Splitting the banks

2011-JUN-18

This week George Osborne, the British Chancellor, announced that UK banks would ring-fence their domestic banking operations from wider banking activities. It is presented as a protection from the riskier activities inherent in international and investment banking.

But is this where the greatest risks lie? These plans have been fomenting for many months against a general assumption that the UK economy would recover on a medium-term view. It is only in recent weeks that this assumption has been turned upside down, in which case domestic banking is significantly more risky than previously assumed. Of course, risk assessments of banking business are produced by the Bank of England as regulator, whose track record in this respect is far from encouraging.

An alternative way of looking at it is to understand that international and investment banking activities have high margins and that these diversified banks use sophisticated markets to cover changes in risk perceptions at a moment’s notice. A borrowing-and-lending bank restricted to real customers has considerably less flexibility, and given the high level of capital gearing permitted, it has significant risks without the offset of diversification enjoyed by modern integrated banks. It is a return to the old from the new.

The models are entirely different. For the last 30 years banking has moved away from interest income towards fees. The advantage of fee income is that it is earned without encumbering the balance sheet, so requires minimal regulatory capital: this is what has driven banks into capital markets. A ring-fenced domestic banking business which loses these benefits becomes less profitable and their customers will probably face rising costs as a result. And so long as domestic banks rely on money markets as part of their business there will still be counterparty risk with the wider banking community.

Of course, it is easy to share the regulator’s concerns about investment banking and cross-border business: the collapse of Lehman is fresh in our minds. Putting aside the question as to whether Lehman collapsed because it was badly managed or whether it was simply the victim of systemic failure, there have to be valid concerns about activities beyond national control, such the chains of counter-party risk in off-market derivatives. But it would be wrong to assume that managements in the banking community are unaware of these risks and have not already taken practical steps to protect themselves.

But perhaps the most worrying aspect of ring-fencing domestic banking is the implication that if there is a global banking problem, the British government will have the option to walk away from it. Logically, there can be no other interpretation. And given the Government is advised by the Bank of England as regulator, the bank itself must not be entirely confident that an international systemic event can actually be prevented.

It will be interesting to see the reactions of other countries, and whether or not they also seek to ring-fence domestic from international banking. If they do so, it will signify a worrying shift away from global central banking co-operation in favour of domestic financial protectionism.