How could Obama hot air become a banking policy?

The President’s wish to split off hedge funds, proprietary trading and venture capital from utility banking on the High Street could be done. If he just tries to do it in one country, even a large and powerful country like the USA, the mega banks will simply shift their ownership of these areas elsewhere in the world. If the US claims extraterritorial jurisdiction, then the mega banks based in the US could switch their HQs to another overseas territory. If he still pursues them, they could split their capital structures.

If all the main banking jurisdictions of the world agree some new Basel accord on the subject it is likely the big banks would get the message. They could sell off their private equity, trading and hedge fund arms as separate companies, or they could split themselves into investment banks containing the “naughty” business as defined by the President, and utility banks.

All this implies two things that I do not agree with. The first is, it implies the three specified areas were the ones that caused the problems, whereas in many cases this is not true. Secondly it implies that future bail outs of utility banks is acceptable. Surely we ought to be seeking a world where bail outs are not needed? Why does the taxpayer have to face more pain for banking incompetence and Central bank idiocy?

What we ought to be discussing is how to regulate cash and capital by banks in a way which makes failure less likely. We need to discuss why the main Central Banks got it so wrong, why they kept interest rates too low for too long to create the bubble, then held them too high for too long to create the slump. We need to understand they ran a boom and bust policy, and both phases were wrong. We need to find people to run the Central Banks who don’t drive by looking in the rear view mirror, but who can think ahead.

If we stick with the regulation of commercial banks, the Regulator could make it clear their guarantees only extended to the utility bank subsidiary in their jurisdiction, and that such businesses could be separately accounted so in the event of a crisis that could remain solvent and independent if the rest of the Group went down. Alternatively, we could just strengthen deposit insurance so all who we wish to protect in a crash have the reassurance that their money is safe and there is no need for a run on the bank to add to its other troubles.

In the UK we need to split up RBS and Lloyds whilst they still have large public stakes. If the minority shareholders do not like it then they must arrange for buyers to take all the government’s shares at a profit for the taxpayer to allow them to call the shots. We need to strengthen our competition policy, by explaining to our Competition authority that the aim of policy is to get much more competition into High Street banking in the UK, supporting the policy of splitting RBS and Lloyds.

Which leaves us with the need to regulate cash and capital. I still favour this, though there is no evidence from the recent past that the Regulators knew how to do it. We should try again. All banks and financial businesses taking positions on their balance sheets and offering to pay people their money back at some point in the future should be expected to keep minimum levels of cash and capital. These levels should normally be higher than they were in 2007. In the short term they should be lower, as we need to generate more loans and financial activity to help the recovery.

Soemtime we need to come off quantitative easing and very low official interest rates. This is just a money go round to let the government spend too much, and to allow the banks to earn easy money. It does not help the rest of the economy, still struggling with too little credit at too high a price as a result.


  1. Ian Jones
    January 24, 2010

    The issue at hand is that the banks have been given access to ultra cheap credit in order to lend to the wider economy and get the economy growing. Instead they just borrow huge sums and play the stock market which they know is a one way bet until the free money is stopped!

    Therefore, Obama is firing a warning shot to the banks to start lending the money rather than speculating with it and then giving themselves multi billion dollar bonuses.

    It should be internationally coordinated as the same problem exists in the UK.

    QE needs to end now, its simply a transfer of wealth from savers to asset holders. Its also known as theft.

  2. Norman
    January 24, 2010

    I'm actually neutral on the whole 'banks are evil' mindset that seems to have sprung up – the real blame lies with the politicians who launched the barmy bail out schemes but it still leaves the question what to do next?

    Splitting up banks seems an easy solution on the surface but as you point out will it really work any better than the whole closing offshore tax havens we heard so much about during the G20? How about the Copenhagen accord? We were told there wasn't a minute to waste and that this was our last chance. What has / is being done? It's easy to make grand pronouncements but at some point you need to deliver.

    As for this banking crisis. We had one in 1930/1. We had one in 2008. What did we do for the 78 years in between that changed at the start of the 2000's? I don't know if banks had investment arms before then. How about banks that never needed bailing out, what was the difference between them and the banks that did? Why were the banks bailed out and not allowed to fail and save what we could?

    Surely these are the questions that must be answered rather than simplistic soundbites designed to get a boost in the polls.

