How to Make Banks Safer -- Lessons From the Swiss

Like the fella says, in Italy for 30 years under the Borgias they had warfare, terror, murder and bloodshed, but they produced Michelangelo, Leonardo da Vinci and the Renaissance. In Switzerland they had brotherly love. They had 500 years of democracy and peace, and what did that produce? The cuckoo clock. -- Harry Lime in The Third Man

UBS is considering incorporating its investment bank, which lost billions during the financial crisis and was rescued by the Swiss central bank, in London, New York or Singapore, where it would have its own capital and be overseen by local regulators.

Culture clash
Separating a global financial firm's investment bank from its retail banking operations is a good idea. In essence, it's the same logic as keeping a piranha in a different tank from the rest of the fish. Since investment banks are complex, opaque and prone to tucking away risk in the nooks and crannies of their parent company's balance sheet, fencing them in (out, really) might help contain their losses. And when disaster inevitably does strike, it could make them easier to shut down.

Another potential benefit: keeping thrill-seeking investment bankers and traders away from the traditionally more sedate parts of the bank, such as lending and wealth management.

That's actually a big deal. Although it hasn't gotten a lot of attention (mostly because it's hard to prove), there's reason to think that the blockbuster mergers that have reshaped the financial industry since the late 1990s also rewired bankers' attitude toward risk.

CEOs who once upon a time might've thought twice about piling on leverage and playing with synthetic collateralized debt obligations gradually became inured to the risk of such activities, especially as profits flowed. In part, that's because the guys who wrote the book on credit default swaps were now parked in the office next door. People talk. As Thomas Hoenig, head of the Federal Reserve Bank of Kansas City, said in a speech this week:

The combination of securities and commercial banking activities in a single organization provides opportunities for the senior management and boards of directors to be increasingly influenced by individuals with a short-term perspective. As a result, the increased propensity of these corporate leaders to take high risks for short-term gain leads to more of a short-term-returns culture throughout the organization.

Walling off investment banks wouldn't prevent them from blowing up, of course. Nor would it put a stopper on systemic risk. Financial firms would remain deeply interconnected, while the shadow-banking system remains largely unlit.

More specifically, UBS is only talking about setting up its investment bank as a separate legal entity in a different locale, not spinning it off. So the question remains exactly how independent the unit would really be from its parent. If the investment bank crashed, local regulators are still likely to press UBS to absorb its losses. And as Yves Smith notes, if the operations are that separate, why do they need to exist under the same roof?

A better idea in the U.S. is to more fully restore Glass-Steagall, the 1933 law that separated investment and commercial banks. Given the lack of political will for such an obvious solution, however, Switzerland's approach is worth considering. Not that it would easy to implement. Bankers would naturally fight tooth and nail to prevent their companies from being partitioned. Structuring and enforcing such a separation also would require global regulators to coordinate their oversight, never a good bet. And unlike Switzerland, it's worth adding, U.S. regulators can't very well banish American investment banks to distant lands.

If successful, however, the financial system would benefit by making it easier to figure out just where the danger lurking within big banks actually lies. You don't have to be cuckoo to see that.

Image from Wikimedia Commons, CC 2.0
Related:

• History Slay: Why HBO's "Too Big to Fail" is Too Dull to Watch
• Why Ben Bernanke Will Regret Declaring Mission Accomplished on "Too Big to Fail"
• TARP Trap: How the Bank Bailout Saved the Financial World -- and Threatens It Anew
• Wall Street, Heal Thyself? If Only It Were That Simple
• "Too Big to Fail" Has Only One Solution