lehman, while a shock, would not have posed a systemic threat.

The bankers than argue it’s impossible to draw a line between investment and commercial banking. As King has previously argued, “it’s hard to see why”. The reality is that existing regulations already distinguish between different bank functions when determining capital requirements.

The real reason the banks are attacking King now is that the Government’s Independent Banking Commission will soon be issuing its interim findings – and the City is worried it could be too heavily influenced by King.

I would argue, conversely, that the signs are the IBC, and ultimately the UK Government, won’t be nearly influenced enough by the Governor’s compelling logic.

The recent “Project Merlin” peace treaty between the banks and the Treasury was a huge tactical blunder in my view. And the IBC, while dubbed “fiercely independent” by apparently knowledgeable commentators has, as far as I can see, already shot its bolt.

Having already ruled-out total separation, the IBC is most likely to recommend “ring-fencing commercial and investment banking”, allowing them to remain within the same institution. While this may be an appealing political compromise, it is absolutely the wrong thing to do.

“Chinese walls” break under pressure. They cannot exist at all levels, as senior executives need to know what’s going on across the entire group. The “ring-fence” option relies too much on sophisticated regulation – ignoring the reality that regulators will be out-smarted by smarter and better-paid practitioners. There will also be huge shareholder pressure for a broad bank to boost profits at the expense of a sound commercial banking core.

That’s why nothing less than total separation will do. That is the lesson of history. King knows this, as do the bankers – which is why their respective language has become so stark.


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