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Over the weekend, Ed Miliband has threatened that if banks do not themselves choose to separate their retail and investment arms then Labour will legislate to force this upon them.  That would be a mistake.

Advocates of separating the retail and investment activities of banks reason along some combination of the following lines:

  1. Governments will have to bail out retail banks if they become distressed.  If those retail banks are combined with investment banks, the cost of bailing out what is wanted (the retail unit) is greatly amplified by the expense of bailing out another entity at the same time (the investment bank).  Separating them would cut the expense to government.
  2. Retail banks are safe entities.  Investment banks are risky entities.  If these are combined, it is more likely that retail banks go bust, meaning governments must bail them out.  Separating them cuts the risk to government.
  3. Depositors place their money in banks to store it.  If those banks use depositor money to fund risky investment banking activities, they place depositors at greater risk.  Separating them cuts the risk to depositors.
  4. Retail banks have access to last resort lending from the Bank of England.  Merged retail/investment banks can use this availability of last resort lending to support risky investment banking activities for which last resort lending is not intended and which the Bank of England finds it challenging to monitor.  Separating them cuts the regulatory burden on the Bank of England and insures that last resort lending is restricted to its intended purpose.

Every part of this argument is wrong, except for those parts that, properly understood, imply it is either unnecessary, counterproductive, or inadequate to separate retail from investment banking activities.

First we should recognise that it is simply false that retail banking is a safe activity.  Retail banking involves taking in deposits that then support lending for mortgages, personal loans, business loans, and so on.  Lending money is not risk-free.  People default on loans.  So retail banks can lose money – indeed can go broke.  Furthermore, retail banks must manage their cash positions, like other companies.  And like other companies, if they manage their cash badly they can be unable to honour their debts even if they are solvent.

Retail deposits in fractional reserve banks are loans made to the bank.  So are bank bonds.  As a risk-taking entity, a retail bank may be unable to service its debts.  There is no good reason for the government to automatically bail out retail banks.  Indeed, if governments do automatically bail out retail banks, that would be even more destructive than recent practice.  For a retail bank without an investment arm will respond to bailout guarantees by taking the greatest risks the regulator permits it.  It will lend for the dodgiest sub-prime mortgages, the personal loans to folk with multiple bad debts, the business loans for absurd schemes.  In the good times, all will seem well – politicians might even boast that they have "got the banks lending again".  But when there is a downturn, these loans will go bad, ruining the bank and ruining the borrowers.  Macroeconomic volatility would be materially increased by guaranteeing retail bank bailouts – Ed Miliband's new mantra could be "lots more boom and bust".

Deposits are fundamentally a form of investment.  However it may well be true that some deposits are intended simply to store money, rather than as a form of investment loan.  An iconic example is when a homeowner has sold one property but not yet paid for the next, due a few days later - she is just storing the money at the bank, not investing it in the bank.  There should be a new category of bank deposit for depositors that simply want to store their money.  I call these "storage deposits".  Storage deposits should belong to a legally ring-fenced entity within every fractional reserve bank, and be required to be 100% backed by government bonds (as per the old Savings Banks, such as the TSB, that existed until the mid-1980s).

The correct separation is not between retail and investment banking activities.  It is between risk-taking and essentially risk-free activities.  Retail banking is a risk-taking activity, like investment banking, like all fractional reserve banking.  People that want to deposit money in risk-taking investment deposits should be free to do so – why should Ed Miliband forbid people from depositing money in a bank that uses that money to support investment banking activities if that's what they want to do with their money?  The issue isn't that they shouldn't be permitted to do that.  It's that when such loans (investment deposits) go bad – as they will, from time to time – investment depositors should not expect the government to bail them out.

Advocates of separating retail and investment banking activities see what they want to achieve – a form of low-risk banking, guaranteed by the state – but they draw the dividing line in completely the wrong place, at a point that would make banking much riskier, be of more burden to the state, and increase macroeconomic volatility.  There should be legal separation – in the form of a legally ring-fenced entity nested within every fractional reserve bank.  But that legal separation should be between essentially risk-free storage deposits and in-principle-risk-taking investment deposits.  Banks could then have different business models – some would just use investment deposits to support mortgages (like building societies).  Others would just make local business loans.  Others would be national retail banks.  Others would be universal banks with investment banking arms.  Investment depositors would get different interest rates depending on the nature of the risks the bank was taking.

Such a system would not, however, take away the need for prudential regulation of or last resort lending to fractional reserve banks (whether retail or universal).  So we would still face the last challenge – what about last resort lending subsidising investment banking cash risk or creating uncertainty for regulators?  The answer to that seems to me to be provided by the shift back to the Bank of England as the prudential regulator of the banks.  Prudential regulation is the flip side of last resort lending.  Its purpose is to establish whether a bank would be a worthy recipient of last resort lending, if it came to it.  The Bank of England need not simply provide cash to a retail bank on a no-questions-asked basis.  If a retail bank is engaged in investment banking activities that create excessive cash-flow risk, the Bank of England can simply say those activities render the bank unsuitable as a recipient of last resort lending and so suspend its licence to accept retail deposits.

So, to summarise, advocates of the separation of investment from retail banking activities dwell under the mistaken impression that retail banking is risk-free and that retail banks must be bailed out by the state.  In fact, retail banking is risky, and automatically bailing out retail banks that are legally separate from investment banks would create even more macroeconomic volatility than bailing out combined retail/investgment banks.  The government should only be willing to bail out activities that are, from the government's perspective, risk-free.  The only risk-free activities are the holding of cash (nominal-risk free) and the purchase of government bonds.  It is harmless for the government to guarantee, without limit, to insure deposits that are, in any event, 100% backed by government bonds – I call these storage deposits.

If Ed Miliband wants to make banking safer, he needs to consider a much more aggressive legal separation than that between retail and investment banking.  Just separating off retail units would make things worse, not better.

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