Banking Reform: The Principles & Proposals

On Monday, a 358 page tome on financial sector reform was delivered to UK politicians and public, the outcome of an investigation into UK banks by the Independent Commission on Banking (ICB). What were the central recommendations and their motivations? Do they go far enough?

The ICB was set up by the Treasury in the aftermath of the financial crisis and is headed by Sir John Vickers, former boss of the Office of Fair Trading and Warden of All Souls College, Oxford. Achieving a stable banking sector is more important to the UK than many other countries. Britain is hugely exposed to turmoil in the financial sector. The balance sheet of banks is £6trillion. To put this in perspective, this is 4 times larger than the total value of our economic output. Incomprehensively huge. This is not the case in all Western countries. In the US banking liabilities are equivalent to ‘only’ 50% of GDP. It is thus of upmost importance that we get the structure of our banking industry right.

Some banking basics

There is a lot of jargon in this field. To help get to grips with what the reforms target, let’s briefly review the basics on the banking system.

In a simple world, one can think of banks as absorbing savings deposits and certain types of debt and transforming them into longer term investments, such as mortgages and corporate & government loans. This means that our savings do not just ‘sit in the bank’, they are re-lent out to generate profits. Banks suffer from a ‘maturity mismatch’; their liabilities are short term (we can demand our savings back right now), while their assets pay back in the long term (the flow of profits from mortgages and bonds might go far into the future).

But what happens if lots of people suddenly want their savings back? In ‘normal’ times banks satisfy the demands of their depositors by lending to each other in overnight inter-bank reserve markets. If you’ve heard the term LIBOR, this is the London Interbank Offer Rate, the interest rate charged in the London overnight reserve market. Banks short on liquidity (i.e. those that don’t have enough free cash to satisfy deposit demand) borrow from those with excess reserves. In this way, it doesn’t matter most of the time that savings don’t just stay in the vaults at the bank.

So what happens when loans go bad? When loans go bad, losses must be absorbed by past profits generated by good loans or depositors, i.e. savers, will take a hit and the bank will be judged insolvent. Thus, it is important that banks carefully monitor the loans that they make and set interest rates to properly reflect the risk they face. Regulators also require that a portion of loans are funded from equity capital. This is the stock of past profits accumulated by a bank. Then if a loan goes bad it is the bank shareholders that shoulder the loss. This is fair. They oversee the management who allowed the bad loan to be made.

Equity capital is thus a lovely safety cushion on banks’ balance sheets. The higher the equity capital relative to the total size of the bank, the safer it is. The Vickers’ report and the Basel III agreement are both concerned with increasing equity capital ratios. What they actually do is specify a minima for:

Equity capital/Loans*risk weighting

where the ‘risk weighting’ figure reflects the quality of the loans made. So, it will be high if all the loans you made were to unemployed teenagers for multi-million pound houses.

In brief, during the financial crisis banks made, or were at least expected to make, losses far in excess of their equity capital. This led to a run on savings deposits, a freeze in interbank lending (banks couldn’t tell if each other were solvent and so wouldn’t lend to one another to help meet high deposit demand), a credit crunch and severe recession. Nice.

The recommendations

The Treasury set up in ICB to help prevent a similar financial crisis from arising again in the future. One can group the ICB’s proposals under three main headings:

1. Ring fencing retail operations

This is the proposal that has gobbled up the most column inches. The ICB argues that we need to separate the retail operations of banks from investment banking. Retail operations are those which ‘normal’ people think of when you say “bank”, i.e. savings, current accounts and mortgages, while investment banking activities include things like the more exotic sounding derivative trading. Ring fencing effectively builds a sort of firewall around the crucial activities which we really care about and will result in our own savings funding the flow of domestic loans.

 2. Promote greater competition

The UK banking industry is dominated by a small number of very big players. To create greater effective competition in the sector, Vickers recommends that the Lloyds banking group be broken up in a way that creates a strong new challenger. Further, measures to make it easier for individuals to switch their accounts between institutions are outlined and the need for a greater amount of clear pricing information is pressed.

3. Raise banks’ ability to absorb losses

This proposal relates to the amount of equity capital banks hold. From above, this is key in determining how safe a bank is as it sets the degree of loss it can sustain. The ICB feels that the proposals achieved by Basel III do not go far enough and want higher equity capital ratios for retail operations.

