Breaking the bank

Bank shares are coming under pressure again as markets scale the proverbial wall of worry over the Eurozone sovereign debt crisis and the risk of another global recession. For the big UK banks there’s an added source of weakness: a week from today (on September 12), the Independent Commission on Banking is due to publish its final set of recommendations on the future of the sector.

The Commission’s interim report raised the idea of forcing the banks to “ring fence” their retail operations from their investment banking activities, in the hope of ensuring that taxpayers would not have to rescue the retail banks again in any future financial crisis. The final report is likely to reiterate that recommendation, fleshed out with more details about how it could be implemented.

The banks are not waiting for the report to appear. They are loudly warning that it would be unwise in the extreme to embark on such major changes when the economy is so weak. The business press is echoing these calls. Today has brought a report by the Ernst and Young “Item Club” that attempts to quantify the damage that could be done. (BBC report here). E&Y believes that separating off the retail divisions of the banks would increase the funding costs for their investment banking operations.

E&Y’s reasoning is that removing the implicit government guarantee from the investment operations (the “too big to fail” guarantee) would impel depositors and investors to demand higher returns on their money to compensate for the increase in risk. The banks would then pass that increased cost on to their business borrowers. This would allegedly push the cost of business borrowing up by 1.5% and chop 0.3% off GDP growth. It seems fair to point out that if the implicit government guarantee really is worth 1.5 percentage points to the banks, then the government has been grossly undercompensated for its past support.

Looking to the bigger picture, the argument that “this is not the right time” for such reforms looks very dubious. Any attempt to implement changes of this sort during a time of strong economic growth would certainly have been batted away by the banks, no doubt supported by the business press, with an “if it ain’t broke, don’t fix it” argument. Likewise, if the government decides to delay implementing the Commission’s recommendations until 2015 or later, and the banks have not blown up by then, they will doubtless argue that the need for such drastic reform has passed.

The government would be wise not to let a good crisis go to waste here. It should perhaps recall the comment of Steve Eisman, one of the US fund managers who made a fortune out of the 2008 financial crisis, in Michael Lewis’s “The Big Short”:

“I can understand why Goldman Sachs would want to be included in the conversation about what to do about Wall Street,” he said. "What I can’t understand is why anyone would listen to them.”