Best answer to casino-style banking could lie in firewalls

By John Plender Published: April 1 2009 03:00 Last updated: April 1 2009 03:00 Recent events have shown beyond peradventure that financial conglomeration is dangerous. Hence the fierce debate over whether the casino element of modern banking should be severed from the utility business of retail banking and payments. But what about industrial conglomerates that own financial businesses, of which General Electric is the pre-eminent example? In the days when finance was boring, central bankers used to worry about industrial companies owning banks. The fear was that the financial business might be affected by the gung-ho, profit-maximising culture of the industrial outfit at the expense of the prudential ethos necessary in a highly leveraged business where liquidity was vital. That all appeared to become academic when mainstream commercial banks turned into financial conglomerates and embraced a bonus-hungry pursuit of higher returns on equity fuelled by ever-greater leverage. The real problem has turned out to be that finance can threaten the viability of a mainstream industrial business. In August 2000, I argued in the Financial Times that GE's business model was fundamentally flawed because the GE Capital subsidiary's balance sheet was over-dependent on short-term commercial paper unsupported by bank lines, leaving it vulnerable to funding shocks. At a time when its return on assets was falling it was only able to meet GE's demanding targets for return on equity by increasing leverage. A consequence, I suggested, was that its margin of safety against recession and financial shocks was very slender. At that time it would have taken only a 5.7 per cent fall in the value of GE Capital's gross tangible assets to make the whole GE group technically insolvent. And as the biggest non-bank financial group in the US, GE Capital was thus capable of posing a systemic threat to the wider financial system. Now the recession and the financial shocks have arrived. GE's share price has plunged, the dividend has been slashed and GE's credit rating has been downgraded by Standard & Poor's. The business model is more widely perceived to be in question. From a regulatory point of view the message here is obvious - regulation will in future need to extend to systemically important non-banks. A consensus probably already exists among the leading countries to go down this route. The outcome of the casino versus utility debate, which will no doubt feature in the deliberations of the Group of 20 tomorrow, is less clear cut. It is not desirable for banks to use deposits on which there is an implicit government guarantee as collateral for speculative trading on their own account. Yet few believe that it would be possible to enact a new Glass-Steagall Act, the Depression-era legislation that separated deposit-taking from securities business. Long before its repeal in 1999 bankers had found ways round it, not least because of the globalisation of capital markets. As Lord Turner pointed out in his recent review of financial regulation in the UK, the services that global corporations need from their bankers in a world where a significant element of debt continues to be securitised, will include activities not on offer from utility-style "narrow" banks. Something must clearly be done to stop large-scale proprietary trading conducted through in-house hedge funds. Penal capital requirements are a necessary, though not sufficient, part of the answer here. Yet any more fundamental divorce between deposit taking and securities business is not a course that any country, with the possible exception of the US, will want to embark on alone. Such unilateralism would be a self-inflicted competitive disadvantage. For countries like the UK, where a bloated financial sector needs pruning, but not to the point where all advantage in global financial markets is lost, that argument will carry some weight. In the end, the new regulatory architecture seems most likely to address the problem through firewalls. This is the path recommended by the Group of Thirty, the club of the great and good of global finance. Firewalls are never perfect, but if there is strong enforcement by financial watchdogs, they may be the best that can be done. The writer is a Financial Times columnist and chairman of Quintain