David Prosser: Brown takes on the Bank, not the banks

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The Independent Online

Outlook It took less than 24 hours for the Prime Minister to slap down the Governor of the Bank of England, who refuses to give up on his campaign for the break-up of "too big to fail" banks. Gordon Brown is, of course, right to remind Mervyn King that Northern Rock had no investment banking arm, while Lehman Brothers didn't have a retail operation, and thus that Glass-Steagall principles would not have prevented their demise. He might have added Washington Mutual and Wachovia in the US, as well as our very own HBOS, which all suffered in the crisis despite having no presence in investment banking.

However, Mr Brown misses the point. The justification for a return to Glass-Steagall – the US legislation which, until its repeal in 1999, banned banks from engaging in both retail and investment business – is not that it would provide a panacea for all future financial crises.

Rather, the case is that since retail banks benefit from a state guarantee – depositors know their losses, in the event of a failure, are recoverable from the state – their investment banking activities are also underwritten. Even if it were these more risky activities that brought down the bank, the state would still have to pay out to depositors.

Separating retail and investment banking ends that problem. No longer must the state implicitly guarantee investment banks' losses, because no retail bank customers are at risk.

Now, as Mr King himself admits, the problem does not end there. Even with this separation, some banks might still be too big to fail. That is, their collapse would cause systemic problems rather than difficulties only for their own customers. But we could deal with that by insisting that on top of a return to Glass-Steagall, the largest banks are broken up.

Don't think this is easy. Imagine Mr Brown telling Barclays that it could not keep both its retail arm and Barclays Capital – and then telling Barclays Capital itself that it was to be broken up. Imagine telling Goldman Sachs it is too big to fail.

You can see why Mr King finds himself on a limb on this question. But he's not out there on his own. The Governor may struggle to persuade politicians – of either main political party – to confront the banks, but he has friends in high places.

Paul Volcker, the former Federal Reserve chairman, who now heads President Obama's Economic Recovery Advisory Board, is one powerful advocate of a return to Glass-Steagall, rejecting suggestions that banking is now too complex to be separated. "That argument brought us to where we are today," he told The New York Times yesterday. And Joseph Stiglitz, the Nobel prize winning economist, says separation would create a "cleaner, safer banking system". Back to you, Gordon.

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