The “electrified ring fence” – does it go far enough?

The announcement by the Chancellor of the Exchequer that the UK Government will introduce an “electrified ring fence” around core retail banking activities, with draconian sanctions for any banks that breach it, is to be welcomed.

However, it begs the obvious question. If it is so desirable to keep retail banking activities separate from investment banking – as I firmly believe that it is – why did Mr Osborne not go the full mile and introduce a British Glass Steagall Act requiring a statutory separation of the two? In other words, any retail bank accepting savings and deposits from the man and woman in the street should be formally prohibited from using these funds to underwrite or trade in financial securities or their derivatives. Depositors’ funds should only be used for lending to households and businesses who, after having undertaken a proper due diligence appraisal, are assessed as having sufficient capacity to service their loans, and are capable of offering adequate collateral should they fail to do so.

Merchant and investment banking have a long and honourable tradition, and are a vital part of the dynamic operation of any market economy. But their functions and incentive structures are completely different from those of a deposit-taking banking institution. Moreover, the risks taken by an investment bank in sponsoring new ventures are typically greater than those taken by retail bank, and therefore require higher capitalisation – typically at least 30% to 40% of assets under management, rather than levels of between 5% and 10% required for a retail bank.

The decision to end the clear delineation between the two banking functions that occurred with Big Bang in the UK in 1986 and the abolition of the Glass Steagall Act in USA 1999 were major contributory factors to the financial crisis that followed.

Reintroduction of the delineation – ideally on an international rather than merely a UK level – would represent a significant building block in the restoration of international monetary stability.

The concern is that the “electrified ring fence” is a rather unsatisfactory halfway house, which may be difficult to monitor and regulate, and which, one fears, will only result in the growth of a self-serving regulatory empire.

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  1. Did any of the British banks that “failed” and required bailout/nationalistion in the latest crisis do so as a result of the lack of a British Glass-Steagal Act?

    1. The apparent answer is negative.

      The true answer is – yes, they did, for the reasons set out in Chapter 6 of The Golden Guinea. The end of the distinction between retail banking, investment banking and Building Societies led to the transmission of investment banking incentive structures, based on bonuses paid for the number and size of transactions completed, to retail banking activities for which they were wholly inappropriate. This in turn led to reckless lending, on insufficent collateral, financed by ever higher leverage, until the whole inverted pyramid collapsed in 2007/08. Big Bang was a major contributor to this process.

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