IBC must try harder in its attempts to let banks fail without the fallout

Regulators are still battling with their thorniest problem – how to let a bank fail without spreading panic and threatening the entire system. The latest attempt comes from the UK’s Independent Banking Commission (IBC) charged with making banks safer and promoting competition.

In its interim report published in April, the IBC proposed ring-fencing retail and making banks hold 10% capital against that part of the business; the wholesale operations would comply with international standards and be subject to the 7% requirement of Basel III.

Bankers in the UK were relieved that it wasn’t a whole lot worse. A complete separation of retail and investment banking would have made them uncompetitive with the European universal banking model and severely hampered London’s role as an international financial centre. Whether a major player was really planning to leave, as had been rumoured, is open to question but the hard-line option would definitely have stymied London’s future prospects.

But having got the balance right between the City’s need for a level playing field and the public’s desire for sound banking, the big issues remain: under this scenario could there really be an orderly failure of a major bank and can banking ever be made entirely safe without other consequences?

Banking is fundamentally about taking and pricing risk. Safe banks would merely invest depositors money in sovereign debt and leave it at that – the so-called narrow banking option. Unfortunately, access to credit would be drastically reduced if the only finance available was in the hands of narrow banks. In contrast, dynamic economies need entrepreneurial banks to match.

Since banks can never be made safe, can they be structured to fail without disaster and would the IBC ring-fencing proposal achieve this? Almost certainly not. History suggests that one small bank in isolation can fail, or be picked up by a stronger player, if it alone is the author of its troubles.

In the last financial crisis, banks collectively exposed themselves to a property bubble that stretched across borders. The hope for preventing this kind of disaster lies with the new macro-prudential regulators (the Prudential Regulation Authority in the UK) spotting the overheating and cooling things down. Even then it will depend on the regulatory body being led by a strong personality with the clout to stand up to the political forces, whose votes and tax revenues depend on the boom continuing. On the basis of this analysis, the IBC has got us nowhere.