The need for structural reform in banking

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While there may be some economies of scope in the provision of financial services, they don’t in any event compare in order of magnitude with the collateral economic damage imposed by recent failures in the financial sector.

There are three principal groups of argument for structural reform in the financial services industry.

Large financial conglomerates proved unmanageable in practice.  Well into 2008, senior executives of large banks gave assurances about the liquidity and solvency of their operations which proved to be wholly at variance with the facts.  The individuals concerned were not lying; they simply did not understand what was going on in their businesses.  Some companies, such as JP Morgan Chase and HSBC, weathered the storm more successfully than others.  But the stability of the financial system cannot depend on exceptional management, or luck, and it is naive to suppose that such deficiencies of management with be remedied by regulatory supervision.

There is a basic inconsistency between the cultures of retail banking – hierarchical, bureaucratic, dependent on processing millions of transactions with a high degree of accuracy – and investment banking –  buccaneering, entrepreneurial, and reliant on the talents of small numbers of egotistical individuals.  This is a conflict in which the investment bankers have mostly come out on top, to the inevitable detriment of retail banking.

Second, the assembly of financial conglomerates has markedly increased the fragility of the system. Contagion from small parts of the overall activities of the business may lead to the collapse of the entire corporate structure.  AIG and RBS are the most obvious cases in point.  While diversification of activities is in principle capable of reducing risks, in practice the diversifications of recent years have often had the opposite effect.  Businesses extended their operations into activities about which they knew less and in which they had no sustainable competitive advantage.

Third, financial conglomerates have not served retail customers well.  The business strategy which emerged has been essentially product driven, emphasising transactions over relationships.   In the retail financial services sector, there is a clear need for businesses whose focus is customer driven and whose strategies are based on long term trust relationships.  The business purpose should be – as it is for other retailers – to extract the most aggressive terms available from wholesale suppliers and product providers.  This will mainly probably be achieved by new entrants from outside the existing financial services industry.  Far from facilitating such entry, proposed regulatory changes – and the consolidation which has followed the crisis – have tended to entrench the market position of established firms.

While there may be some economies of scope in the provision of financial services, there is no evidence either that they are substantial or that major benefits arising have accrued to customers.  In any event they do not compare in order of magnitude with the collateral economic damage imposed by recent failures in the financial sector.

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