Chinese banks and UK taxpayers

The decision by the Chancellor to allow Chinese banks to operate in the UK as branches rather than subsidiaries has caused something of a stir. And as usual, the implications have been widely misunderstood.

This from Willy Hutton in the Guardian (in an otherwise strong piece) is typical:
Compounding the error, he has decided to allow Chinese banks to trade in London through branches. Iceland's bankrupted banks operated in Britain through branches. Never again, we said. If a bank wants to function here, it must put its own capital behind its British operations. But desperate to win the City's right to trade in renminbi, Bambi wants to waive this obligation uniquely for Chinese banks. China's banking system is precarious; non-performing loans could be as high as $5trn, proportionally far in excess of pre-crisis Iceland. At least the British taxpayer will be able to underwrite their British operations when the system crashes, as it almost certainly will.
This is simply wrong. Let me explain.

A branch of a bank is an integral part of the bank. It is not legally separated from any other part of the bank's operations, except for activities held in separate subsidiaries. So if a Chinese bank sets up a branch in the UK, it IS putting its own capital behind its British operations.

What it is not doing is ring-fencing a proportion of capital for exclusive use by the British operations, which is what it would do if the British operation were a subsidiary. This has both positive and negative aspects.

On the positive side, if the British operation got into serious trouble, the entire capital of the Chinese bank would be behind it, whereas if the British operation were a subsidiary only the capital of the subsidiary itself would be available to absorb losses: there would be no guarantee that the parent would provide extra capital. This is the current situation with the Co-Op Bank, and the likeliest outcome is that investors (though in this case not depositors) will have to take losses. Compare this with the losses incurred by the London Whale in J.P. Morgan's London office (a branch), which automatically rebounded to the American parent. Operating as a branch can ensure that local losses are fully absorbed by the parent.

On the negative side, if the Chinese bank failed, the British operation would go down with it, and any British investors and depositors would (in theory) take losses. This is what Hutton is referring to in relation to Icelandic banks. But really he is only talking about Icesave.

Icesave was the UK branch of the Icelandic bank Landsbanki.  Landsbanki was one of the three giant Icelandic banks that went bankrupt in 2008 with massive losses when capital markets froze after the fall of Lehman: the other two were Glitnir and Kaupthing. The introductory sequence of the film Inside Job poignantly talks about the damage that was done to the Icelandic economy by the expansion and sudden collapse of these three banks. What it does not mention is the damage that was done to the UK economy by the collapse of Icesave and the UK subsidiaries of Kaupthing and Landsbanki - and the refusal of the Icelandic government to honour deposit insurance for British depositors in Icesave.

The UK government compensated insured British depositors for their losses, then attempted to claim back the insurance from the Icelandic government. Iceland, bankrupted by the crisis and unable to borrow on the financial markets, refused. This sparked an international dispute: the British government used anti-terrorism legislation to freeze the remaining assets of Landsbanki in the UK, and the British and Netherlands governments took legal action against Iceland in the European Free Trade Area (EFTA) court. In January 2013 they lost their case. The court concluded that in a systemic crisis, the sovereign is not bound to honour deposit insurance.

The scars of the Icesave failure run deep. Not only did the UK government lose money: large depositors, including UK local authorities such as Kent, did too. And since then, UK regulators have encouraged foreign banks to convert their UK operations to subsidiaries.

Operating as a subsidiary means that a foreign-owned UK operation would not necessarily be affected by the failure of its parent. UK subsidiaries of foreign-owned banks have to meet UK regulatory requirements for capital and liquidity, irrespective of the capital and liquidity position of their parents. This can lead to some bizarre effects: Santander UK, for example, has a higher credit rating than its Spanish parent.

But it does NOT mean, as Hutton suggests, that the UK taxpayer is not at risk if foreign-owned banks operate UK subsidiaries. On the contrary. The UK taxpayer backstops the UK's deposit insurance scheme, which covers all depositors (including foreign ones) in UK subsidiaries of foreign-owned banks. And if is large and significant enough, a UK subsidiary of a foreign bank may be bailed out and/or closed down by the UK Government - and there is no right of recovery from the foreign parent or its government.This is what happened to the UK subsidiaries of both Landsbanki and Kaupthing.

