I have spent quite a lot of my life looking at the regulation of industries other than financial services, so it is appropriate to start by spelling out some lessons of regulatory history.  A central lesson is that regulation works well when it is focussed on a limited number of well defined objectives.  Regulation works badly when it seeks to engage in the general supervision of activities to ensure the adoption of what are considered industry-wide good business practices.   The latter kind of generalised supervisory regulation tends to be extensive, intrusive, and prone to regulatory capture, discussed elsewhere in this volume (see Parry, ‘The Past is another Country’).  Capture means that despite its intrusiveness it is, taken as a whole, ineffective.  Today, financial services is the paradigm case of regulation that has the character of generalised supervision.  Financial services regulation achieves all these outcomes: intrusive, extensive, ineffective and prone to capture.

       The textbook example in all books on the history of regulation is the US airline industry.  It is obvious that we need to regulate airlines because we cannot have unsafe planes flying over the City of London.  So we need to regulate airline safety.  Such regulation has been in place since the beginning of  the industry.  But if we were going to have safe aircraft these safe aircraft needed to be maintained by well-run and well-financed companies.  So regulators started looking at the capital structure and finances of airline businesses.  Then they started looking at their business plans.   Eventually regulation in the airline industry extended to the regulation of routes and fares.  By the 1970s the scope of regulation embraced not just these matters: regulators reviewed the distance between seats and even in one notorious instance what was and what was not appropriate for an airline sandwich. 

In the 1970s all that regulation in the United States was dismantled.  It was dismantled by a US Congressional coalition of Left and Right.  On the Left many thought that this regulatory structure had become a racket for large corporations – and they were correct.  On the Right, many thought that market forces were almost always to be preferred to regulatory structure.  They were correct too. 

The result of deregulation, as is well-known, is that today we have regulation that focuses on safety.  We do have safe planes and we have a competitive market for airline services.  The kind of services that have been offered to consumers have been transformed, mostly for the better, in the last thirty years.

       The approach of focussing on specific public policy objectives and confining regulation to these areas was – belatedly – adopted in aviation.  Such focussed regulation was also introduced in other industries like telecommunications.  More recently, more structures for electricity and gas were created in this style.   That is the regulatory model that is needed in financial services.

       We do not, contrary to much opinion, need more regulation.  We do need better regulation.  The better regulation we need is narrowly focussed on important public policy objectives. The rest of the supervisory apparatus should be dismantled as quickly as possible.

       Let me spell out some specific lessons.  What are our public policy objectives?  The principal one is to protect the integrity of the payment system.  The financial services industry provides the mechanism by which we all receive our salaries and pay our bills.  The integrity of the payment system requires that we protect the deposits of retail customers, both personal customers and small businesses.  Protecting payments is the primary purpose of banking regulation.

More generally, there is a need for regulation to ensure better outcomes for retail customers. I do not know anyone who thinks that the retail financial services industry today is delivering a good deal to its customers. We need regulation which is focused on these objectives of consumer protection and of protecting the integrity of the payment system. 

Most other financial services regulation should be left to the market.  Businesses may choose to construct appropriate self- governing regulatory institutions without state involvement.  But the Government should regulate wholesale financial markets as little as possible.  We should under no circumstances accept that the Government should act as unpaid insurer of counterparty risk for off-exchange transactions.

That role which is now being cast for government when a wide variety of wholesale markets transactions are described as involving systemic risk.   Either people transact through exchanges and the exchange polices them; or they make transactions with counterparties knowing they must do their own due diligence in relation to the counterparty.  

When we are told that institutions are too big and too complex to fail –  the only acceptable public policy response is to say that if institutions really are too big and complex to fail they must be restructured as institutions that are simple enough and small enough to be allowed to fail.  Anything else contradicts fundamental principles of a market economy. 

I have used the metaphor of the utility and the casino and it has become quite a successful metaphor.  What we have had over the last two decades in financial services is a casino attached to a utility. There are two things we can do to resolve that problem.  We can regulate the casino to such a degree that no one will ever lose enough money in the casino to do any damage to the utility.  But those who believe that is a feasible outcome do not know anything at all about casinos or the kind of people who go into them.  Alternatively, we can separate the utility from the casino. And that is what we should do.

