Andreas Whittam Smith: The first rule of any regulation – bankers cannot be trusted

They will seek to avoid any control up to the limits of ending up in court
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The Independent Online

"Heads I win, tails I'm bailed out." This is what the banks have learnt from the financial crisis and the Governor of the Bank of England, Mervyn King, is right to attack this assumption.

There are two difficulties with this state of affairs. In the first place, banks are enjoying an unofficial guarantee of enormous value without paying for it. In effect taxpayers provide the underwriting. No formal decision to extend this "too-big-to-fail" insurance has ever been taken. Nowhere in the world does it have statutory backing. It has never been debated in national parliaments. Yet we have just seen it in operation on a grand scale in every advanced economy.

The second problem is when governments subsidise something, as they are doing with this implicit guarantee, more of it is produced. If you subsidise, say, sugar production, you will get more sugar. Likewise if you subsidize risk, which is what is happening here, you will get more risk, more of "heads-I-win, tails-I'm-bailed-out" kind of business. In fact with this guarantee, governments have removed what would be the most powerful check on bank excess – the fear of failure.

In this light, the letting go of Lehman Brothers a year ago can be seen as a perfect example of the exception that proves the rule. For it is clear that as things stand, governments wouldn't want to go through such a traumatic event again. In a paradoxical way, the Lehman episode has proved beyond doubt that the guarantee remains fully operative unless it is specifically withdrawn.

The Governor is sceptical about the efficacy of conventional bank regulation with its make-do aspect. This requires banks to hold sufficient capital to act as a buffer against adverse events. However, as Mr King said in a speech earlier this week "capital requirements reduce, but not eliminate, the need for taxpayers to provide catastrophe insurance". And to this I would add a further consideration. Bankers cannot be trusted.

This should not come as a surprise. Business executives, for instance, are naturally collusive. They will compete hard until one of their rivals suggests a deal that would serve to carve up a market. Then they will work together. That is why states need watchdogs such as our own Competition Commission.

We know also that businesses in their roles as taxpayers will act in the same amoral way as many rich people. They will take whatever legal steps are available to avoid paying. What we must also accept is that this same dubious behaviour extends to bank executives in relation to financial regulation. They will seek to avoid it up to the limits of ending up in court.

This is what was happening towards the end of the 1980s when banks learnt to take the individual loans they had made, each underpinned by a legal agreement between the bank and the borrower, and combine them together so that the bundle became a security that could be traded. The process is known as securitisation.

It started with mortgage loans. The banks would place these packages into specially created companies or trusts which new investors would be invited to finance in return for the interest that the underlying loan agreements provided. This was shadow banking. It was not subject to prudential regulation. And in due course, shadow banking collapsed under its own weight with calamitous consequences. It was legal but reckless.

While the Governor made no mention of bankers' dubious behaviour, he nonetheless advocates a draconian solution. He would split the big banks into two parts. One would undertake utility-style banking. Utility banks would provide companies and households with a ready means to make payments for goods and services and they would accept deposits and make loans. If Northern Rock had been such a narrow bank, it would not have got into trouble. Narrow banks would be closely regulated and government would in effect guarantee the service.

The other part would be the remainder of what the big banks do, "casino" banking as some have called it. Casino banks would still be regulated, but all concerned would know that they could go bust. Had it been understood that Lehman Brothers could actually fail, rather than the event coming as a complete surprise, then all who had dealt with the bank, its depositors, its customers and its counterparties, would long before have behaved more cautiously as would no doubt its management. Indeed the rule may be this: if you can go bust, you won't.

So to the Governor's proposals, I would apply Nelson's dictum: the boldest course is often the safest.