Tuesday, 13 September 2011

A word of reason

Beginning in 2008, I have several times pointed out that banks would come out of this recession downsized and with dramatically lower profitability than has been the case in the past two decades.

For a while it appeared that panic-stricken politicians had given banks yet another opportunity to consolidate and get even bigger – and even more unlikely to be allowed to fail.

Now, it appears that the UK is leading the way in how to get out of the mess. The Independent Banking Commission delivered its proposal for a bank reform yesterday, and it makes a lot of sense.
Instead of breaking up the banks, the Commission suggests to consider banks as two different businesses. 

One, the sexy one, is investment banking, securities trading, and all that. The other is the boring part of banking: savings, lending, payments services. We could call it a utility.

The utility part of banking is the services that are absolutely indispensable to a society, and the banking commission suggests that this part of the banking sector is “ring fenced” by higher capital requirements and in essence kept separate from the investment banking activities.

That would turn the utility banking into a dull, but safe economic activity. It would prevent the banks from using the capital base from utility banking for funding of investment banking activities. It makes a lot of sense – and it harks back to the US Glass-Steagall act from the ‘30s, which even legally separated the two kinds of activities. The introduction of that act marked the beginning of the longest period of the US without banking failures.

The recommendations from the UK banking commission make an awful lot of sense. It recognises that the society needs banks, but not all activities currently categorised as banking. It makes it clear that the profitability of the utility banking will be (much) lower – just like that of water supplies, telephone services, electricity etc. It makes it clear that the banking industry finally will have to pay the price for two decades of foolish greed.

For a second – in 2009 – I had started to have my doubts as bonuses in the banking sector again took off into the stratosphere.

Predictably, the UK banking sector is already lobbying heavily to avoid the “disaster”. But I am afraid that the lobbying will not work any longer. One of the members of the Commission, Martin Wolf, Economics editor of Financial Times is quoted for saying:  If you live in a world in which the real rate of interest on safe government bonds, bonds that the world regards as safe, is about half a percent or less, you might wonder whether you can reasonably expect a reasonably safe return of 15 percent on equity in a bank.

An equally simple word of reason from a man who cannot in any way be accused of left-leaning tendencies, UK Chancellor George Osborne: We should not confuse the interest of bank shareholders with those of British taxpayers.

So right. In America, Jamie Dimon, CEO of JP Morgan Chase, made a rant against the proposed Basel III capital requirements, qualifying them as “anti-American”. His concern is that the Basel rules will force the banks towards deleveraging and lower profitability. Obviously, US banking lobbyists are not as successful in Basel as they are in Washington DC, so Dimon suggests that the USA withdraws from Basel-based BIS altogether to avoid such disasters.

In Europe, the banks are in no position to tell the politicians what to do. With an impending bankruptcy in Greece and still carrying huge losses forward, many European banks are or will be de facto insolvent. They will depend on government support going forward. It might be that the Eurozone governments let themselves be inspired by the UK thinking.

Utility banking may be the right solution, as well as a healthy way of thinking. Contrary to what the banks have tried to make us believe, it will not be the end of the world as we see it if the banks are forced to downsize. Unfortunately, the banking lobby is still strong enough that it can persuade politicians to wait and postpone, which only delays the necessary.

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