Mervyn King and narrow banking

Over the weekend, Bank of England governor Mervyn King restated his support for narrow banking, the idea that ‘casino’ investment banking should be kept structurally separate from ‘utility’ high-street banking.

In one respect, I agree with King: we have not yet dealt with the biggest issues in financial regulation. In particular, the ‘too big to fail’ problem has not been addressed. And King is right that reforms need to be radical and fundamental – regulatory tinkering is not going to do anyone any good.

But I’m not sure that King is right to be pushing the narrow banking line. After all, Northern Rock was a retail bank without an investment banking arm, and it tanked. Lehman Brothers was an investment bank with no retail wing, and it is widely regarded as having triggered the worst of the financial crisis. HSBC, on the other hand, is a big, universal bank with a ‘casino’ and a ‘utility’ under the same roof, and it didn’t run into any trouble at all.

This does not represent a complete refutation of the narrow banking idea, but it does, I think, indicate that simply ‘separating the casino from the utility’ would not solve all our problems. Indeed, I would go further and suggest that it fails to deal with the real flaws in our financial system.

Ultimately, the problem with modern banks is that they do not operate in a free market. They haven’t done for decades. Deposit insurance means depositors take no interest in the stability of the banks they give their money to. The inevitability of bailouts means bondholders and shareholders take no interest either. Expansionary monetary policy encourages banks to lend too much and reserve too little. Accounting regulations encourage all banks to invest in certain asset classes, ensuring that when problems emerge, they are likely to be systemic. All of these things are government interventions, and all of them make the financial sector more risky and less stable.

The rational solution, surely, is to get rid of these interventions and let the market do its job. We ought to be introducing an effective resolution regime so that failed banks do not need to be bailed out. We ought to be unwinding deposit insurance while, perhaps, requiring banks to offer their customers risk-free 100 percent reserve accounts if they want them. And we ought to be fundamentally reassessing the role the central bank plays in the economy and the financial sector.

Compared with all that, doesn’t narrow banking seem like a bit of a red herring?

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