Intended effect

Lots of our problems in the financial crisis stemmed from two main things: 1) Banks made bad loans and 2) Banks weren’t holding enough equity capital to cover the bad loans. So ideally the reforms will:

1)       Reduce the likelihood that bad loans will get made

Ring-fencing retail services should work to discourage reckless risk taking and promote more sensible lending. The ‘too big to fail’ problem is often mentioned in this context. During the financial crisis, it was felt that the government had no option but to intervene to bail out the banks. The costs of not doing so were unfathomable. However, this created a “moral hazard” problem. Banks knew that, when push came to shove, the taxpayer had little choice but to bail them out and cover their losses. This reduced their incentive to make good loans and monitor the amount of risk they took on, encouraging the dodgy lending and trading practices at the heart of the crisis. If the government could have credibly promised to stand back and watch banks fail, it is likely that many of the bad loans would never have been made.

The reforms should make it easier for the government to do just this. Stand back and allow banks, or certain parts of banks, to fail, reducing this moral hazard problem. Ring fencing allows for better targeted bailout policies making it easier to force the creditors of failing investment banks bear the consequences of their investment decisions. Not just the good ones. The government can choose if it wants to support the investment banking arms of banks rather than being compelled to do so because of the risk to the retail services it really cares about.

2)       Make banks better able to cope with losses

Raising the capital requirements of banks enhances their ability to shoulder losses and ring fencing should also help insulate the banking of the layman from international troubles as much of the complex international exposures of UK banks relate to their investment banking divisions.

Answering some criticisms

There have been noises made on the cost that these reforms will impose on the already fragile banking industry. Critics also mention that the proposals will damage the global competitiveness of the UK banking industry. Neither criticism is particularly strong.

Vickers estimates that banks will face costs in the region of £4-7billion per year as a result of the proposals. So, actually, given the total size of the industry these costs are relatively trivial. Also, these costs are nothing compared to the bill the government is footing: The New Economics Foundation argues that the 5 biggest UK banks received a £46bn government subsidy in 2010 alone. Furthermore, these costs are the result of returning risk bearing to where it should be, i.e. with investors rather than taxpayers, and so are not wholly bad. One can argue that the cost of capital has been artificially low for banks because of the implicit government bailout promise outlined above. Banks have been able to borrow at lower cost than they should have been able to because lenders have known that it is highly unlikely that they won’t get paid back. In the past it was known that the government would step in if things got bad. Therefore, interbank interest rates and borrowing costs have been lower than those which actually reflect the social risks.

On the issue of global competitiveness, the proposed regulations largely apply to high street business. By definition, the high street has to stay where it is (!), reducing the international ramifications of reform. The ICB estimates that only a relatively small portion of investment banking activity will be affected and all operations outside the ring-fence will continue to be regulated according to international standards. The enhanced equity capital ratios also only apply to the retail operations of banks. Operations outside the ringfence will continue to be policed by international standards.

Is it enough? Short answer: No. 

This is where I’m sceptical. Yes, the proposals are relatively wide reaching but they are also moderate. Meek even. The fact that there has been relatively little fuss and bother in the aftermath of the report is strong evidence that nothing really challenging has been put forward. Furthermore, implementation is far on the horizon. 2019 to be precise. That is a long time in the future. Who knows what issues will have arisen by then and this also gives the banks a long time to work out every way to minimise the impact of the proposals on their activities.

What Britain can achieve on its own is limited with respect to banking reform. Sadly, an international solution is needed. This is I think why Vickers’ proposals are not going to bring the radical change we need. The ‘sadly’ qualification is because the terms international, agreement and radical are not often found together in this environment.

I want more sensible debate and research on an international financial transaction tax. Such a tax would bring in revenue, which could then be directed to helping those in need at home and round the world, and would help to curb certain types of destabilising financial activities. For example, the growth of ‘High Frequency Trading’ (HFT), identified by the Bank of England as a serious systemic risk, could be reduced by a minimal tax on each transaction as these trades all rely on minuscule margins. However, such a tax does need to be international. The UK could not implement this on its own.

In summary, the Vickers’ report outlines sensible but mild reforms to the UK banking industry which certainly won’t make anything worse. However, they are not enough and their implementation is too far on the horizon. Creative, serious thinking on a challenging international solution is required. Sadly, I’m sceptical about what will be achieved.

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