The banks must be broken apart

The recession has not lasted long for the banks. They are back in profit while the rest of the economy is still struggling.

This grim irony is bitterly unpopular with people without jobs or who are having to make do with less. Insult is added to injury when they read about the restoration of bank executives' bonuses. But the situation is not wholly unwelcome to the Government. It is keen to see the banks' balance sheets made whole again so that the taxpayers' money can be repaid. Nevertheless, if nothing – or something less than adequate – is done to make real changes to the banking sector, there will surely be another crisis.

What is to be done? The Government has set up an independent banking commission to answer that question. This ought to lead to radical reform when the commission reports next autumn, but will it? Unfortunately, signs of compromise have already appeared. The Government has required the commission to take into account the "competitiveness of the UK's financial sector". This may rule out recommendations such as breaking up the big banks which comprise in one entity a deposit-taking retail business and investment banking.

The big UK banks are indeed big. Six of them hold nearly 90 per cent of all retail deposits, which in the last resort the Government must protect. These banks are coming into profits which owe much to contributions from their investment banking arms. In the current debate, the big composites are being called, variously, "behemoths" or "universal" banks, depending on which side of the argument you are on. The bank "splitters" include Alan Greenspan, the former chairman of the US Federal Reserve. In October 2009, he said; "If the banks are too big to fail, they are too big." This is also the view of Mervyn King, the Governor of the Bank of England. But it is emphatically not the view of those who run the banks themselves, several of them, like Vikram Pandit at Citigroup and Bob Diamond of Barclays, investment bankers themselves. They can be relied on to argue vehemently that breaking up the banks by splitting off their investment banking businesses will make the City less competitive. Alan Greenspan had an answer to that too. "In 1911," he said, "we broke up Standard Oil. So what happened? The individual parts became more valuable than the whole. Maybe that's what we need to do."

Much has been written about the contrasting cultures of retail and investment banking. One is bureaucratic and conservative. The other is entrepreneurial and adventurous, concerned with a relatively small number of large and often innovative deals, whose fees are high, sometimes obscenely so.

The danger is that when the two cultures are housed in the same entity, the activities of the investment bank cannot be policed effectively. This type of failure can lead to the collapse of the composite bank and can endanger other banks as well. Governments are not prepared to see depositors lose their money, so a bailout becomes inevitable. The best way to encourage prudent behaviour in a risky business like investment banking is to expose its practitioners to the discipline of the market. Counter-parties who are familiar with the market are better judges of what is a reasonable risk than either a regulator or a management brought up in the traditions of retail banking.

It cannot be emphasised too strongly that regulators can only enforce rules. They cannot monitor the way risk-takers behave. The point was made forcibly by Lord Turner, the chairman of the FSA, in his 8 December article in the Financial Times on the regulator's investigation into the collapse of the Royal Bank of Scotland. "The FSA," he said, "simply did not believe our remit included preventing the ABN Amro acquisition."

Faced with the depression of the 1930s, the US President, Franklin Roosevelt, considered that it was necessary to separate "good" banks from "bad", and that nothing short of that would do. The Glass-Steagall Act of 1933 did just that. The House of Morgan was split up into its retail and investment banking constituents and, like Standard Oil before it, the constituents were found to be more valuable than the whole. It is true that comparisons between the Great Depression and today's hard times can be misleading. But there is, if anything, a stronger case for radical banking reform now, because the banks were the immediate cause of this recession, whereas the depression of the thirties started on the Stock Exchange.

The sector now is in need of reform. The pictures of small depositors queuing outside branches of Northern Rock for their savings cannot be allowed to be seen again. The danger of that happening cannot assuredly be dispelled so long as deposit-taking banks are permitted to carry on the risky business of investment banking as well. It is to be hoped that the banking commission will have the courage to say so.

The author was adviser to the Hong Kong government after the 1987 financial crash