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'Ring Fencing' UK Banks

Government Regulation
CNBC.com
Government Regulation

The report from the UKs Independent Commission on Bankingoverestimates the competency of regulators.

The commission said on Monday that the UK's biggest banks do not need to be broken up to reduce systemic risk. Instead, they should be forced to hold more capital and 'ring fence' retail units so they cannot be brought down if a bank's trading and investment units fail.

This ring fencing idea sounds good in theory—but only in theory. We saw in the collapse of Citigroup's SIVs and Bear Stearns' hedge funds, and we learned that pushing something into a supposedly separately capitalized and non-guaranteed subsidiary does not really help in a crisis. The failed units get forced back on the books of the broader bank.

The commission imagines that clever regulators can prevent far better paid and typically better educated bankers from undermining the separation of retail and speculative enterprises. But this situation has never worked outside the imaginations of regulators.

Bankers find ways to get their institution to draw profits from the off-balance sheet entities—through loan commitment fees, management fees, brokerage fees, and interest payments—and those relationships inevitably compromise the 'ring fence'.

Incidentally, this system of underestimating bankers and overestimating regulators works out very well for the bankers. It almost seems designed to allow them to accumulate risk and profits in good times, while fobbing off losses in bad times.

You can almost imagine the British bankers fighting off the urge to smirk while telling the regulators: Oh, what a delightfully clever plan you have hatched! There's no way we'll ever be able to get up to any naughtiness under all these new rules!

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