Evercore Pan Asset

I have always been careful to go along with the conventional wisdom that there are banks that are too large to be allowed to fail. No sensible person wishes more carnage in markets, and few enjoyed the collapse of Lehmans.

To concede that does not mean, however, that I have to support the huge sums of money the UK government has made available to bail out bad banks, and certainly does not mean I agree with buying shares in them which can delay sorting them out. If the authorities are foolish enough to get themselves into the position where some banks are too big to fail, it is even more important they take prompt action to break them up so they cease to be too big to fail.

The correct strategy with an unwieldy conglomerate like RBS is to break it up into its constituent parts and find answers for each of them. Some could be sold immediately. Some will need managing to health and some like the Investment bank can be closed down after the bits of value have been sold. You should also keep RBS short of capital and cash to force it to raise more of its own, and to prevent it from paying the absurdly high salaries and bonuses it is still paying when it is no longer making profits and raising private money to do so.

This is a good policy for the taxpayer, cutting the taxpayers risk and getting some cash back. It is a good policy for the banks’ customers, leading to more banks and therefore more choice in the marketplace. It is a good policy for the regulators, making it easier to see what is going on with each business having its own balance sheet and its own more visible and accountable management team.

The dangers of the present UK policy is the easy access to taxpayer capital will delay the weak banks from owning up to the overriding need to cut costs, to cut out loss-making business, to recognise losses on their trading and investment portfolios and to get themselves quickly into a shape where they can sustain themselves again. We need less banking than we had, less gearing than we had, and fewer fancy financial instruments than we had. We need rather more bank facilities than are currently available, and more money circulating productively through the system.

The Competition authorities were asleep on the watch in recent years. They should not have allowed the Lloyds/HBOS merger, nor some of the constituent mergers that created RBS. Allowing banks to become that big does damage the market, putting too much banking under common decision-making and ownership.

The regulatory failure in the UK occurred thanks to the tripartite system created in 1997. Splitting responsibility for banks’ capital and solvency by making the Bank of England responsible for the banking system and making the FSA responsible for individual banks, left the Treasury in ultimate control to ensure there were no cracks between the regulators. Unfortunately there were.

This system failed to see the obvious. Banks were allowed to expand their balance sheets far too much. It does not take more people to work that out. Just one person who knew what they were doing could have seen that the top four banks were all expanding too quickly and had too little capital in relation to the amount of business they were writing. If I could see that from the sidelines, surely the Chancellor could see it aided by all the advisers he enjoys at the Treasury, Bank and FSA? The authorities had the powers to make sure banks have more capital for any given volume of business and should have used them.

In the summer of 2007 I wrote:

“… there is considerable uncertainty about how far the Fed, the ECB and the Bank of England may go in raising rates to squeeze inflation out of the system. They must know there are huge pyramids of debt throughout the system, and inflation will not be killed unless the appetite for more debt is blunted. They also know that if they push interest rates too high for too long they could bring the debt structures crashing down, as we have seen with the sub- prime mortgage collapse in the USA, leading to falling asset prices, rising unemployment and even recession. “

Today we know they did not understand just how precarious the system had become. The MPC misjudged the length and severity of the squeeze they needed to administer. As a result we have banks that are badly weakened by the excesses prior to 2007 and by the tightening of 2007-8. We need to work our way through those difficulties as quickly as possible. Sterling and the prospects for UK markets rests to a considerable extent on how long it takes to sort the banks out and how much damage finally emerges from that process. Given the size of the banks, and given the degree of financial risk now resting with taxpayers, we remain of the view that there are better investment opportunities elsewhere. We continue to avoid UK equities.