The Vickers Commission Interim Report on UK Banking
What’s at stake
Global banking regulation took a step towards convergence on Monday as a UK commission proposed measures that will bring the country’s financial rules closer to the US, reducing fears that British lenders will flee London for New York. The proposed reforms by the Independent Commission on Banking (ICB) – chaired by Sir John Vickers and composed of Clare Spottiswoode, Martin Taylor, Bill Winters and Martin Wolf – are aimed at preventing any future difficulties in banks’ investment arms from affecting savers’ deposits, and protecting taxpayers from future bailouts. The proposed changes – which have to be finalised by September – are similar to regulations in the US, where banks are limited in the amount of deposits they can use for investment banking and commercial banking activities.
Reform options for stability: ring-fencing activities
Robert Peston points that the central recommendation of its interim report– which is arguably the most important response in the UK to date to the financial crisis of 2007-8 that triggered the worst recession since the 1930s – is that a protective firewall should be put around the British retail banking operations of big universal banks, such as HSBC, Barclays and Royal Bank of Scotland. Customers' deposits, business lending and the transmission of money would be ring-fenced within the universal banks as new subsidiaries, endowed with increased capital resources to protect against losses. The thinking behind the ring-fencing recommendation is that if the wholesale or investment banking arm of a universal bank were to go bad, the retail operation - which looks after our savings, lends to business and moves money around - would not be tainted. And if in the event it was the universal bank's retail banking side that ran into difficulties, rather than the wholesale or investment arm, then in theory it would be cheaper and easier for taxpayers to rescue the retail bank as a ring-fenced, separable subsidiary: there would be no need for taxpayers to bail out the entire giant universal bank, as British taxpayers were forced to do in 2008 in the case of Royal Bank of Scotland.
As a matter of illustration, the Vickers Commission report writes that the retail ring-fence might require rules such as: under no circumstances can the parent company transfer capital out of the retail entity if it would result in a drop below the minimum regulatory capital ratio prescribed; the retail subsidiary cannot own equity in other parts of the group; intragroup exposures by, or guarantees from, the retail subsidiary will be treated as third party exposures for regulatory purposes. Cross-defaults between the retail subsidiary and the rest of the group may also need to be limited; the retail subsidiary must have access to operational services, which will continue in the event of insolvency of the rest of the group.
Reform options for stability: 10% capital ratio coupled with loss-absorbent debt
The Vickers Commission argues that TBTF banks should hold equity of at least 10%, together with genuinely loss-absorbent debt, so that banks’ owners and creditors (other than ordinary depositors) stand to lose when things go badly. The 10% equity baseline should become the international standard for systemically important banks, and that it should apply to large UK retail banking operations in any event. Subject to that safeguard for UK retail banking, and recognising that wholesale and investment banking markets are international, the Commission believes that the capital standards applying to the wholesale and investment banking businesses of UK banks need not exceed international standards provided that those businesses have credible resolution plans (including effective loss-absorbing debt) so that they can fail without risk to the UK taxpayer.
Interesting estimates from the report
FT Alphaville highlights a couple of interesting data points from John Vickers & Co’s interim report. First, the value of implicit government support for TBTF Banks is estimated to cheapen bank funding by £10bn per year. Second, the report estimates the cost to the Exchequer if Diamond Bob and other banks followed through with their threat to leave the UK. The entire financial services sector contributed around £53.4bn in taxes to the Exchequer in 2009/10, of which £30-36bn came from domestic financial services. This includes all direct and indirect taxes, as well as employment taxes, across all financial services.
Reactions to the report
The Economist’s Newsbook argues that because of its reasonableness, the commission’s recommendations will be difficult to dismiss. The proposals are far less radical than some banks may have feared. They will probably also not cost that much to implement. Industry estimates put the cost of ring-fencing at about £5 billion ($8 billion) a year, mainly because funding costs of the separate parts will rise as each will be less diversified than the whole. These estimates are probably overstated. Moreover, the real impact of the commission’s proposals is that they may help to bring about a measure of transparency and market discipline to bank funding.
Stephanie Flanders argues that although it may not solve it the Vickers Commission addresses directly the issue of the enormous downside of having a financial system that 'punches above its weight'; when things go wrong, all of us had to make up the difference between the banks' punches and their underlying strength. But it does not address the other potential downside of playing home to a "world-beating" financial centre – which is that the financing needs of the average domestic company start to look pretty uninteresting to UK bankers.
Simon Johnson and Peter Boone write that Vickers or no Vickers, without serious reform, it will soon be a case of here we go again. The fight to reform the banking system in the US and more broadly is largely over – and the bankers won. A number of sensible ideas were put forward – including on creating a resolution authority, reducing the scale and scope of big banks, and significantly increasing capital requirements. But all of these initiatives have essentially failed. The Dodd-Frank reform legislation in the United States, for example, creates a "resolution authority" for megabanks but with a big loophole: It does not apply to cross-border banks like JPMorgan or Citi. For megabanks in trouble, the choice therefore remains: Lehman-type collapse or TARP-type bailout.
Patrick Jenkins, Sharlene Goff and Megan Murphy argue that the toughest proposals, in fact, came not on the widely feared structural issues but on competition in retail banking. Lloyds, the biggest high street lender, was told it must sell “substantially more” branches than the 600 it is already hiving off under European competition rules.
The absence of a TBTF debate in continental Europe
Morris Goldstein and Nicolas Veron argues that it is remarkable that the TBTF problem is barely present in substantial financial policy debates and initiatives in most Continental European countries and at EU level, including the European Commission. True, the discussion on possible remedies to the too-big-to-fail problem is not a simple one, and no silver bullet is at hand. There are different dimensions to the problem, each of which is associated with different policy options: absolute bank size (which may be addressed with size caps or capital surcharges), market concentration (which calls for competition policy or limits to market share), conglomeration (Glass-Steagall-like separations, or the more recent Volcker rule), internationalisation (requirements for local funding and/or capitalisation), and complexity (central clearing of transactions, living wills). Depending on the context, definitions of systemically important financial institutions generally rely on a mix of these criteria. But these analytical gaps should not be taken as an excuse to avoid an in-depth debate on the TBTF problem in Europe. In a working paper, the authors explain the absence of debate on TBTF on the higher degree of concentration of banking markets in continental Europe, on a general reluctance to let banks fail, on the interdependence between banking and political systems tends, and on nationalism, which continues to play a significant role in shaping Europe’s financial policy choices which tend to differentially protect and favour domestic “banking champions”.
In a column in the Telegraph, Simon Johnson and Peter Boone point that in Europe the problem of regulation has an added dimension, provided by the additional bureaucratic layer of eurozone institutions. There is a strong incentive for national regulators to hide the scale of the problems in their local banks, to maintain access to unconditional easy money from the European Central Bank's liquidity window. Unfortunately, while the Vickers Commission is sensible, it can't change global politics.
In a 2009 column, Charles Goodhart argued that narrow banking is not the answer to systemic fragility. The proponents of narrow banking focus, almost entirely, on the liability side of banks’ balance sheets, and their concern relates to the need to protect retail depositors and the payments system. While this concern is entirely valid, it has been notable in the recent crisis that virtually no retail depositors lost anything, and the payment systems continued at all times to work perfectly. The crisis was not much about that, and policies served to protect these key elements satisfactorily.
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