The Bankwatch

Tracking the consumer evolution of financial services

Real banking innovation requires separation of basic banking from the rest of financial services

Reading Competition creates a Race to the TOP: The EU should seek Liberalisation not Harmonisation over at the thoughtful “The Extended Society” blog, and some of the other links there such as this at the Economist, got me to thinking more about regulation of financial services.

The Dodd-Frank act | Economist  [emphasis mine]

The law that set up America’s banking system in 1864 ran to 29 pages; the Federal Reserve Act of 1913 went to 32 pages; the Banking Act that transformed American finance after the Wall Street Crash, commonly known as the Glass-Steagall act, spread out to 37 pages. Dodd-Frank is 848 pages long. Voracious Chinese officials, who pay close attention to regulatory developments elsewhere, have remarked that the mammoth law, let alone its appended rules, seems to have been fully read by no one outside Beijing (your correspondent is a tired-eyed exception to this rule). And the size is only the beginning. The scope and structure of Dodd-Frank are fundamentally different to those of its precursor laws, notes Jonathan Macey of Yale Law School: “Laws classically provide people with rules. Dodd-Frank is not directed at people. It is an outline directed at bureaucrats and it instructs them to make still more regulations and to create more bureaucracies.” Like the Hydra of Greek myth, Dodd-Frank can grow new heads as needed.

At Extended, Henry makes the point that we need less regulation, not more.  This will he argues, prepare financial markets for life in the wild and we will be the better for it because

“Competition creates a Race to the TOP”.  This is an admirable argument, and in a green field situation when designing markets from scratch, as in the Amsterdam 1602  example provided, makes eminent sense.  That is not the case today.

That said, I would not advocate strong deterministic regulation that is politically nor socially motivated.  That is for smarter and folks, and not for this blog.  What is for this blog is a closer look at what financial services has learned and actually needs based on experience of the last 4 years in particular and how we got here.

What is regulation, and what is expected of regulation?

The purpose of regulation is presumably at its core is to provide control and protection of citizens.  At least that would be the basic belief of free market advocates.  Where regulation becomes shakey and on much thinner ground is when it is used to reshape society, business or groups of people.  This is the realm of social democrats whose desire is to make life better for certain segments.

This is where Dodd-Frank and EU Financial Directives are straying into dangerous territory that is fed by news headlines.  They are designing regulation in the name protection, yet there is an almost emotional aspect;  the one that focusses on bonuses as the largest example, but including prima donna chief executives, and general corporate greed.

Yet despite the relatively light 118 pages that made up the US banking system and which reduced by 37 when Glass-Steagall was repealed, we still had the 2008 crash.  Where the thinking falls off the rails, is that by adding 10 times more pages that the problem will be solved.

One of the largest fears exhibited by smart thinkers at the 2009 Davos meeting was that new regulation cannot be designed to solve problems that are in the past.  They should be, the argument went, be designed to solve future problems and provide stability.

This led to the entire Too Big to Fail discussion, and enormous bailouts and quantitative easing combined to kick the proverbial can down the road such that we are now dealing with a new problem.  We have the pre 2008 system with its global system of financial entangled products that far exceed commercial trade, now layered on with financial organisations that are so large that any one going down, would be so catastrophic in and of its self, even without the aforementioned global entanglement.

What regulation do we need, and what regulation are we getting?

At a high level, and having watched the events play out for the last 4 years, it seems quite clear, at a high level, that we need regulation that will accomplish 3 things:

  1. A soft landing break up of large financial institutions
  2. A soft landing unwinding of the consumer debt cycle, and (the 64 thousand $ question)
  3. A firewall between Government borrowing and the risks associated with points 1 & 2.

Instead the EU is looking at a myriad of rules that seem to be mirrored on Dodd-Frank.  The French are also pressing for a new tax on financial investment activity.  These are rules guaranteed to provoke unintended consequences that will have no bearing on the problems that need to be solved.

