Another chapter from "Changing the Debate", released online during the Disraeli Room's ICB week
It was at the Buttonwood gathering of central bankers in New
York last autumn that Mervyn King, Governor of the Bank of England, dropped his
first bomb-shell. In his speech, entitled Banking: from Bagehot to Basel, and
Back Again, the Governor gave his analysis of what caused the Great Crash of
This is what he said: “At
the heart of this crisis was the expansion and subsequent contraction of the
balance sheet of the banking system. Other parts of the financial system in
general functioned normally. And we saw in 1987 and again in the early 2000s,
that a sharp fall in equity values did not cause the same damage as did the
banking crisis. Equity markets provide a natural safety valve, and when they
suffer sharp falls, economic policy can respond.
But when the banking system failed in September 2008, not even massive
injections of both liquidity and capital by the state could prevent a
devastating collapse of confidence and output around the world. So it is
imperative that we find an answer to the question of how to make our banking
system more stable.”
The Governor went on to warn his prestigious guests that
"of all the ways of organizing banking, the worst is the one we have
today". He was right.
It was a hugely significant, and largely unreported speech, in
which the Governor went on to question the very
nature of the fractional reserve banking system which has existed for
centuries; the way banks take in deposits and then – in such cavalier fashion –
lend them out for longer-term loans at higher risk; ie, leverage. In his own
words: "For all the clever innovation in the financial system, its
Achilles heel was, and remains, simply the extraordinary – indeed absurd –
levels of leverage represented by a heavy reliance on short-term debt."
And he added, that any solution to this must ensure that the costs of
"maturity transformation" (the costs of bailouts) fall on those who
enjoy the benefits - the bankers.
It was also a well-timed bomb as it was dropped soon after the
Independent Commission on Banking was set up by the Coalition government to
look into the future structure and shape of the UK banking industry, and into
its competitiveness. But it shouldn’t have surprised those in the know since
the Governor has been one of the most vocal critics of the industry since the
crash, and one of the first among policy-makers to suggest that some sort of
separation between the more ‘risky’ investment banking and retail
deposit-taking should be introduced to curb the worst excesses of this leverage
while protecting depositors. King has been careful not to call for a full
split, but it has been quite clear from his subsequent speeches and comments
that he does’t believe a legal ‘ring-fencing’ would be sufficient.
Indeed, the idea to
create the ICB is understood to have come from King originally, an idea he
passed on to the Chancellor, George Osborne, and Business Secretary, Vince
Cable, shortly after the election as the most neutral way of navigating a
thorough investigation of the industry independent of the all powerful banking
Reforming the banking industry so that the UK is never again in
a position of ‘ privatising the profits and socializing the losses’ was
integral to the Coalition agreement. And behind the inquiry are three fundamental
issues; how to reform the structure of banks so that the taxpayer never again
has to foot the bill, how to improve competition between the banks such as
improving barriers to entry and how to improve lending to small business.
Among the politicians, Cable in particular had been particularly
forthright in his criticism of the bankers, claiming that their actions had
destroyed the economy and that the only solution was splitting out the ‘casino’
– or investment banks – from the retail arms.
Fast forward a few months to March this year, and this is what
Mr King said next. In a wide-ranging interview with the Daily Telegraph, he
went on to drop what can only be described as a couple of cluster bombs. He
claimed the banks are still taking bets
with other people’s money, they are still trying to maximize short-term profit
at the expense of customers, that the practice of banks paying out huge bonuses
to their employees is highly questionable and that the failure to reform the
sector could result in another financial crisis.
Mr King’s criticism did not stop there. He went on to draw a
contrast between manufacturing companies, which he said largely cared about
their workforces, customers and products, and the banks, which don’t. He said:
"There's a different attitude towards customers. Small and medium firms
really notice this: they miss the people they know," adding that over the
past two decades, too many people in financial services had had thought
"if it's possible to make money out of gullible or unsuspecting customers,
that's perfectly acceptable".
And, answering his own question about why the banks want to pay
bonuses, he said: “It's because they live in a 'too big to fail' world in which
the state will bail them out on the downside.”
Yet no one – not on Wall
Street or in the City – has solved the too big too fail conundrum despite acres
and acres of new regulations, including the much more stringent Basel capital
ratio requirements and resolution processes being put in place. As King acknowledged: "We've not yet
solved the 'too big to fail' or, as I prefer to call it, the 'too important to
fail' problem. The concept of being too important to fail should have no place
in a market economy.” Once again, he was right.
