Breaking up banks is not so hard to do

May 28, 2010

-Laurence Copeland is a professor of finance at Cardiff University Business School and a co-author of “Verdict on the Crash” published by the Institute of Economic Affairs. The opinions expressed are his own. -

As far as I am aware, you cannot buy insurance against speeding tickets (please, someone let me know if I am wrong!).

This is so because motorists who were insured would be more likely to ignore the speed limit and hence cause more accidents, which is bad for society and bad for insurers.

It would also have the drawback that, however finely the insurers calibrated their quotations, the more patient driver would end up having to pay a higher premium so as to subsidise the less patient.

For speeding, read excess leverage and reckless lending, with the new bank tax as the insurance premium, and you have the outline of the scheme proposed by Michel Barnier, the EU Internal Market and Services Commissioner.

In fact, the situation is somewhat worse than the comparison with speeding would suggest, because in the case of the banks, “society” and the insurers are one and the same, aka the taxpayers of Europe.

As far as cross-subsidisation is concerned, it will be argued in defence of the scheme that the tax will be levied at a rate which reflects the risk each bank chooses to carry, but that immediately raises the question of how the risk can be quantified. Pre-crisis, we might have relied with some confidence on the credit rating agencies to assess the risk of the assets, meshing with the established Bank for International Settlements methodologies for computation of the overall value-at-risk and capital adequacy requirements.

Post-crisis, can anyone seriously believe that the regulator (or whoever is to be landed with responsibility for setting the tax rate for individual banks) will have the information available to set the levy at the appropriate rate? If banks are again able to put up a smokescreen to conceal the true state of affairs – as they did to such devastating effect to get us into this mess – it will become impossible to set rates equitably, with the result that the incentive to be prudent will disappear. Cautious banks will again be penalised, and when the next crash comes, the taxpayer will again be left with the bill – which points to another major weakness of the proposal.

Insurance works by exploiting the law of large numbers. The premium quoted for insuring my home against fire is predicated on the assumption that there will be only a few housefires in any given year, which is precisely why Acts of War are explicitly not covered.

In the same way, the proposed bank levy can only fund an insurance scheme against one-off bank failures of the kind that occur in normal non-crisis times (remember those?), not in systemic collapses – which is the problem we ought to be most concerned with.

Don’t be deceived by the squeals of pain. As I have argued before, the banks are getting off lightly – what they really fear is the truly radical approach, the one favoured by (among others) the Governor of the Bank of England, who put the matter succinctly: “too big to fail means simply too big”.

Separating the casino from the utility, the investment banking from the deposit-taking and money transfer, the risk-taking from the routine servicing would have two advantages.

First, it would mean that the banking functions most important to society would no longer be subject to the risks which are inevitably associated with less essential activities like securitisation and derivatives trading. Secondly, it would actually reduce the size of the largest banks, which itself would be highly desirable.

After all, given that deposits are now de facto 100 percent insured, as we saw in 2008, what earthly reason can there be for allowing banking to remain concentrated to a degree that would never be tolerated in any other major industry? On both sides of the Atlantic, the authorities responded to the crisis with shotgun marriages between what were already among the biggest banks in the world by any yardstick (except, of course, net asset value).

As soon as the market recovers, they should be broken up and sold – and I mean not simply have pieces chipped off their edges, as has been the case so far, in Britain at least. Given that two of the biggest UK banks are effectively nationalised, the new Government owes it to the taxpayers to maximise the value of selling the assets, which may in any case turn out to involve a break-up.

Last, but by no means least (in terms of public anger at any rate): the vexed question of bonuses. Smaller banks are bound to mean smaller paychecks for chief executives – which you can be sure is one of the main reasons why they hate it so much, and why the nonbank public should be so keen on making sure that the new PM, who advocated breaking up during the campaign, sticks to his promise

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