The ICB's fig leaf

It was announced on Monday 19th December that the Independent Commission on Banking's (ICB) proposals for reform of the UK banking system would be accepted in full. Or not quite, actually - HSBC managed to wring a concession from the Government that it would not have to meet higher capital requirements for business it conducts overseas.  As HSBC's overseas business dwarfs its UK business this is important for them, but the quid pro quo must surely be that problems in the overseas businesses cannot be bailed out by its UK operations. The ringfencing proposal should help to achieve this, although it remains to be seen how well this would hold in practice.

Inevitably, there have been criticisms of both the proposals themselves and the Government's handling of them.  Tony Greenham of the New Economics Foundation (NEF) wrote this post describing why he believes the proposals are ineffectual. I think the Vickers reforms are indeed ineffectual, but not for the reasons Greenham gives.

These are my concerns about the proposals.

1) Ring-fencing and full legal separation

Ring fencing will only apply to three banks – HSBC, Barclays and RBS. And the Government has also announced proposals to reduce the size of RBS’s investment banking significantly and force it to concentrate on retail and corporate lending as its major business activities. So that leaves only two whose investment banking operations might conceivably present a serious threat to their retail arms.

I have previously criticised the ringfencing proposal as failing to address the risks in retail banking, which were the main cause of UK bank failure in the 2008 failure crisis. However, I accept that ringfencing would make universal banks easier to resolve in the event of a collapse.  And as I noted above, it may prevent HSBC and Barclays from using their UK retail bank to support overseas operations.   

Full separation would not provide greater protection than a ring fence unless steps were also taken to prevent retail and investment banks from trading with each other. Northern Rock was heavily involved in “risky” securitization with the assistance of a tame investment bank. It was fully separated from that investment bank.

This whole proposal is a cave-in to the demands of politicians for a headline-grabbing solution. The ICB was primed to look at the options for separation, and the media and political hype around the idea of a "UK Glass-Steagall" meant that it was difficult for the ICB to propose "no separation" as a serious alternative. But the Glass-Steagall Act in the US applied to a banking environment that is very different from the UK's. We do not have their extensive investment banking sector, we do not routinely securitise retail loans and we have no equivalent of the American GSE. There is no way that American-style regulation is appropriate for UK banking.  It seems yet again we have looked across the pond for an instant solution to our problems, rather than doing the painful job of analysing the faults in our own system and coming up with our own solutions.

2) Lack of competition in UK banking 

The Lloyds/HBOS merger should have been unwound. The ICB report concluded that it was a mistake, but it chose to protect the Brown government’s reputation instead of doing the right thing by the British public. Frankly I thought this decision – explicitly stated in the report – was disgraceful. The merged Lloyds/HBOS business is the largest bank in the UK and dominates the UK mortgage market. Forced sale of branches is no substitute for breaking it up.

Nor did the ICB consider the future of RBS and Northern Rock, the other two nationalised banks. It did not look at the possibility of remutualising Northern Rock or breaking up RBS (demerging NatWest). Both of these would have given clear indication to the UK banking sector that further concentration is not acceptable. Because the ICB failed to address this issue, Northern Rock has now been sold to an existing player in UK banking (though admittedly one that did not previously have a high street presence), and RBS remains a publicly-owned megalith with no clear business direction.

This failure is bad enough.  But the ICB was mandated to consider ways of improving competition in banking. It has actually recommended practically nothing that makes any significant difference. There are no suggestions for ways of lowering barriers to entry to new entrants into the banking marketplace, apart from a minor tweak that might make it easier for  customers to switch accounts. There is no consideration of appropriate regulation of alternatives to traditional banking or ways of relaxing the stranglehold that clearing banks have on payments. The banking sector desperately needs more competition. These proposals do little to encourage it.

3) Higher capital requirements 

The additional capital requirements will at the present time be very difficult to raise without asset sales and serious cuts in lending activities, which could potentially have a catastrophic effect on a very fragile economy.

To my mind the ICB's proposals rely too much on simple increases in amount of capital and do not address the far more difficult question of how capital is allocated. For that they rely on Basel – and that I think is partly the reason for the delayed implementation to 2019, which is also the Basel III final implementation date. Capital allocation in the financial crisis turned out to be utterly deficient, because the banks were allowed to use their own models to calculate risk weightings for more complex instruments, and because some classes of asset turned out to be much riskier than their weightings would suggest. Basel III still relies on bank-calculated risk weightings and therefore does not really address this matter adequately. Increasing the capital amount without vastly improving its allocation is an expensive and inefficient way of reducing risk.

I wish NEF writers - and other critics of the Western banking system - could get out of their heads the idea that the size of a bank’s asset base is an indicator of its risk. It is not. We should pay far more attention to the quality of its assets – including getting some proper regulatory supervision of risk weighting calculations – and the size of the gap between lending and borrowing maturity profiles. Unfortunately the ICB  ignores these completely and simply throws money at the problem.

4) Regulation and supervision of banking activities

The ICB does not address the appalling failure of regulation and supervision by the Fiinancial Services Authority (FSA). It makes no recommendations for a more rigorous regulatory and supervisory regime that is less open to errors, conflicts of interest and corruption.

I have little confidence in the new regulatory body replacing the FSA, since it is under the aegis of the Bank of England (which notably failed to supervise BCCI and Barings adequately), and seems to be made up of many of the same players who failed so spectacularly to regulate or supervise HBOS, RBS and Northern Rock. Giving people a second chance to get it right after making errors of such magnitude seems like crass stupidity to me.

5) Risks in retail lending

No curbs are proposed on retail lending activities, despite the fact that it was excessively risky retail lending that brought down three of the four UK banks that failed in 2008. Instead, the ICB's report preserves the commonly-held – and totally wrong – belief that the financial crisis in the UK was caused by investment banks “gambling” with retail depositors’ funds. It wasn’t – it was caused by retail banks speculating on property. Yes, the worldwide crisis was focused more on investment banks, tho even there the ultimate cause was the excessive risk and fraud in American mortgage origination and securitization. But the UK crisis was definitely one of RETAIL banks.

In short, these proposals are long on "shock and awe" and short on anything that will make a real difference to the way in which banking is conducted in the UK. Banking is boring, and proposals to make it safer even more so. The nitty-gritty detail of loan-to-valuee caps, loan to deposit ratios and the like don't interest the media or politicians - which is the audience that the ICB plays to. So we may now go ahead with a half-baked separation of investment and retail banking, which will only really affect two banks, and higher capital requirements, which we dare not implement until the means are in place to calculate the allocation adequately and the economy is strong enough to take the increased cost and tighter criteria for lending that will result from them.  We won't, it seems, make the deep detailed adjustments that we really need. Or if we do make them, it will be despite, not because of, the work of the ICB.

The ICB's proposals are nothing but a fig leaf.


  1. It's a bit of Glass-Fig-Leaf then; Doesn't do anything for modesty!


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