The nightmare of taking on ‘too big to fail’

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Britain’s Independent Banking Commission has recognised that it is better to create a structure that secures the right incentives than to try to control behaviour arising from the wrong incentives. I expected it would do so; that was the conclusion of an article I wrote 20 years ago with another academic economist, Sir John Vickers, who led the commission.

It has also recognised that the objective of regulation is not to prevent bank failures. Governments cannot prevent them – though they can bail out failed banks. Such an objective would stifle innovation and undermine management autonomy and responsibility. Institutions that run into trouble – like Lehman Brothers and Northern Rock – should be able to fail without unacceptable consequences for the financial system.

Too big, or too complex, or too diversified, to fail cannot be tolerated in a competitive market economy. A government backstop gives an overwhelming competitive advantage to large established firms and encourages the kind of risk-taking in which risk-takers receive much of the upside and little of the downside.

So the commission correctly focuses on increasing competition and on the separation of retail and investment banking. The analysis is effective, the direction of travel is right. But are the specific measures they propose sufficient to achieve the outcomes they seek?

The commission disposes of the widely reiterated assertion, that separation would encourage banks to move their headquarters abroad. The plan is to ring-fence UK retail banking activities, whether conducted by British or foreign owned firms, and UK retail banking activities are, by definition, conducted in the UK.

The other main argument the banks have deployed is better, but not much. They emphasise the costs of the split. As the report explains, the bulk of that cost is incurred in capitalising and funding investment banking without the support of a large retail deposit base and an implicit state guarantee. The cost is a measure of the cross-subsidy that depositors – and the taxpayers – provide today. The banks’ loss is directly matched by the public gain.

But the devil is in the detail. While the commission discusses the possibility of making depositors preferred creditors and correctly concludes that there are strong arguments for such a move, it fails to recommend such a change.

So their proposal is to rely heavily on a 10 per cent capital ratio on these ring-fenced UK retail banking operations. This is a more than adequate equity base for a traditional, conservative retail bank. But would the retail banking subsidiaries of a financial conglomerate controlled by investment bankers resemble a traditional conservative retail bank?

Or would the treasury operations of such a bank develop to a size and scale more appropriate to an investment bank – the process that undermined the Glass Steagall act’s separation of US banking activities long before its 1999 abolition. Have we not learnt that a capital ratio is an inadequate regulatory tool on its own once the range of balance sheet assets multiplies?

And there are to be no limits on cross-dealing with other businesses in the group so long as the 10 per cent capital ratio is maintained. Is this consistent with the overriding objective that government can confidently seize control of the retail activities of the retail arm of a failing conglomerate over a weekend, and put the rest of the institution in the hands of a liquidator?

There are no adequate answers to these questions. I continue to believe ring-fenced retail banking would have to restrict the assets that a retail bank could hold as well as the activities it could engage in. The report’s discussion of these core issues is disappointingly thin.

The public can applaud the principle of separation of utility and casino banking. The detail of how it is to be accomplished is of interest only to the banks. We can expect such detail will face intense lobbying from now until the publication of the final report and long after the commissioners have filed their papers and gone home. If the initial position is not clear and robust, the final outcome will never be an effective one.

We can apply two tests to the proposals. Do market prices reflect an expectation that a failed investment banking division of a conglomerate bank will be allowed to fail? Are these banks beginning the radical simplification of corporate structure needed to make such resolution a realistic possibility?

The market reaction so far suggests a view that the banks have got away with it. Sir John is understandably angry at this suggestion, as he stood up to unacceptable pressure from vested interests. But that the outcome is at once radical and weak is a measure of how biased the debate so far has been.

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