How big is too big?

What to do with the problem of banks which are 'too big to fail'? Tom Toulson looks at the controversy surrounding banking reform

Mervyn King has been thinking along these lines for some time. The governor of the Bank of England has been muttering about the dangers of moral hazard since the run on Northern Rock in September 2007. Back then, when he was brought before the Treasury select committee of the House of Commons to defend the Bank's handling of the crisis he said:

"It is moral hazard that has led us to where we are. I don't want to blame anyone. All the players have acted rationally given the positions they were in."

Clearly, he has been worried for a while about banks escaping from the consequences of their own bad decisions. But last week he went so far as to actually propose a solution. In calling for the large investment banks to be broken up he cuts a lonely figure. His proposal leaves him at odds with (in no particular order) Downing Street, the Treasury, the Financial Services Authority (FSA), his own deputy at the Bank of England, the US government and the G20. Only the Conservative shadow chancellor, George Osborne, welcomed the governor's proposals (and only because they annoy the government). Even he wouldn't go so far as to say he'd actually adopt them. The reaction to the announcement has revealed the divisions between the different UK authorities who are collectively responsible for regulatory reform. The one thing they all agree on is that reform is urgently needed. Yet two years on since Northern Rock and we are still at the proposal stage. Meanwhile, the next financial crisis could be round the corner. At this rate, it doesn't look like we'll be ready.

Moral hazard refers to a disruption in the normal chain of cause and effect. A bank which makes mistakes is supposed to lose money. The fear of upsetting its shareholders or going out of business is supposed to keep it honest. This fundamental tenet of freemarket theory is why the US regulators let Lehman Brothers fall. But the realisation that they made the wrong decision and the subsequent international bail out schemes have sent the opposite message: that some banks are too big to be allowed to fail. The fact that some large financial institutions which mismanaged risk have not only survived, but have benefited from the collapse of competitors and cheap government money, is also worrying. The guarantee of survival (and of public money) provides an incentive to take excessive risks. Furthermore a system in which bank losses can be passed on to the exchequer, whilst the profits are converted into bonuses is unlikely to promote social harmony. As Mr King put it: "the massive support extended to the banking sector around the world, while necessary to avert economic disaster, has created possibly the biggest moral hazard in history. "The 'too important to fail' problem has become too important to ignore".

His proposed solution is to split the banks into those which provide direct services to consumers (so called "utility" banks) and those which engage in riskier activities (so called "casino banking"). The former would be providing useful services and would therefore be entitled to state guarantees. The latter should not be allowed to become too large. "There are those who claim that such proposals are impractical. It is hard to see why," he said.

Well, for one thing, no one is exactly sure how you make such a separation. It is doubtful whether "utility" and "casino" are meaningful categories. Trying to label the different operations of financial institutions as either one or the other is an awkward and arbitrary process. For example, mortgage lending would presumably be labelled "useful", but the transactions used to protect the mortgage lender from losses (such as the infamous mortgage-backed securities - MBS) would be examples of "gambling". And to make matters even more complicated, the same products might be classified differently depending on how they were used. The same types of transaction can be used to reduce risk (or "hedge") or to make profits ("speculate").

Aside from the difficulties of distinction there are more obvious flaws with the proposals. Risk cannot be easily contained within "casino" banks. In the US the Glass-Steagall Act, which was introduced after the 1929 Wall Street crash, enforced a separation between retail and investment banks. The idea was that investment banks should be allowed to fail. They changed the system after Lehman Brothers fell and threatened to take the rest of the economy down with it. Nor is there much to suggest that abstaining from the trading of complex securities makes institutions safer. Northern Rock had no engagement in investment banking activities.

The government are not impressed by these proposals. As one official put it "Mervyn isn't just wrong: the empirical evidence is there to prove he's wrong." The Treasury already ruled out the idea in its white paper back in July. According to chancellor of the exchequer Alistair Darling, the situation is "more complex" than Mr King allows: "I don't think a Glass-Steagall approach, which might have been right for the 1930s, is right for the 21st century," he said. The Treasury has its own ideas on how to deal with the problem of banks which are too big to fail. Having ruled out a windfall tax on bonuses it is instead in favour of "recovery and resolution plans". In theory, the banks could be forced to draw up "living wills", which would include provisions for the disposal of their assets and liabilities in the event of a collapse. Legislation is being prepared. It is unclear exactly how it will work in practice. Mr King has warned that this approach is likely to require heavy regulation and costly oversight.

