We must press on with breaking up the banks

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Two years after the collapse of Lehman, the case for structural reform of the financial system rather than closer supervision of behaviour and the prescription of ever more elaborate rules is stronger than ever.

When Lehman Brothers collapsed two years ago, the demise of investment banking seemed only a few days away. With Merrill Lynch agreeing to sell itself to Bank of America, two big independents had vanished. Goldman Sachs and Morgan Stanley rushed for the support of the US Federal Reserve. Governments around the world came to the aid of every retail bank with a significant investment and trading arm.

Today, investment banking and investment bankers are back on top. Profits and bonuses are booming. In the universal banks, Vikram Pandit, who lost out in a power struggle at Morgan Stanley, is now in charge at Citigroup. Bob Diamond has finally seized control of Barclays, and an investment banker is favourite to take over at HSBC. The non-financial economy, however, continues to suffer. Credit is pricey and difficult to get. In most countries non-financial output has not yet regained pre-crisis levels.

The pledges of co-ordinated international action to reform global finance made in the immediate aftermath of the crisis have proved empty. Tougher global regulation is seen as principally an extension of capital requirements. The minimum capital ratio is to be raised to 7 per cent. (Actually, it used to be 8 per cent, but capital did not really mean capital. That tells you most of what you need to know.) The Basel regime based on capital controls proved useless in averting the crisis: indeed it was a principal cause of the regulatory arbitrage that led to the proliferation of complex debt instruments. In any other industry, we would see these measures for what they are – an officially sponsored cartel to raise prices by limiting supply.

The European Union has devoted its attention to strengthening the regulation of alternative investment managers. But systemic problems did not originate in this lightly regulated sector: they emerged from extensively regulated mainstream financial institutions. Alternative investment managers were small and heterogeneous, and their risk-taking was restrained by their own investors and by their market counterparties – their banks and principal brokers. Such regulation was more effective, it transpired, than official supervision.

The lesson is obvious, but ignored. A financial system populated by smaller institutions with diverse business models monitored by other market participants with skin in the game is robust; an oligopoly of conglomerates ineffectually regulated by a public agency that lacks either technical competence or political authority is not.

But this time it is supposed to be different. The system that failed to apprehend Bernard Madoff will be beefed up to second-guess the risk management strategies of Goldman Sachs. Unfortunately, that hope is what we must rely on to avert the next crisis, and such a crisis is therefore inevitable. The basic mechanism of financial meltdown – herd behaviour leading to asset price mis-evaluation, which generates temporary profits and is then corrected imposing substantial collateral damage, remains intact.

Serious reform must begin with a realistic assessment of what regulation can actually achieve. Regulators can observe compliance with prescribed procedures – and in reality that is what they mostly do – but have very limited ability or opportunity to assess whether behaviour is prudent. It is much easier to observe whether a retail bank is engaged in investment banking than to judge whether it is managing its investment banking well. Regulation of structure is enforceable. Supervision of behaviour is simultaneously extensive and intrusive yet ineffective and prone to regulatory capture. That is the experience not just of financial services but of many other industries.

It is hard to think of business activities with cultures as different as those of retail and investment banking. The former is intrinsically bureaucratic and hierarchical, relying on the accurate processing of millions of transactions every day with an infinitesimal proportion of errors. It is done best by people who empathise with their customers. The latter is naturally buccaneering and entrepreneurial; the people who do it best are aggressive and self-centred. Successful retail banking is based on relationships; modern investment banking is based on transactions. The tension between different parts of a conglomerate business is evident in all of them, and the investment bankers, more political, better paid, and generally abler, have usually come out on top. As at Barclays and Citigroup.

The creation of financial conglomerates owed more to the aspirations of a small number of ambitious individuals than to any business logic, and has not served customers, employees or shareholders well. The businesses that have emerged have been unmanageable and their activities incomprehensible even to their own boards, as the events of 2008 demonstrated.

Public underwriting of banking activities must be limited to their deposit-taking and credit supply. There is no possible justification for insurance by taxpayers of the exposure of market counterparties. To offer it exposes ordinary working people to risks of which they know nothing and whose rewards go to people far richer, and less scrupulous, than themselves – see Iceland or Ireland. At the same time the doctrine of too big, or too complex, to fail undermines the market mechanisms that are the most effective means of restraining imprudent risk-taking. Both customers and financial stability will be better served by a larger number of institutions, individually specialised and more diverse in their business models.

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