This second bomb-shell was astonishing in many respects. It was
extraordinary because, once again, King made his disdain for our banking system
so clearly that this time there was no room for any other interpretation other
than his total vilification of the country’s bankers. If his words had come
from a politician or trade unionist, you’d have been forgiven for wondering if
they weren’t just trying to whip up more public’s anger towards the bankers for
their own populist causes. And it was all the more extraordinary because from
next year the Governor and the Bank of England will take back the task of
regulating the banks from the Financial Services Authority.
It was also carefully choreographed. King’s comments came
shortly after the so-called peace pact, Project Merlin, which was drawn up between
the UK’s five biggest banks and the Government and was meant to draw a line
under public hostility towards the banks following their promise to lend more
and to mend their ways. I suspect his remarks were also made for maximum impact
just as Sir John Vickers, chairman of the ICB, and his commissioners were due
to publish their interim findings into the structure of banking. As you might
imagine, King’s comments provoked the usual outrage from the powerful banking
lobby made up of the big five UK banks – Barclays, Lloyds Banking Group, Royal
Bank of Scotland, HSBC and Santander – which retaliated by claiming that they
had learnt from past mistakes, and that King was making mischief again.
But the big question now to ask is whether, for all King’s shock
and awe tactics, has he lost the battle? For, as predicted, the ICB’s interim
report, which was published in April, came to the conclusion
that universal banks – those which like Barclays, RBS and HSBC, combine retail
banking and riskier investment banking under one roof – should be allowed to
"ring-fence", or "subsidiarize", their various parts.
On the surface, this compromise looks clever The ICB has tried
to find a solution which will appease the ‘splitters’, the politicians such as
Cable, ex-Chancellors such as Nigel Lawson, ex-bankers such as John Reed of
Citibank and economists such as Professor John Kay who have been arguing for
‘narrow banking.’ At the same time, the ICB’s compromise, some would say
elegant whitewash, is a victory for the banking lobby that has campaigned
against a total split of retail and investment banking because, it argues, such
a split will raise the costs of funding their capital, thus making their
investment banking activities more expensive. Introducing a more strict ring-fencing
will put up the costs for the banks – but about £5bn in total – but not as much
as if they had to hive off their retail activities into new businesses with
separate shareholders as we had in the UK before the City’s Big Bank in 1986,
and which the US had from the 1930s until President Clinton repealed
Glass-Steagall in 1999.
What we don’t know, because he hasn’t told us, is what the
Governor thinks of this compromise from the ICB. But what is clear is that
those who argue for a complete split and the introduction of a Glass-Steagal
style separation, will now step up their campaign over the next few months to
try and persuade the ICB that its made a huge error, and an error based on
myths. As Liam Halligan, the Daily Telegraph writer and economist argues, these
are myths promoted ruthlessly by the banking lobby. He warns: “Such myths needs
to be uncovered if we are to avoid another early sub-prime type debacle.”
says the first myth is that Chinese walls work when, infact, experience shows
they don't. “If this divide isn't
emphatic and complete, investment bankers will inevitably keep levering-up
retail deposits and taking ill-judged bets, while enjoying the security of a
taxpayer-backed guarantee, precisely what got us into this ghastly situation.”
At present, banks such as Barclays and RBS, use the deposits of
their retail arms to leverage off to allow their investment bankers to take big
risks and leverage up their trades. When the bankers make money, their
businesses are run like co-operatives as they, the employees, take out most of
the money as bonuses. When they lose, as they did in 2008, the state guarantees
those losses because it was so terrified that the financial system would
Economists such as Halligan fear that the ICB’s proposed
‘ring-fencing’ will allow this arrangement to continue as Chinese Walls always
break under extreme pressure and because bankers will always find ways of
The second myth is that if London goes it alone by imposing a
full separation it would harm the UK’s big banks since they would be
uncompetitive compared with the world’s biggest universal banks, thus
committing "commercial suicide" as one Barclays director put it to
me. But this is not necessarily the case.
Others who support separation, such as Nigel Lawson, and other
senior City financiers argue the reverse – that by cleaning up the UK banking
system, the UK would actually be strengthening it’s financial credibility.
Let’s not forget there were 500 banks operating in the Square Mile even before
Big Bang allowed banks to become all-singing, universal banks.
