Tussle in UK over Banks May Influence Future Regulation

Mervyn King of the Bank of England has inserted himself into the bank regulation debate:

Bank of England Governor Mervyn King opened a rift with Prime Minister Gordon Brown’s government by signaling the biggest banks could be broken up to prevent taxpayers having to shoulder the cost of future bailouts.

King’s suggestion to separate investment banks from operations that take deposits from consumers and manage payment systems was ruled out by Chancellor of the Exchequer Alistair Darling as recently as yesterday.

“The key issue is not one of breaking up banks but of financing the economy,” Angela Knight, chief executive officer of the British Bankers’ Association, said in an e-mail. “Big businesses may want big banks which offer a range of products and services while individuals may look to something smaller. Large universal banks are the way forward.”

The G-20, whose finance chiefs meet in two weeks for talks in Darling’s native Scotland, is focusing on pushing banks to raise capital and restrain pay rather than devising an international approach to curbing the size of banks. Darling is writing laws to make banks write a “living will” that enables a quick wind-down of institutions that fail.

King said yesterday that, while global efforts to bail out banks had prevented economic disaster, they had created “possibly the biggest moral hazard in history.” He said that it is “hard to see why” proposals such as those made by Volcker to separate proprietary trading from retail banking are “impractical.”

“What does seem impractical are the current arrangements,” King said. “Anyone who proposed giving government guarantees to retail depositors and other creditors and then suggested that such funding could be used to finance highly risky and speculative activities would be thought rather unworldly. But that is where we are now.”

Brown, Darling and other ministers have repeatedly said such a split would have failed to prevent the collapse of Lehman Brothers Holdings Inc. or Northern Rock Plc.

King’s remarks put him somewhat at odds with the US Treasury, which wants separation based on size, not function.

Assiduous Readers will remember that I prefer separation of function based on parallel regulation, in which institutions that consider themselves banks would be, by differentiation of risk-weighting, encouraged to buy-and-hold long term assets. Institutions opting to be regulated as brokers would be discouraged from buy-and-hold investing. I greatly prefer this to be done by means of risk-weighting than by flat prohibitions, because sharp lines between asset classes and investment styles increase systemic cliff risk.

Note that I similarly believe that Canadian banks’ insurance operations should be penalized via risk-weighting; Canada’s current policy on bank-owned insurers is just plain dumb.

It was buy-and-hold arbitrage that brought down the dealers; it was excessive funding risk, combined with poor credit quality that brought down Northern Rock.

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