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A three-way split is the most logical

By John Gapper

Published: October 28 2009 20:37 | Last updated: October 28 2009 20:37

When the history of the global financial crisis is written, it may record that Neelie Kroes, the
European Union’s competition commissioner was the only politician willing to respond in a
logical manner.

By insisting on the break-up of the ING Group into its banking and insurance divisions –
and on it divesting its US direct savings arm – Ms Kroes set a welcome precedent this week.
She made a troublesome too-big-to-fail institution shrink.

The US, meanwhile, is joining the UK and others in proceeding in the opposite direction.
Rather than making the Citigroups and Deutsche Banks of the world get smaller, they are
bolstering them and preparing to deal with them next time they sink.

As Terry Smith, chief executive of the broker Tullett Prebon and a former banking analyst,
puts it, this is “like the designer of the Titanic arguing that the provision of extra lifeboats
would solve the problem”.

Along with Ms Kroes, central bankers including Mervyn King of the Bank of England and
Paul Volcker and Alan Greenspan, formerly of the US Federal Reserve, and now,
improbably, John Reed, an architect of Citigroup, I prefer the simpler, sterner approach.

My colleague John Kay has described this as splitting banks into utilities and casinos – or
deposit-taking banks that need to be backed by governments and investment banks indulging
in proprietary trading that do not.

I think a more logical division would be a three-way split into utilities, casinos and people
who visit casinos to gamble. That means retail banks, investment banks and asset managers,
including private equity and hedge funds.
It may sound like a three-way split rather than a two-way one is a fine distinction. Yet it
matters because this mix of businesses is what many too-big-to-fail institutions contain, with
all the conflicts of interest and systemic problems it creates.

A country that was brave enough to enact a Kroes-like split would be left with three types of
institutions (or four if you count insurance companies).

First, there would be retail banks, gathering deposits and using them to lend to individuals
and small and medium-sized businesses. Such institutions, like the old UK clearing banks,
would be tightly regulated, operate boringly and predictably, and be bailed out if necessary.

Second, there would be corporate banks, which would offer advisory, capital-raising and
underwriting services to large companies and investors. Like traditional US investment
banks, they would fund themselves independently without the backstop of a retail balance
sheet. That would require, for example, Barclays Capital and the investment banking arms of
UBS Deutsche Bank and JPMorgan to be spun off from their parent banks and operate
independently. If they ran into trouble, they would be allowed to fail.

Such banks would have to operate with much less leverage, more capital and greater balance
sheet liquidity than at the height of the financial bubble through sheer market forces. Unless
they did so, they could not fund themselves.

“There is a huge amount of embedded leverage in the investment banking arms of European
banks that would have to be wound down if they were to stand alone,” says Davide Taliente,
a partner of the consultancy Oliver Wyman, which does not support splitting up banks.

That sounds like a good thing to me. One problem of investment banks is that their
employees have an incentive to take risks with capital for which they are not paying the full
cost. Forcing these banks to confront the cost – and fragility – of capital head-on would help.

The final step would be to force investment banks to halt pure proprietary trading and to
divest their asset management arms. Everything from management of mutual and hedge
funds to private equity would be done independently.

Investment banks such as Goldman would, of course, scream blue murder if they were told
to shed asset management (although Morgan Stanley might well choose to be an asset
manager rather than a bank) but it would have several benefits.

To start with, it would reduce the risk profile of investment banks by removing proprietary
trading. They would still be taking capital risk in market-making but the high octane trading
desks would be gone.

It would also end the conflicts of interest in investment banks managing an opaque cocktail
of their own and other people’s money while simultaneously being advisers and financiers on
private equity deals.

Last, it would create an asset management sector in which large firms could co-exist with
hedge fund managers and even boutique proprietary trading desks (if they could raise the
capital outside the fold of investment banks).
These could take whatever risks they chose with investors’ money, provided they were honest
about it, and pay themselves what they could get away with. The government would know
that these gamblers would bear their own losses.

Some politicians and regulators have argued that modern-day finance is too complex to be
divided and those who suggest such divisions are being simplistic. But a three-way split
would be easy enough to implement given the will.

There lies the rub. So far, Washington and London show no signs of being as forceful as Ms
Kroes (and Paris and Berlin would no doubt resist the splitting of universal banks). At least
someone has done something.

john.gapper@ft.com
More columns at www.ft.com/gapper