Why focus on the size of banks? Great Britain shows other ways to achieve financial reform.

Commentaries on economics and technology.
April 20 2011 7:06 AM

The Failure of "Too Big To Fail"

Why focus on the size of banks? Great Britain shows other ways to achieve financial reform.

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Over the last three years there has been no shortage of schemes to solve the conundrum of "too big to fail" banks. Many academics and pundits have castigated regulators and central bankers for their inability to understand the obvious attractions of so-called "narrow banking," a restoration of Glass-Steagall-era separation of commercial and investment banking, or dramatically higher capital requirements. If only one of these remedies were adopted, the world would be a safer and happier place, and taxpayers would no longer be at risk of bailing out feckless financiers.

In response, bankers have tended to argue that any interference in their business would be an unconscionable assault on their inalienable human right to lose shareholders' and depositors' money in whatever way they please. Moreover, they argue that the cost of any increase in required equity capital would simply be passed on to borrowers in the form of higher interest rates, bringing economic growth to a grinding halt.

One might characterize this as a dialogue of the deaf—except that most deaf people manage to communicate with each other quite well, through sign language and other means.

Onto this fiercely contested terrain marches the United Kingdom's Independent Commission on Banking, set up last year by Chancellor of the Exchequer George Osborne, with a brief to examine possible structural reforms to the banking system aimed at safeguarding financial stability and competition. The commission is chaired by Sir John Vickers, the warden of All Souls College, Oxford, and at his side sits Martin Wolf of the Financial Times. The commission's interim report, published on April 11, is both lucid and penetrating. It also persuasively demonstrates that all the proposed remedies come with significant costs. The reader is obliged to conclude that regulators might not have been so dim after all.

One obvious point is that it is hard to identify a clear relationship between the financial industry's structure and success or failure in the crisis. Some universal banks did well; others badly. Some investment banks prospered (in Goldman Sachs' case, perhaps too much); others collapsed. Some retail banks went belly-up, while others stayed afloat.

Vickers gives short shrift to some of the more beguiling options. Narrow banking, which entails retail deposits being kept in distinct entities, backed only by safe and liquid assets like government bonds, does not fare well under his microscope. "The social costs would be significant," he warns, as the synergies between deposit-taking and lending would be lost. And governments would almost certainly have to back some lending banks, too, so the claimed benefits in terms of insulating the public purse would not be realized. Vickers is no more enamored of so-called "limited purpose banking," in which all debt is effectively securitized. "There would be a decrease in economic value added from intermediation," and loans to small and medium-size enterprises would be badly affected.

Straightforward size limits on banks also find no favor. The Volcker rule? "It is unlikely that the impact would be significant in the UK," or, by implication, elsewhere outside the United States.

Glass-Steagall detains the commission for rather longer, but also comes up short: "The costs of full separation could be higher than is necessary to address the problems," owing in part to potential "economies of scope between retail and wholesale/investment banking services." Moreover, "full separation would remove all intra-bank diversification benefits and so eliminate the possibility that one part of the group could save another part."

By this point in the report, readers in the boardrooms of British banks must have been pleased. If they were, it was premature. One reform that does find favor is what the commission describes as a "retail ring-fence." The impact would be to require a bank carrying out retail activities in the United Kingdom to put them in a separately capitalized subsidiary. The capital requirements attached to that subsidiary would be more burdensome, with minimum Tier 1 capital set at 10 percent, compared with the new Basel 3 standard of 7 percent.

Such a requirement would impose costs on universal banks by constraining their ability to transfer capital within the group. The scale of these costs is unknown, but the share prices of the banks that could be affected (Barclays and Royal Bank of Scotland in particular) rose when the report was published, suggesting that they are not as high as had been feared.

The major advantage of the scheme is that it dovetails with other reforms under development in Basel. A retail ring-fence makes most sense if coupled with new a new resolution regime, which would allow a retail subsidiary to be wound up without contagion across the group. If efforts to allow bondholders to share the pain are also successful, we might be within sight of a sensible and not-too-costly reform with which the market can make peace—and which regulators would have a realistic chance of managing.

Those who want the banks "cut down to size," even if it is a case of cutting off one's nose to spite one's face, are not happy with Vickers. But, by providing an honest, rigorous assessment of the major reform proposals, the commission has performed an invaluable service and deserves recognition for a job elegantly done.

This article comes from Project Syndicate.

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