Everyday banking with no bill to the taxpayer


Government underwriting of deposits should be matched by assets of comparable quality. Otherwise the mismatch of risk provides an unjustifiable public subsidy to the banking sector.

In the year since the collapse of Lehman, the phrase “a new Glass-Steagall” has often been used as shorthand. The reference is to regulatory measures that would separate the utility of everyday banking from the casino of financial markets.

The Glass-Steagall Act was a response to the Wall Street excesses of the 1920s. Bankers stuffed their clients with overvalued securities. That pleased the corporate clients who issued the securities but did not please, for very long, the retail clients who received them. Ironically, at the very moment in 1999 at which the Glass-Steagall Act was finally repealed, the New Economy bubble replayed the abuses that had led to the act’s passage in the first place.

Serious though the conflict between corporate advice and retail financial services is, it was not at the centre of the credit crunch. That was the result of combining deposit-taking – effectively insured by governments – with speculation by conglomerate banks on their own account. So a “new Glass-Steagall” would not work. Proprietary trading is distinguishable only by its motive and extent from the treasury operations of any well-run deposit-taking institution.

Separation of the utility from the casino requires, at a minimum, that institutions that take insured deposits do so through a separate corporate entity. Financial institutions will fail from time to time, and should. An administrator should then be able to continue essential economic functions without delay or disruption. That is how the trains keep running, and the water flowing, even when badly run businesses that conducted these activities – such as Railtrack or Enron – disappear. Regulatory reforms that do not incorporate such “living wills” are plainly not serious.

But a living will is not enough to protect taxpayers. In principle the costs of deposit protection fall on the financial services industry. But, in the last year, Britain’s Financial Services Compensation Scheme paid out £19.9bn ($33bn, €22.7bn) for failed deposit-takers and imposed related levies of £171m. The balance was funded, directly and indirectly, from the public purse. If the state has to pay out, it needs to ensure there are corresponding assets. An 8 per cent capital cushion is inadequate as the amounts for winding up these banks will show.

Depositors (or the scheme that stands in their place) should have preferential status in a liquidation. This would throw responsibility for policing the security of deposits back on financial markets – and on the businesses themselves, where it belongs. But in the last year the “too big to fail” doctrine has shown that, if governments protect all creditors, preferential status is meaningless.

A further option is to insist that deposits are backed by safe assets. In practice, that means government securities. Some corporate credits and even synthetic securities are safe assets, but assigning responsibility for deciding what are safe assets to privately owned rating agencies proved a disaster. Government underwriting of deposits should be matched by assets of comparable quality. Otherwise the mismatch of risk provides an unjustifiable public subsidy to the banking sector.

Would effective protection of deposits make “narrow banking” boring? The whole idea of divorcing banking from gambling is to make it boring for gamblers. But dedicated retail bankers need not be bored, even after the reforms that consumers need. A vibrant financial services retailing sector would, like other vibrant retailing sectors, provide ample scope for innovation. Good retailers focus on customer service and derive profits by interpreting consumer needs and driving hard bargains with manufacturers and suppliers. They compete aggressively on margins. They build businesses by developing trust with customers, rather than maximising the return from transactions. Now that would be a change for the financial services industry – and an exciting one.

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