Breaking up the banks is hard to do

“Never in the field of financial endeavor has so much been owed by so few to so many.”
— Mervyn King, Governor of the bank of England

I have said before I’m too lazy busy to feel able to update you about every trade I make in the active portion of my share portfolio.

But I don’t mind saying that I’ve now sold all my Lloyds shares.

While I didn’t catch the highs — and have already explained how my heady trading profits were pretty illusory — the quick gains I did bank were too tempting in light of the ongoing risks of holding Lloyds.

Lloyds shares still look cheap – and sitting through the many risks is what investors will likely be rewarded for – but with even the Bank of England governor Mervyn King last night stating banks must be broken up, the uncertainty just keeps mounting.

I’d already sold because Lloyds is rumoured to be pulling out of the Asset Protection Scheme that would insulate it from 90% of £260 billion of bad debts.

Analysts believe operating outside the scheme could be more profitable for Lloyds — at the cost of a rights issue — but as I’m still bearish on UK residential property, I can’t be bothered with the extra risk.

The danger of the EU commission forcing a clumsy break up of the merged Lloyds and HBOS ‘superbank’ was also worrying me. The whole reason I’d bought Lloyds was for the economies of scale that merger would bring.

King’s call

But while it’s not been personally good for my bank shares, I fully agree with Mervyn King’s sentiments.

In his speech last night, King said that:

“The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.”

And he is absolutely right.

Failure is part of capitalism, not to mention human nature. It is particularly a feature of banking, where ‘once a century’ blow-ups seem to come along every couple of decades.

We should therefore concentrate on making the economic system robust enough to cope with the fallout from failure (and to avoid encouraging it) rather than thinking we can legislate against it.

That doesn’t mean we should do nothing about the structure of banking – far from it.

But we shouldn’t daydream that a financial meltdown can “never happen again”, whatever measures are imposed.

Why banks blow-up

Take, for instance, the idea that you can make banking safer by obliging the banks to hold more capital depending on the risks they’re taking.

Sounds great in theory, but in practice the rocket scientists they employ will always find ways to ‘hide’ the risk in order to reduce the need for it to be backed by capital, as this is what makes banking more profitable.

I don’t mean they will do so fraudulently.

I mean lots of smart people in lots of banks will find ‘innovative’ ways to make bets with ever less equity at stake.

Ideas such as providing more debt that converts to equity as a buffer should disaster strike are all well and good (and a warning to those many private investors punting on Lloyds and RBS preference shares) but no measure can stop risk diffusing away from the regulator’s eyes.

Even splitting up the banks to hive off ‘casino’ elements such as proprietary trading from everyday High Street banking won’t solve the problem.

For starters, investment bank failure is a systemic risk, too – it was Lehman Brothers’ collapse that brought the world to its knees, after all.

More importantly, the fall of Lehman’s showed the bigger problem by threatening the solvency of insurer AIG, which had vast quantities of assets and obligations that nobody would have expected it to own when the regulations were drawn up.

This growth in ‘shadow banking’ is inevitable whatever regulations you have in place, for the simple reason that eventually people will become complacent, chase higher returns, and flock to pump up the size of whatever market agents can provide it, be they investment banks, hedge funds, or even a fraudster like Bernie Madoff.

You just can’t regulate against the madness of a bull market.

Profiting at our expense

Mervyn King is therefore right to suggest we should reduce the size of the biggest banks in anticipation of future disasters to come.

Yet all the financial crisis has done so far is concentrated power in even fewer hands, and added state guarantees to the mix.

What about self-restraint on the bankers’ part, I hear some optimist cry?

That’s a good one. We’ve already seen how laughable calls for ‘better behaviour’ from investment banks are in the light of the ludicrous profits and bonuses Goldman declared last week.

Goldman makes such outsized profits partly because it’s clever, but mainly because at the highest level investment banking is not prone to competition in the way that most businesses understand it.

This is especially true given that when the risk blows up, the investment bank gets bailed out.

Yes, Goldman has repaid the TARP bailout money the US government loaned it.

But that’s irrelevant. I’d happily spreadbet the FTSE for £10 million if I thought the Government would cover my temporary losses in the down years.

Vast profits, excess risk, and ridiculous bonuses all need to be stamped out, mainly by scaling down the size of banks and altering the market to enable more competition, as well as ensuring operators have more of their skin in the game.

There’s even a case for investment banking to be forced back to its original un-quoted roots, where the partners risk everything and take all the rewards.

Banking as a utility

Retail banks vulnerable to bank runs will always require the implicit guarantee of the State, whatever regulations are in place.

But financial companies shouldn’t be able to make huge profits from those guarantees – low risk and low returns should be the order of the day for any such quasi-public utility.

I still own HSBC and Standard Chartered because I think banking is a vital component of the financial system, and it makes sense to buy and hold while there’s so much uncertainty around depressing the outlook.

And in my view, those two banks are already close to where we’ll likely end up after any restructuring of the bank sector is done with (and I don’t say that it will go far enough). I also like their big focus on Asia, which is awash with savings.

But the farce of a banking collapse and state bailouts turning into multi-billion pound bonuses in the blink of an eye needs to be addressed as a matter of moral urgency.

I don’t think it’s too extreme to suggest that faith in capitalism is at stake.

The trickier question for legislators is not how to reform banking, but how to provide a safety net for the economy that doesn’t accidentally underwrite even greater risk-taking in future.

King has opened the debate, but it’s up to politicians to seize the gauntlet.