Fix banking by separating ‘utilities’ from the ‘casino’, says Prof John Kay

The campaign to separate “utility” banks from the “casino” of financial markets has stepped up a gear, following an intervention from John Kay, the leading economist and author of The Long and the Short of It : A Guide to Finance and Investment for Normally Intelligent People Who Aren’t In the Industry.

By focusing on their post-crash regulatory efforts on building a framework for lumbering financial conglomerates that bridge the “utility” / “casino” divide but which are incapable of surviving without state aid, the politicians and regulators will only prolong the crisis, says John Kay.

In a paper for the Centre for the Study of Financial Innovation (CSFI) John Kay says there is no such a thing as “too big to fail”, and warns that the billions of pounds already pumped into the fragile financial sector have seriously distorted the market. The money is at risk of encouraging dangerously unethical behaviour in some banks.

John Kay, a fellow of St John’s College Oxford, said: “Companies [such as Citigroup and RBS which are the biggest recipients of state support] represent a concentration of unaccountable private power, answerable neither to an electorate nor to a market place.”

He believes policymakers ought to enact a modern-day version of the US’s Glass-Steagall Act, which separated retail and small business lenders from investment banks following the crash of 1929, but which was formally repealed by Bill Clinton in 1999.

John Kay on how the banks should be split

In John Kay’s scenario, “narrow” or “utility” banks would focus on the more boring activities of lending to individuals and small businesses and would be obliged to fund themselves through retail deposits. Such banks would be required to hold a high level of liquid assets in government bonds, and governments would guarantee to rescue them in the event they got into difficulties.

But John Kay believes that institutions engaged in investment banking activities, which can borrow crazy sums in order to perform proprietary trading largely so that their own executives can enrich (or impoverish) themselves, should still be allowed to exist. But he said the government should make it plain that, if such banks get into difficulties, they would be given the Lehman Brothers treatment and left to go to the wall.

Citing seemingly spurious reasons — including that “utilities” such as Northern Rock and HBOS failed during the crisis — the FSA chairman Lord Turner and chancellor of the exchequer Alistair Darling have already rejected John Kay’s proposal. Turner is among those who has said it “not feasible.”

Professor Simon Johnson, professor at the Sloan School of Management at MIT and a former chief economist at the IMF, this morning warned that the seeds of another financial crash already sprouted. If major banks are allowed to keep making crazy bets that are ultimately backed by taxpayer guarantees, they are certain to return to the recklessness that caused the 2008 crisis. “They will run up big risks, they will fail again, they will hit us for a big cheque,” he told the New York Times.