King clashes with Chancellor over how to regulate banks

The Governor of the Bank of England, Mervyn King, yesterday clashed with the Chancellor at the Mansion House dinner over the right approach to fixing the regulatory failures that saw the first run on a British bank in over 150 years and the near collapse of the entire financial system.

Proposing that all banks be required to make a "will" or run-down plan in case of their unexpected demise, the Governor also repeated his sympathy for the concept of "narrow" or "utility" banking. But the Chancellor rejected that idea, and told the banks themselves to manage their risks.

Mr King said: "It is not sensible to allow large banks to combine high-street retail banking with risky investment banking or funding strategies, and then provide an implicit state guarantee against failure. Privately owned and managed institutions that are too big to fail sit uneasily with a market economy."

However the Chancellor differed from this "moral hazard" approach: "The solution is not as simple, as some have suggested, as restricting the size of banks. We have learnt that you don't necessarily need to be a big bank – or indeed a complex one – to threaten to bring the system down... And you can also ensure that banks themselves have in place proper plans, to mitigate those risks and to deal with the possibility of a failure. This is the right way of dealing with the big bank problem."

But one possibility, according to Mr King, was for guarantees to retail consumers to be confined to those banks that undertook "a narrower range of investments".

Mr King joins the former chancellor Nigel Lawson and other senior figures in calling for consideration to be given to a new, UK version of the old US Glass-Steagall legislation. Passed in the aftermath of the Wall Street Crash, the US law prevented retail and investment banking from taking place under the same roof. Glass-Steagall was repealed in 1999, with, critics say, the disastrous results we see today. However, it is also argued that, in the UK at least, narrow institutions such as Northern Rock and the Britannia Building Society also ran into problems.

The "big bank" issue is acute in the UK because of the unusually large size of the banking sector in relation to GDP – larger proportionately than in the US, for example – and the concentration of the UK's financial services in a relatively small number of firms.

Mr King also pleaded for the Bank to be given a "macro-prudential toolkit" to regulate the credit cycle: "We need instruments to prevent the size, leverage, fragility and risk of the financial system from becoming too great. The resulting macro-prudential toolkit will contain a number of instruments to reduce risk, both across the system and over time."

Yet Mr Darling also implicitly placed himself outside the consensus running from Washington to Brussels via Threadneedle Street on new supervisory institutions and instruments: "Institutions are important, so are the tools for them to do the job. But to concentrate only on institutions is to miss the point. At its heart, this is about judgements that are based on a clear understanding of what's happening. It is about making the right call at the right time."