Come back, Glass-Steagall

There is a simple way to fix our financial structure, writes Edward Russell-Walling

Given the trouble that they have caused, you would expect big bankers to be hanging their heads, waiting for punishment like guilty schoolboys at the headmaster's door. One of the most infuriating things about the whole mess is - apart from some early ritual observances - their almost complete lack of contrition as they slip back into their old ways. But it takes only two words to send a shiver down their little spines - "Glass" and "Steagall".

The Glass-Steagall Act - formally the Banking Act of 1933 - was the US response to widespread bank failure during the Great Depression. Its most instructive measure for us today was its separation of commercial ­and investment banking. Broadly speaking, it meant that commercial (high-street) banks could not deal in securities and investment banks could not take deposits.

Glass-Steagall was repealed by the Clinton administration in 1999, along with other laws that prohibited tie-ups between banks, brokers and insurance companies, allowing the creation of "universal" banks. And that's when the trouble began. Though different in form, the UK's Big Bang of 1986 had a similar effect, allowing banks to engage in securities trading. Between them, these reforms created organisations that were ridden with basic conflicts of interest while being "too big to fail" - or perhaps, as some prefer to put it, "too big to succeed".

If we are to avoid going through all of this again, something in banking needs to change. The rumpus over bonuses is colourful and easy for the public and the media to grasp, but it is low-hanging political fruit with little significance for the financial system's future stability. Strengthening international awareness of where risks are building up in the system - better macro-prudential regulation, in wonk-speak - is more to the point.

So, too, is the question of capital adequacy, the amount of regulatory capital that banks retain as a buffer against losses or demands for the return of deposits. There is no shortage of proposals on this front. The Group of 30, a private body of influential representatives from the financial sector that includes the former Federal Reserve chairman Paul Volcker, wants capital requirements to be raised across the board.

It also proposes that obligatory capital-to-asset ratios be expressed as a range, rather than a specific number, and that banks be required to move to the top of the range in "exuberant" times. The idea is to make it harder to lend in booms and easier in recessions, smoothing the credit cycle in much the same way as changes in interest rates are used to moderate the economic cycle.

The Bank of England agrees and has published its own discussion paper on the subject, pointing out that, as in all other aspects of banking reform, it might need international co-ordination to make it wholly effective. Unless everyone applies the same rules, financial business may migrate to jurisdictions of greatest laxity. In December 2009, the Basel Committee on Banking Supervision, a forum composed mainly of central bankers, called for consultation on proposals to strengthen international capital and liquidity, including a "counter-cyclical" capital framework along G30 lines.

Banks don't want to keep more capital for a rainy day because it makes it more expensive for them to lend. However, they are not putting up too much resistance - they know that some price has to be paid. Yet higher capital requirements are not, in themselves, going to stop a
repeat of the last meltdown. Even if they had been in place, they would not have come close to covering the banking shortfalls that had to be made good by the public purse.

The stark fact is that there are serious flaws in the architecture of the financial industry as it stands. Concealed under the bonnet of the large universal bank are two very different types of mechanism, taking different kinds of risks and needing different kinds of regulation. One is the old-fashioned bank that takes in customer deposits and lends the money on to others. This is essential to economic life at the most basic level, which is why it is sometimes called "utility" banking.

This is also why it requires strict regulation (including a capital-adequacy regime) and public support to protect customer deposits and the payments system in times of trial. Investment banking does not. This is a game for grown-ups. It does many useful things, such as underwriting the issue of securities and advising companies on how best to conduct their financial lives. But it increasingly serves itself, rather than its customers, and has become focused on - and reliant on - profits from proprietary trading, placing its own bets for its own account.

Investment banking is now "casino" banking. It wants to be a player, not a service industry, and the smartest firms are adept at manipulating industrial strategy and investment trends to line their own pockets, playing both ends against the middle.

Investment banks cannot be serious players without serious money, and that's where utility banking comes in, with its tempting pots of retail deposits. Commercial banks have the capital, whereas investment banks have the brains and the aggression. The combination is potent and intoxicating.

It is also dangerous, because players sometimes take the wrong gambles - as they did massively and disastrously with mortgage-backed securities in the years before the credit crunch began.

In universal banks, this colossal error of judgement threatened the deposits of utility customers, and governments quite rightly came to the rescue. It was no time for debate: the recession has not morphed into depression, and this vindicates their action. But if it is not to happen again, utility banking - some call it "narrow" banking - must be separated from investment banking.

Taxpayer support should only be available for closely regulated narrow banks. Investment banks that get themselves into trouble must get themselves out again, or perish. The knowledge that they are no longer too big - or rather, too important - to fail will impose a welcome and self-regulatory restraint on some of their more aggressive behaviour. Their shareholders, who will have a clearer idea of the risk they are buying, should impose their own form of restraint.

Last December in the US, two senators, one Republican, one Democrat, formally proposed the reinstatement of Glass-Steagall. The governor of the Bank of England, Mervyn King, has come out in favour of stand-alone narrow banking. Gordon Brown and Alistair Darling have opposed it. The Conservatives say that the UK won't do it alone.

Politicians will have to decide. In doing so, they face what a former Clinton appointee to the US commerce department, Jeffrey Garten, called one of the great challenges of our times. "How," he asked, "does a sovereign nation govern itself effectively when politics are national and business is global?"

This article is taken from the New Statesman supplement Held To Account: What's next for UK Banking? sponsored by Barclays