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One more time: The break-up-the-banks debate

by Robert Teitelman | Published July 10, 2012 at 2:13 PM

The LIBOR scandal has brought back to the fore the debate over what to do with the banks -- though more so in the U.K. than the U.S., which with the exception of the usual critical voices, like Simon Johnson, have mostly been preoccupied with other matters. (That may well change when big U.S. banks such as Citigroup and JPMorgan Chase & Co., and U.S. bank regulators like the Federal Reserve, get called into the principal's office.) In Britain, the cries have again been heard that we need everything from a cultural transformation of banking to a complete breakup of the largest institution. The tempest is quite hot, as fallen Barclays chief Robert Diamond can attest, and it's fed by a variety of British issues: the harsh bite of austerity, the fact that Diamond was widely viewed as an arrogant Yank interloper, even the Murdoch hacker scandals. It's difficult from New York to foresee the British politics, beyond sheer outrage (which can be effective over the short term) that would result in breaking up the big banks. In the U.S., those politics are even more elusive. American politics is both polarized and in flux. The banks do not loom here quite as large as they do in the smaller U.K., despite too-big-to-fail. And the traditional forces that fought the evolution of big banks in the U.S. -- community banks, insurance agents, populist rumps -- have been diminished by the very consolidation they oppose. Even the forces of Brandeisian populism have been undercut by the split between Tea Party right and progressive (or OWS) left. For all the high-flown academic and Internet discussion about banking, stirred anew by episodes like JPMorgan's big trading loss or (perhaps) the LIBOR scandal, banking reform really has no role in the current election. At least not yet.

Again, in the U.K. it does. The U.K. has already created a blue-ribbon committee, the Vickers Commission, to recommend bank reform. John Vickers famously has come up with the plan to ring-fence retail bank operations, strictly regulating them in exchange for some measure of government protection, while allowing what we once thought of as investment or shadow banks to take on greater risk with less government protection. This resembles a sort of British variation on Glass-Steagall. But LIBOR as tinder, the calls for more radical measures begins again. The Financial Times today features one of its usual point-counterpoint debates on this issue, featuring Boston University economist and presidential candidate (on the Americans Elect and Reform tickets) Laurence Kotlikoff pouring scorn on the Vickers solution, while advocating for so-called Limited Purpose Banking, which restrains banks to core functions, against Martin Jacomb, a former chairman of (the U.K.) Prudential and Barclays de Zoete Wedd, who argues against "rabid" calls to smash "the banks into tiny pieces."

We've been here before; we'll be here again. Both men drag out their arguments and try to place them in the best light. They talk past each other, always a danger in these commentary debates. Kotlikoff, who has a book coming out this week attacking Vickers, takes an extreme view that banks can (and should) be made perfectly safe, and doesn't seem to struggle with whether his utility-like banks can perform all of the functions demanded by advanced, complex economies. Jacomb takes a broader view. He does understand how reform is less about structural changes and more about the larger context of politics, regulation and shareholdership, but he never lays out a path to altering that context in a way that makes banking safer. He also never touches on too-big-to-fail and ends up arguing that "engendering confidence is now an even higher priority" than criticizing and analysis, which is pretty lame.

There is an underlying issue here. Do we want big banks to be essentially utilities, tightly regulated so that it's (almost) impossible for them to get into serious trouble, and small enough if they do that they can't cause harm? Do we want the entire financial system to become utility-like? That latter question is particularly apt. One of the big lessons from healthcare, and from the larger deregulatory movement, is the pernicious effect of a partially privatized, partially regulated industry; this includes banking under Glass-Steagall. The problem of adverse selection, so endemic in healthcare, also crops up in other partially regulated industries. Utility banks will not be innovative, nimble or creative. They can offer safety and transparency, particularly if they are sensibly regulated and are able to make a decent return. It's an open question whether utility banks, particularly those serving retail customers, should be publicly owned; shareholders, after all, have demonstrated a propensity for risk. At the very least, they should be high-dividend payers, making up for the fact that they're never going to generate big profits from basic banking. We saw the great threat to utility banks with the S&Ls: Limitations on what they can do, plus mounting competition through disintermediation (from nonutility providers) to macroeconomic blows, can drive them to the wall in large numbers. (Disintermediation, by the way, is another form of adverse selection: the unregulated get the good, profitable business; the regulated are left with the least profitable. See the U.S. Post Office.) Then what?

There are choices, several of which the federal government attempted. First, you can allow them to take on more risk, or enter new, supposedly more profitable businesses. That resulted in the second mass slaughter of S&Ls, which were simply unable to handle that risk (and in many cases slid into fraud). Among the commercial banks, liberalization allowed banks to get larger (and supposedly safer) and enter investment banking and trading. We know how that ended. You can also move in the other direction: broaden regulation so that no one is outside the tent. The theoretical end of this path is nationalization of finance; you can't leave anyone outside because they will pose both a risk to utility banks and to the system. You will then cover all of finance with a blanket of regulation, including hedge funds and money managers. This may have a number of economic effects: less liquidity, fewer new products (including less sophisticated derivatives), perhaps less credit. But you will be safe -- or safer. The trouble here is that in a globalized world, customers -- particularly the biggest and best customers, adverse selection again -- can go elsewhere to find what they want: to London or Hong Kong or the Cayman Islands. The only way to resolve that problem is to establish capital controls. This is not a pretty picture.

Clearly, the Vickers folks wrestled with these issues. Is ring-fencing a perfect solution? Are some of the provisions in Dodd-Frank panaceas? Well, no, but that's the point: There are no perfect solutions unless you want to live with the tradeoffs of both extremes, no regulation or total regulation. Is there a way out? Sure, in the form of flexible and wise regulation, which depends on a body politic that has some sense of the risk and reward equation. OK, that's asking a lot; maybe it's even utopian. But you can't demand a cultural change -- in which bankers suddenly shed their own self-interest and grow selfless and wise (there's also a lot of nostalgia about the "good old days" in banking, I suspect) -- by not recalibrating the system as a whole. Critics demand increasingly radical structural change from the banks. But we have a shareholder system that is increasingly short term and speculative and one that we insist calls the shots. We have regulators juggling different, often contradictory missions, like prudence and efficiency, or safety and liquidity, not to say monetary stability and job growth. We have a society of borrowers, risk takers, gamblers and plugged-in technophiles. Perhaps this explains why the "Move Your Money" movement hasn't helped save many small banks.

We can have a safer banking system. The odds are, we just won't like it. Maybe banking is too important to like it. - Robert Teitelman

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