TO FIX THE SYSTEM WE MUST BREAK UP THE BANKS / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( RECOMMENDED READING )

To fix the system we must break up the banks

By Philip Augar and John McFall

Published: September 10 2009 21:56

In coming up with solutions that address the immediate crisis but fail to tackle dangerous systemic issues, the Group of 20’s emerging ideas on the banking industry bear a striking resemblance to the Americans’ response to the dotcom crash of 2001-02. Back then, the burst bubble exposed biased research and stock price manipulation on Wall Street and dubious accounting practices in US companies. Out came a new set of rules cleaning up the links between research analysts and investment bankers and laying a heavy hand on corporate chief executives.

These measures extinguished the fire but neglected more fundamental problems. By the time the regulations were in place, the investment banks and elements of the corporate sector were already deeply involved in new and even more dangerous practices. We speak, of course, of the derivatives-based leverage of banks’ balance sheets that brought down a range of previously sound institutions, dragged the global economy into recession and ripped up accepted economic theories.

We see exactly the same mistakes being made this time around. If effectively implemented (not the only possible outcome), the G20 finance ministers’ steer towards more and better capital, constraints on leverage and contingency plans for banking failures would help to avoid a repetition of the current crisis. But they are barely sufficient to give the financial services system the kind of radical overhaul it needs.

That would entail tackling a defective business model. Banks are allowed to mix plain vanilla deposit-taking and lending with high-risk investment banking. They are allowed to act for clients on both sides of a trade and take a proprietary turn out of the middle. In capital markets transactions they are able to act for those seeking capital and those providing it. Conflict of interest is embedded and this is unfair on other market users. It is “heads we win, tails you lose” as the banks make off like bandits in the good times and become pious onlookers as the taxpayer foots the bill when it all goes wrong.

Fixing the system requires this business model to be broken up and we would go beyond conventional Glass-Steagall type solutions. Activities such as corporate finance, providing advice for investors and proprietary trading should be separated from each other as well as being split off from deposit-taking. This would create smaller, less profitable institutions and solve a number of problems, many of which have been caused by financial institutions over-trading. The system we advocate would restore the balance of economic power towards industries other than finance. It would stem the flow of capital that goes into bankers’ bonuses (a problem that the proposals coming out of G20 seem unlikely to solve) and would rid the world of financial institutions that were too big to be allowed to fail.

Many heavyweight thinkers have dismissed narrow banking (a less radical option than the one we advocate) as, to quote Lord Turner, chairman of the UK’s Financial Services Authority, “not feasible”. They point out that although Northern Rock was not an investment bank and Lehman was not a deposit-taking bank, both failed. This is another example of fighting the last war. The real problems are not the specific causes of the crises of 2008 (banks) or 2001 (dotcom) or 1998 (Long-Term Capital Management) or 1989 (US Savings and Loans), but the enduring power of finance to be socially and economically disruptive.

We do not expect politicians and regulators to restructure the global financial services industry at what is still a critical moment for the economy. But it is regrettable that they appear to have shut the door on even having such a conversation. A starting point, as we have argued before, would be to set up a banking commission informed but not dominated by people from outside the industry. Its remit would be to consider structural change and how the financial services industry can serve the wider social and productive needs of the economy.

This crisis has offended people’s basic notions of fairness. The connection between effort and reward must be proportionate and the playing field needs to be level if we are to secure a fully functioning market economy underpinned by political stability. That is why there is no option but to start the discussion we advocate.

John McFall is chairman of the Commons Treasury committee. Philip Augar is a former investment banker and the author of Chasing Alpha

Copyright The Financial Times Limited 2009