Why not do this:

  • Isolate a section of banking for consumers that seek it from financial risk. There was a time, and it was only 5 or 6 years ago depending on which country where deposits up to $60K – $100K had a government guarantee through the Federal Deposit Insurance Corp (or Canadian Deposit Insurance Corp, or UK £85,00 – wikipedia – deposit insurance).  While these legal limits remain, no-one believes it.  Everyone assumes entire banks and their deposits are protected.   The result is that trust is now focussed upward to Government and now the question is which government do we trust with our money?
  • Time to change that, and make it clear anything outside the deposit schemes are NOT protected.  This takes one line of regulation but has the largest potential impact.  If I was in government, I would insist on the Volker Rule/ Glass-Steagall to backstop this provision.
  • Keep regular consumer debt inside the utility banks.  The technocrats will figure it out with debt reductions, consumer proposals, debt re-arrangements.  Fancy words that will align real consumer debt with the allowances on the banks’ balance sheets.  Think 10 – 15 years; it can be done.
  • Fix Basle 3x to treat sovereign debt like any other debt.  Let analysts look at the debt servicing capacity of the nation, and determine the interest rate, or even whether to participate.  You will see the Eurozone rapidly decide who is in or who is out.
  • Peripheral point.  The Euro zone must be broken up.  This Euro currency is the dream of central European bureaucrats.  There is no basis in reality, nor popular expectation that aligns the bureaucrats dream with the average person.  There is too much mixing of disparate objectives (freedom of work, freedom of movement, social equality, none of which squares with the local pressures felt and political objectives required of the individual countries.

This would bring us to a period of utility banking.  Boring.  Just like buying water, and electricity.  But it is there for those that prefer the security of those basic services, which I would suggest are likely the majority of people.  When people go to the grocery store, or pay their phone bill they need to know the money that was there yesterday is still there.  This is the definition of utility banking, and even the richest person needs to know his debit card will work tomorrow.

Beyond utility banking, there are many with investments that seek additional return and they can look outside the utility banking framework.  Then there are another group with super investment needs.

Beyond utility banks let the remainder organisations create diverse and no doubt novel products that offer the services, returns and whatever else the customers desire.  They will succeed or fail; this is no matter for government.  Let these organisations design their products to attract utility bankers other needs beyond day to day payments, through novel design and products that provide a balance of risk and reward which fits with their customers risk profiles’.

A final point to note.  These risk-taker banks will be initially very attractive to governments (think London vs Paris) and governments will be motivated to design tax positive zones to attract them.  Let them.  Provided the three principles above are embedded it is their risk (and their citizens) to take on, but it is NOT the risk of other countries to support them.  (Euro-desingers take note.)

Relevance to Bankwatch:

Thank you Henry for focussing my thinking on the underlying problem with regulation.  Bureaucrats are making it at best too complicated and at worst wrongly directed.

There is no hope for banking innovation in my mind, until we first separate basic banking from the rest.  Only then can we have clarity of strategy and design on services that are either risky or risk free.  The amalgam we have today is more like a social safety net, that no-one believes nor trusts.

Written by Colin Henderson

February 20, 2012 at 16:23

Posted in Uncategorized

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4 Responses

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  1. Glass-Steagall Act took 4 years to be in place. This means that this year we need a new Glass-Steagall Act in place too.:)) It is not a question if we need the bank separation in place. It is only a question of time. The bankers and their shareholders do not need to wait for an act like this to be in place. It is a common sense decision to be made. It is a risk management strategy tool. It is a business development tool also, allowing each business unit to be on its own feet, focusing on flexibility. In this competitive world, flexibility is the name of the game. It allows you to be innovative and take quick actions to follow your customers.

    Mr. Horia Sas

    February 21, 2012 at 05:07

  2. […] you Colin for writing an interesting and though provoking post: “Real banking innovation requires a separation of basic banking from the rest of the financial ser…. Whilst  agree with most of the post I do not see why a separation is a requirement. I agree that […]

  3. This immediately sparks another question in my mind: are payments part of that utility banking service or are they a separate utility?

    Dave Birch

    March 1, 2012 at 08:50

  4. Its a great question Dave. Certainly in terms of consumer basics security of money (deposits) and movement of money (payments) at some level are as essential as electricity and water.

    Colin Henderson

    March 1, 2012 at 09:34

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