  3. Mick Anderson
    January 24, 2010

    My preference is to split retail banking from everything else, and to have some (if not all) High Street banking regulated. Only deposits should be protected; the banks themselves need not be.

    However, if a covered bank were to fail, there needs to be a mechanism in place either so that depositors can use the facilities of one of the other retail banks while the dust settles, or a BofE management team be parachuted in to maintain day-to-day business while the company is wound up. This is to make sure that all those electronic payments that so many organisations insist on are maintained, and to stop people from losing normal access to their (protected) money.

    It's not that the joining of retail and investment necessarily caused the problems – more that by keeping the retail banks separate and simple, it's much easier to diagnose and deal with problems early on. Apply the engineers principle of KISS (keep it simple, stupid).

    The likes of Northern Rock failed because of poor business models (borrow short, lend long). These seem to have been supported with money from the investment banks (aka the international money market). Indirect influence, not direct cause and effect. If they need short term support, they can borrow from the BofE. If they need long term support, there is something wrong!

    Keeping them at arms length did not cause a problem before repeal of the Glass-Stegal act (and the UK equivalent). So, rather than trying to invent a new alternative, start with something that did seem to work safely.

    It doesn't matter if the UK strikes out alone with this. The UK taxpayer should only support resident depositors – I don't really care how other countries around the world solve their financial problems. If the UK system is good enough, others will follow it, and what I'm suggesting doesn't affect world-wide investment banking.

  4. Kevin Peat
    January 24, 2010

    "We need to discuss why the main Central Babnks got it so wrong, why they kept interest rates too low for too long …"

    Y'know – when I watched those planes slam into the World Trade Center the very last thing I expected to follow it was the biggest economic boom in history.

  5. David Belchamber
    January 24, 2010

    Was the credit bubble partially created by the MPC of the BoE trying to control inflation based on an inaccurate measure of inflation i.e. after Brown had replaced the RPI by the CPI ?

    If so, why were they so naive?

  6. John Moss
    January 24, 2010

    The idea that if the banks had been allowed to fail ther world would have come to an end is not one I agree with. The banks funded the purchase of businesses, property, etc. Those things have real value and whilst in a crash, that value falls, there is still value there.

    The problem we have now is that nobody knows whether the banks' debts are covered by the income from those assets so the interest bills at least can be paid – and if not, what the underlying assets are worth so the necessary write down can be taken on the banks' balance sheets.

    Until we get to that, then we risk a dead decade like they have had, and are still having, in Japan, with banks unable to lend because they are not recovering interest on their loans, but the necessary correction in their balance sheets having been postponed

  7. Alan Wheatley
    January 24, 2010

    A convincing analysis.

    As to Obama, having talked the talk I hope he walks the walk, both as to direction and as to resolve, to the benefit of us all.

    One area that would seem to deserve more attention is the analysis and categorisation of risk. I would have thought that rather than regulate risk and tell banking institution what risks they are allowed to take, it makes more sense to know what degree of risk is being taken taking . Then, in a free market, customers of banking services can choose which institution best suites their needs.

    For those undertaking guarantees, such a governments, they need to know the size of the potential liability and the likelihood of the guarantee being call in.

    Risk is surely the inverse of credit worthiness. The credit rating agencies are deserving of the same attention currently being given to banks. I have heard an opinion recently (on the BBC!) that the ratings agencies are not really worth having for all the good they do, and their assessments of the Icelandic banks would seem to add weight to that view. But at the very least every regulator must have a good evaluation of the risk for all organisations they are regulating, else how can they do their job. One thing the regulator have, hopefully, learnt by now is that a lack of clarity about what is going on within an organisation is a sure sign of higher risk.

  8. English Pensioner
    January 24, 2010

    I personally would like to see banks split into retail and investment banking. There is one simple solution to banks finding devious ways around this, and that is to offer the guarantee of up to £50000 (or whatever it is) to investors in retail banks and building societies which behaved prudently. Those which prefer to be involved in investment banking could be allowed to have retail arms, but would not have this guarantee would have to make it clear to customers and could be allowed to fail.

  9. Lola
    January 24, 2010

    "Which leaves us with the need to regulate cash and capital. I still favour this, though there is no evidence from the recent past that the Regulators knew how to do it. We should try again"

    Yes, but. If the freedom to issue their own money was returned to the banks, over time, bank's cash and capital this would sort itself out. Markets working.

