The UK has committed itself to an independent review of its own banking system. Although the international bank regulators, the so-called Basel Committee, have come up with some major proposals (named ‘Basel 3’) that are designed to help make global banking a safer place, the UK (like many other countries) is also concerned that its banks are strong and that the needed lessons are taken from the crisis. For the UK this is particularly important. Banking and financial services are big contributors to the economy. London is one of the world’s major financial centres and it has always been a global banking hub. The UK also has some banking behemoths and there is now a global concern that some banks are apparently ‘too big to fail’.
Under the chairmanship of the highly respected Sir John Vickers, the ICB (Independent Commission on Banking) made its eagerly awaited Interim Report in April, 2011. Although the main proposals are far-reaching, some will continue to argue that they are not nearly strong enough. Many argue vehemently that the banks should be ‘punished’ for their alleged excesses that helped fuel the crisis. The continuing concerns with bankers’ pay and bonuses are seen to be reflective of a rapid and thinly disguised banking return to ‘business as normal’. There are widespread concerns on the apparent poor showing of banks and their regulators in the build-up to the crisis.
On one important matter, though, there is no real argument. Banks and banking are particularly important to the well-being of any economy. Love them or hate them – we just cannot do without banks. If anything, the crisis has strongly underscored this stark reality. So it is important that we get ‘banks and banking’ working in a way that maximises their input into the economy.
Against this backcloth it is hardly surprising that Sir John’s Interim Report generated massive interest and excitement. Its website even collapsed under the huge volume of traffic it attracted. This kind of attention is given only to the most important of news.
The main proposals of the Commission are certainly far-reaching, but they are not excessively dramatic or unexpected. They are measured and apparently well-founded, rather than being unsupported emotional or ‘political’ responses. Those who wanted the big banks broken up, for example, will be disappointed. In essence, the proposals bolster many aspects of the new international bank regulatory proposals, the so-called Basel 3. The proposals of this Interim Report are set out for consultation and to seek responses.
The Commission begins by arguing the case for better macroeconomic policy so that there are ‘fewer and smaller shocks’ to the system. The build up of ‘asset bubbles’ (especially in sectors like property) are widely accepted as part of the complex tapestry of events that helped in the build-up to the recent crisis.
In this context, so-called ‘macro-prudential’ policy applied to banks is also emphasised to be important for wider economic stability. This means in practice that bank regulation has to take account of the wider macroeconomic environment in which banks operate and within which they are an integral part and contributor. This is why (and preceding the Commission’s work) UK banking supervision was returned (from the FSA) to the Bank of England.
The Commission talked about two alternatives in banking reform. One is for simpler and safer banking structures. This could entail, for example, a complete separation of retail (so-called ‘utility’) banking from investment (so-called ‘casino’) banking. This move might break up banks and produce a larger number of smaller banks. The other alternative is to require the banks to have greater loss-absorbing capacity. When things go wrong and banks experience exceptional losses, these losses have to be absorbed in their own internal capital cushions. In practice, this means a need for more bank capital, especially more equity capital and greater amounts of debt capital that provide additional loss-absorbing capacity.
The Commission emphasised that banks ought to be subject to the discipline of the market. Such market discipline should help ensure that banks respond to the needs of the market, especially a bank’s customers. And when a bank fails (and this is part of the market -disciplining process) , the burden should not fall on taxpayers to bail them out. This is a particular problem with the very big banks, the so-called ‘too big to fail’ banks. If a bank is too big to fail, it has an implicit incentive to take on more risks (in an attempt to earn higher profits for its own shareholders), safe in the knowledge that if things go wrong then Government (ie taxpayers) will save them. There is a widespread view in the aftermath of the crisis that this is now unacceptable.
At the same time, the last crisis was a reminder that it is not just big banks that get into trouble. Northern Rock in the UK was not a big bank, but it had to be supported in the face of liquidity pressures. In practice, whenever a bank of any size is threatened with a run on it by its depositors (when a large block of a bank’s depositors all demand their deposits back at the same time), other banks in the same banking system may as a result be threatened by a generalised loss of their own depositors confidence. This is a so-called a ‘systemic risk’ and it is the nightmare of banks and their regulators. It is also reflective of another fact of banking life – banks rely ultimately on the confidence of their depositors.
Recent events also confirm that a system of small banks can have its own problems. The Spanish savings banks, for example, comprise a regionally dispersed system of small banks by international standards. Present Spanish reform proposals include merging failed savings banks to help make them more prudentially safe. The bigger a bank, the more opportunities to diversify its business and their respective risks.
Experiences to date in banking, then, do not seem to confirm that there is an optimal size of bank that reduces the probability of a bank failure or a wider systemic risk. A risky economic environment, weak bank regulation, excessive risk taking and poor bank management, for example, are probably more important and they can affect a bank of any size. They are also a reminder that bank soundness and safety are influenced by many complex factors, often working in combination.
Against this backcloth, the Commission took the view that it should develop a combination of measures that encompassed both structural reform and greater loss-absorbing cushioning. On the one hand, this produces a less extreme set of measures (like breaking up the big banks). On the other hand, it recognises that a more encompassing set of measures (covering some structural reform and building up greater loss cushioning in banks) is needed to tackle the complexity of events that were seen in the build-up to the crisis.
The first part of the Commission’s proposals is to separate internally, to ‘ring fence’, a bank’s retail banking (its High Street operations and payment system services) from its investment banking activities. Ring fencing means a financial separation within a bank’s balance sheet and legal structures. The Commission recognises that such ring fencing could take many forms, but they fall short of a complete breaking up of a bank.
Investment banking often involves higher risks (and higher potential returns) and is generally concerned with trading , capital market activities and more structured and complex forms of financing. The ring fencing proposals are aimed at ensuring that this kind of banking should not be in a position to obtain (implicitly or explicitly) any state support. These moves would also restrict the extent to which other parts of a diversified bank may have access to retail bank deposits. There are other important advantages of ring fencing. It is easier and less expensive to sort out banks that get into trouble. For example, different parts of the bank can be handled in ways best tailored to their specific needs. It would also help to protect retail banking from risks that are not part of the retail banking portfolio.
The second of the Commission’s main proposals is that UK banks should have stronger capital (loss-absorbing) cushions. It recommends that systemically important banks (like all large retail banking operations) should hold an extra equity capital cushion of 3% above the Basel 3 minimum of 7% (and Basel is also considering a similar extra tranche of capital for all systemically important banks). The Commission also wants banks to hold debt capital that can also be converted into equity during a crisis, but it has not yet specified how much and the exact forms allowable.
The third proposal is that the Lloyds group should be forced to shrink its market shares (typically over 20% and around 30% of current accounts) in retail banking. The present Lloyds group is the result of a state-sponsored merger during the crisis, described by The Economist (April 16) as ‘a massive merger-from-hell’. In its concern to promote more banking competition, the Commission is also exploring how account switching may be improved.
The Commission’s Interim Report, then, is certainly a positive step forward. Generally, the recommendations so far have been well received. But there is still a long way to go before the final report is completed (in September 2011). Much needs to be done and more needs to be clarified . The Devil is likely to be in the detail yet to be addressed. It will also be important that the competitiveness of UK banks is not compromised in the global banking marketplace. This may require a new international consensus on banking regulation that is wider than the present Basel remit.
Professor Bullion
