Separation, rather than size, matters

Anthony Hilton
23 Oct 2009

Given that one of the causes for the failure to control the financial sector was a lack of proper communication between the Financial Services Authority, the Bank of England and the Treasury there's some irony seeing them all at odds again over the best future structure for the banking industry.

Governor of the Bank of England Mervyn King's spirited espousal of the need to split banks' government-guaranteed retail operations from their other securities-related activities has been batted away by Chancellor Alistair Darling. The FSA has expressed its scepticism on earlier occasions.

It is telling though that the Governor's critics don't attack the logic which guides him to his conclusion — his observation that alternatives such as extra regulation and more onerous capital requirements will be costly, ultimately ineffectual and will stifle innovation. Rather they take refuge in the spurious argument that Northern Rock was a narrow bank while Lehman was a casino bank but both imploded.

Yet had Northern Rock stuck to narrow banking, lending only what it took in as deposits, it would not have had a problem. But the point is it was rescued because it was a deposit taker — as it would continue to be under the Governor's blueprint, which would separate utility banking from markets activity.

Lehman's bankruptcy was a disaster because of the contagion it spread through investment banking. Had it simply paralysed other investment banks such as Merrill Lynch and Morgan Stanley, governments might have been able to stand aside.

The real problem arose in those retail banks which also had big investment banking arms — firms such as Citigroup and Royal Bank of Scotland. Let us not forget that RBS with almost 200,000 employees was brought down by the activities of fewer than 2000 of them — those who went overboard on sub-prime structured products. If RBS and Citi had not had investment-banking activities then they would certainly have been tossed around in the stormy seas, and they may have faced a liquidity squeeze but they would not have been made insolvent.

Separation would lead to more appropriate management. Conventional banks would be heavily regulated and not expected to shoot the lights out with fast growth and booming profits. They would be like a utility — judged on their reliability, stability, and service to customers. Investment banks would also temper their activity because they would need more capital if the subsidy from retail disappeared, and because if they took too much risk they would be left to fail. Their shareholders would not allow management to gear up every £1 of shareholder equity with £50 of borrowed money and bet the entire amount in the markets because they would know that an adverse swing of only 2% in the price of those assets would indeed wipe them out.

There is absolutely no evidence that large banks are more efficient than small banks — as some of their leaders will privately admit. There are very few synergies, and almost nothing which they cross-sell which could not be provided by a third party. One of the lessons of the crisis could be that as well as being too big to fail, the banks had got too big to manage.

The Governor has got it right but with the Government having been captured by the self-serving lobbying of the banking industry is unwilling properly to debate his ideas.

It is reminiscent of the Seventies when a previous Labour government refused to confront the reality of trade union power — barons with a similar sense of entitlement and a belief that the role of the rest of society was to make life comfortable for them. The banks are the over-mighty subjects of today. Eventually the unions had to be cut down to size and, eventually, the banks will too.

That is why Whitehall's attempts to dismiss the Governor's views with snide asides and attacks on his competence are not only wrong in themselves but ultimately bad for the country.

Ban Goldman from state work

While it is obvious that Chancellor Alistair Darling views with distaste the return of the big banking bonuses, he has not taken the obvious step open to him. He — or at least the Government — could ban those organisations which displease him from tendering for any government work.

A generation ago accountants Arthur Andersen and Andersen Consulting — now Accenture — upset the then-Tory government because of its involvement with DeLorean, a failed Northern Ireland car maker, and a separate disastrous IT project.

It got no more government work for years — although having been helpful to Labour when it was in opposition in the Nineties, it got back on the lists when Labour won in 1997.

Why not make a rule that Goldman Sachs and other high bonus players will simply not get any of the vast amount of government work. The only thing these guys understand is their wallets so that is where to hit them.