Privately both the Treasury and Downing Street are said to be increasingly frustrated with the governor's approach. The prime minister, Gordon Brown, responded to the proposals by pointing out that they wouldn't have saved Lehman Brothers or Northern Rock. "The cause of the problem is that banks had been insufficiently regulated at a global level and we have got to set standards for that in the future", he said. In other words, new regulations not new banking structures are required. But according to Mr King: "The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion."

This latest difference of opinion should be put in the context of a souring relationship. Downing Street officials have not welcomed comments made by Mr King on the handling of the public deficit. They in turn question the governor's judgement, echoing the criticisms made recently by David Blanchflower, who suggested he was slow to react to the crisis. The monetary policy committee should have cut interest rates and injected liquidity sooner.

This spat has not gone unnoticed by the government's opponents. The Conservative shadow chancellor George Osborne chose to interpret the Mr King's proposals as implying criticism of government policy: "Mervyn King's speech is powerful and persuasive. His analysis of how the government's system for regulating banks failed and how there has been 'little real reform' is one I share." However he did not go so far as to commit his party to adopting the plans. The proposals would have to be adopted in all other major countries before the Conservatives would consider them. Which means the US would have to reintroduce a new Glass-Steagall bill having just scrapped the last one, which isn't going to happen any time soon.

The criticism of Mr King is not confined to the government. Not even everyone at the Bank of England agrees with him. The deputy governor, Paul Tucker, said of the proposals: "Personally, I do not much like the notion of a list of 'systemically important firms' because, as a previous generation of policy makers taught us, what proves to be systemic depends so very heavily on the circumstances." The head of the FSA, Lord Turner, also takes a different view. He said it would be "extremely hard" to separate core banking facilities from speculative operations. Instead, in an FSA discussion paper published last week, he favoured the introduction of higher capital requirements. These would include capital surcharges. Banks would be forced to hold a higher percentage of their assets as common equity. In other words, they would have to hold on to more money. Banks in the UK are currently required to keep 4 per cent of their assets as what's called "tier one" capital. The FSA estimates that raising this level by 3 per cent could boost Britain's output by £91 billion. Lord Turner believes this would have desirable side effects: "if that means banks tend to be a bit smaller, that's fine." He also hopes it would mean more money is saved rather than paid out in bonuses.

This is much more in line with international developments. Last month the G20 countries resolved to introduce stricter capital requirements. The central banks are working together on new proposals. In the US, the Chairman of the Federal Reserve, Ben Bernanke, recommended reforms which are strikingly similar to Lord Turner's, including a capital surcharge. Meanwhile a bill drawn up by the Obama administration is going through the House of Representatives. It is currently being picked apart by various committees and interest groups. The original proposals included a "clearing house" system for complex financial products (another thing the FSA called for in its report). This would essentially mean that only sanctioned derivatives could be traded. However the bill is a long way from becoming law and its final format is anyone's guess.

The global trend is clearly towards regulatory (as opposed to structural) reform in general and stricter capital requirements in particular. But higher capital ratios are not the solution to all evils. The difficulty lies in their enforcement. As Martin Wolf of the Financial Times puts it,

"One danger is that banks may take on even more risk, to sustain high returns on equity. Another is that banks would again find a way around higher capital requirements via off-sheet vehicles and exploitation of risky derivatives strategies. [...] In short, they will only work if they come with a huge increase in regulatory will and effectiveness. I am not holding my breath."

But the major enemy of any reform based on capital requirements is time. It took seven years to formulate the last major set of international rules on capital ratios (The Second Basel Agreement) and then several more years to implement them. Banks cannot make these adjustments over night. The chief finance officer of Goldman Sachs recently said that it would take the firm 12 to 18 months before they were even in the position to make meaningful changes to their capitalisation. Who knows how long it will be before we see a coordinated global set of rules and regulations? We can only hope it happens before the next crisis hits.