Breaking up banks is no silver bullet

By Hugo Dixon
May 4, 2010

– Hugo Dixon is a Reuters Breakingviews columnist. The opinions expressed are his own –

Breaking up the banks is no silver bullet. Politicians on both sides of the Atlantic — including two of the party leaders fighting the UK election — want to separate so-called casino investment banks from utility lenders. But such simple rules would create arbitrage opportunities and rigidities without curbing excess risk-taking.

In the last of the UK’s election debates, the Liberal Democrat and Conservative leaders vied with one another to see who could be tougher on banks. As a soundbite, the notion that nasty, risky investment banking should be split from nice, safe retail banking may well be a winner. Gordon Brown, the Labour leader who has a more nuanced position, was left looking like a defender of big banks.

The politics are similar in the United States, where the Obama administration has proposed the so-called Volcker rule, which would prevent banks from engaging in proprietary trading. Some version of this rule may yet emerge in the financial regulation bill now going through Congress.

But these initiatives ignore the fact that excess risk-taking was a feature of all types of financial institutions during the credit bubble. Utility lenders — such as the UK’s Northern Rock or Washington Mutual of the United States — bit the dust. So did casinos like Lehman Brothers.

Politicians also risk missing the main target. Take the Volcker rule. It wouldn’t do anything to curb “non-proprietary” trading, where banks trade but not on their own account. What’s more, as soon as the regulators define proprietary trading, banks will find ways of doing the same business under a different nomenclature.

The other problem with structural separation is that it would create rigidities. This is most obvious in the type of “narrow banking” proposed by John Kay, the British economist. Under his scheme, deposit-taking institutions would only be allowed to invest in government securities. While this might appeal to governments that need to fund their deficits, it could gum up the flow of savings to industry — and it won’t give savers a good deal either.

Once the political grandstanding is over, these ideas will hopefully fade into the background. Politicians and regulators should then focus on combating risk-taking across the board by jacking up the capital banks have to hold against all types of risky positions.

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