    As this is very unliekly, the State love's its monet monopoly becuase it is Power, then e have to construct the simplest and most direct and smallest level of sensible supervision we can think of. Over to you Mr R. I am content that you would be able to do this on my behalf – probably. But are a Tory government able to do this, at all? Answers ona postcard please.

  10. Ex Liverpool rioter
    January 24, 2010

    I think they stop "QE" only to have to restart it again with in 6 weeks. Once they see little in the way of overseas investment they have no choice.

    It can't be seen to happen on "Gordon watch".


  11. Nick
    January 24, 2010

    Which leaves us with the need to regulate cash and capital.

    I disagree.

    1. We need an insurance scheme for the 50K guarantee.

    Relatively easy to arrange. Just make sure the 50K has a priority on the banks capital and/or a guarantee with an insurance firm is in place.

    2. We need something in place to manage systemic risk.

    The obvious answer is a regulator. However, they have failed completely.

    I suggest a different mechanism. As a condition of a bank license you have to publish weekly your market and credit risk in a standard form. Then everyone can read it. Ratings agencies aren't guessing. They can simulate systemic risk. Every bank can do so. If that's in place, what's the regulator for?

  12. Demetrius
    January 24, 2010

    The USA is different. Critically there are a large number of local/regional small banks providing various services with limited areas. They are an asses to their communities and the proper functioning of the US system. However, the crisis of the big banks and the muddling of functions has back fired badly into this sector and a lot of the smaller banks have gone down with many still at serious risk. This has compounded in many localities the wider damage done centrally and across the banking sector. The President's proposals has this sector as much in mind as the big banks. In the UK we are stuck with a small number of global banks and to our loss and cost have no local banks.

    1. Demetrius
      January 24, 2010

      Oh crumbs, assets not asses.

  13. Martin
    January 24, 2010

    I agree that RBS and Lloyds should be split up.

    Regarding the good vs bad banking debate- I'm not sure how you define good and bad banking. All loans have an element of risk. We need sensible regulators who will ensure that banks have sensible risk management.

    The present regulators are almost daft. I remember being asked some years ago by a bank when applying for a mortgage how much I spent on haircuts! This sort of trivia passes for risk management!

    Directors also need a statutory duty in banks to ensure sound management of shareholders funds. To what extent the present crisis was caused by dis-interested directors needs to be examined.

  14. angela king
    January 24, 2010

    In today's Observer, Boris Johnson debates with economic expert Will Hutton on whether to shrink the financial sector.

  15. Ex Liverpool rioter
    January 24, 2010

    I heard Ken Clake today, the hint is VAT to 20%?

    Do you think "People" understand that the econ-model has now changed?

    It was "borrow & consume", it must now become "Save & produce"?

    If so WHY in Gods name do we tax savings????

    It must be better to have large numbers of people saving rather than the nation trying to borrow from overseas?

    Perhaps savings should be TAX FREE up to a certain level?

    Get the nation saving & producing?

    Just a thought.
    Oh Yes

  16. mikestallard
    January 24, 2010

    I am lost here because the blog is too difficult for a non economist like me to understand fully although I have been reading this blog now for over a year.
    Why cant the Bank of England, with hundreds of years of experience and skill be left to get on with the regulation?
    How can we taxpayers support the Banks? We simply haven't got the money. They think really big – bonuses, adverts, football clubs. We think pathetically small: our mean little incomes and taxes go nowhere.
    How has the government got so involved? They know NOTHING about banking. And it really shows. What they do know about is votes.
    And wasn't it the American Governments who insisted that the banks lent money to people for their houses which they knew – and everyone else knew too – they had no hope of repaying? So where is all this toxic debt now? Does anyone know? How much is it?
    Meanwhile we are asked to criticise the banks because they are richer than we are.
    So are politicians………..
    (Roll on May 3-6th!)

    Reply: Taxpayers are being made to support banks which are too big for us and the state – that has been my argument throughout this crisis. The bad mortgages are still out there. Eventually we will find out how much money has been lost. To lose the mortgage the bank has to reach the point where they think the homeowner can no longer meet any mortgage payments, and then can sell the hosue to see what the final loss is. The loss will not be 100% of the mortgage, as the house will have some value. This can be a long process. The UK taxpayer stands behind a lot of these potentially loss making mortgages.

  17. Ex Liverpool rioter
    January 24, 2010

    Shame it didn't happen on Gordon's watch

    Yes WE know it did, but those who are a hard of thinking (90%) will just remember it happened under Tory Goverment.

