Britain's banks are too important to be permitted to go bankrupt.
That fact was revealed in spectacular fashion in 2008, when the previous government rescued the sector with taxpayers' money. This was the only route available. The alternative was to see a general economic collapse, quite possibly followed by social breakdown.
But this privileged status enjoyed by the banks has created a disastrous system of incentives for the employees and managers of these institutions. These giant banks do not only take deposits and make loans – they also place large bets with borrowed money. The blanket state guarantee of banks' liabilities means that when these gambles pay off bankers generate large profits and pay themselves obscene bonuses. But when these gambles fail, as they did in spectacular fashion in 2007/08, the taxpayer ends up with the bill. Profits are thus private; losses are socialised. This is not capitalism: it is a welfare state for bankers and their financial backers. Worse, now that the state guarantee has been made explicit, bankers have a direct incentive to take ever more irresponsible risks.
The Independent Commission on Banking (ICB), established by the Coalition last June, was tasked with proposing a cure for this illness in our financial system. The commission's interim report, published yesterday, recommends the medicine of "ring-fencing". Banks' retail operations (the part that is vital to the functioning of the British economy since it administers the deposits of ordinary savers and businesses) would be turned into subsidiaries, separate from risk-taking investment-banking arms. The committee claims this will ensure that the vital retail operations of banks continue when large institutions run into difficulties. The banking arms, on the other hand, could go bust.
Will this create better incentives within the banks? That depends on how credible those who lend money to banks find ring-fencing. Will investors demand a premium for putting their money in the bonds of an investment banking subsidiary of a giant bank because they perceive it as more risky than the debt of the retail operation? If they do, the reform could be effective in imposing market discipline. But if not, it will mean that the assumption of a state rescue for a stricken investment bank has survived. The managements of those firms will then continue their business as usual. In other words, the proof of the pudding will be in the eating. Ring-fencing is probably better than the present situation, in which investment bankers can gamble with the cushion of an unlimited state guarantee. But that is not the standard against which the ICB should be measured. The crash of 2008 was the largest financial catastrophe since the First World War. The job of the ICB was to recommend ways of making the banking sector safe, not marginally less dangerous.
And the ICB had a clear alternative path: complete separation of retail and investment banking. That would have wiped out any doubt in the mind of bankers or investors about the limited nature of the state's guarantee. Yet the committee's members chose not to go down that road. The report's justifications for this are terribly weak. It hints at the "costs" of a full separation and the "benefits" of the universal banking model. Yet it does not spell out what it thinks these are, or how much they are worth.
The report reads as if it lacks the courage of its own convictions. The substance points one way, but the conclusion does not follow. The committee's chairman, Sir John Vickers, bristled yesterday at the suggestion that the ICB had "bottled" the challenge handed to it. But in its failure to explore a truly radical restructuring of Britain's dysfunctional and dangerous banking system, that is the description that is likely to stick.