       So we should restore boring banking – the sort of banking described by John McFall as  ‘Captain Mainwaring type banking’. But he and a lot of other people have said that such a restoration is not possible because financial innovation means that global financial markets are now too complex to permit that kind of structure. That is, in my view, just the opposite of the truth. Actually financial innovation makes narrow banking a lot easier to introduce.  The case for this was made twenty years ago:  it is a book by Lowell Bryan called Breaking Up the Bank (1988).  Now Head of Global Banking Strategy Practice at McKinsey, he explained in his book that the likely outcome of financial innovation was that we would have specialist providers of all the individual services which were traditionally encompassed by the traditional bank. 

In saying that Bryan was half right and half wrong.  He was right in that almost all the individual services that were historically provided by banks are now provided by what in the retail area are called monoliners – that is firms that specialise in one particular business.  There are many more specialist product providers than there were. But Bryan was also wrong: the same period has seen the growth of a limited number of very large financial conglomerates.  If one asks why he was half wrong the reason is simple.  The scale of the retail deposit base is so large that getting control of it is irresistible to traders and investment bankers and that is what they have done and that process – the financing of the casino from the utility – is the fundamental source of the problem we have today.

       In a recent article in The Atlantic  by Simon Johnson in which he likens the power of investment bankers in Britain and the United States  to the power of the Russian oligarchs and to similar corrupt groups in developing countries (Johnson 2009).  While Johnson may be overstating to make his point, he correctly identifies a central issue.  In a society when individuals become too rich and too powerful, they establish a symbiotic relationship with the political class.  That symbiosis leads to reinforcement of the original power and influence and enhances their wealth. 

That is exactly what has happened in Britain and the United States over the last twenty years.  That is the nexus that needs to be broken.  It is only by the existence of that nexus that we can explain the extraordinary fact that the Governments of Britain and the US have provided unimaginably large amounts of money to the financial services sector without imposing any substantive conditions on how that money is used and without demanding any meaningful reform of the way in which these institutions operate.

What we need, then, is structural reform – to separate the utility from the casino.  In short, we need ‘narrow banking’.  What I mean by a narrow bank is an institution that takes deposits and invests them exclusively in a limited and previously defined group of safe assets.  Basically these are government securities and equivalents.  Narrow banks would have a legal monopoly of deposit taking.  They would also have a monopoly of access to the money transmission system.  They would be the only institutions allowed to call themselves banks and the only institutions qualified for deposit protection or any other kind of scheme of government support.  Narrow banks would be allowed to engage in consumer and small business lending and would be encouraged to do so.  But they need not do so and institutions other than narrow banks might engage in consumer and small business lending.

       Narrow banks could be owned by larger or more diversified financial institutions and in the short term they probably would be. Barclays Bank – a narrow bank – might be a subsidiary of the Barclays Group.  But a subsidiary that was a narrow bank would be required to operate from physically separate premises and would be subject to the kind of restrictions that I describe.  These restrictions would include reserving requirements that would effectively insulate the activities of that organisation from the rest of the Barclays Group or other business activities.

       Here space restraints permit only the outlining of the main elements of this solution.  But there is no doubt that with modern financial innovation one can restructure the financial system in this way to restore narrow banking.  These banks are not quite the same as the ‘Captain Mainwaring banks’ but are recognisable to the British public as being the kind of banks with which they used to deal and in which they are justified in having confidence.  Most of wholesale financial services regulation ought to be returned to market forces to deal with.

       The final criticism that will be made of this kind of proposal is that now is not the moment for this kind of radical restructuring:  we should get through the wider economic crisis first and we can think about these longer term issues after that.  But in my view the truth is exactly the opposite.  I have already described the degree to which the financial services industry has become in two decades by far the most powerful industry lobby in the country.  We have today a British Government that is almost entirely beholden to it – otherwise it would not have behaved as it has done.   

We thus have a moment when the future of financial conglomerates is wholly dependent on direct and indirect measures of government support.  If we are not in the position to insist on and implement reforms now, we will never be able to insist on and implement reforms.  What we need to do in Britain today is to build a consensus both on the need for that reform and on the specific measures that need to be implemented to start that process of reform.

References

Bryan, Lowell L. 1988  Breaking up the Bank: Rethinking an Industry under Siege (Dow Jones-Irwin, Homewood, Ill).

Johnson, Simon 2009 ‘The Quiet Coup’, The Atlantic, May (http://www.theatlantic.com/doc/200905/imf-advice).