The UK’s Independent Commission on Banking puts chickens and foxes inside the same the same “ring fence”.

The purpose of the ring-fence is to separate retail banking from the riskier investment banking activities: i.e. to separate the essential money transfer functions which cannot be allowed to fail from the risky, clever clever stuff. (Of course there are still systemic risks from the clever clever instiutions, (e.g. Long Term Capital Management), but the basic money transfer system is more important.)

The basic problem with the ICB proposal is that they’ve put BOTH risky AND stuff which is supposed to be safe (i.e. not to be contaminated by risky stuff) inside the ring fence! It’s a bit like putting foxes inside the chicken coop.

Paragraph 2.27 says that deposits from and loans to individuals and firms or corporations should be inside the fence. But this involves significant risk. How in God’s name does one stop banks lending to firms, particularly large ones, which turn out to be thoroughly dodgy and high risk?

Still on para 2.27, the ICB says that loans to “non financial companies” should be inside the fence. That’s just asking for squabbles over exactly what constitutes a “financial company”. I can see lawyers earning big fees there. Or as Martin Jacomb put it in the Financial Times, “The fingfencing proposal involves much detailed regulation.”


Some small retail depositors actually WANT risk.

The next problem is that some small depositors actually WANT to expose themselves to risk, and why not? There is nothing wrong with the basic idea behind capitalism, namely that people can take a risk and possibly make money or lose money.

As pointed out above, the ICB ring fencing does not guard small retail depositors against risk, but just supposing it DID guard those depositors against risk, that is a nonsense in that some small retail depositors actually WANT to have a flutter or take a risk. They are not catered for under the ICB regime.

So what is the solution to all this? Well the solution was given very eloquently by Mervyn King, governor of the Bank of England. As he said, “If there is a need for genuinely safe deposits, the only way they can be provided, while ensuring costs and benefits are fully aligned is to insist such deposits do no coexist with risky assets”.

In other words why not give depositors a choice. Choice No 1 is to have an account which is 100% safe and taxpayer backed. But in keeping with Mervyn King’s principle outlined above, the money in such accounts cannot be invested in commerce or exposed to any kind of risk. The money can only be deposited at the central bank or perhaps invested in government securities.

On the other side of the fence so to speak is choice No 2. This is for customers to let banks invest their money any way the bank sees fit. Alternatively banks could offer a range of accounts with different levels of risk, or other characteristics, like “money will only be invested in the UK”. But that is a minor detail. The important point is that the money is used for commercial purposes, and it is NOT the job of taxpayers to subsidise commerce. Thus there would be no taxpayer funded rescue if it all goes wrong.

The latter “two choice” system involves minimal regulation. For example there is no need to distinguish between financial and non financial firms. Investing in ANY firm is commerce. The investment will thus earn more interest than the safe No 1 choice above. But there is no taxpayer funded guarantee.

Likewise there is no need for regulators to look in detail at what loans banks are making and try to decide whether individual loans are too risky to be acceptable. Indeed the very idea that regulators are able to make this judgement is laughable. Banks themselves are scarcely able to quantify the riskiness of those they lend to: look at the disastrous loans they made prior to the crunch.

As to what to do with the commercial or risky activities or divisions of banks, those can only be made less of a systemic risk by reducing leverege, enlarging capital requirements, insisting on bail-ins and so on.

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Afterthought (26th Oct 2011): I just noticed that the Guardian’s City editor, Jill Treanor, is also critical of the commission’s hazy ideas as to what does and does not go inside the fence. She says, “The commission is vague about whether banking to large companies should be in or outside the ringfence.”