Ring fencing Banks – no silver bullet

It sounds like a great idea; separate the investment part of banking from the retail part. So a financial meltdown in the more risky arm of the bank would not put at risk ordinary current (check) account customers. The devil is in the detail.

The reason for the financial crisis was a lack of liquidity based on short term loans that some investment banks used to make a profit on or tide them over. The credit crunch prevented that, and they become insolvent. The second part of the crisis was defaults and the inability to create new debt as a successful business model as in the good old days – because it was now too risky.

The second part features in people’s minds more then the first. Some banks did make bad loan decisions but equally some just had a poor business model to finance their deals; with no risk assessment to take into account changes in the financial market. Ring fencing retail arms was not the issue here; with the exception of Northern Rock there was no run on retail banks in the UK. Other banks like Royal Bank of Scotland or Halifax survived through mergers or public financing.

The benefit here is that an investment arm cannot take down it’s retail arm to bail it out. In essence this should mean that your savings are safe if over the threshold that the government guarantees (wait for detail to see). Peace of mind but this does not address the global financial meltdown that happened.

Capital ratios of 10% – higher than the international standard – addresses the issue of getting money quickly (liquidity) when needed. However, in addition scrutiny of operations of investment banks need to be effective – or at the least the deterrent of bankruptcy must be real. Perhaps the added stick of legal repercussions for not following good banking practises. Not fines but white collar crime incarceration. May focus the mind …

The ring fencing may end one arm subsidising the other in good times too. This will increase costs on customers by reduction in real interest rates on savings, charging for normal current accounts (when public mood can stomach it – it will happen if the banks can get away with it). How investment banks insure themselves too may result in less dividends and returns.

It is a first step in saying that an investment arm will be allowed to fail. The question is the cost on the banking customers, and whether if a domino shock effect on banks happened the over burden tax payer could be saved from bailing them out. The questions we need to ask is how will oversight be better more effective. The real solution is to allow them to fail, and not be able to get so big without adequate safeguards for that possibility.

More on the government’s response to reforming banking system here – ahead of the Chancellors’ Mansion Speech.

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