Davos: Where the battle for financial reform was lost?

BBC business editor Robert Peston on overhauling the banking system

The eminences at Davos aren't always that brilliant at spotting the next crisis, even when it's under their noses. I was at a meeting on Wednesday at which an intelligence specialist assured us all that Egypt would not turn into an inferno of protest, only hours before the portals of chaos opened.

That said, the response to the Egyptian crisis from world leaders, from government, business and civil society was fast and coherent: President Mubarak was left in little doubt that he is an isolated figure, who would be spurned by the global elite unless he listens to the voice of his people.

But what about when crises abate, and we're left with the hard choices about how to make the world safe again for a generation?

As you'll have guessed, in this instance I am talking about two of my obsessions: how to mend the banking and financial systems; and how to fix the eurozone.

Here, some would argue, Davos shows all the flaws in the world's system of governance for issues of significance for the entire world.

Because as the great crash of 2008 has become a hateful memory rather hard painful reality, and as there are signs of strengthening recovery in the US - still the world's biggest and most important economy - the voice of reform is increasingly drowned out by the voice of those claiming that everything is broadly okay again and time will be the greatest healer.

Two contrasting synopses of where we are: "The boom is back" said one of the world's more powerful bank bosses; "We're beginning to lose the battle for change", said an influential regulator.

Those two statements are connected: the more that some kind of apparent "normality" returns to economic life, the more that politicians fear a return to recession caused by the short-term effects of further measures to strengthen banks (for example).

It's this tension between short term prosperity and long term stability which could bring the reform train to a grinding permanent halt.

In that context, two of my conversations with decision-makers stand out.

First, a senior member of the French government told me that President Sarkozy would oppose any capital surcharge on Globally Significant Financial Institutions, or the mega banks.

The French reject the need to require the largest banks to hold more capital as a protection against potential losses than other banks - even though many central bankers and regulators now accept that the enormous interconnected balance sheets of the mega banks are the San Andreas fault of the financial system and global economy.

Why does the French government oppose any requirement on the biggest banks to hold more capital than the new Basel minimum?

Well, it's because giant eurozone banks are warning that if they have to increase the ratio of their capital to their loans and investments further than they're already being required to do, the likelihood is that they'll do this by restricting how much they lend - thus snuffing out anaemic eurozone recovery.

And an alternative for eurozone governments of their taxpayers injecting capital into eurozone banks to strengthen them is profoundly unappealing to most governments - especially at a time when some of these governments are struggling to fund and reduce fiscal deficits.

That said, if eurozone banks were better capitalised, arguably investors would be less reluctant to finance not only those banks but the states standing behind the banks (though few eurozone ministers quite yet see how intimately connected is the perceived weakness of eurozone banks and the eurozone itself).

So why does opposition to a mega-bank capital surcharge from the government of a medium size economy like France actually matter?

Well, it's because agreement on a capital surcharge can only be reached if all the G20 countries sign up for it. And that looks highly unlikely, especially with France as current chair of the G20, able to control the agenda and priorities for the world's most powerful decision-making collective.

Now the second conversation that resonated most for me was with the head of one of these globally significant financial institutions. He was musing on the possible implications of any kind of attempt to forcibly separate investment banking from retail banking, either by the explicit break-up of universal banks or a requirement that universal banks (like his) put all their investment banking operations into discrete, separately capitalised subsidiaries.

What he said was that it was all very well for the UK's Independent Banking Commission to muse on the theoretical benefits of such separation of retail and investment banking, but the Commission was not on planet Earth: the interconnection of retail and investment banking is now so intense, thorough and complex that it would be impossible to unscramble.

There are two aspects to this. First, that it would be pointless for the British government to unilaterally mandate such separation, because a bank like his would simply transfer all its international investment banking out of the City of London to operations elsewhere in the world.

Second, and more importantly, such separation would be a legal, logistical and economic nightmare.

How so?

Well, hundreds of billions of dollars have been lent to mega banks like his on terms and at interest rates that were set on the basis that the loans were to the bank as a whole, not to just the investment banking part or the retail banking part.

So if the bank were split up, all of those borrowing agreements would have to be renegotiated - an almost impossible task, which would take years and enrich only the legal profession.

And, what's worse, the uncertainties created by the renegotiation could well lead to a funding freeze for all universal banks subject to the new stipulation that retail and investment banking should be separated. Which at best would prevent these banks from lending and at worst would bankrupt them.

So let's think about this for a moment. How likely is it that the Chancellor George Osborne would wish to call the bluff of Barclays, HSBC and RBS by ordering that they put an unimpeachable legal wall between their investment banks and retail banks, against their advice that to do so would risk destroying them and the British economy?

The chancellor could decide that the appropriate response to any recommendation from the Banking Commission for separation of retail and investment banking would be to argue for this in the G20 and at the EU Economic and Financial Affairs Council. But given that unease with the structure of universal banks appears to be a largely British pre-occupation, that would probably be to consign this kind of organisational and formal change in banking to the dustbin of history.

Perhaps I am mistaken. But I made my meandering escape from Davos largely persuaded that those arguing for a radical overhaul of the global banking system may already have lost the war.

You can keep up with the latest from business editor Robert Peston by visiting his blog on the BBC News website.

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