Thursday, October 07, 2010

By Michael Prowse, Senior Visiting Fellow

A few weeks ago I accused the banking regulators in Basel of “intellectual cowardice”. I was driven to this intemperate language by their obstinate decision to plough ahead with a regulatory model that is a proven failure and their refusal to consider truly radical reform of the dysfunctional financial services industry.

I have already discussed one possible radical reform: Professor Laurence Kottlikoff’s “limited purpose banking”*. This would turn banks into providers of mutual funds: in essence savers and depositors would always remain beneficial owners of the cash they place with banks. All investments by banks would have to be transparent and in the name of the provider of funds. Recycling of cash, without the owners’ consent, into speculative investment for the benefit of banks’ senior staff would be prohibited.

But there are other possible radical reforms, such as John Kay’s version of “narrow banking” Mr Kay, a former professor at the London Business School, is both an unusually creative economist and a thoughtful economic commentator for the Financial Times of London. Even those who strongly favour the Basel approach could not help but benefit from a close reading of his monograph: “Narrow Banking: the Reform of Banking Regulation”**. It is one of the most perceptive analyses of the financial crisis yet penned.

Mr Kay fundamentally disagrees with the policy of Financial Stability Board, which continues to rely on a discredited system of capital requirements – one that allows banks themselves to assess the riskiness of their asset portfolios. “No rules on capital adequacy, however complex, can account even approximately for the varying circumstances of all the banking institutions in the world,” he writes. This problem would not be soluble “even if committees sit in Basel until the River Rhine runs dry, or at least the local hostelries, run dry.”

Mr Kay rejects the idea that any public agency should have “financial stability” as its goal. Given regulatory capture this translates all too easily into policies that enable financial conglomerates to prosper no matter how poor their management – which, after all, was the effect of the massive taxpayer bailouts of 2008/09. A degree of instability is a characteristic of all competitive markets: prices fluctuate, firms gain and lose market share, and some inevitably go bankrupt. Rather than trying to achieve stasis, the goal of policy should be to minimise the costs of financial instability for the non-financial sector and to ensure that consumers get better value for money.

This latter point is central to Mr Kay’s vision of a healthy financial sector. In competitive industries that function well, big retailers compete to satisfy the demands of consumers. They take a long-term view because they need to win the trust of their customers. They therefore impose discipline on producers and wholesalers, by insisting they supply quality products that will genuinely satisfy their customers. Because retailers are knowledgeable purchasers, manufacturers who produce faulty products tend to go out of business.

Financial services evade this discipline. Investment bankers (and the investment banking divisions of commercial banks), rather than retail bankers, dominate the industry. One might have thought the fiasco of 2007-09 would have dented the prestige of deal-makers.

But no: Barclays Bank, one of Britain’s leading retail banks, has just appointed Bob Diamond, an American investment banker, as its new chief executive. We can be certain that government-insured retail deposits will continue to find their way into risky speculative investments (as yet the UK lacks even the Dodd-Frank restrictions on proprietary trading).

In financial conglomerates the manufacturers of exotic products – the “quants” – dominate. At present this producer-dominated industry is transactions rather than customer oriented. The focus is on bonuses and perks for senior executives rather than on satisfying customers. Such groups frequently sell products designed to produce short-term profits which are not truly in the best interests of their customers, be they individuals or companies.

Hence the old slogan “life insurance is sold, not bought”, hence the padding of portfolios with risky dotcom shares in 2000 and hence the aggressive marketing of mortgages to borrowers without stable incomes – the behaviour that made the sub-prime crisis inevitable. The subtext needs no spelling out: ordinary Americans are jerks on whom Masters of the Universe can dump whatever they please.

One of the principal goals of Mr Kay’s “narrow banking” is to transform this arrogant culture and produce effective financial retailers – firms whose purpose is to identify and satisfy the real needs of customers. In a nutshell its aim is to separate the “utility” and the “casino” aspects of banking.

Narrow banking is in the spirit of the Glass Steagal Act of 1933 but involves a different division of banking functions. The catastrophic losses of 2007-09 occurred in proprietary trading, yet this activity straddles the division between commercial and investment banking established under Glass Steagal.

The aim of narrow banking is to create institutions that focus on two traditional “utility” functions – running payments systems and taking deposits from individuals and small and medium sized businesses. No economy can function without the stable provision of these essential services. Such narrow banks would be the only institutions permitted to take deposits from the public and they would be the only institutions capable of accessing the payments system and qualifying for government deposit insurance. They would also be the only institutions permitted to call themselves “banks”.

Retail deposits qualifying for deposit insurance would have to be 100 per cent backed by genuinely safe liquid assets. Ideally this means government securities but Mr Kay would allow a less restrictive view of asset quality if circumstances demanded it. Some corporate bonds, for example, are nearly as safe as government securities. The taxpayer interest could also be defended by giving retail depositors priority over general creditors in the event of liquidation – which would limit their access to wholesale funding.

Narrow banks would be prohibited from classic investment bank activities, such as acting as an issuer of securities or trading securities (other than to achieve their legitimate objectives). They would be permitted to undertake retail, mortgage and small company lending but could not use retail deposits for this purpose. (Such lending would mainly be undertaken by specialist institutions, funded in wholesale markets, which would not qualify for deposit insurance). The general rule is that narrow banks would lose their licences if they deviated too far from their core role of deposit taking and running payments systems.

Mr Kay conceives of narrow banks as utilities and stresses the parallels with gas, water and electricity companies, all of which provide mundane but essential services for consumers. He notes that the boards of utility regulators tend to be dominated by experienced professionals from other walks of life who are therefore capable of independently representing the public interest. Narrow bank regulators would conform to this pattern rather the practice hitherto favoured in financial market regulation, where most board members are chosen for their financial experience.

Having secured the crucial utility functions of banking, Mr Kay would abolish all other regulation of financial services. The Basel regime of risk-adjusted capital requirements would be dismantled. Governments would continue to fight fraud but take no further interest in imprudent behaviour.

The “casino” side of banking would be left to regulate itself, or not, as it chose. Investment bankers could still engage in speculative trades but would no longer have access to cheap funding in retail markets. Well managed financial institutions would naturally take care to maintain sufficient capital reserves. Those that did not would fail to attract equity or debt funding and ultimately go bust. They would not be bailed out.

Such a tough line would be possible because narrow banks – financial utilities - would be protected from the follies of traders and dealers. The froth would be wiped from financial markets. If reinvented along these lines, financial services would begin to operate more like other businesses, and cease to pose periodic threats to the stability of entire economies.

There are doubtless flaws in Mr Kay’s vision. He may be too optimistic in arguing that regulatory structures can be dismantled outside the narrow banking sector. But his arguments should not be simply ignored by the Financial Stability Board on the grounds that no deviation from a failed status quo is possible.

It is worth remembering that versions of narrow banking were endorsed decades ago by some of America’s most respected economists, including Irving Fisher, Frank Knight and Milton Friedman. It is an idea worth debating.

*Abolish banking as we know it?

** Available (with other articles) at www.johnkay.com