King to Brown: you're deluded

Hot on the heels of the FSA's none-too-soon plan to ban self-certified mortgages, Bank of England Governor Mervyn King has demonstrated that he too is determined to learn the lessons of the financial crisis. His speech in Edinburgh last evening to "Scottish business leaders" (presumably excluding Sir Fred Goodwin) was hard hitting to the point of being downright hostile. The whole thing is worth reading but here are a few key quotes:

It is hard to see how the existence of institutions that are “too important to fail” is consistent with their being in the private sector. 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.

When bank failures impose costs on the rest of the economy, it is reasonable to insist that banks themselves purchase a sufficient degree of insurance in the form of a large capital cushion available automatically before insolvency.

Anyone who proposed giving government guarantees to retail depositors and other creditors, and then suggested that such funding could be used to finance highly risky and speculative activities, would be thought rather unworldly. But that is where we now are.

These are not new themes for the Governor. It's been clear for some time that he believes that some UK banks are now too big for the economy to support, and that he sees no reason why government guarantees should stretch beyond what he calls "utility banking" to cover the banks' riskier and more speculative activities.

So both the Bank of England and the FSA "get it", but it seems as if Gordon Brown doesn't. At PMQs today he outright dismissed the Governor's advice. Acoording to The Man Who Saved The World, King is misdiagnosing the problem. In Brown's view, Lehman, which was an investment bank, went broke, but so did Northern Rock, which was a retail bank; ergo, the problem has nothing to do with the distinction between "utility" banking and investment banking.

The problem with this is that Northern Rock wasn't really a retail bank. Sure, its main assets were retail in nature: mortgages, mostly. But it was rubbish at the other side of retail business, the gathering of deposits. Because of that, the only way it could pursue its hyper aggressive growth strategy was to turn to wholesale funding markets and structured financial products, provided by Lehman et al. The Rock needed Lehman, and the Lehman needed the Rock: they were part and parcel of the same problem.

According to Brown, what's needed is better regulation. Seems as if King may have guessed that the PM would say that, though. Here's another excerpt from last night's speech:

The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.

You'd love to be in the room if King says that to Brown next time they meet face to face. But maybe King's not too worried. His likely next boss, Tory Shadow Chancellor George Osborne, has already said he agrees with most of what King had to say last night. If King saw this as an audition, I'd say it went quite well.