An Immodest Proposal: Break Up the Banks

(MoneyWatch)  Bank of England head Mervyn King has a solution for banks that have grown too big to fail: break them up.

King, viewed within financial circles as an industry wise man, in a speech Tuesday in Edinburgh advocated separating banks' core businesses of lending and taking deposits from riskier activities, such as proprietary trading, in which they buy and sell securities for their own accounts.

His explanation for why that cleavage would strengthen the financial system is simple, but profound: Lending and taking deposits is essential to the health of the economy -- trading isn't. This approach, he said,

. . . draws a clear distinction between different activities that banks undertake. The banking system provides two crucial services to the rest of the economy: providing companies and households a ready means by which they can make payments for goods and services and intermediating flows of savings to finance investment. Those are the utility aspects of banking where we all have a common interest in ensuring continuity of service. And for this reason they are quite different in nature from some of the riskier financial activities that banks undertake, such as proprietary trading.

The ultimate goal is "to reduce the dependence of so many households and businesses on so few institutions that engage in so many risky activities," King said. He also noted that it's common in other industries to separate critical functions, which are regulated, from less vital activities, which can be left up to the market's animal spirits.

Another financial sage who shares King's views about breaking up big banks is Paul Volcker, one of President Obama's chief economic advisers. He favors rebuilding the wall between retail and investment banking, which was torn down in 1999 with the elimination of Glass-Steagall.

Volcker's masters in Washington disagree The NYT in a piece today highlights how little progress he's made selling his plan within the Obama Administration.

His disagreement with the Obama people on whether to restore some version of Glass-Steagall appears to have contributed to published reports that his influence in the administration is fading and that he is rarely if ever in the small Washington office assigned to him.

Too bad. The White House, under the advice of economic viziers Larry Summers and Treasury chief Tim Geithner, thinks tighter bank regulation is sufficient to ward off future financial calamities.

I'm with King on this one. Forcing banks to hold more capital or setting up regulated exchanges to derivatives may help financial companies weather crises like the current one. Trouble is, each meltdown, while sharing certain characteristics, is different.

Custom-fitting regulations to present-day systemic problems may not prevent future collapses stemming from new, spookier forms of financial innovation. In other words, there's simply no way to know that capital requirements set today will protect banks from the economic shocks of tomorrow.

Think of it this way. Rather than regulating banks that are too big to fail, isn't it more sensible to stop them from getting too big to begin with?