National interests

The government owns stakes in three major banks. Philip Augar looks at the likelihood of one or more

The 141-year gap between the 1866 run on Overend, Gurney & Co, a previously respected financial house in the City of London, and panic-stricken depositors queuing to withdraw their savings from Northern Rock in 2007, led to the perception that banking was just another business. Banks had their ups and downs, but customers, shareholders and governments assumed that stewardship could be left to the management and the invisible hand of the market. It scarcely crossed anyone's mind that a major financial institution could fail.

We now know different. This reassessment was brought about by the collapse of Northern Rock and the revelation that it was the Bank of England's last-minute intervention in 2008 that prevented the Royal Bank of Scotland (RBS) and HBOS from closing down. We have come to appreciate that banks play a vital role in society. If the banks fail, the country fails, and so the stability of banks is a matter of national interest. This realisation, together with the government's current ownership of stakes in three major banks - Northern Rock, RBS and Lloyds Banking Group -has led to suggestions that there should be one or more nationalised banks formed from this portfolio.

However, although nationalisation has its merits and is theoretically possible to achieve, it is actually very unlikely to happen. The state would not have the appetite for risk or the skills to manage the "casino" activities of investment banks; as such, the nationalised banks would need to be focused on core savings-and-loans products.

There are several potential role models to follow. In New Zealand, the award-winning Kiwibank is a successful state-owned institution that operates from the country's post offices. In the UK, the state-owned National Savings & Investments and the member-owned Co-operative and Nationwide banks have shown that simple and well-executed strategies can succeed outside of the stock market.

Solid Rock

Creating utility (or "narrow") banks that the public sector could manage would entail selling off parts of RBS and Lloyds Banking Group. Structuring such organisations in this way would not be difficult and, as the economist John Kay has shown in a paper for the think tank Centre for the Study of Financial Innovation, they could be viable business entities.

The problem is that, despite interest from Mervyn King, governor of the Bank of England, the idea has been dismissed by Treasury ministers and Adair Turner, chairman of the Financial Services Authority, on the grounds that narrow banks would not have averted the credit crunch. With utility banking off the agenda, Lloyds Banking Group and RBS (the major banks in the government's portfolio) will remain broadly in their current shape and will be too complex to be candidates for permanent state ownership.

The third large member of the portfolio, Northern Rock, is much simpler and closer to the narrow retail bank concept. It could be run as a state bank with very little change to its business model. Yet there is no sign that it will be, for the government evidently views its holding in this, as in other banks, as temporary. The organisation that looks after them, UK Financial Investments, has a mandate to maximise value, maintain stability and promote competition, but there is little doubt that the first of these is the priority. Choosing a former investment banker, Robin Budenberg, to be UKFI's chief executive suggests that the government has a markets-based, and not a nationalised, solution in mind. It seems likely that these stakes will be sold off to investors or a single-trade buyer as soon as stock-market conditions allow.

The Conservatives, for fiscal as well as philosophical reasons, would also be likely to follow this course if they were returned to power in this year's election. History shows that a fully reprivatised banking sector, as seems likely to emerge in 2011 or 2012, will need careful supervision and a re-evaluation of what banking as an industry can deliver.

Until the late 20th century, investors regarded banks as utilities, offering low margins and unspectacular growth rates. Then Citicorp, initially under the leadership of Walter Wriston, targeted growth of 15 per cent per annum through more aggressive strategies. Others copied this, and banks acquired a reputation as growth stocks. Investors' expectations rose and the stock market was harsh with those that failed to deliver. Examples include Midland, which was taken over by HSBC in 1992, and NatWest, whose unpopular diversification strategy caused it to be taken over by RBS in 2000.

Risky business

In the 21st century, pressure from investors led senior banking executives to leverage their balance sheets in an ill-fated attempt to meet expectations. Once again, the failure to keep up with the pack was punished by a critical market. Philip Purcell, the chief executive of the US investment bank Morgan Stanley, was allegedly removed from office by a group of shareholders wanting it to take more risk. On the eve of the credit crunch, HSBC, which emerged from the crash better than most, was under attack from an activist investor seeking to shake up the board and the strategy.

In future, in the absence of nationalised banks, investors must be encouraged to return to their pre-Wriston assessment of banks as utilities. This will be easy in the current financial climate, as investors digest the lessons of the recent past. But as memories fade and some banks become more successful than others, it is likely that investors will once again put pressure on chief executives to be more adventurous.

At that point, there will be a requirement for regulators and central banks to play the role in banking governance that a responsible state shareholder would play in a nationalised bank, reminding management of the need for moderation and risk awareness. Failure to do so would surely cause us to regret that we let slip a unique opportunity to develop a major nationalised bank out of the state's banking portfolio.

Philip Augar was a group managing director at Schroders before becoming a writer. He is the author of five books, the latest of which is "Chasing Alpha: How Reckless Growth and Unchecked Ambition Ruined the City's Golden Decade" (Bodley Head, £20)

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