Wrong Diagnosis & Prescription: Osborne is wrong on banking separation

Osborne’s Banking Reforms Would Not Prevent Another Crash

It must be politically very appealing for the Chancellor and his colleagues to try and perpetuate for public consumption the narrative that a, if not the, principal cause of Britain’s 2007-08 banking crisis was the non-separation of retail and investment banking. Asserting, over and over again, that it was mainly the reckless mixing by irresponsible banks of “high-street” and “casino” banking that ended up requiring the UK taxpayer to bail out the banks that failed, makes it easier to pretend that the banking reforms he announced on Monday 4th February will go a long way towards ensuring this never happens again.

Unfortunately, he’s being simplistic and disingenuous, both about cause, and remedy. The mandatory separation of retail and investment banking operations he talked up as a preventive to another crisis partly implements some of the recommendations of the Vickers Commission, and is an improvement: but to imagine that the separation and ring-fencing of retail from investment banking is a panacea for all ills, and safeguards against any future failures or bailout needs, is a mistake.

Taken in isolation, the Vickers recommendations on this score are something of a red herring. Four out of the UK’s five banks that needed taxpayer bailouts were in fact almost entirely retail operations, with either no or insignificant investment banking activities, and it was the retail operations which failed. The investment banking involvement in their failures came from their use of mortgage-bundling instruments and derivatives which they contracted from investment bank counterparties, as part of their attempts either to leverage profits or procure matching funding for their own over-exuberant lending as deposit growth dwindled. But those packages of sub-prime mortgages that investment banks traded started life as poor-risk loans in retail banks and building societies, whose failure was primarily due to their own mismanagement of lending and risk.

The table shows the main players in the 2007-08 crisis, split according to whether (a) they needed taxpayer bailout, and (b) whether they had significant investment banking operations.

Significant Investment Banking?



Needed Bailout?


Royal Bank of Scotland Northern Rock

Bradford & Bingley

Alliance & Leicester






Lloyds TSB

Standard Chartered


The results are quite instructive. Of the investment banks, only RBS actually failed and required a bailout: and it failed, not because of its investment banking activities per se, but primarily due to its pressing ahead through management hubris with the acquisition of the Dutch ABN-AMRO, and at an inflated price on woefully inadequate due diligence which overlooked the toxic assets sitting in ABN-AMRO’s books. However, Barclays and HSBC recapitalised themselves, one externally and the other internally, with no governmental support, and Lloyds TSB would have emerged unscathed had it not been pressured by Gordon Brown into a takeover of HBOS – only to find, again after unsatisfactory due diligence, that HBOS’ balance sheet was so stuffed with bad assets as to stymie LTSB’s own survival outside public ownership.

On the retail banking businesses, statute-backed separation of retail and investment banking assets and reserves would have done little or nothing to prevent the collapse of Northern Rock, HBOS, Bradford & Bingley, or Alliance & Leicester. They had little or no investment banking operations of their own: they collapsed because their funding model for their retail bank mortgage book relied on a constantly revolving re-supply of short-term liquidity from wholesale money markets, which petered out when institutions’ concerns about the poor quality of each others’ debt led to the freezing of inter-bank credit markets from 2007 onwards.

The horizontal integration of retail and investment banking played a part in the genesis of the crisis, as investment banking operations utilised retail arms’ capital to boost gearing and reserves: but this was an amplifying effect, not a causative effect. The failures which occurred were attributable mainly to poor business and risk management by boards and executives, and inadequate scrutiny on the part of regulators, auditors and shareholders, not largely because of the systemic structure of the industry.

So Osborne’s separating and ring-fencing of retail from investment banking, on its own, does little to prevent retail failure stemming from mismanagement. For all its non-efficacy, though, it will probably be done, and will probably give the public a false sense of security. Until next time.

Of more use in preventing another banking crash, however, would be measures designed to move the industry away from the state-protected, crony-corporatist model which has built up over the past 50 years, with risk reverting more to shareholders and bondholders, rather than taxpayers. That would mean no implicit state bailout guarantees or “too big to fail” assumptions creating moral hazard, and reduced barriers to entry, more competition, and risk dispersed more widely around the system with  less concentration in a few institutions which become systemically critical because of size. For the cautious, non-radical Osborne, however, that would be several steps too far.


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