In 2008, the British government, like the governments of other western countries, was faced with the alternatives of watching economic collapse or granting massive subsidies and guarantees to financial institutions.  Despite bailouts of almost incredible magnitude, considerable disruption to economic activity has occurred.  Many ordinary people, in no way involved or responsible, have lost their jobs or much of the value of their savings.   It is unforgivable that this should have happened, and unacceptable that it should ever happen again.

The public interest in financial services has several components.  Consumers are entitled to expect that the financial services industry will provide reliable services of good quality at low prices.  Instability is inseparable from speculative markets, but the real economy must be protected from the most serious consequences of instability in the financial sector.  The industry should operate profitably and be internationally competitive, with the result that it makes a substantial contribution to, and no demands on, the public purse.  None of these objectives has been achieved.  The need for radical reform of the structure of the industry and the way it is regulated is therefore self-evident.

       Proposals for regulatory reform must be judged today primarily by the strength of the assurance that they can offer that mistakes made in financial institutions cannot in future inflict such damage on innocent individuals and businesses.  By this criterion, the measures in the White Paper published by the British Treasury in July fail even to register on the scales.

       The most urgent purpose of reform is to protect the non-financial economy from financial instability.  But an equally important objective is to secure better value for money for customers from a healthy industry.  A competitive marketplace is one in which well run businesses earn profits through domestic and international competition, and badly run businesses go to the wall.   That is the process by which the market system promotes innovation and economic progress, and suppression of that process damages innovation and economic progress.

       ‘Too big to fail’ is not something either a liberal democracy or a market economy can tolerate.  We need to distinguish sharply – as we do in other utilities – between the continued conduct of essential services and the continued existence of particular corporate entitles.  There is no necessary inconsistency between a more competitive environment and economic stability.  The key to such a solution is narrow banking – often described as separating the utility from the casino – which all retail deposits are secured on safe assets.

The case for narrow banking rests on the coincidence of three arguments.  First, the existing structure of financial services regulation (supervision) has failed.  Consumers are ill served, the collapse of major financial institutions has created the most serious economic crisis in a generation, and the sector has been stabilised only by the injection of very large amounts of public money and unprecedented guarantees of private sector liabilities.

It is time to learn lessons from the more successful regulation of other industries.  Those lessons point clearly to the need to retreat from supervision and to regulate through the mechanism of relatively simple, focussed structural rules.

Second, the most effective means of improving customer services and promoting innovation in retail financial services is market-oriented.  It is based on the ability of strong and dynamic retailers to source good value products from manufacturers and wholesalers and to promote consumer oriented innovations. The growth of financial conglomerates, a consequence of earlier measures of deregulation, has not been in the interests of the public or, in the long run, of the institutions themselves.

Third, a specific, but serious, problem arises from the ability of conglomerate financial institutions to use retail deposits which are implicitly or explicitly guaranteed by government as collateral for their other activities and particularly for proprietary trading.   The use of the deposit base in this way encourages irresponsible risk taking, creates major distortions of competition, and imposes unacceptable burdens on taxpayers.  Such activity can only be blocked by establishing a firewall between retail deposits and other liabilities of banks.  

The intention is that in the event of a future failure such as that at Northern Rock or RBS, an administrator could immediately take over the retail activities of the bank, and would find within the bank the material and financial resources to do so.  The financial needs of individuals and non-financial businesses would continue to be met at little or no cost to the taxpayer.  It is important to distinguish sharply between the continued provision of essential services and the continued existence of particular corporate entities.

       The term narrow banking sounds restrictive;   the concept of a utility boring.  The implications are not restrictive or boring, but liberating and exciting.  A much needed restructuring of the financial services industry would establish a retail sector focussed on the needs of consumers, rather than on the promotion of products and the remuneration of producers.  We could look forward to an industry in which new technologies are used, not just to reduce costs, but to deliver better services.  We should establish a market in which customer satisfaction is the measure of success.  That would be an outcome very different from our recent experience.  But it is an outcome we can – and must – achieve.