Unlike the U.S., Brits Show Some Steel in Policing Big Banks
Financial reform in the U.S. is bogging down, with Wall Street delaying the adoption of derivatives rules and Republican lawmakers blocking the appointment of someone to lead the Consumer Financial Protection Bureau. The U.K., by contrast, is charging ahead in trying to fix its banking system.
The British government plans to force the country's biggest banks to fence off their respective retail and investment units. The idea is to insulate a bank's safer deposit-taking and lending divisions from its trading and other riskier businesses. Chancellor of the Exchequer George Osborne also voiced support today for a proposal requiring Barclays (BCS), HSBC (HBC), Royal Bank of Scotland (RBS) and other large U.K. banks to hold even more capital as a cushion against financial losses than required under the Basel III standards.
Good fences make good neighbors
Partitioning big banks with a government-enforced "Chinese wall" wouldn't end the problem of "too big to fail" in Britain, where The City took even crazier risks leading up to the housing crash than Wall Street did. Mega-banks won't suddenly find religion and swear off gambling. And as solutions go, this approach is less bold than simply breaking up such institutions, as Bank of England chief Mervyn King proposed.
But "ring-fencing" could make it more difficult for investment bankers to borrow recklessly against a firm's retail assets and use that leverage to speculate, reducing the necessity of a taxpayer bailout if (when) those bets sour. Buttressed by higher capital standards, that could also make it easier to shut a unit down if (when) it gets into trouble. Felix Salmon writes:
This is bold and welcome thinking. From a regulatory perspective, banks have good profits and bad profits. Bad profits are the ones coming from risky structured products and leveraged trading desks; good profits are the ones which come from the lending investment capital to individuals, small businesses and large companies. State-insured deposits should be use to fund good businesses, not risky and speculative businesses -- as should any access to central bank liquidity windows.Haven't we tried this before?
There is, of course, one great weakness to Chinese walls -- they leak. Such boundaries are hard to police, both internally within financial companies and through regulation. Bankers talk. They "innovate," developing products that appear to respect the line of demarcation but that continue to expose the entire enterprise to risk. Over time, government watchdogs have a tendency to doze or get "captured."
During the dot-com era, for instance, Wall Street firms all had barriers in place ostensibly aimed at keeping investment bankers from colluding with a firm's own equity analysts. We know how that turned out. Re-instituting this approach could work in the short-term, but fail miserably over time as the tunnels between investment and retail banking multiply.
A related question: Where exactly do the Brits intend to build the frontier within banks? As the NYT notes, for instance, will the derivatives banks use to hedge their bets be placed within investment banking, or is that a retail activity? Whatever the merits of this proposal, it's hard to judge until the U.K.'s banking commission presents a detailed plan in September.
And no matter how sturdy the fence dividing a bank, finally, traders are still likely to eventually take the kind of risks that result in calamitous losses. Quarantining them may make it easier to keep them under observation, in other words, but in an interconnected financial world it may not avert the necessity of a government rescue.
Still, U.K. Prime Minister David Cameron's government -- conservative, it's worth noting -- deserves credit. Someone has to lead the way on financial reform. Pity it can't be us.
Image from Flickr user altogetherfool
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