Liberal Democrats, are in favour of the forced break-up of the likes of Barclays and Royal Bank of Scotland into so-called narrow banks

TO BE NOTED: From the BBC:

"Making banks safe

Robert Peston | 12:05 UK time, Tuesday, 28 April 2009

Let's talk about banks' capital ratios, or the amount of capital banks are forced to hold as a proportion of their assets (or their loans and investments).

Stay awake. This stuff matters to you.

For those who don't know, banks' capital is a buffer against the losses they always face on lending and investing.

It's supposed to be the guarantee to depositors like you and me that we wouldn't be damaged when banks' loans go bad or when banks lose money on trading in securities: the hurt would instead be felt by shareholders and other providers of assorted forms of risk capital.

Now one of the main reasons the global economy is in such a mess is that big banks systematically lent far too much relative to their capital resources - which is mainly their fault but also that of numpty regulators, who allowed banks to drive a coach, horses and an entire wagon train through international rules that were supposed to ensure they kept adequate amounts of capital.

A few banks - such as Royal Bank of Scotland, Switzerland's UBS, Merrill Lynch and Citigroup of the US - took leave of their senses with their manic lending (by the way, the FT's Gillian Tett gives a particularly hair-raising account of their descent into madness in Fools' Gold, her new book).

The way most banks stretched their capital resources in their lending sprees both pumped up a dangerous bubble in asset prices and meant that when the bubble burst they didn't have enough capital to cover the losses.

So taxpayers, all over the world, had to step into the breach.

We taxpayers have pumped hundreds of billions of dollars of new capital into banks - we've nationalised or semi-nationalised loads of them - because the alternative of allowing the banks to fail was too scary for governments to contemplate (there was no desire to see the mobs of anxious depositors which formed outside Northern Rock's branches in September 2007 turn into a rampage outside most other banks).

But to state the bloomin' obvious, this global banking rescue is not something we'd want to repeat in a hurry.

It's quite important therefore that measures are taken to minimise the likelihood that banks will again systematically extend far too much credit relative to their capital resources.

However, closing this particular stable door is by no means simple, for two main reasons:

1) banks are global businesses, so new rules will have to be agreed by governments and regulators all over the world (never easy);
2) if we clumsily implement hastily and crudely devised requirements that all banks have to hold vast amounts of additional capital relative to their assets, there could be a permanent and significant reduction in the availability of credit - which could significantly reduce the potential for future global economic growth (we could all end up poorer from our natural desire to have a safer banking system).

For me, one of the big questions (about which there has been almost no public debate) is whether we should endeavour to make safe the global financial system that developed over the past few years - characterised by massive flows of capital across borders and the packaging of debt into securities for sale to investors - or whether we should give that up as a bad lot and regulate ourselves into a simpler but possibly poorer world, in which credit extended in any particular country is more closely matched by savings in that country.( NB DON )

The efforts of most governments, including our own, appear to be to sanitize the globalised status quo. It's obvious in our case why that's happening: as a nation, we don't save enough to meet households' or businesses' demands for credit (so we have to import credit from abroad).

But our government is doing its best to preserve the structures of financial globalisation, without explicitly making the case for doing so.

By contrast, it's possible to see in the words and deeds of the governor of the Bank of England that he believes some important elements of financial globalisation need to be rolled back (the Bank of England has, for example, been much more cautious about helping to rekindle securitisation - the conversion of debt into tradable securities - than Downing Street would like).

Here's the danger: we'll muddle through and devise yet another sub-optimal regulatory system.

Some of the second order issues were aired yesterday by Adair Turner, chairman of the Financial Services Authority (although he raised one very important question, which is whether financial innovation will always engender instability, and whether it's now clear that the costs of that instability outweigh the benefits of innovation).

Strikingly Turner said he was "open-minded to a [proposal]...that large systemically important 'too-big-to-fail' banks should have to maintain higher capital ratios than applied on average".

This is a nod to an idea that the chancellor is planning to float in a couple of weeks in a white paper on reforming regulation of the banking system (and the US authorities are moving in the same direction).

For what it's worth, there are two reasons why it might make sense to force our biggest and most complex banks to hold more capital than their smaller, simpler peers: if big super-banks have the privilege of knowing that we as taxpayers would always bail them out in a crisis, surely they've got to put in place treble protection against the risk that they'd call on us for such help; also the costs of holding the extra capital might encourage them to slim down and simplify their operations.

That said, such a regime could achieve the precise opposite of what would be intended.

The public imposition of a higher capital requirement on, for example, Barclays than on smaller, simpler banks would be a public declaration that Barclays would never in any circumstances be allowed to collapse.

And, paradoxically, that could give an unfair competitive advantage to Barclays - because safety-conscious depositors might well choose to give Barclays a disproportionate amount of wonga in the belief that there are no circumstances in which that wonga could be lost.

Which is partly why some, like the Liberal Democrats, are in favour of the forced break-up of the likes of Barclays and Royal Bank of Scotland into so-called narrow banks, so that these sorts of competitive distortions are minimised and so that banks don't abuse ordinary depositors' cash by gambling it in the supposed casinos of wholesale markets.

As I've recently noted, the Tories have also come out in favour of dismantling the big banking conglomerates - and Mervyn King, the governor, has said it's an idea he would like explored properly.

Even so, Lord Turner isn't in favour of the prohibition of Barclays-style universal banks, and nor are the chancellor and prime minister. They believe that delineating wholesale banking and retail banking in a clean way is easier said than done.

Certainly what's been striking over the past 20 months is that disaster has not been confined to one kind of bank: there have been egregious losses and humiliation for universal banks, such as Citi, UBS and RBS, as well as for narrower, more specialised banks, including Lehman, Bear Stearns, Washington Mutual and Northern Rock.

Oh, and lest we forget, the single biggest stimulator of the excesses of the banking system wasn't a bank at all: it was AIG, whose crazy insurance of financial products gave banks the lethal confidence to lend to those who could never repay."