The possibility of breaking up banks into investment and commercial or retail operations appears to be gaining renewed interest in some quarters – with Mark Carney’s appointment as Governor designate of the Bank of England adding to the enthusiasm for this idea.
Before addressing this, please let us not fall into the Vince Cable trap of referring to investment banking business as 'casino' banking. It is trite and simplistic – typical of Cable himself perhaps. It may suit his political agenda, but it leads to sloppy thinking about the business those banks engage in, and thus will lead to bad regulation. That said, different banks clearly run different levels of risk. We must ensure tax payers never have to bail out a bank again, and the only way to ensure this is to create conditions in which they can be allowed to fail. To do that while also protecting depositors requires some way of differentiating between their business models and pricing that into the decisions of people placing their money with them.
The idea of splitting higher risk activities from the rest has superficial appeal. However, anything which leaves government deciding the business model of commercial entities is an inherently bad idea – and let us remember, Northern Rock was not an investment bank, and nor was HBOS. Lending long and borrowing short is every bit as dangerous if not properly managed as trading in credit default swaps – possibly more so as so many banks do it.
Regulation should be kept to a minimum and market forces should prevail where possible. Splitting the banks – or even ring fencing them - runs counter to this. As an alternative, why not look again at deposit insurance, but utilising market forces, not running against them ?
It is clear banks currently enjoy an implicit guarantee from the tax payer. So why not make that guarantee explicit and charge for it? To give depositors a choice, don't make it compulsory that they all be covered, only that they are all offered it and must actively opt out if they do not want it. The percentage covered could also be left to the choice of the depositor. To take account of the different strategies and competitive positions of the banks, tailor the premium for each entity individually, based on a range of measurable indicators (along the lines for capital requirements - market, credit, liquidity and operational risk profile) and market indicators (such as CDS levels and agency credit ratings). This would lead to higher premia for banks with higher risk business models – such as a high exposure to investment banking activities.
The depositor would decide what percentage of the deposit to insure and pay a similar percentage of the premium set for that bank. It would be charged as a deduction from whatever uninsured deposit rate the bank is offering, collected by the bank and paid to the Treasury. The scheme would be open to all depositors and all sizes of deposit - for in reality this is what we have now. However anyone not insuring their deposits would risk receiving little or nothing in a default. Bond holders would not be covered in any event.
In the case of current accounts or any other account where the interest rates were too low to cover the premium, depositors wanting insurance would have to pay for the cover. Equally, a bank could offer a current account option for which it charges and include the insurance cover in that charge – or offer an un-covered current account.
The notion that we are all entitled to free banking must have now run its course. However, to ensure the availability of low cost low risk banking services for 'the man in the street', the post office could offer a no fee, uninsured current account, but place all funds collected with the Treasury.
The insurance proceeds would accrue to the government and be earmarked to track how much is collected over the years, but unless and until it is needed, it would simply reduce government borrowing.
There are no doubt many objections and practical obstacles to such a scheme, but none of the alternatives is perfect and it does tick a lot of boxes: It minimises distortion of market forces and could even promote competition while leaving choice with depositors at the same time as offering them protection and generating much needed government revenue – currently a deficit reducing income stream would no doubt be most welcome.