Banking can be made honest but not fail-safe

Too many restrictions on banks will cut the growth-promoting flow of capital to industry

Perhaps you didn’t notice, but throughout much of this week the Parliamentary Commission on Banking Standards has been hosting a series of high-powered witnesses among them the Chancellor, George Osborne, the Governor of the Bank of England, Sir Mervyn King, and his likely successor, the Deputy Governor, Paul Tucker. Much of the discussion was quite arcane in nature, involving as it did the deeper intricacies of the banking reform agenda. Even for those of us who claim to know about this sort of stuff, it made tedious listening. The temptation to switch channels was at times almost overpowering. Especially when you consider that back in the real world, a truly shocking tale of greed, hubris, and negligent behaviour was beginning to unfold that compares to some of the worst the banking crisis had to offer. If finance has learnt its lesson, it was not apparent from this little escapade.

Last year, Hewlett-Packard, the world’s largest PC manufacturer, coughed up a humongous $11.1 billion to buy the British software company Autonomy. Even at the time, HP was widely thought to have overpaid horribly, but by quite how much only became apparent this week, when the firm wrote off more than three quarters of the purchase price. In the process, HP claimed that it had been deliberately sold a pup the books had been wilfully cooked, it alleged, to make profits seem higher than they really were.

On one level, this is just another case of caveat emptor, albeit on a rather grander scale than the buyer of a second hand car. But it was not as simple as this. One of the most shocking aspects of Autonomy’s alleged heist was the extraordinary array of top-drawer investment bankers, accountants, lawyers and general hangers-on who managed to extract a fee from it. In total, these advisory fees amounted to close on $100 million this for a deal which, whether fraudulent or not, had within months reduced HP to a pile of rubble. For the record, Mike Lynch, the former chief executive, denies any wrongdoing.

Despite all that’s happened over the past five years, it seems to be back to business as usual for many bankers. Where was the duty of care, and what on earth could advisers have been thinking to allow such a value destructive acquisition to take place? Take the money and run remains the prevailing mindset, leaving others to clean up the mess. And financiers wonder what they have to do to win back public trust. The more high finance misbehaves, the angrier people have become. Bankers surely deserve everything that’s being thrown at them, don’t they?

Undoubtedly so, but reform made in anger rarely makes for sound policy, and that’s the danger in much of what’s going on in the banking backlash right now. There are two basic aims behind the international reform effort. One is to ensure that banks can be made safe to fail and therefore don’t have to be bailed out by taxpayers. The second is to stop the perceived excesses of the credit cycle by preventing investment bankers from using ordinary, insured deposits for reckless, casino banking activities.

Given what’s happened, these are laudable, not to say necessary, goals. But are they realistic, and are governments pursuing them in the right way? At this week’s banking standards hearings, there was general agreement that there are no silver bullets, yet that hasn’t stopped policymakers attempting to find them.

Some of what’s being done is relatively uncontentious, even among bankers. Much higher capital requirements for “risky” trading activities, adequate recovery and resolution regimes, bail-in arrangements for senior creditors no one quarrels too much any longer with these initiatives.

Yet most jurisdictions want to go further, by ensuring that trading is legally separated from ordinary banking activities, a recreation in modern form of the old Glass-Steagall arrangements, introduced in the US during the Great Depression, but dismantled in the years leading up to today’s banking crisis. Everyone seems to have their own version of this ring-fenced, structural reform. Britain has Vickers, America has the Volcker rule, Brussels has the Liikanen proposals. Not to be outdone, France has its own peculiarly ill-thought-out variant, whereby banks would be banned from proprietary trading but allowed to do market making. There’s to be no single market here, it would seem. Unfortunately, lack of unanimity is the least we have to worry about in this rush to separation. Nor is it even that ring-fencing won’t in fact bring us any closer to the twin goals of making banks safe to fail and preventing the use of insured deposits for reckless, bonus-inspired gambling.

In truth, banks don't use insured deposits for trading, and never have done. What is obviously true, however, is that if the trading arm gets into trouble, it can bring down the retail banking arm as well. Unfortunately, it is by no means apparent that separation would prevent this from happening in a big systemic banking crisis. Any bank that defaults on its trading business will soon find its retail arm ostracised by creditors whether ring fenced or not. Even where there is separate ownership, retail banks are bound to be affected as counterparties to the capital market banks. Modern finance is too inter-linked to make it fail safe.

Yet the much bigger concern is that if you effectively ban banks from taking part in capital markets, or at least make it much more difficult and costly to do so, you are depriving industry of a huge potential, and vitally necessary, source of finance. Nowhere is this more apparent than in Europe, where traditional bank finance is shrinking fast because of the financial crisis. To fill this gap, and to provide the credit to fund future growth, there needs to be a rapid expansion of capital market activity. The only organisations in a position to provide deep and liquid markets of this sort are, er, banks, or bank-like vehicles.

The bottom line is that it is virtually impossible to legislate for completely safe banking. Nor would you really want to. For all the undoubted traumas of the credit cycle, fractional reserve banking has delivered phenomenal economic progress over the past 200 years. To have decent levels of growth, it may be necessary to let finance do roughly what it wants.

Make banking more robust by all means, but in the end the sort of relationship banking we all want to see honest, responsible and with the customers’ interests firmly back in the saddle will come not from lawmakers, but from banks themselves. To judge by the scandal of Autonomy, there’s a long way to go.