Why trust the ring fence?
George Osborne’s speech on banking reform sets out the idea that the proposed ring fence around retail banking will be 'electrified'. The purpose of electrification is to discourage banks from doing what might otherwise come naturally – a gradual erosion of the enforced separation of their retail and investment banking operations. Flouting of the rules will lead not to a regulatory slap on the wrist, but to full break up.
It sounds like a good enough idea. But is it? What was needed after the financial calamity of 2007-09 was a radical remaking of finance, but that is not what we are getting – far from it.
Start with the ring fence itself, before electrification. The truth is that the very idea is extremely complex to turn into a workable reality – earlier documents in the reform process showed just how tricky the operational side of this is going to be. Adding electricity is adding more complexity by requiring additional judgments from regulators as to what is ‘flouting’ and what is stretching the rules. It’s equivalent to the tax avoidance/evasion distinction. And if the eventual outcome of perceived naughtiness is break up, why not start with that position and save us all a whole lot of bother?
Then consider the implications of the ring fence. One might assume that a bank inside the fence is safer than one operating outside it, but is that correct? There are plenty of examples from history of stand-alone retail banks blowing up and a ring fence won’t by itself alter that risk in future. Osborne’s stated aim is that the 'essential operations' of a retail bank continue 'even if the whole bank fails'. But it is quite conceivable that a bank inside the ring fence could be unable to deliver essential services even if it had not technically failed as measured by its capital ratios – what if the payments system crashed, as happened at RBS last year? The services consumers rely on would have failed, ring fence or none. How are taxpayers protected from that eventuality? The assumption that a future failure will come from the investment bank, and that somehow branches and cash machines will be protected from that is the central mistake of the reform package. What if the real weaknesses in the system are in fact concentrated inside the ring fence?
And here is another consideration: separate managements. We are told that the retail bank will have its own bosses and these will be different from those running the investment bank. The retail bankers will manage their own risks, but not those of the investment bank. It sounds a lot like full separation, but apparently it isn’t. So what is it? Given that there is something of a shortage of talented bank managers, requiring two sets of them might be viewed as a new risk to the system, not a prudent guarantee of better risk management. And it seems a nightmare for anyone concerned with standards of corporate governance. Who will call the shots when it comes to Board meetings? Presumably the investment bankers won’t pay too much attention to the financial plumbing that is so vital to the retail bank. But how can we expect the retail bankers to have anything to say about some new complex investment banking product or strategy? They simply won’t be qualified. So, how will investment decisions be made?