  18. Adrian Peirson
    January 25, 2010

    'All the major Depressions have been caused by us by no other means than the withdrawal of money from circulation'.

  19. Mark
    January 25, 2010

    Gresham's Law: Bad money drives out the good.

    People hoard good stores of value, and use the bad ones for payment. I always spent any Ulster banknotes (issued by the local banks) I got as quickly as possible. That's what's already happening with dollars and pounds, and why banks are so busy and profitable in commodities trading. Fear that fiat currency may become worthless or heavily devalued drives investment in gold, oil etc. Unfortunately, commodities have other economic uses, and the stock available for use as a store of value is limited and variable, exposing investors to huge swings in value: despite Arrow-Debreu theory, a commodity basket will not be a stable long term solution.

    1. Mark
      January 25, 2010

      The above was really a reply to Lola.

  20. Javelin
    January 25, 2010

    The FIRST ISSUE with Obama's PLANS are the creditmarkets. I completely understand where Obama is coming from. He is trying to achieve a version of the the Glass-Stegal Act (ie seperate the investment banks from the retail banks). However instead of trying to achieve it structurally he is trying to achieve it functionally – by seperating the funds rather than the banks.

    A lot of commentators have said his solution would not have stopped the recent crisis – which is only partially true – but it's much more complex than that.

    There is nothing in his plans to stop retail banks raising funds in the money markets (again) by bundling up their mortgages into mortgage backed bonds and selling them on else where. So retail banks will STILL be exposed to drying up of credit from the investment banks. What Obamas plans would do is to limit the supply of funds to investment banks to buy these mortgage backed bonds – so retail banks would find it more difficult to raise money in the first place.

    However – retail banks could always find somebody ELSE to lend them money on the markets. For example there is a lot of money sloshing around in the East looking for a home, or new Hedge funds could be set up. I could well see a bank in Japan or China buying mortgages. Hopefully the buyers of mortgage backed would have learn their lesson so they would account for risk better, meaning that mortgage rates would rise to cover the risks. However – UK lenders would still be exposed to the risk of drying up in the credit markets if the mortgage backed bonds started to fail OR (more likely) these Eastern banks were exposed to different shocks.

    So the cost of Obama's plans are (1) raise mortgage rates to reflect risk (probbaly rightly) (2) expose UK mortgage holders to drying up of credit for entirely arbirary reasons (e.g. revolution in China or India) or new laws on hedge funds.


    I think a watch word for the next decade will be "asset security" and asset inflation.

    In a global market – we will not have wars but – we will have global competition for assets. It is clear to me that credit (e.g. mortgages) should be treated like any other asset and will be globally prone to inflation, like any other asset.

    * food security
    * enery security
    * raw material security
    * CREDIT security

    I think Obama is looking back to past and not to the future in this respect.

    A SECOND MORE PRACTICAL ISSSUE with Obamas plans – is quite where banks are allowed to invest savers deposits?

    Previously banks invested in AAA mortgage backed bonds. So Obamas plans would have presumably allowed AAA investments? So his new law would not have stopped the retail banks buying mortgage backed bonds – and would not have stopped the crisis. In fact it may have made the crisis worse because retail banks would have been encouraged to invest in them.

    His plans ALSO assume the it is possible to correctly value asset risk. Which is very difficult to do because risk measures the amout of loss given a negative event, and assets are dependent on multiple and interelated things. As an aside, I worked at top risk company called Algorithmics and was tasked with designing a simulator to test the risks on assets. Even with the most simple assets, like currency holdings, the currencies are interlinked in a very complex manner and its difficult to state what your risks are due to say a drop in Sterling of 10%. When you are holding equities, bonds and derivatives you basically have to create an economic simulator to give any meaningful measure of risk, which is basically very difficult.

    If risk cannot be measured very well, what would his plans allow? Perhaps he would only allow investors funds to be sunk into Government Mortgages. This would certainly help demand for the T-Bill, and raise yet MORE money for Western Governments, and more debt, which further raises the risk of Government bankruptcies. Is this what we want?

    Bottom line however is that savers rates would fall because they were being placed in less risky asset (and therefore lower yielding assets). Banks would have to compete on costs because the range of instruments they could invest in would fall – and that would lead to the end of free bank accounts and a poorer customer service, and the squeezing out of smaller banks.

