More competition and a reduction of the conflicts of interest between different financial services activities is the antidote to gouging. The separation of retail and investment banking would begin a move away from the transaction-focused, sales-driven culture of recent years and reassert the development of long-term relationships with customers.
The banking industry has many stakeholders and few of them are happy. Taxpayers have paid for capital injections and are still on the hook for bank liabilities. In many countries, including Britain, these liabilities are several times annual national income. Shareholders have lost most of the value of their equity. Corporate and retail customers see reduced competition among banks, wider margins and less availability of finance. Ordinary bank employees are unhappy: jobs have been lost, more cuts are in prospect and morale in activities unrelated to the wholesale market operations that led to the credit crunch is low. As citizens, we have all experienced the worst recession in decades.
So when investment bankers awarded themselves record bonuses for 2009, they pushed once more beyond the limits of prudent risk exposure. A backlash has followed. The public might seek reassurance that smiles on the faces of traders in financial markets are not achieved at the expense of frowns on the faces of traders in the real economy. But that is exactly how it is achieved. It is not hard to run a successful hedge fund if the government underwrites your liabilities at near zero interest rates, or to make money trading on wide spreads. You just need to be lucky enough still to be employed in a large conglomerate bank, given official encouragement to strengthen capital ratios from the profits earned in a market rigged in its favour.
The report of the Which? Banking Commission, published this week, makes a powerful case for reform. It starts from the perspective of non-financial customers, in contrast to the inward, self-referential view that has dominated the regulatory debate. The value of the financial services industry lies in what it does for the rest of the economy, not in what it does for itself. The report’s case for structural reform is based not on the needs of the banking industry but on the needs of other stakeholders.
Taxpayers benefit from structural reform, because of the urgent need to limit government underwriting of banking. Nothing is more seductive, or dangerous, than the argument that since such guarantees probably will not be called on they do not cost anything. Not only do such guarantees distort competition, they cost enormous amounts when called – as the US experience with Fannie Mae and Freddie Mac has proved.
A disaggregated banking structure would allow potential shareholders once more to understand what they might buy. The balance sheets of conglomerate banks proved too complex even for their own boards and senior management. Shy investors will not readily recapitalise such banks on the scale required. That money has been coming instead from government subscription and the gouging of customers.
More competition and a reduction of the conflicts of interest between different financial services activities is the antidote to gouging. The separation of retail and investment banking would begin a move away from the transaction-focused, sales-driven culture of recent years and reassert the development of long-term relationships with customers. That reform would be a prelude to addressing the conflicts within investment banking itself. It is only necessary to list the typical functions of an investment bank – market-making, corporate advice, securities issuance, asset management and own account trading – to see how entrenched such conflicts are.
Employees of retail banks are today mostly imprisoned in organisations whose overall culture is dominated by investment bankers. Restructuring would allow them to serve customers rather than promote products, to behave like salespeople in other, profitable, retailers. These work for companies whose horizons extend beyond the next bonus round.
Two small but powerful groups benefit from the existence of conglomerate banks. The people who run them, and investment bankers whose trading or underwriting benefits from the scale provided by a retail deposit base and the implicit government support that comes with it. The power of the Which? report is that it represents the views of a wider community. Not before time.