Breaking up banks: 1

In an address to Scottish business organisations in Edinburgh last week, Mervyn King, governor of the Bank of England, again repeated his call for banks too big to fail to be broken up.

This is a call that has gained some prominence in recent times with the former Federal Reserve Chairman, Paul Volker, having said the same thing, while arguing for the return of the Glass-Steagall Act in the US, and even our own much respected former banker and BHP Billiton Chairman, Don Argus, concurred in a speech to the Melbourne Mining Club on Thursday.

It is unlikely however, that the call will gain much traction as those who are making the arguments to support the call are not those who are going to make the decision.

While the G20 finance ministers and central bank heads will meet next in Scotland on November 6, and will have the opportunity to debate the merits or otherwise of the proposal, those responsible in the UK and US governments have already rejected the proposition.

Nevertheless, it is worth reviewing the arguments being put forward. In his speech King observed that market participants, prior to the advent of the GFC, had said that the incentives to manage risk and increase leverage in the banking system were distorted by the implicit support provided by governments to creditors of banks that were seen as being too important to fail.

(Interestingly, this was the rationale used by Moody's Investor Service to raise the ratings of many banks around the world to 'Aaa' under its joint default analysis methodology in late 2006. The market overall did not accept this interpretation, forcing Moody's into a rapid reversal of the implementation. There is more on revisions to Moody's bank ratings in another article today.)

This gave the affected banks a significant competitive advantage that allowed them to raise debt at a lower cost and expand faster than other financial institutions. Not that this particularly helped the banks when the GFC hit, but creditors (and Moody's) had been correct in their assumptions about government support.

King went on to state that the government of Britain has invested almost ₤1 trillion, nearly two-thirds of its annual GDP, to support its banks deemed too big to fail but may well see little benefit, in terms of significant reform, for that investment.

From this perspective, banks that are too big to fail should not be allowed to reside in the private sector.

But it is not the business of national governments to be running global banking operations. Thus there are only two possible structural solutions to the problem.

The first solution, and the one seemingly favoured by governments and regulators, is to impose significantly greater capital requirements on banks.

However, King questions how much capital is enough to cover all the risky activities of global banks.

Any amount or ratio decided upon will be arbitrary and cannot exclude the possibility that tax payers will again be called upon to provide catastrophe insurance.

The alternative solution is to separate the utility function of banking, such as providing access to, and operating the payments system, from all other proprietary activities. As in other industries, the essential utility functions are regulated and other activities are left to the discipline of the market.

The Glass-Steagall Act in the US to a large extent embodies this call for the separation of the utility functions of banking from other activities because it provides a framework for how this could be achieved. It is also significant because its origin is the Great Depression of the 1930s, to which the actions of lightly regulated US banks were considered to be contributing factors.

But of possibly even greater importance is the significance of the role played by the Act in the development of US bond markets - the deepest and most liquid bond markets in the world. There is a distinct contrast between the development of the US financial system last century, with the separation of commercial banks from the investment banks that developed the bond markets, and the universal banking model of Europe.

It was this that Don Argus was alluding to in his speech on Thursday when he said that we need a strong and liquid bond market and we need a Glass-Steagall distinction between traditional commercial banks and investment banks.