How Darwin would reform Britain's banks

Top down design is flawed even in finance

By Matt Ridley

It is not yet clear whether the current rage against the banks will do more harm than good: whether we are about to throw the baby of banking as a vital utility out with the bathwater of banking as a wasteful casino. But what is clear is that the current mood of Bankerdämmerung is an opportunity as well as a danger. The fact that so many people agree that some kind of drastic reform is needed, all the way along a spectrum from Milibands to mega-Tories, might just open the window through which far-reaching reform of the financial system enters.

All the actors involved bear some blame. First, investment bankers and the principals in financial companies that cluster around them have trousered an increasing share of the returns from the financial markets, leaving less for their customers and shareholders, while getting "too big to fail", so passing their risks to taxpayers.

Second, regulation has failed. As Niall Ferguson argued in his recent Reith Lectures, the perverse consequences of bad regulation bear more responsibility than deregulation, especially given the lack of banking trouble in lightly regulated Australia and Canada. With a Financial Services Authority handbook that runs to 6,000 pages of rules, evidence of rampant deregulation is hard to see.

Examples of bad regulation are legion: the easily gamed Basle capital rules; the US Congressional mandates that virtually forced mortgage lenders to increase lending to those who could least afford loans; the hyper-regulation of British customers in the name of preventing money laundering, making it far harder to move your account, in stark contrast to the minimal regulation of the cosy Libor-setting cartel (or "cesspit" as the Bank of England's Paul Tucker called it).

Third, central banks have failed. What we might call the Greenspan- King doctrine - that central banks should intervene by cutting interest rates if asset prices fall, but not if they rise thanks to cheap money fuelled by a deliberately undervalued Chinese currency - was merely the latest example of central banks actively, if unwittingly, encouraging volatility.

Enough diagnosis. What is the cure? A change of personnel will not do it. The search for chief executives who are not motivated by greed and for regulators who are sufficiently god-like to know how to design rules that cannot be gamed will never succeed. The truth is, the financial system, like the whole of human society, was not designed in the first place; it evolved. And the answer is to allow a better one to evolve.

My own personal experience reinforces my view here, as I was chairman of Northern Rock when it ran into trouble. During that crisis it quickly became clear that not only did I not fully appreciate the liquidity risks in the markets but nor did far more expert people, including rivals and regulators.

That experience, plus some appreciation of evolutionary biology, makes me suspicious of utopian solutions. Regulating Libor will not prevent a scandal somewhere else; reinventing Glass-Steagall's separation of retail and investment banking would not have prevented the failure of Lehmans or AIG; paying executives in shares rather than cash to lengthen their horizons has been tried and it failed; a culture of compliance can become lethally complacent.

What we need is an evolved, organic, bottom-up system that hands power back to customers and gets innovation working on potential improvements. The way to get that is to open up the banking sector to plentiful competition, dismantling its cosy, crony oligopolistic structure - in which, for example, the biggest customer, the Government, hands the bigger firms handsome income streams from the taxpayer for bond issuance.

So the first task is to tear down the barriers to entry that have prevented the emergence of new clearing banks for decades. Make it much easier not just for the supermarkets' new banks but for mobile phone companies to set up financial services systems as they have so successfully in Africa where few people are trapped in conventional banks. Make it easier for customers to move between banks. Punish size - make regulation fall more heavily, not more lightly, on the biggest companies. And break up the state-owned banks into small units before selling them. Innovation would then follow.

In the future we could open up the world of currencies so that you are neither limited to using pounds nor even to traditional forms of money. Transactions could be in synthetic digital currencies such as mobile phone credits (already big business in Africa) or something yet unheard of. Such ideas about competition between currencies should be encouraged, not stomped on by a jealous state monopoly.

The one politician who is thinking hardest in this way is a radical Tory MP, Douglas Carswell. He points out that Germany has 2,000 banks, most of which are utilities serving local businesses, not casinos serving gamblers. There is nothing inevitable about the concentration of banking into a stodgy oligopoly of banks as in this country - a concentration that has only grown as a result of the crisis, since Barclays now owns Lehmans, Lloyds owns HBOS and Bank of America owns Merrill Lynch.

Mr Carswell would reinvent Glass-Steagall's distinction between investment and retail banking but horizontally within banks rather than vertically between them. Under his system, when you deposit a sum at the bank you would tick one of two boxes. Box 1 would mean the money remains yours and the bank just stores it for you, safely, and probably for a fee.

Box 2 would mean the money would be lent on by the bank in the normal "fractional-reserve" way, with the promise of interest. Only Box 1 money would attract a deposit guarantee from the State.

Who knows how much money each box would attract? The traditional divisions of banks would have to sharpen their act to attract customers. And any institution that could not convince many people to risk their money in this way would automatically have a higher capital ratio. No need for an artificial calculation.

As Adam Smith and Charles Darwin showed, you cannot plan an economy or predetermine innovation any more than Mother Nature can design an ecosystem or a giraffe. These things evolve. So banking reform must concentrate on finding a mechanism to put trial and error to work, not on defining a perfect system that only works with angels in post.