Illustration: Jim Cooke

From the 2008 recession all the way through to the current presidential campaign, reformers of all types have been advocating for a breakup of the world’s biggest banks. Why? And how? We have just the right author to explain.

David Shirreff is a veteran financial reporter with The Economist and author of the new book “Break Up The Banks! A Practical Guide to Stopping the Next Global Financial Meltdown.” We questioned him about what breaking up the banks would mean, how to make our financial system safer, and what might happen if we don’t. (European spelling is his, and it’s just fine.)

What in your view was the biggest missed opportunity for financial reform in America after the 2008 recession?

David Shirreff: The failure to impose radical cultural change when the biggest banks were bailed out, There was an opportunity to break up complex banks and drive the bonus culture back to where it comes from – Wall Street firms whose partners share the gain and the pain. But the government lost its nerve after forcing the banks to accept state capital and a temporary $500,000 cap on pay. It should have kept up the pressure while it had them on the hook.

New rules are requiring big banks to hold more money in reserve as a cushion in case things go bad. Is this enough to protect against the risk of them blowing up?

Shirreff: No. Forcing them to add more capital is not the remedy when the business model of these banks is broken. The old guard – still nicely rewarded - are reluctant to change the way they operate. But as new regulation and global recession bite these banks aren’t making the trading profits that they used to. They should downsize, simplify what they do, and unload assets. That is the way to make these banks safer.

You advocate breaking up huge global banks into separate entities for separate purposes—retail banking, corporate banking, and investment banking. Big banks would say that their size and variety of services are good for customers. Why are they wrong?

Shirreff: They are wrong because the main reason that they decided to put all these businesses under one roof was to obscure the cost and risk of each activity. One activity subsidises, or is subsidised by, another. The bank’s biggest customers may think they benefit from this one-stop-shop arrangement, but that’s lazy: they should be taking prices from more than one bank. The smaller customer certainly does not benefit. He’s usually the one who does the subsidising. So why should I, as a small customer, put my deposit with a global investment bank?

You advocate a return to the “partnership model” of investment banking. Why is that safer than what we have now?

Shirreff: A partnership model is not a appropriate for a giant, complex institution, but it is for a specialist investment bank. The advantage of a partnership is that partners share any losses as well as the gains. So they are less likely to take reckless bets. The partnership model poses less risk to the system than a giant bank with a bonus-pool culture.

If investment banking returned to the partnership model the activity would probably benefit from much lighter and less costly regulation than it is threatened with today.

And how does the way bankers are paid effect the risks that banks decide to take?

Shirreff: Employees who know they will share a bonus pool, which pays out even if the bank makes a loss, are far more likely to risk the bank’s or other people’s money short-term for personal gain. Worse than that, the perverse incentives offered by the bonus culture today affect the behaviour of the entire sector. The rewards even today are out of scale with other sectors. Employees and cliques within banks put themselves first, before shareholders, customers and the institution itself. Clawbacks and the deferral of payouts do not correct the problem. The bad incentive culture is alive and well.

What are your thoughts on a financial transactions tax, as some have proposed?

Shirreff: I like it as a way of putting a brake on some types of needlessly high-volume trading. It might also reduce the volume of securities lending and repurchase agreements, which are a means for hedge funds and other traders to take leveraged speculative bets - financed usually by banks and insurance companies. In my view that in turn would reduce the risk exposure that big banks run daily with hedge funds. We should worry about hedge funds only because their failure might trigger bank failures, (That was the main reason Long-Term Capital Management, a hedge fund, was rescued in 1998.)

What can average people concerned about the possibility of another global financial meltdown do—and where do you recommend they keep their money in the meantime?

Shirreff: I don’t see myself as an investment adviser. People concerned about another meltdown should buy the safest asset they can think of, which might be an insured bank deposit or an index-linked US government bond, or a house. But that’s not very helpful, is it?

David Shirreff’s new book is available here.