Separate as well as regulate

Why we must seize the day and reform the banking system

“It is not sensible to allow large banks to combine high street retail banking with risky investment banking or funding strategies, and then provide an implicit state guarantee against failure. Something must give”

Mervyn King, Governor of the Bank of England, at the Mansion House, 17 June 2009

“Deposit insurance and central bank liquidity facilities are properly confined to deposit taking institutions. It is, after all, those institutions that remain the backbone of the financial system. …In my view it is unwarranted that those same institutions, funded in substantial part by tax-payer protected deposits be engaged in substantial risk-prone proprietary trading and speculative activities that may also raise questions of virtually unmanageable conflicts of interest.”

Paul Volcker, former chairman of the US Federal Reserve, chairman President Obama’s Economic Recovery Advisory Board (PERAB), to the Institute of International Finance, 11 June 2009

A year ago our banking system was on the verge of collapse. It is still on life support but it has begun to recover. There is even talk of going back to ‘business as usual’ yet the financial crisis has led to recession and unemployment in the UK and around the world. The worldwide slowdown has hurt the poor and cost lives. We must make every attempt to prevent that happening again. Amidst the current debate about spending cuts, we must not forget that we still need to reform the banking system. The window of opportunity for action is fast closing.

While the roots of the crisis lay in the securitisation of sub prime US mortgages and the derivatives based on them, the crisis was also caused because banks did not properly control their exposure to such securities. Banks became highly leveraged and when the bubble burst the market for the toxic assets they held disappeared. This was not merely a problem for a few investment banks which had over-extended themselves. Many banks with traditional retail deposit operations were also involved because they had exposed themselves to the same risks. The inability to determine the size and nature of their exposure meant that retail and business banking was threatened and even the ability to make payments could have been called into question. The run on Northern Rock in 2007 was merely a foreshadowing of what awaited those banks.

The collapse of the US sub-prime housing market triggered a series of events which led to the bankruptcy of the investment bank Lehman Brothers. It was soon apparent that Lehmans was a vital part of the global financial system, because it had been allowed to become so entwined with traditional retail banks, and the shockwaves spread around the world. The UK, as a large financial centre, was particularly affected. As trust in banks plummeted, some banks faced particular difficulties. One of these was Royal Bank of Scotland, which combined both retail banking with a speculative investment banking arm. In October 2008 confidence in RBS dropped to such an extent that the government had to implement rescue measures, including an injection of capital. Its acquisition of part of ABN Amro had increased its exposure to toxic assets. This exposure was a world away from the kind of traditional retail banking undertaken by its subsidiary NatWest. Lloyds TSB and HBOS, about to merge, also had to be rescued.

Bold action led by the UK government and followed by other governments around the world saved the financial system. It could not prevent the sharp drop in economic confidence at the end of last year and at the beginning of 2009, even though stimulus packages have limited the damage. The world economy shrank. The effects are still being felt and demand in economies remains at low levels. Unemployment continues to rise and confidence remains subdued. Recession or low growth impacts development in poor countries and the effects can be severe affecting hundreds of millions of the poorest people in the world. This is why the banking crisis is not simply a mistake from which we should quickly move on. It has real moral implications.

There is an international consensus that stronger and wiser regulation is required. Banks will be required to hold more capital in future to provide a cushion against future losses. In the UK, banks will need to write so-called ‘living wills’ which outline how a bank in trouble can split off its retail deposits. The Managing Director of the IMF has revisited the idea that banks could be required to pay an insurance premium against future bailouts by taxpayers. Ultimately, the American economist JK Galbraith was right when he said that all financial innovation comes down to a matter of leverage (borrowing). Regulation should aim at full transparency and limit banks leverage in whatever form it takes.

Strong regulation, while necessary, is not sufficient. It will never be applied perfectly at all times, and the speculative side of a bank will introduce new financial instruments that are not covered by the regulations. It may also try to circumvent the regulations. While regulators may be vigilant in the near future, the next bubble will no doubt take a different form. Regulators will need to be shrewd and sceptical yet past experience demonstrates that over time memories of financial crises fade and old mistakes are repeated anew. Another period of low inflation and stable economic growth will encourage greater risk taking and pressure to ‘relax’ regulatory regimes to take account of new thinking.

For the same reason better financial education, though important, is no guarantee against future disasters.

Regulatory errors and financial crises cannot be completely banished. The systemic risks must be minimised however. Higher risk trading must be separated from traditional banking operations. A ‘living will’ does not remove the risk of a run on a bank since until it has come into effect depositors cannot know it has been effective. We have seen over the past couple of years that people understandably do not want to wait to find out what might happen to their deposits.

Separation of banks into ‘casino’ and ‘traditional’ models would improve financial transparency and prevent higher risk investment banking practices bringing down the entire system. Government would continue to guarantee retail deposits but moral hazard would be reduced in the investment banking sector; lower systemic risk would mean investment banks which made mistakes could go bankrupt without triggering financial collapse. Such a separation would raise the cost of certain speculative financial instruments for businesses because there would no longer be the guarantee of a taxpayer bailout of the bank if things went wrong but the cost increase would simply mean risk was being correctly priced. The City of London would retain its reputation as a leading financial centre.

The impact of the financial crisis will continue to be felt for years to come. It is a moral crisis because ethics and a sense of the common good were left behind as banks traded their new securities. It is also a moral crisis because people’s lives and futures have been adversely affected. There is a moral duty to do more than tinker with the system and hope it will repair itself; bold and essential reform is required. Separating banking functions is a key way of helping ensure the world does not face another financial and economic meltdown with taxpayers again having to bailout the banks.

Stephen Beer is CSM’s political communications officer and works as an investment manager.
John Mitchell is a CSM member. He worked for the World Bank for 17 years and was previously Director of the World Development Movement for 12 years.

This article represents the authors’ personal opinion.

Stephen Beer and John Mitchell, 16/02/2010