Professor Laurence Kotlikoff, the US economist who argues for
even more radical reform with his ‘limited purpose banking’, goes further,
arguing that London should take this opportunity to once again lead the world
by being the first to restore credibility to the financial system – and it may
even give us a competitive advantage. It’s interesting to note that Kotlikoff’s
views have the ears of King.
There’s another myth that
needs lancing, and it’s perhaps the most insidious. Those that argue most
vociferously against splitting the banks claim that the financial institutions
that caused the most trouble – such as Lehman Brothers, Northern Rock, HBOS and
Royal Bank of Scotland – were not universal banks. In some ways, it’s the most
tricky argument to counter as technically they are right – only RBS was a
universal bank - and each instance has its own root causes. But the point is
that Lehman collapsed because it had taken on so much leverage with the other
big commercial banks – it was the pus if you like, on a very large boil which
lay festering at the heard of the banking system.
At the same time, Northern Rock got caught because it had been
trying to behave as though it were an investment bank by borrowing and playing
long in the wholesale markets. The collapse of Sir Fred Goodwin’s RBS had more
to do with personal ambition – it was his mania to turn RBS into one of the
biggest banks in the world which was to blame. But Goodwin would have found it
far more difficult to do so if he hadn’t had the pressure from his investment
bankers to keep maximizing profits, which meant he had to keep expanding the
Even those who support a full split know that it’s only part of
the cure to making our banking system
safer but it’s a crucial one. There have always been banking failures and there
were many over the last few decades when investment banking and commercial
banking were fully separated but nothing as devastating as we have seen over
the last few years.
There have been other changes to finance triggered by the crash
and post the election that have merit – there is a now a much more open
appetite for looking at alternative sources of funding such as co-operatives,
credit unions and even a new Social Stock Exchange is being launched. Project
Merlin has also spawned a new fund, the Business Growth Fund which the five big
high-street banks have pledged to put £2.5bn to invest equity directly into
small businesses, and the government’s Green Bank, raising funds for investing
in new clean and green technology, is due to take off next year.
On opening up competition within the banking industry, the ICB
has taken the right route by recommending that Lloyds sell off more branches
and will be proposing ways of reducing the barriers to entry to make it easier
for new banks to be created – it can’t be right that Tesco is the first new
fully-fledge bank to be set up in a 100 years.
As the new Tory MP,
Andrea Leadsom, and a member of the Treasury Select committee who is turning
out to be a terrier on the back benches, points out, the number of banks has
actually halved to 22 over the past decade while the gross assets of the big
high street banks have increased almost four times. This must be changed.
Leadsom wants the Government to take this once-in-a-lifetime chance to
introduce competition by making four to five new banks from the various stakes
owned by the taxpayer through UKFI – stakes in Royal Bank of Scotland, Lloyds,
Northern Rock and Bradford & Bingley. It’s an excellent idea and one that
the Chancellor, George Osborne, should look at carefully at as he prepares to
consider the ICB report this autumn.
Sadly, the latest proposals in the ICB’s interim report, that
banks should be ring-fenced and not split, is a missed opportunity. And it’s
one that appears to have been received with an uneasy acceptance by most
politicians and policy-makers. Sir John and his four commissioners now have a
few more months to continue talks with the industry and interested parties and
they will be holding a number of public debates before deciding on, and
presenting their final recommendations, to parliament in September.
It’s too much to expect the public, however angry they may be
about bankers, to get worked up enough to start barracking Sir John about such
a technical issue at these public meetings. Instead, we need our leading
experts and policy-makers who do support such a break-up to continue putting
pressure on the Commission to take another look at the ‘lite-touch’ option of
ring-fencing and to persuade them instead to go for the ‘nuclear’ one of
splitting. We need the
Governor to drop a few more bombs before it’s too late, or at least tell
us whether he believes the Chinese Walls are nuclear proof.
This a chapter from ResPublica's collection of essays, entitled "Changing the Debate: The Ideas Redefining Britain".
ResPublica is publishing chapters from the collection on The Disraeli Room blog, encouraging other thinkers, politicians and members of the public to join the debate and contribute to the development of ideas.
The full collection is also available to purchase, online using Paypal via this link or by sending a cheque for £20, made payable to "The ResPublica Trust", to: Publication sales, ResPublica, 50 Broadway, London SW1H 0RG