Ringfencing won’t work

George Osborne is set to announce his intention to require banks to ‘ringfence’ their retail operations. Essentially, the retail part of universal banks (the bit that deals with your savings, and makes loans to individuals and small businesses) will become a separate subsidiary within a wider ‘group’. That subsidiary will be separately capitalized and subject to its own capital adequacy requirements (the suggestion is 10% equity capital to risk-weighted assets).

The idea is that this ring-fencing will make it easier for the government to let failed investment banks go bust, since they’d be able to fail without ordinary depositors being wiped out in the process. And if ringfencing does make it clear to investment banks that they will not be bailed out, that would remove the implicit risk subsidy they currently receive, and make them behave more cautiously.

I’m not so sure. It seems to me that both Osborne and the Independent Commission on Banking have missed the point somewhat. The issue is not just that universal banks are using the implicit government guarantee that comes with their retail operations to take more risks on the investment side – as the ring-fencing proposals would suggest. In fact, banks are generally taking more risks – across their whole businesses – because of the government guarantee. It simply isn’t the case, as most people assume, that retail banking is safe whereas investment banking is risky. Remember Northern Rock? Or US sub-prime lending? The ‘utility’ has caused us as much trouble as the ‘casino’.

And the big, big problem with what Osborne and the Commission are proposing is that they are effectively making the government guarantee of retail banks explicit. And that, as Andrew Lilico convincingly points out over at the Telegraph, means retail banks “will have incentives to engage in the riskiest practices the nature of their businesses allow.” Ringfencing might reduce the risk subsidy that we’re giving to investment banking, but it increases the risk subsidy to retail banks, and will inevitably make them less stable and more problematic in the long run. Slightly higher capital adequacy ratios will do next to nothing to offset this.

I’ve said before that no amount of regulatory oversight is ever going to be able adequately replace proper market discipline in banking. If we want our financial system to be safe and stable, we need to get depositors, bondholders and shareholders to realize that their money is only safe as the bank that’s holding it. We need to get banks competing on their risk profiles, rather than just ticking the regulatory boxes and declaring to the world that they are safe as houses. And we need bank executives to know that their livelihoods depend on their investment decisions.

Whatever ringfencing would achieve, it would not achieve any of that.

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