Mervyn King’s endorsement of narrow banking is a big relief. A worrying gap has been opening between politicians and economists on bank reform, so let’s hope King’s call for a structural review of the sector will sway the decision makers in the right direction.
Politicians from all parties are focussing on G20 ideas about regulation and capital requirements, and earning column inches with talk of windfall taxes.
While politically attractive, these alone are a long way from the complete restructuring of the industry called for by leading economists.
John Kay, the champion of narrow banking, Martin Wolf and now Mervyn King all agree that the current structure of the industry is unsustainable. They call the current situation the “biggest moral hazard in modern banking history”, “impractical”, “inconceivable”, “breathtaking” and “intolerable”.
Their core idea is Kay’s concept that banks should not be permitted to use publicly guaranteed retail deposits to fund speculative activity.
The separation of utility and casino banking operations limits the public’s guarantee substantially to just the utility part - defined as payment systems and deposit-taking - and forces the casinos to bear responsibility for their own risks.
“Encouraging banks to take risks that result in large dividend and remuneration payouts when things go well, and losses for taxpayers when they don’t, distorts the allocation of resources and management of risk,” said King.
Unbelievably, the government does not agree with this. Gordon Brown told the commons this week that he has no plans to split the sector, saying narrow banking would not have saved Northern Rock or Lehman Brothers as neither was an integrated bank. NR was a retail mortgage operation and Lehmans a pure investment bank.
This misses the point that these failures led to the withdrawal of trust in other integrated banks, including RBS, that needed to be bailed out with public money.
It also fails to recognise that structural reform of the sector creates a chance to build disincentives to the kind of activity that led to the demise of these two banks.
In Northern Rock’s case, if it had been defined as a narrow bank and its depositors given priority as creditors, then lenders in the wholesale market would have been reluctant to lend as they did. The Rock might not have developed the dependency on wholesale funding that ultimately killed it.
In Lehman’s case, the bank may have gone bankrupt anyway but other large banks would have been insulated from its impact and the bail-out requirement much smaller.
Kay makes another point, that the bancassurance model is a hindrance on the provision of decent retail banking services.
He says the buccaneering, transaction-led culture of investment banks led to, for example, “casino” bankers demanding raw material for securitsation and causing in-house “utility” bankers to lend badly in the sub-prime market.
King used the words of Sir Walter Scott to say something similar. Writing about the Ayr Bank crisis in 1772, Scott said the bankers were mostly good men but a few were “capitalists who sought gain not by the encouragement of fair trade and honest industry, but by affording temporary fuel to rashness or avarice”.
Narrow banking would break this model and allow retail banking to re-establish a client-focussed culture, focussed on payment innovations and good value financial products.
There may be more on this to come; Mervyn King hinted that in a paper later this week the Bank of England would describe policy tools to “limit the growth of the financial sector.”
Let’s hope he can persuade George Osborne of his arguments. Fury over bonuses makes it very tempting to build policy around windfall taxes, or even ongoing taxes as proposed by Nick Clegg.
However, these are not the answer. They would punish bank shareholders in general, which means the investing public and the Treasury. It won’t really affect bonuses and it certainly won’t help banks to start lending again.
If anyone has a moral duty to pay tax into the Treasury’s bail-out fund, it should be just the investment banking arms of integrated banks that received public support. Those public subsidies allowed high leverage to boost earnings - and stock compensation - and powered the one-way incentive schemes that led to so many write-offs and bonuses.
If windfall taxes cannot be avoided, at least split the banks along narrow banking lines first so the taxes can be targeted at the real culprits without affecting lending in the real economy.