Is the BoE's Mervyn King's plan to break-up RBS brilliant today?

In his Telegraph column, Philip Aldrick looks at Sir Mervyn King's plan to break-up RBS into a good bank and bad bank and concludes that four years ago it would have been brilliant, but it would be a disaster today.

Actually, the plan would not have been brilliant four years ago or a disaster today.

Quite simply, the whole plan is unnecessary.

What is necessary?

First, Sir Mervyn King gets it right that RBS be required to recognize upfront all the losses on the bad debt currently hidden on and off its balance sheet.  This takes the burden off of the real economy to divert capital needed for reinvestment and growth to support the debt service on the bad debt.

Second, RBS must be required to provide ultra transparency and disclose on an ongoing basis its current global asset, liability and off-balance sheet exposure details.  With ultra transparency, market participants can confirm that RBS has recognized all its losses and exercise restraint on management's future risk taking.

Third, the UK government should avoid bailing out RBS as it is unnecessary.  The combination of deposit insurance and access to central bank funding mean that RBS can continue to operate and support the real economy even when it has low or negative book capital levels.  As a result, RBS can be left to rebuild its book capital levels through retention of 100% of pre-banker bonus earnings.

Royal Bank of Scotland should be broken up, the Governor of the Bank of England reckons. And not just that. It should be seized control of, restructured, split into a good bank and a bad bank, made to declare losses that would blow out the public finances, and finally be sold – or at least the good part – a year later. 

As an idea, it’s brilliant. It’s what the Scandinavians did in the 1990s during their banking crisis. It would also release the “good” RBS to support economic growth through lending, unencumbered by its disastrous past decisions. In fact, it’s a model that the Treasury has already put to good effect with Northern Rock. There’s just one problem. It’s not going to happen.

In fact, the Swedish Model is still effective today.  The issue is how to implement it.

Sir Mervyn King is four years too late. He argued for a good bank, bad bank split at the time of the bail-out in 2008, when he also demanded more capital be injected that would have certainly pushed RBS into “temporary public ownership”, as Labour insisted on calling nationalisation....

Sir Mervyn King's implementation was and still is flawed.

This is not surprising given that there are very few, if any, economists who actually understand the FDR Framework on which the western economies' financial systems are based.

Why don't economists understand the FDR Framework?

It is not covered in either their undergraduate or graduate course work.

Could economists understand the FDR Framework?

Of course, but it would require that they actually were open to listening to what anyone without an economics PhD says.

Regular readers know that under the FDR Framework banks are designed because of the presence of deposit insurance and access to central bank funding to be able to operate even when they have low or negative book capital levels.  Simply put, taxpayers become the banks' silent equity partners and, as if by magic, the banks have abundant capital to use to support the real economy.

Why was this designed into the FDR Framework?

To create a mechanism to protect the real economy from those times when banks and the financial markets created too much debt.

So why did governments bailout the banks?

The bankers wanted the bailouts as it insured that their bonuses would be protected while the real economy bore the cost of the excess debt (recall the principle of privatizing the gain and socializing the losses puts bankers first).

Sir Mervyn’s argument is that a broken-up RBS would support economic growth more than RBS as it is. That would be one hell of a gamble.

Actually, this is not much of a gamble as the RBS good bank would continue to support economic growth at levels that are at least as high as the current RBS consolidated good and bad bank is.

Despite Sir Mervyn’s unfair claim that “nothing has been achieved” at RBS since Stephen Hester took over as chief executive in 2008, RBS is on the road to recovery. Last week, it accelerated its restructuring – pledging to shrink the investment bank faster and float the US retail bank with two years.

In the absence of ultra transparency so that market participants could see if anything has been achieved, I will side with the financial regulator who actually has information from the bank examiners at RBS over a newspaper columnist who like myself is guessing what is inside the contents of the black box that is RBS.

Take control of RBS and the investment bank will haemorrhage staff. With less skilful people in charge to wind down the business, it could prove to be a time bomb – racking up far greater losses than currently....

Isn't 4 and half years enough time to wind down the business?

It is not clear that the current approach is minimizing losses.  We don't have any data to prove or disprove that.

What is clear is that the current approach maximizes bonuses paid to the bankers.

Given that there is no chance the politicians will follow through with Sir Mervyn’s recommendations, there can only be one explanation for why he would be so brash. His legacy. The Governor leaves office at the end of June, and he clearly wants to ensure he will be remembered for championing the little man – and battling against the banks. 

His comments will certainly achieve that. But they also expose him as insecure and lacking in the diplomatic statesmanship you would expect of a Governor. 

One more thing. RBS shares barely twitched at the threat of such huge disruption, which can only mean the markets are no longer listening.

The markets have already seen that David Cameron is incapable of admitting that his policies are wrong.

Here is Mervyn King saying that a response to the financial crisis has proven itself to be demonstrably wrong and that it is not too late to go down a different, better path (adopt the Swedish Model and require banks to recognize upfront the losses on the excess debt in the financial system).  A path that has been proven to help restart the economy which is a goal of Mr. King.

What the market are saying is that David Cameron is not capable of changing a failed policy that he inherited.

Imagine that, a politician who has no idea how to blame the other party for the problems in the economy.