The simple questions are the toughest to answer. I got a series from a thoughtful reader last week and her first one was how big did a bank have to be to be "too big to fail".
It is one of the two questions at the heart of President Barack Obama's plan to rein in US banks – the other question being how, in practice, straightforward commercial banking would be split off from the more risky things that banks got themselves into and which have come to grief.
But the "too big to fail" test is hard to apply, as in indeed is judging what constitutes risk. The first bank to collapse here in the UK was Northern Rock. It was by world standards tiny but it was too big to fail because had it folded there would have been a run on all other banks – indeed, one was starting at the much bigger Alliance & Leicester, one that subsequently spread to Royal Bank of Scotland. So even small banks are in practice "too big to fail", because if they are allowed to go under, other larger ones are likely to be brought down with them.
What about risk? Under President Obama's plan, which to be sure we have only seen sketched in a couple of paragraphs, lending to hedge funds is deemed risky. But actually loans to hedge funds did not play a significant part in the banking meltdown. Northern Rock was in the boring business of home loans; it simply lent on too easy terms, including its infamous 125 per cent mortgages.
There is a good deal of common sense behind the President's ideas. They have been driven by Paul Volcker, the chairman of the Federal Reserve between 1979 and 1987, and currently the President's adviser on economic recovery. He is hugely experienced, having essentially re-established monetary discipline after the inflation disaster of the 1970s.
There are two key reasons why there needs to be a similar return of banking discipline now by ring-fencing old-style commercial banking from the new proprietary trading activities that banks have come to carry out. One is that the nature of deposit-taking is special to all economies, developed and emerging alike. You cannot run an economy if there are fears that banks might go bust. The other is the nature of different types of banking. Commercial banking is different from investment banking. It requires different skills, different management structures and investors with different priorities. But I feel the President's rhetoric is naive and the plans, if put into action insensitively, could be destructive not just of the US banking system but of its economy.
One thing is certain. No one country, not even the US, should impose new banking regulation unilaterally. It may try, but it would be vastly better for regulation to be done globally. Have a look at the chart. This shows the world league table of banks ranked by market capitalisation. This value varies from day to day with changes in share prices and foreign exchange rates, so don't bother about the detail. The big message is that the world's largest banks are Chinese. It is true that HSBC is up there near the top, but remember that though it is currently British-registered, its past was in China; it was the Hongkong and Shanghai Banking Corporation Limited and that is still its Hong Kong legal entity. Its future looks increasingly likely to be in China too, as is recognised by the move of its chief executive, Michael Geoghegan, from London to Hong Kong last year.
So if you want to know what will happen to the structure of banking, you should not listen to politicians in the US, and certainly not to those in UK or Europe. Listen instead to the monetary authorities in China. They might well go along with any G20 plan to reform banking, but as both Alistair Darling, and in a rather different way, George Osborne, acknowledge, it has to be on a global basis. I do hope the US authorities understand this.
At any rate, banking will be reformed. We cannot see the detail but we can see some of the consequences. At a micro-economic level, some locations will probably suffer. Mayor Bloomberg in New York was railing against the President for the impact that his measures might have on the New York tax base. His worry was that if banks were cut down in size and pay was restrained, he would have less money with which to run the city and there would have to be job losses in the municipality. He was fighting for his corner, of course, but he does understand the industry.
The bigger concern is what might happen to the world economy. If banks are to be smaller they will be less able to fund economic growth. Now some of the activities that banks have funded in the past probably should not have been funded at all. We have had an excess of credit over the past few years, which has led to wasteful investment. Part of the blame was too loose a monetary policy, particularly in the US under the Federal Reserve's previous chairman Alan Greenspan, but part of the blame must be carried by some of the banks.
But from now on, bank credit will be harder to find. As a banker friend in New York told me last week, the banks are besieged on several fronts. The public has deserted them and politics will run against them.
From the perspective of the US, that will lead to a more orderly banking system and that is welcome. We – and people in the US – have to hope that the re-regulation of the system will be done sensitively and within a global framework. But from a global perspective this means there will be a global funding gap that will have to be filled in other ways. I can see at least half a dozen consequences.
The first, and most obvious is already happening: companies funding themselves by going to the capital markets rather than going to the banks. There has been a huge increase in bond and rights issues, and that will continue.
Second, companies will tend to hoard cash. They know they will need to rely more on their own resources so they will wait until they can fund investment from retained profits rather than bank loans.
Third, hedge funds will continue by simply borrowing less. That industry may become smaller – actually it is already shrinking – but it will be more profitable.
Fourth, if in effect investment banking is split off from commercial banking, investment banks may become even more profitable because the competition will be lower.
Fifth, if the US does go it alone in regulation, international banking will shift from New York, mostly to Asia.
And sixth, if as a result of these US measures banking worldwide takes on a calmer, more responsible, more cautious tone, we as consumers and mortgage-seekers will find it harder to borrow money. That may be no bad thing.
It's good to see growth, but too soon to say whether it will last
This Tuesday we will get news that the UK has exited recession, for the first estimate of GDP for the final quarter of last year should be quite strong – strength reflected in the slight fall in unemployment as well as other indicators.
Phew. I still reckon that when all the revisions are done, we will be seen to have come out of recession somewhat earlier, but whether that proves right or wrong, let's recognise and celebrate that there is some growth at last.
But there are some obvious headwinds. One will be the ending of the cut in VAT. Another will be the continuing rise in household savings, which while welcome and necessary, inevitably puts a damper on consumption. Another is the spike in inflation, for the obvious reason that if people have to pay more for goods and services the volume of what they buy goes down. And we are approaching a Budget, which will have to start outlining what might be done about the deficit.
The Budget will be intensely political and in all probability will be replaced by another emergency one three months later. Labour will try to take credit for getting the country out of recession while the Tories will seek to demonstrate that the UK has had a worse experience than other large developed nations.
The Tories argue that Britain has had a longer recession than other G20 nations, actually being the last to exit, and note that the exploding national debt has forced up the cost of borrowing and in particular the cost that gilt-buyers have to pay to insure against a government default. There has not as yet been a meltdown in gilt prices and the pound has strengthened somewhat in recent weeks, which is a relief, but the sudden focus on the plight of Greece has shown how quickly the mood might change.
So while we welcome the return to growth let's also be aware that the weeks through to the election will be twitchy and it is not realistic to expect sustained growth until much later in the year.Reuse content