The head of the Government’s HM Treasury Banking Commission , set up to investigate ways the banking system can be reformed and asked to review the Financial Services (Banking Reform) Bill, has reported back. The Bill does not go far enough to ensure that the retail activities of banks are protected from the losses from the risky investment arms. Nobody should really be surprised by that. It is a Conservative government, after all. But you should be worried.
Here’s why: Remember the scenes of folk queueing up at Northern Rock and other banks in 2008 , only to be told that, er, sorry you can’t have your own money back? Well, this protection is necessary to prevent that from happening again. It wouldn’t have happened that way in any case if Thatcher and Blair had not dismantled the regulatory framework that already existed to prevent this sort of thing from happening. You see, they (government, bankers et al.) already knew that you needed to keep the investment activities of banks separate from their retail operations. In fact, it is the most obvious thing in the world – I don’t want my deposits in a retail bank being used for investing in highly risky ventures because, when the investments turn bad I’m going to lose all my cash.
Ironically, it was a tool invented to help banks out of a housing bubble that ultimately became the sector’s nemesis (well, it would have been their nemesis if only we hadn’t bailed the bastards out). So here’s how it worked in the old school: I loan you the money to buy a house at a given interest rate for a given number of years, and you pay me the principal plus interest until the loan is paid off. Easy – you get your house and I get to grow fat on the interest from the loans. Nothing wrong with that. Here’s how it began to be done post-1986: I lend you the cash to buy a house, along with a whole load of other people, at interest. However, I decided that I like getting fat and bloated and want to find a way to get gourmandised a bit quicker. So I come up with a cunning plan – what if I get all the loans I’ve made, chop them up and reconstitute them into a sweet looking deal that we can sell to some sucker for cash. Not only does that provide me with my cash almost immediately, but it also insulates me from the risk of unpaid loans.
Sounds, well, cunning no? Banks are safe and capitalized, and so are your deposits. Fun for everyone. There is one small problem though. In the old paradigm, it is in the lenders best interests to make sure that the folk you lend to are financially solvent enough to repay the loan – you’ll be out of pocket if they can’t. In the new paradigm, there is no need for you to care. After all, it will be some other douche who’s stuck with the bad debt not the bank, so who cares if they pay up? And so begins the sub-prime mortgage market.
For you and I, this is no huge problem because, to start with, the retail banks which sell these ‘Collateralised Debt Obligations’ (CDOs) are not exposed to the bad debt that sub-prime mortgages will inevitably create. It’s those other gimps that bought them. This is clearly an economic red flag – you can’t be letting the banks stick bad debt out into the markets in such massive quantities. This was what caused the hedge funds and pension funds to go under so dramatically.
But wait, it gets worse! Much, much worse in fact. Whilst the collapse of those investment bodies would have been dire for the economy, it may have been alright as long as the capital kept flowing. The moment the real problem began was when the aforementioned deregulation of the financial markets began in 1986. One of the results of this was that investment banks became able to use the capitalisation of their retail arms (the part that we have our current accounts with) in their investment portfolios. Remember how I pointed out that the CDOs got the banks their money quick-smart whilst insulating them from the risk of sub-prime mortgages? Well, the greedy investment banks just couldn’t help themselves but start trading these CDOs with their own retail arms. Once the fake money from that started rolling in, everyone had to follow suit. They started believing their own bullshit! Suddenly, the investment side of a bank was no longer insulated from this risk.
Again, once it was ‘discovered’ that the securities were worthless it was a disaster for the investment banks and the hedge funds and pension funds. But we, the humble taxpayer, may have been kept insulated were the investment and retail arms of banks still separate. But they weren’t – the investment banks had been gambling with our money and when the proverbial hit the fan, we got royally shagged too. And that’s why so many banks would have failed if we hadn’t bailed them out. So we got to pay twice for this debacle. Lucky us.
There was of course more to it of course – the corruption of the ratings agencies and the remarkably low capitalisation of the fractional reserve banking system (I’ll leave you to bore yourself with that on your own time) to name but a few issues – but the nub of the situation is this: We cannot allow that same mistake to happen again because if banks are ‘Too Big To Fail’, then they have absolutely no incentive not to do the exact same thing again. Why be prudent when you know the taxpayer will come and bail you out when you fuck up?
Once you know all this it is clear how important the separation of banking operations is. The reform bill as it stands is not enough. More must be done.