Heritable Bank was a wholly-owned UK subsidiary of Landsbanki, and Kaupthing, Singer & Friedlander (KSF) was a wholly-owned subsidiary of Kaupthing. In October 2008, the UK Government nationalised Heritable Bank and placed KSF in administration. Heritable Bank's assets were subsequently sold to ING along with KSF's internet bank Kaupthing Edge. Depositors in both subsidiaries were compensated by the UK's Financial Services Compensation Scheme (FSCS): the FSCS itself was bailed out by the Bank of England (later reimbursed by the Treasury) and is still obtaining funds from solvent UK banks and building societies to make good its losses. The Icelandic banks were certainly not the only cause of the FSCS's insolvency, but they were a significant contributory factor. It is the cost of these bailouts that Hutton is referring to.

So of the Icelandic banks bailed out by UK taxpayers, only Icesave was a branch. The others were subsidiaries - exactly what Hutton suggests UK operations of Chinese banks should be. And the Icelandic disaster demonstrates that the UK government can be on the hook for the failure of both branches and subsidiaries. Hutton's argument is confused, to say the least.

The UK taxpayer's real liability in the event of overseas bank failure is as follows.

  • The UK's FSCS is not responsible for reimbursing depositors in branches of foreign-owned banks. That responsibility rests with the deposit insurance scheme (if there is one) operating in the parent country.  
  • The FSCS is, however, responsible for reimbursing depositors in UK subsidiaries of foreign-owned banks. Since the Iceland disaster, the FSCS has also bailed out UK depositors in the UK subsidiary of the Bank of Cyprus, and the UK branch of Cyprus Popular Bank (which was in the process of being converted into a subsidiary at the time of its failure).
  • The EFTA court's decision limits the sovereign's responsibility in a systemic crisis: a sovereign does not have to honour deposit insurance if to do so would bankrupt it. But this could apply equally to domestic depositors: Iceland chose not to honour deposit insurance for foreign depositors, but it could actually have refused to pay deposit insurance at all once the resources of its deposit insurance scheme were depleted. And this is also a get-out clause for the UK government - but one it might hesitate to use. 

The real problem with the Icelandic banks was not their legal status. It was their attraction to UK retail depositors, most - but as it turned out, not all - of whom were covered by European deposit insurance schemes. It is very hard for the UK government to resist rescuing domestic retail depositors even if the real responsibility lies elsewhere.

Small retail depositors in UK subsidiaries of Chinese banks would be covered by the FSCS, and those banks would also be subject to UK regulatory requirements. No doubt the Chinese authorities were not too keen on the UK regulators supervising their banks - hence the concession. However, the UK government argues that the Chinese banks would not be aiming to establish a retail presence in the UK, so there would be no need to bail out domestic retail depositors in the event of a Chinese bank failure. Osborne's strategy of allowing these banks to operate branches in the City of London does not expose the UK taxpayer to risk through the FSCS scheme, as Hutton seems to suggest. The risk is to institutional investors. 

The Chinese banks are indeed somewhat fragile: they are highly exposed to Chinese local authorities, many of which are thought to be unable to pay their debts. And as the Chinese authorities do not shrink from brutality, there is little doubt that overseas investors in Chinese banks would be thrown to the wolves in the event of the Chinese government having to rescue one or more of its banks, which may well happen at some time. But this should not bother a UK government that has made it clear that it will not rescue institutional investors that make unwise investments. After all, that is the point of the ring-fencing proposal for UK banks. If all the Chinese banks are going to do is use London as a trading post for the renminbi and a springboard for investment in the UK, it is difficult to see what direct risk there would be for the UK taxpayer.

But there is a risk for the UK economy. If London becomes the principal European trading hub for the renminbi, a crisis in the Chinese banking sector would be very destabilising for the City. And although there are many who would like the City to be less significant in the UK economy, the fact remains that the UK is a primary provider of financial services to the world and its economy is critically dependent on the health of its financial sector: the UK was more badly damaged in the 2008 financial crisis than any other major economy (pace Ireland and Iceland) and has taken longer to recover. There is no doubt that the Chancellor's concession to the Chinese banks exposes the UK economy to serious damage in the event of another Far Eastern financial crisis similar to that which destroyed the Japanese banks in 1997. I fear it is a mistake.


Related links:

UK eases rules for Chinese trading - BBC
George Osborne in China - wide-eyed, innocent and deeply ignorant - Will Hutton, Guardian
Inside Job (video)
Icelandic financial crisis - Iceland Chamber of Commerce
EFTA Court judgement - EFTA Surveillance Authority
Groundbreaking deal set to make London global currency centre for investment in China - UK Government
Chinese banks feel strains after long credit binge - WSJ (paywall)
Asian financial crisis timeline - Frontline

Comments

  1. “But this should not bother a UK government that has made it clear that it will not rescue institutional investors that make unwise investments.” The problem with that idea is called “Lehmans”. That is, letting privately owned firms fail is basically a good idea, but in the case of large banks, the damage is so large that that “failure” policy is debatable.

