Papering over the rot

A few years ago, I planted two young apple trees. I cut each sapling down to two feet, to encourage it to branch out, and encased each growing point in a plastic bag to protect it from beasties that would devour its new young leaves. And then I waited for them to grow.

One grew quickly, and soon pushed lovely young leaves against the plastic bag. But the other didn't. Mystified, I removed the plastic bag. Inside was a denuded shoot and a VERY fat caterpillar. 

I had ringfenced my apple tree to protect it and allow it to grow unmolested...but inside the ringfence was the very creature I was trying to protect it against.

Fortunately I was able to remove the caterpillar and the apple tree is now flourishing.  But of course I am not really writing about apple trees....

Today, George Osborne announced measures to force UK banks to ringfence their retail operations in separate legal entities. The aim is to protect retail depositors from possible losses arising from failures in investment banking operations.

Three of the four UK banks that were bailed out by taxpayers failed because of excessively risky retail lending (mortgages and corporate lending), and although dodgy investment banking was implicated in the failure of RBS, high-risk corporate lending was equally to blame. In other words, retail operations failed in ALL FOUR of these UK banks. No UK bank failed solely because of problems in investment banking - despite what the politicians (and the bankers) would have us believe.

So we ringfence retail operations. And inside the ringfence are our precious retail deposits - but also our mortgage lending at silly income multiples and ridiculous LTVs, and our highly-leveraged lending to dodgy businesses. And we haven't done ANYTHING to prevent such high risk lending happening again. Retail banks can still lend as much as they choose to whomever they choose, at whatever risk level they choose. And we can't raid investment banking for funds to support high-risk retail lending any more, because it's separated by chinese walls, isn't it?  So ridiculously risky retail lending will bankrupt our retail banks FASTER than before. 

Conversely, investment banking will no longer have to fund idiotic retail lending and its products will no longer be underpinned by junk loans. So investment banking might actually benefit from the retail ringfence (although cost of capital will be higher - see my blogpost Bank breakups, red herrings and elephants).

So does George really want to protect retail depositors? Well, to be fair, he probably does. Let's face it, he doesn't understand any of this stuff, and he's being advised by.....bankers.  Hmm. They caved in very fast over the proposal to ringfence retail, didn't they? Only Stephen Hester objected (a straw man, maybe). The rest have tamely acquiesced.  If this was REALLY going to hurt the banks surely they would have fought harder? Call me suspicious, but it's hard not to conclude that it not only doesn't hurt them, it directly benefits investment banking at the expense of retail.

In effect, the retail ringfence protects investment banking from the consequences of excessively risky retail lending, leaving retail depositors bearing ALL the risk of this lending. And because deposits are guaranteed, firstly by FSCS insurance and ultimately by the taxpayer, it means that the taxpayer is now on the hook for ALL retail lending losses that are not covered by insurance, capital or provisions.

Well, ok, capital reserves have to go up, a bit.....but 10% doesn't seem very much if the rest is to be borne by the taxpayer, does it?

The rot at the heart of our banking system is the system of guarantees provided to retail depositors that spills over into lending activities and encourages excessive risk-taking. The proposed ringfence does nothing about that rot. But it hides it under a thick layer of wallpaper so we cannot see the destruction taking place underneath. And when retail banks start to collapse again while the investment banking sector flourishes, will we blame the investment banks again - or will we finally deal with the real cause of the problem?


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