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Thursday, 22 October 2009

Turner and Brown prove King right

Gordon Brown added more weight to Mervyn King's argument for the separation of commercial and investment banks, by his answer at yesterday's Prime Ministers Questions when he said Mr King "has got to remember that Northern Rock was effectively a retail bank and it collapsed. Lehman Brothers was effectively an investment bank without a retail bank and it collapsed. So the difference between having retail and an investment bank is not the cause of the problem."

All of which shows that a soundbite is not as good as a few minutes clear thinking. I am sure that Mr King is fully cognisant of the difference. Northern Rock was a mortgage bank that took retail deposits, but it relied to an increasing extent on wholesale funding. If it had been forced to grow organically by growing its branch network and increasing its retails deposits it would not have had the liquidity issues that Mr Brown's FSA failed to spot.

15-love to Mr King.

Lehman on the other hand was a full blown investment bank with little involvement with the man on the street. It failed because it took too many of the wrong sort of bets, but although it is in administration, the losses suffered by its investment bank counterparties on Wall Street are largely survivable. Why is that? Because with constant provisioning and margin calling in traded markets the absolute extent of any loss is likely to be capped. The rest of the market takes some big knocks, but pretty quickly gets back to trading and picking up cheap assets, which is why so many of the Wall Street investment banks are making so much money at the moment.

But the same isn't true of the commercial banks, particularly those that were hit my the Lehman default. Not directly, but by the impact that Lehman had on the credit default swap market, which in turn impacted the banks available risk capital and their ability to lend. If the banks had been prohibited from getting into such a mess by being prevented from using monoline insurance to reduce their equity requirements, there wouldn't be a problem right now.

First set to Mr King.

But then if it wasn't obvious that Mr King is completely right, his point is proven by Adair Turner and the FSA who have today published a 66 page discussion paper on banks that are too big to fail and what should be done about them. The answer is that if a bank is too big to fail, then it should only be allowed to do the sort of business that is unlikely to cause it to fail. The government isn't there to underwrite every risk that a bank wants to make. Well Mr Turner thinks differently and he seems to think that there is some merit in allowing banks to punt on whatever they see fit saying, amongst other things :

"Reform to trading book capital should significantly increase capital requirements and differentiate more strongly between basic market making functions which support customer service and riskier trading activities, with a bias for conservatism in relation to the latter."

In other words value and regulate ordinary banking treasury activities differently from proprietary trading. He also gets worked up about systemic risk and the need for regulators to control that.

Like I said yesterday, keep it simple. Separate the normal banking operations into regulated banks and put the go-go punt-u-like boys in another company and you have killed two birds with one stone.

Game, set and match to Mr King.

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