    I think Laurence Kotlikoff in his book on Vickers said that Vickers wouldn’t come clean on whether the system Vickers advocated would let a Lehmans fail.

    My preferred option is a very large increase in bank capital: enough to make bank failure almost impossible, as advocated by Martin Wolf. Even better: as per Laurence Kotlikoff, make all bank creditors loss absorbers (i.e. quasi shareholders). That way, bank failure is totally impossible, though shareholders can lose heavily.

    ReplyDelete
    Replies
    1. Ralph,

      Sad to say it, but as usual you are missing the point.

      The UK authorities have no jurisdiction over the capital levels of Chinese banks - that is a matter for their own regulators. Similarly, it is not up to the UK authorities to decide whether or not a Chinese bank should be bailed out - that is a matter for its own government. If the Chinese banks chose to operate in the UK through subsidiaries, then the fate of failing subsidiaries would rest with the UK regulators and/or government, and the failure of parent banks might not affect the UK subsidiaries. But Osborne's concession means that would not be the case. Therefore there would be a significant risk to the UK economy in the event of a Chinese bank failing, about which the UK authorities could do very little. That is the point I was making.

      I think you need to understand that the discussions about capital, liquidity etc. that we are having in the West simply don't apply to Chinese banks.

      Delete
  2. But it may be another fine mess in the making. In general the more funny money there is rebounding round the worlds financial computers the greater and more unpredictable the risks.

    ReplyDelete
  3. Since Communists are accustomed to just creating the money as necessary to roll over non-performing bank loan portfolios it can choose to rescue whatever it wants short of creating abnormal inflation and whether it makes any geo-political sense to damage the British economy. With the latter probably not right now but later maybe.

    ReplyDelete
  4. I'm afraid the rest of Willy's piece was as incoherent and ignorant as his usual tripe. It's rare to find someone as consistently wrong as Mr Hutton.

    Anonymous at 17.23 - the Chinese got away with covering up their bad debt problem at the end of the 90s (see Nicholas Lardy's book for the background) because their economy grew. Their bad debts didnt shrink, but the denominator grew massively. They have bad debts again and they are again engaging in sticking plasters. They'll be fine as long as the economy grows... growth slows and bad things could happen.

    ReplyDelete
    Replies
    1. "It's rare to find someone as consistently wrong as Mr Hutton."

      Ah, but he has an answer for that. He once admitted that almost all of his predictions - mainly from The State We're In - have been incorrect, and then added "But the core analysis remains valid."

      My brain goes into spasm when I try to imagine how that could be.

      Delete
  5. "the British government used anti-terrorism legislation to freeze the remaining assets of Landsbanki in the UK"

    Sorry to be pedantic, but tho' this action was widely reported in these terms at the time (and ever since), it's a misleading characterisation.

    The British Government used its freezing powers, which, though they may be used against terrorism, have nothing to do with terrorism as such. The relevant part of the 2001 legislation doesn't even refer to terrorism explicitly: it refers to "the detriment of the United Kingdom’s economy" (hence the Landsbanki freeze) and "threat to life or property".

    These powers were date back to the Defence (General) Regulations of 1939, superseded by the Emergency Laws (Re-enactments and Repeals) Act of 1964.

    In 2008 confusion (in some cases, one suspects, wilful confusion) arose because the current incarnation of these powers (replacing the 1964 Act) is contained in the 2001 Anti-terrorism, Crime and Security Act. But as its title indicates this is not pure anti-terrorism legislation, it is also security and crime legislation. It may not be inaccurate in a narrow verbal sense to call it "anti-terrorism legislation" (much of it does relate to terrorism), but it's misleading in this instance, because the part relating to freezing powers is much broader.

    ReplyDelete
    Replies
    1. Yes, I'm afraid you are being pedantic. Really it does not matter. The point was that the use of those powers caused a diplomatic incident.

      Delete
    2. Then why introduce the "anti-terrorism" red herring?

      It leads the uninformed reader to assume that point is that there was some sort of abuse of legislation intended for a quite different purpose, when, as you say, the question is not whether the action was legitimate, but whether it was politically wise.

      Delete

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