Andreas Whittam Smith: Obama's Wall Street reforms aren't nearly radical enough

When is a bank too big to fail? This conundrum lies at the heart of an intense debate about how to regulate the financial sector. As a matter of fact, as with all good conundrums, there is no answer. You cannot say that banks above a certain size are too big to fail and that the smaller ones can be let go if they get into trouble. For Northern Rock was a tiny financial institution and yet its collapse would have had dire consequences.

That is why Alistair Darling, Chancellor of the Exchequer, has rejected President Obama's proposals to reduce the range of activities in which large banks can engage. Mr Darling argues that such measures would not have prevented the crisis. "You could end up dividing institutions and making them separate but that isn't the point. The point is the connectivity between them in relation to their financial transactions."

But is connectivity really a better test? Each unit in the financial system is connected to every other unit, whether they are banks or not. It is like the party game in which one is asked how many steps are you away from, say, knowing the Pope. That is an easy one for me: I know the Archbishop of Canterbury and he knows the Pope. And Clint Eastwood? That would be harder. But I know a person who is likely to know somebody who in turn will know Clint Eastwood. The point is how few are the connections that are needed to reach almost anybody. The same goes for the financial markets. So connectivity cannot be the criterion because it would mean that every financial unit that gets into trouble, including non-banks such as money market funds, would have to be rescued.

As there is no useable answer to the question who is too big to fail, we should pose the problem in a different way. What is the special characteristic of banks and non-banks alike when they are classified as too big, or too connected, or whatever, and thus must to be rescued when they get into trouble?

It is that they are enjoying a guarantee from their national governments for which they pay nothing but yet confers on them the inestimable advantage that their solvency is protected in all circumstances. Whatever wild, reckless or stupid things that, for instance, Barclays Bank might do, there will still be a Barclays Bank, more or less the same as it is today, employing the same staff and managed by the same executives minus a few incompetents. For the rest of industry, that is emphatically not the case.

Banks are given this guarantee because many of their activities are in effect a utility, like the supply of gas and electricity. We can no more do without the means of money transmission and access to credit than we could get along without the availability of power at the touch of a switch.

Seen in this way, the problems with the present arrangements are manifest. They make no distinction between utility banking services – what is called narrow banking – and the rest. Moreover the all-enveloping nature of the guarantee encourages reckless behaviour. It also defrauds the taxpayer who receives no benefit – rather the reverse – from acting as a lender of last resort as well as a supplier of capital when all else fails.

That is why I favour a much more radical policy than President Obama has proposed. I believe we should split banking between "utility" and the rest and put each under separate ownership. We should then guarantee the former but not the latter, as was done in the US immediately following the Great Crash. In Britain, the Tories go some of the way. In reaction to President Obama they said they would seek to separate retail banking from investment banking at the "riskiest end" of the market. The Liberal Democrats pointed out that they, and Vince Cable specifically, have been calling for "narrow banking" since the crisis began.

It also looks as if the Governor of the Bank of England, Mervyn King, is in the same camp. In evidence to the Treasury Select Committee earlier this week, he told MPs that what the Obama proposals did was to "make very clear that radical reform is on the table and that is the most important thing". Looking deeply at the structure of the financial sector and asking radical questions about the structure is the right way to conduct the debate. "Tinkering" with capital and liquidity rules might not be enough to limit systemic risk. The UK might even have to consider unilateral action in the absence of an international consensus. In every respect, the Governor is right.