    So Obamas plans would lead to rising interest rates and falling savings rates. Is this what we want?

    1. Alan Wheatley
      January 25, 2010


      I fully understand your point about making a quantitate measurement of risk. In a sense it is probably just as well we can not predict the future with certainty.

      It seems risk and regulation are interrelated: leaving aside dishonesty, the need for regulation is to make the investor aware of the risk being run for the the reward being offered. The more difficult this is to do to then the more sensible it is it to spread your investment.

      There is then the question of what, if any, guarantee there is for the investment to mitigate against loss. And the related question of who gives the guarantee.

      It seems to me governments should be very restrictive and selective as to what guarantees they offer. And the should recognise that "too big to fail" is too big, and act accordingly.

    2. Mark
      January 26, 2010

      In any banking bust the lessons are learnt, and the same mistakes are not repeated for a generation – just different ones. What are the lessons of the present bust? That whenever you hear of a "new paradigm" assume that someone has simply forgotten history. Mortgages got out of control because normal criteria on income multiples and LTV ratios were abandoned, and consequent galloping house price inflation that signalled the bubble ignored. Mortgage derivatives were a smokescreen rather than a cause. Within banks, despite the warning from LTCM which exploded on a gearing ratio of 200 according to some accounts, high gearing became the only way to make money out of artificially low interest rates that have persisted for the last decade. This article from 1999 seems strangely prescient:

      Of course, 1999 was not long before the dot com bust, which really was a repeat of the South Sea Bubble of 1720 (which also has parallels with PFI) and had plenty of its own ventures "for carrying on an undertaking of great advantage, but no-one to know what it is". People learn from such mistakes, yet seemed doomed to repeat them at intervals. This paper from 1999 by G Wood of City University Business School gives history since the late 18th century:

      What is being ignored in all of this is the problems caused by international imbalances. Indeed, we act to exacerbate them by closing our industries and increasing our reliance on imports. Without recycling creditor nation surpluses we are dooming ourselves to ever increasing debt. We need as a nation to persuade e.g. China as a major creditor nation to buy our goods. Instead, we encourage our more talented citizens to emigrate and be employed by the Chinese directly in running their enterprises and providing engineering and design expertise by offering them a poor future here.

  21. Javelin
    January 25, 2010

    First sorry about the typos. It's the iPhone.

    I agree with John that you need to regulate cash and capital better.

    Savings and loans need to be kept in balance in terms of risk. For savings that must be zero risk must be matched by lending that is low risk. For example banks should use money raised from mortgages to deposit in governent bonds. Pensions should become less risky as you get closer to retirement. Banks who want to gamble should be able to create funds to do so.

    It strikes me there is a natural balance to risk in savings and loans. When lower risk savings are overloaded into higher risk loans/investments you end up in trouble.

    Seperating customer funds from investment banking funds is too crude a way of balancing risk. Far better to have a risk rating on deposits and loans and banks to publish how much of what risk they have on their books and ensure it is kept in balance. But this puts the emphasis on the Government to regulate the publication to risk clearly.

    Of course if banks and the Government can't ascribe risk correctly then the system will just keep collapsing again and again.

  22. Lindsay McDougall
    January 27, 2010

    Split up RBS and LLoyds. YES
    Sell them off to the private sector. YES
    Regulate cash and capital requirements. YES
    End QE and the very low base rate. YES.

    So two and a half cheers. But there are still two elements missing:

    (1) A veto of all bonuses within RBS and LLoyds until their share price recovers to what (on average) the government paid for its shares.
    (2) Tell all the banks – and MEAN IT – that if they get into trouble again, a receiver will be appointed.

    I simply don't buy this arguement that depositors must be protected at all costs. If you put your cash under the matress at home and it is stolen, or a pet chews it, you don't expect the taxpayer to bail you out. By the same token, if you put your money into a bank that is behaving recklessly, you are running a risk which should be your problem.

    The point about RBS especially is that it was known to be behaving recklessly ever since 2001. It outbid BOS to acquire NatWest, using borrowed money to do so. It outbid Barclays to acquire ABN Amro, using borrowed money to do so. It paid top dollar to take over insurance companies like Direct Line. And it carried on buying housing related debt, even when house prices had reached record highs on both sides of the Atlantic and sub-prime borrowers were defaulting. The first three of these items were widely reported in the City Press.

  23. credit fix
    March 5, 2010

    Lots of different ideas listed here – simply astounding….

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