Too big to fail

by Ed Bowsher on 21 October 2009  |  5 comments
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How can we stop bankrupt banks dragging down the rest of the economy?

So Mervyn King said yesterday that banks should be broken up. He thinks the boring bits, like current accounts and loans to small businesses, should be housed within 'utility banks'. 

Then the highly profitable bits, such as investment banking and trading with derivatives, should be spun off into 'casino banks.' The idea is that casino banks wouldn't pose a systemic risk to the UK economy, so the government and regulators would be willing to let these risky operations go bust if they made mistakes. Whereas, as things stand, bankers know they can take big risks in the knowledge that if they get things wrong, the government will bail them out. 

The 'utility banks' by contrast, would be safer. They'd be unlikely to go bust because they wouldn't be allowed to do the risky stuff. 

However, there are some problems with this proposal. Northern Rock was basically a utility bank, so these 'plain vanilla' operations wouldn't be risk-free. On top of that, a couple of people in the industry tell me it would be very hard to do a split between utility and casino banks. The utility and casino strands are too closely entwined at several banks. I also suspect that when it came to it, the wider costs of a casino bank going to the wall might still be too scary for a regulator. That's basically what happened with Lehmans after all.

So maybe the utility/casino split isn't such a good idea. But there are other things we can do to ensure that risks taken by bankers can't inflict near-fatal damage on our economy. 

For starters, we could break up our biggest banks. Letting Royal Bank of Scotland go to the wall last year would have been horrendous. The economic damage would have been too great. But if banks are smaller, a government might just be willing to let the market pull the trigger. The smaller banks could still be a mix of utility and casino, they'd just be smaller.

Smaller banks are also in the interests of the consumer. More competition will mean better products, better rates, and fewer rip-offs. 

The second approach is to tighten up capital and liquidity requirements. That's what politicians and regulators have been focusing on this year. If you force a bank to leave more of its money in the vault, it's less likely to go bust. Its profitability will also be reduced, but that's just tough. 

King also suggested that banks should be forced to issue 'contingency capital'.  This would probably be in the form of bonds that would automatically become shares if a bank's capital levels fell too low. A bank's debt level would be reduced because some of its debt would become shares. This is a nice idea although King worries that these bonds wouldn't be popular with investors. I reckon there would probably be buyers if the price was right..... 

So what would I do? 

I'd carry on pushing for higher capital requirements. I'd also see if contingency capital could fly as an idea. And I'd carry on trying to strengthen and improve our regulators.

But, most importantly, even if we can't have separate utility and casino banks, I'd want to have smaller banks. That should be a priority for our next government.  

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