Breaking up UK banks: necessary but not sufficient

UK Chancellor George Osborne says the government will move forward with plans to force banks to "ringfence" their retail operations from their investment activities, in the hope of reducing the need for future taxpayer bailouts. Bankers and others contemplating a rearguard action against these plans will have to explain away an awkward historical fact. For decades after WWII, when the US banking system was strictly split between retail and investment activities, under the so-called Glass-Steagall rules, stability was the order of the day. When these regulations began to be loosened, in response to lobbying by the banks (and with the explicit encouragement of the world's worst central banker, Alan Greenspan), two consequences soon followed. There was rapid consolidation in the US financial sector, and financial bubbles started to pop up with remarkable regularity, culminating in the crisis of 2007-08. At the height of that crisis, we witnessed the offensive spectacle of investment banks hastily converting themselves into commercial banks in order to benefit from government (i.e. taxpayer) assistance.

But if separating retail from investment banking seems in principle to be the right thing to do, getting the split right in practice is likely to prove tricky. This is reflected in the wide variety of reactions to Osborne's announcement, and it's striking to see that the divisions are not along standard left/right lines. For example, the right-wing economist Andrew Lilico wrote on the Daily Telegraph website that ringfencing retail banking would guarantee more rather than fewer bailouts, on the grounds that it would impel retail bankers to take greater risks. (His logic is a bit bizarre for my taste, so take a look for yourself if you want to give him a fair hearing). In contrast, over on the "old" right, former Chancellor Nigel Lawson thinks only a full separation of retail from investment banking will suffice, because any firewall will never be impermeable enough.

Lawson seems closer to the mark here, but even a clean break would pose problems. We have a very current example to instruct us: Greek debt. When Greece's bondholders take the inevitable haircut, a lot of banks (especially in France and Germany) are going to feel the pain. But if you had been charged with divvying up the assets of large banks into retail and investment buckets a couple of years ago, where would you have put sovereign bonds, including those of Greece? Strong credit ratings, Euro-denominated: are you sure you wouldn't have put them on the retail side, as the kind of assets you'd want retail banks to invest in so as to keep their depositors' funds safe? Wrong choice, it now seems, but it might not have looked that way at the time.

These are presumably the kinds of issues that the Independent Banking Commission will be wrestling with over the summer months, so that Osborne can announce firm plans some time in October. Good luck with that. In the meantime, it's worth recalling that the 2007-08 crisis, and the rolling Eurozone debt crisis, were not just caused by irresponsible investment bankers. The truly underlying cause was the systematic underpricing of risk resulting from the irresponsible policy stance of the Greenspan Fed. For this reason, it's worrisome that the "emergency" lending rates put in place by the Fed and the Bank of England after the crisis hit are still in place, three years on. Even as the world economic outlook falters, those rates are contributing directly to yet another tech bubble, as well as to record rises in commodity prices. Economists constantly warn that "there is no such thing as a free lunch". In the longer term, there may be no such thing as "cheap money" either.