Proposed banking reforms should go further

Royal Bank of Scotland went bust. Halifax Bank of Scotland had to be hustled into a merger with Lloyds TSB and then expensively bailed out by the government. A string of smaller mortgage lenders from Northern Rock to Bradford & Bingley had to be rescued in one form or another. And what has Britain come up with in response to the worst banking collapse in its history? A fiddly proposal to ring-fence the risky trading activities of the main banks from the deposits of ordinary customers. The Vickers Report, which was finally published on Monday, has been dismissed by many analysts as a damp squib. But it's much worse than that. It has forgotten the most important lesson in finance: that the rules are always for someone else.

The Vickers Report sounded tough. British banks will, by 2019, be forced to separate out their retail and investment banking operations. In theory, there will be a strict divide between the day-to-day business of running current accounts, offering mortgage loans and providing credit to small businesses, and the high-stakes investment banking operations. The banks will also face tougher capital requirements than most of their rivals in the rest of the world.

The banks certainly don't like it. They've all complained vociferously. A few have even threatened to move their operations abroad if the regime is too tough. They needn't worry about scouting out locations in Zurich or Shanghai just yet though. The reforms will leave the British banking industry as generously subsidised by the taxpayer as ever.

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The history of modern finance has been a story of financial institutions learning to dance around the regulators. In the 1960s, restrictions on interest rates and lending rules imposed by the American government led to the creation of the Eurodollar market, a vast offshore and unregulated trading arena based mainly in London that dealt in dollar loans. In the 1980s, when the City's Big Bang' reforms swept away the old divisions between stockbrokers, gilts traders and what were then merchant bankers, to allow the creation of modern investment banks, there were meant to be Chinese Walls' preventing information flowing between different departments. The only thing Chinese about them was that they turned out to be as solid as a prawn cracker.

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The sub-prime boom was in large part created by banks sweeping up lots of dodgy mortgage loans, putting them into a basket with some slightly better ones, and getting ratings agencies to stamp the whole bundle Triple-A so that they could be sold on to investors who had no idea what kind of risks they were running. Similarly, the eurozone's peripheral countries managed to mask the extent of their borrowing by getting the investment banks to issue swaps that made it seem as if their debts were lower than they really were. In short, when it comes to gaming the system, the banking industry has a long history of getting it right. And the regulators have a long history of being outwitted.

The problem with ring-fencing is that it ignores just how good the bankers are at getting around the rules. There should be no great surprise about that. Inevitably, twisting the rules is a lot better paid than enforcing them. The banks will hire the best brains they can find to get around the restrictions. After all, what counts as retail banking and what counts as investment banking is largely a matter of how you define the words, and where you place a few numbers on a balance sheet. With eight years to play with, and a vast financial incentive, it is very hard to believe that a few loopholes won't be found. In time, that is going to become a big problem.

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The trouble with much of the regulation of the last half-century is that it virtually forces the banks to fiddle the system because that is how they get around the rules. It was because so many institutions were restricted to investing in Triple-A securities that the investment banks manufactured so many of them during the sub-prime boom. The result was that a lot of very bad investments were made and when they turned sour the financial catastrophe hit the entire world. In the same way, the fiddling of the sovereign-debt markets meant that when the markets started to get nervous about the peripheral members of the eurozone the crisis was far worse than it would have been if everyone had been straight about the numbers from the start.

The only way to have made the British banking industry safer would have been to demand a total split between retail and investment banking. As Mervyn King has put it, if a bank is too big too fail, then it is too big. There is no practical way of micro-regulating banks so that one part can be isolated from another. Retail banks should handle deposits and be protected by the government. Investment banks should be private companies or, even better, partnerships free to take whatever risks they want and responsible to no one apart from their shareholders if they go bust. Maybe that is a step too far it would certainly have been a dramatic move effectively to blow-up what remains, for all its problems, one of Britain's most successful industries. But if Vickers wasn't prepared to do that, it would have been better to do nothing at all.

This article was originally published in MoneyWeek magazine issue number 555 on 16 September 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.