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|Ring-fencing banks: are you sure that´s wise, sir?|
The Times - June 20th 2011
One of the great not-actually-said sayings, alongside “Play it again Sam” and “It’s too soon to judge” (the French Revolution), is the supposed remark by Hermann Goering that whenever he heard the word ‘culture’ he reached for his gun. I am beginning to get similar feelings about ‘ring-fencing’.
During last year’s election campaign, this phrase offered a spurious way for both Conservatives and Labour to sound caring by promising to exclude nice things like overseas aid and the NHS from spending cuts. So ring-fenced was the NHS that Andrew Lansley went at it immediately with his reforming wire-cutters, to try to save £20 billion. Now the same phrase has given George Osborne a way to sound as if he is going to protect taxpayers from the depredations of reckless banks.
It certainly sounds good. The phrase enabled the Chancellor of the Exchequer to make two noble claims in his speech at the Mansion House last Wednesday: that he was going to endorse two recommendations from the Independent Commission on Banking Reform—heavy stress on that first word—even before it delivers its full report in September; and that one of them was that “high-street banks” should be “ring-fenced” to protect their “vital services to the economy” if things go wrong.
This notion of “high-street banks” being special, precious things brings forth an image of Captain Mainwaring spending his day doling out loans before parading with Dad’s Army at night. And a ring-fence is just the sort of thing that his troops might have managed to erect. The trouble is that Osborne’s fence is likely to be just as effective in protecting the economy as Mainwaring’s would have been against the Nazis. But it serves the same function: of making it seem as if something is being done.
The difficulty is plain. The financial services industry is important and dangerous for the same reason: that it is connected to everything in the economy, and many things internationally too. A big banking collapse poses what has long been known as “systemic risk” because it risks making other financial firms bust too, and making lenders and investors less willing to shell out their money, producing what we came to know in 2007-08 as a credit crunch. That crunch destroyed the business model of the previously booming Northern Rock, since it depended on wholesale borrowing for its funds rather than on retail depositors, and those wholesale funds suddenly became unavailable.
The question is: what has “ring-fencing” got to do with this systemic risk? There is only one connection, and that is the government’s guarantee on deposits, which was found to be vague and poorly understood at the time of the run on Northern Rock’s deposits, and has now been clarified and increased to cover all deposits up to £85,000. That guarantee acts as an implicit subsidy to banks by making it cheaper for them to collect money from the public. The notion of the ring-fence is that only banks inside it will get that benefit, and in return they will have to hold larger reserves of capital to make it less likely that they will ever have to draw upon the guarantee.
Yet the deposit guarantee is not really the most important, or costly, form of government support for financial services in times of crisis. None of the big, economy-endangering collapses in 2008-09 came from the high street: Bear Stearns, Lehman Brothers, even Royal Bank of
That separation will not, unfortunately, protect the economy from the effect of a banking crisis, whether it is done by ring-fencing—ie, the creation of super-capitalised retail subsidiaries—or by splitting retail and investment banking altogether as others advocate. The reason returns to the fact that in finance everything is connected to everything: there is no neat division between retail and investment banking, nor between utility functions and casino ones. In which category, for example, is a big loan for a commercial property development, arranged at a high-street bank branch, but syndicated in the City and perhaps complicated by derivatives being based on the original loan, sold to German state banks? If something big goes down, it will bring everything down.
In his speech, Mr Osborne did acknowledge this. The aim, he said, must be to ensure that “the City is able to be the leading financial centre of the world, without putting at risk the entire economy”. In that case, the the right place to look is at how firmly the City is regulated, at whether new global capital standards are rigorous enough, and, crucially, at whether financial firms will be allowed to dodge the rules again through “off-balance-sheet” vehicles and other dangerous wheezes.
The work to improve all of that is under way, and includes the new Financial Policy Committee inside the Bank of England which began work last week, with a mandate to spot credit or asset bubbles in advance. But it will be difficult to tell how well or effectively this is being done. Hence the lure of ring-fencing, which is at best a tactic to divert attention away from the complex and towards the simple, or at worst a placebo, a front for continued lax regulation that is designed to make people think they are safe when actually they are not.
Moreover, the placebo has a price. The need to set up separate subsidiaries and to carry special reserves of capital will make retail operations costlier, whatever ultimate definition of retail the Independent Commission comes up with. The price of financial services offered by these protected institutions will rise, both to individual and corporate customers. And for what benefit? If tighter rules and standards for the City work, the economy is protected anyway. If they don’t, the ring-fence will make no meaningful difference.
It was poignant, really, that Mr Osborne announced his plan to sell Northern Rock in the same speech. In the end, the taxpayer is likely to make a profit on its nationalisation of that bank. Yet the Rock is a nice case study: a ring-fenced Rock might not have suffered a run on its deposits but would still have gone bust if the credit crunch had been severe enough to defeat its capital reserves. And whether it did or it didn’t was unimportant compared with the systemic effect of the broader financial collapse that followed Lehman Brothers’ demise on Wall Street. Ring-fences are made to be broken.