Plan to ring-fence banks misguided

The British government is right to be examining ways of shielding taxpayers from the costs of bank failure. However, proposals to ring-fence the retail operations of banks, and indeed to give the government to power to order the complete break-up of banks, are deeply misguided. The plans appear to be based on the misapprehension that retail banking is intrinsically safe, while investment banking is intrinsically reckless and dangerous. But recent history would appear to contradict this viewpoint.

Many of the banks that failed were largely or entirely retail operations, including Northern Rock, Bradford and Bingley, and Lloyds/Halifax Bank of Scotland. Indeed, this pattern has been characteristic of numerous economic crises, with institutions focusing on mortgage lending particularly vulnerable to collapse. By contrast, institutions that combine retail and investment arms may be better able to diversify risk. Losses resulting from a collapsing property market might be balanced by gains in other asset classes for example.

There are further problems with the government's proposals. Clearly the possibility that banks will be forcibly broken up creates risk and uncertainty for investors. There is a real fear that it will put British banks at a competitive disadvantage. The tight regulation of the retail sector will also distort the allocation of capital within the banking sector, with a negative effect on the wider economy.

Worse still, the reforms risk exacerbating the problem of moral hazard within retail banking. The notion that retail banks are ring-fenced, regulated and safe, may further discourage depositors from favouring institutions with conservative lending practices. This echoes one of the major contributory factors to the financial crisis. Reassured by state-backed deposit insurance, regulation and an implicit bail-out guarantee, savers piled into banks that offered higher interest rates but engaged in risky activity, such as Northern Rock.

Rather than focusing on counterproductive ring-fencing, the government should tackle moral hazard head on. Deposit insurance should be phased out gradually and state bail-outs prohibited so that depositors are incentivised to bank with conservative institutions. This in turn would encourage banks themselves to behave more conservatively and to advertise their prudent practices to potential customers. Removing deposit insurance and reducing bailout expectations would change the whole culture of the banking sector, greatly lowering the risk of future crises.

At the same time, policy-makers need to address other fundamental causes of the economic instability that leads to banking crises. Large increases in the money supply instigated by central banks created the unsustainable asset price booms that turned to bust. In many ways, the explosion in bank credit that led to disaster was a symptom of reckless behaviour by central bankers who flooded the markets with liquidity as they attempted to counteract economic slowdowns.

Ring-fencing will do nothing to prevent central bank inflation from destabilising the banking sector; neither will it address the moral hazard that encourages reckless behaviour. It will, however, impose significant additional costs on an industry struggling to recover from a severe crisis, with knock-on effects on those businesses reliant on bank lending to fund new investment. It is not too late to reverse the reform plans and focus instead on addressing the deeper causes of the financial crisis.

This piece originally appeared in Public Service Europe. 

Dr Wellings makes many valid points. I had also misunderstood the arguments for ringfencing until I read the original recommendations in more detail. Their point was that it is impossible to "tackle moral hazard head on" as Dr Welling suggests unless the non-deposit elements of a bank can and will realistically be put through insolvency. However, no democratic government will ever choose to inflict losses on all depositors (voters) in a crisis, and will change laws as necessary to make that possible. Suggesting the removal of deposit insurance is an illusory solution because it will be reinstated in a crisis. The argument is not that investment banking is inherently more risky - it is that it is possible to put it (and a bond-issuing holding company) through restructuring, whereas haircuts cannot realistically be imposed upon small depositors in a democracy. The only way to protect the taxpayer and truly eliminate moral hazard is to require a structure that realistically ensures that haircuts can be imposed on bond and equity holders in a bank without disrupting the entire economy.

@John Myers - While my preference would be for deposit insurance to be phased out completely, it would be possible to limit it to say 90 per cent of the value, which would be more politically acceptable in a crisis and would still improve the incentives facing both depositors and banks.

Alternatively the government could charge for deposit insurance (commercially, i.e. costing more depending on the financial state of the deposit bank, term of deposit etc). The charge would be collected by the deposit bank - a customer at a risky bank could end up receiving negative interest. They should then create a market for private firms to insure deposits, with the aim of exiting the market...

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