Kay: If ring-fencing works, it will be Glass-Steagall

"The proper economic role of banks is to operate the deposit channel, directing short-term balances towards borrowers—principally home-owners—and managing liquidity provision to reconcile safety of deposits with the long-term needs of users of capital", he writes. "The policy objective should be to restore a linear framework of intermediation between depositors and borrowers. That simplification is key to the achievement of security for savers, economic and financial stability, effective control of the costs of intermediation, and transmission of the information needed to make good decisions on capital allocation."

Kay emphasises the importance of separating deposits from all other financial activities, the Glass-Steagall principle; however, the UK in 2013 legislated a weak version of this separation called ring-fencing, which still allows the retail division to remain inside the banking conglomerate. This is the term Kay uses: "The first step in implementing structural reform is to ring-fence the deposit channel to ensure that the operation of the payments system cannot be jeopardised by the failure of financial conglomerates. The subsidy to trading activities arising from the availability of the deposit base as collateral should be removed; the likelihood that the taxpayers' guarantee of routine deposits will be called will therefore be limited, if not altogether eliminated."

He observes that mere ring-fencing, as opposed to Glass-Steagall, is problematic, because bankers will try to get around the barrier. "In the interim", Kay says, "financial conglomerates might become financial holding companies, as envisaged by the UK's Independent Commission on Banking and the Liikanen Report commissioned by the European Union. But there are disadvantages to such a half-way house. The ring-fence between deposit-taking and other financial transactions requires careful policing. And the problem of cross-contamination of cultures remains."

Kay then makes the very important point that an effective ring-fence will actually result in a full separation, because the only benefit banking conglomerates derive from holding deposits is being able to use them to collateralise their gambling. He predicts that if applied effectively, ringfencing will see banks sell off their retail divisions, because managing them will become a net cost. "Still, so long as ring-fencing is effective, there will be little if any financial advantage to the conglomerates themselves from trading as holding companies. Since the management problems of combining investment and retail banking impose costs on the institutions themselves, it is likely that effective ring-fencing would lead them to choose voluntarily to spin off their deposit-taking activities."

This prediction provides a good metric for evaluating the effectiveness of the UK's ring-fencing law, which, however, doesn't come into force until 2019, and to which the UK's Too Big To Fail banks are already seeking exemptions. If under ring-fencing those banks don't split off their retail deposit businesses, it must be assumed they are finding ways around the ring fence. Further more, given how vehemently the TBTF City of London banks opposed the strong push for full Glass-Steagall in 2013, and lobbied for the ring-fence instead, it must be concluded they always intended to find ways to keep exploiting deposits for their gambling. Indeed, this was predicted in the 2013 House of Lords debate on Glass-Steagall, by Lord Forsyth of Drumlean, himself a former investment banker, who warned the Lords that "bankers are extremely adept at getting between the wallpaper and the wall. If they can find a way to get around something they will." The bottom line is that if the intention of those advocating ringfencing is genuine, they might as well go for a full GlassSteagall separation in which the deposit-taking institutions are split off and kept right away from speculators.

Kay concludes that separating deposits from other activity is the first step towards what should be the goal of shrinking the financial system—an objective that will terrify those bankers in the City of London who boast that the UK's financial services sector has expanded from 100 per cent of GDP in 1975 to more than 450 per cent of GDP today, and that they intend it to expand to 950 per cent by 2050. "This ring-fencing should be the first step in a process of fragmentation", Kay writes. "If the large financial institutions of today are not permitted to take advantage of their retail deposit base, and are deprived of government funding, subsidy or guarantee, they will be unable to maintain volumes of trading on their present scale. The leverage within them would be so clearly excessive that other traders would be nervous of dealing with them. This reduction of trading volumes to more sensible levels is a further, central objective. …

"Many people struggle with the idea that the world could be more than slightly different. People I talk to in the financial world find it difficult to conceive of a future financial system in which large corporations are not active in the repo market, in which asset-backed securities are not integral to housing finance, and where there are no futures contracts or stock market indexes. Yet there was a time when none of these things existed, and there could be such a time again. We need some of the things that Citigroup and Goldman Sachs do, but we do not need Citigroup and Goldman Sachs to do them. And many of the things done by Citigroup and Goldman Sachs do not need to be done at all."

All emphasis has been added. Other People's Money by John Kay is available from Amazon.com and other on-line bookstores.

From the Australian Alert Service 22 June 2016.
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