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It’s no use trying to change the banks’ behaviour – we must have the power to break them up

Felix Martin's "Real Money" column.

The financial crisis of 2008-2009 exposed huge flaws in the UK’s banking system: but what should we do to fix them? One conventional answer to that has been in the news over the past three weeks. Since the crisis, the Basel Committee – the main forum for the international co-ordination of financial regulation – has been busy refining a new set of global banking standards. And in the UK, a Financial Policy Committee (FPC) has been set up at the Bank of England with a mandate of “protecting and enhancing the resilience of the UK financial system”.

Early this month, the Basel Committee reaffirmed new global rules under which banks will have to keep more of their assets in safe and liquid securities such as government bonds, and fewer in risky and illiquid securities of the sort that turned toxic during the crisis. And on 14 January, the FPC announced that banks will in future be required to keep larger buffers of loss-absorbing capital when their loan books are growing rapidly or when they are financing bubble-prone sectors.

The rationale for these measures is clear enough. Banks provide essential financial services – the operation of the payments system, deposit-taking for savers, lending for businesses and mortgages for individuals. But banks can also engage in activities that look suspiciously like gambling – from speculative lending to trading equities and bonds on their own accounts.

Fixing the banking sector is about discouraging banks from gambling while stimulating their useful activities. Requiring banks to hold more loss-absorbing capital makes it more expensive for them to go to the casino. Requiring them to devote a higher proportion of their portfolio to highly liquid assets limits the tables they can play at. Doing both at once is the best way to avoid another financial meltdown.

It’s a sensible-sounding answer to the ques - tion of what it will take to fix the banks. It is also, unfortunately, wrong.

I first understood why, and what a better answer is, last October, when I went to see Paul Volcker – the ex-chairman of the US Federal Reserve and architect of America’s current banking reform efforts – testify to the Commission on Banking Standards that parliament established to scrutinise the government’s current banking reform plans.

Watching the commission members file in to Portcullis House was not wholly reassuring. It was the sort of roll-call that only Britain can produce. First in line came a hereditary peer, Viscount Thurso, the fifth generation of his family to represent the constituency of Caithness as MP. Then came the Bishop of Durham – as he then was – Justin Welby. Both he and Thurso sounded curiously plummy. No wonder: they were both at Eton. In fact, they were both at Eton at the same time.

In the chairman’s seat was Andrew Tyrie, the backbench Tory MP and thorn in George Osborne’s side – a sure sign that the commission’s recommendations would be ignored. And to cap it all, there was Nigel Lawson. At first I thought I wasn’t seeing straight. Could the man who turned the Square Mile into Las Vegas in the first place and presided over the last great crash in 1987 really have been given responsibility for sorting out the banks?

What on earth, I wondered, was the greatest American central banker of the 20th century going to make of this cross between Kind Hearts and Coronets and Nineteen Eighty-Four? The whole thing, I thought, was clearly a waste of time.

I could not have been more wrong.

Volcker explained that the problem with modern banking is not in the details; it is in the structure. The regulators’ efforts are important, he explained, but banks have always found ways to circumvent controls and always will. If they really want to play at the tables, they will find a back door where entry is free.

In any case, there’s nothing wrong with gambling – as long as you do it with your own money. The problem with the present set-up is that the bill for the banking sector’s gambling debts comes to us. When banks go bust the taxpayer has to step in, because the government has to protect the essential services that they provide.

So the solution is not to change behaviour within the structure: it is to change the structure so that bad behaviour doesn’t matter. Financial institutions that take deposits from customers, make loans to businesses and allow you to pay someone in London from your bank account in Liverpool should be separated legally from financial institutions that shoot for profits by trading on their own account. The former should enjoy a government guarantee; the latter should not.

The good news, Volcker concluded, is that the government’s own adviser, Sir John Vickers, made many of these points in his 2011 report. The bad news is that the Vickers recommendations don’t go far enough. Vickers advised only the “ring-fencing” of separate business units within existing conglomerates. Volcker warned that nothing short of full legal separation of utility banks from casino institutions will do.

Just before Christmas, the parliamentary commission published its answer to the question of how to fix the banks. It has taken Volcker’s view that fundamental reform is needed. Any “ring fence”, it explains, needs to be electrified: the Bank of England should have the statutory power to break up banks properly if required. Better still would be to break them up to begin with.

It is a bold answer – and it is the right one. The reforms that have been announced this month by the regulators are useful, but insufficient. And if it takes a quaint British combination of lords, bishops and poachersturned- gamekeepers to speak this truth to the Treasury, let’s have more of them.

Felix Martin is a macroeconomist and bond investor. His book, “Money: the Unauthorised Biography”, will be published by the Bodley Head in June

Felix Martin is a macroeconomist, bond trader and the author of Money: the Unauthorised Biography

This article first appeared in the 28 January 2013 issue of the New Statesman, After Chavez