Want Virtuous Banking? Start By Splitting Banks Into More Than Two Pieces

Yesterday I was engaged in a discussion about 'virtuous banking' which seemed to stick on the definition of 'banks' and 'banking'.

No one does 'banking' - not even 'banks'. What we call 'banks' are actually giant corporate groups that carry out a vast range of quite distinct activities. Some are listed here, for example, and some were discussed by John Kay in his report on "Narrow Banking". These group activities tend to be broadly classified as either retail (utility) banking or wholesale (proprietary trading). But some of their activities arguably span this distinction, including the banking groups' role in creating money (by making loans with a central bank as lender of last resort) and money transmission (by co-operating in various payment systems). And of course wholesale business units often provide one or more services to retail business units within the same group. 

Those group activities also face into different national and international markets, with differing levels of profitability, growth, customer needs etc., and require management and staff with wildly different skills and levels of remuneration. But working capital will be allocated to the business units where it will generate the most return for the group as a whole, not according to the needs of, say, small business customers in the UK. And outdated IT systems in areas of low profitability, for instance, might only be replaced or upgraded if they actually fall over rather than to keep pace with the technological innovation. What might appear virtuous to one set of customers may not appear so to others. Taxpayers may not be materially impacted either way, or the impact may be so long term as to avoid detection. But banks are ultimately motivated by solving the problem of group profitabilty at their customers' expense (which makes them 'institutions' rather than 'facilitators', in my view).

Accordingly, figuring out what is 'good' and 'bad' behaviour on a day-to-day basis across a banking group is not only an extremely complex task, but also an archaelogical one. Regulation and internal policy only catches up with bad outcomes once they and their causes are identified. That process is painfully slow. A decade will have passed before any real regulatory changes related to the global financial crisis take effect in the UK, for example. Enforcement lag also means that fines and compensation bills come far too late to be factored into the main board's assessment of the likely return on capital across business units. They just end up as the the group's general 'cost of doing business'.

At any rate, regulation is a poor basis for assessing virtue. In the current framework, direct regulation only addresses some of a banking group's existing bank products and activities, not all of them; and is based on how banks do things, rather than on the activities and needs of customers. Some indirect regulations, like capital adequacy controls and accounting rules, are aimed more generally at how a banking group operates for the public good, but these are open to very broad interpretation in terms of how they impact specific products and activities. Market forces were previously thought to act as a control on behaviour. But the banks' conduct both before and during the global financial crisis has disproved that hypothesis. And they have few genuine competitors because complex regulation, the state guarantee of their liabilities and other subsidies intended to make the banking system safer have merely protected the banks from competition and innovation.

So it seems we can't even begin to be assured of 'virtuous banking' unless we are able to make and enforce that assessment for each business unit within a banking group independently. On that basis, splitting the banks in two is just a start.