Brown and King miss the point on bank break up

Earlier this week, Mervyn King argued for the split of the retail and investment banking operations of institutions that are “too big to fail.” He said the Government’s approach of more regulation would do nothing to prevent a return to casino banking, with taxpayer money funding a new spree of reckless gambling. The Prime Minister pointed to the failure of retail bank Northern Rock, and the pure investment bank Lehman Brothers, as evidence that King was mistaken. The PM said the problem lay with a lack of regulation rather than the business mix, and size, of institutions.

They are both wrong (though King less so than Brown). Bank employees have a significant proportion of their salaries paid in company shares, and so have little incentive to run their employer into the ground on purpose. King’s absolute focus on the importance of “moral hazard” is misplaced. Gordon Brown seems to have forgotten that the ‘problem’ was not the individual failure of two banks, but rather the need for the taxpayer to bolster the entire banking system with unprecedented financial support.

Both these men have failed to point out that the banking system was brought to its knees by the interdependency of institutions. Ties between banks were debilitating precisely because of the size and complexity of their businesses. Breaking them up into smaller chunks and separating retail from investment banking reduces the domino effect seen last autumn. Banks can play in the casino all they want – as long as when they lose they do not bring the rest of the house down.

But there is a more important reason why banks need to be split up. Supernormal profits, like those recently announced by the major investment banks, are emblematic of monopoly power. Banks lobby against being broken up because the smaller they become, the lower the barriers to entry for competitors – driving profits, and bonuses, down. Their argument that breathtaking rewards are justified by the operations of the free market is a therefore a fallacy.

It is only by making banking truly competitive, and breaking the cartel, that the government can kill the bumper bonus.