Two Cheers for Britain’s Bank Reform Plans

How well is the government planning to implement the proposals of the Independent Commission on Banking, chaired by Sir John Vickers, of which I was a member? Rather well, on the whole.

Chancellor of the Exchequer George Osborne holds Disraeli's original budget box as he leaves 11 Downing Street for Parliament.
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Chancellor of the Exchequer George Osborne holds Disraeli's original budget box as he leaves 11 Downing Street for Parliament.

But I have some important concerns.

This is how George Osborne, UK chancellor of the exchequer, explained the government’s intentions at the Mansion House dinner on Thursday: “High street banking will be ringfenced so that taxpayers are better protected when things go wrong.

We will be able to bail in creditors when a bank fails rather than turning to the public purse.

And I believe that we have found a workable way to solve what I called the ‘British dilemma’ – so we are proposing to protect taxpayers in a way that does not make the UK uncompetitive as a home of global banks.” As the ICB’s interim report noted, the assets of UK banks were close to five times gross domestic product in 2009, against just one time in the US and three times in Germany and France.

Against this background, the ICB made two principal recommendations relating to financial stability: the ringfencing of domestic retail banking from other banking activities and a need for greater loss-absorbing capacity, in the form of both equity and “bail-enable debt”.

As Mark Hoban, financial secretary to the UK Treasury, noted on Thursday: “The ringfence won’t stop a bank failing, but it will insulate the deposits of families and businesses and, if a bank does fail, these essential parts of the banking system can continue without recourse to the taxpayer.” Mr Hoban added that “the government proposes to strengthen the ICB’s recommendations by applying strict controls on the use of derivatives a ringfenced bank uses to hedge its own balance sheet”.

That is a response to the recent losses at JPMorgan.

Furthermore, the government plans to reinforce the governance of the ringfenced bank by “establishing separate risk and possibly remuneration committees”.

I see no objection to such ideas, though the first seems to be fully in keeping with what the ICB itself proposed, rather than an extra.

Yet, more significantly, the government has rejected proposals from the ICB that equity should fund at least 4 per cent of the balance sheet of systemically important banks, instead of the 3 per cent proposed by the Basel committee.

The government also proposes to let ringfenced banks offer “simple derivative products” to its clients, contrary to the ICB proposal that these banks act as agents only for their clients.

In addition, it has agreed to waive loss-absorbency requirements for foreign subsidiaries of globally significant international banks, provided these entities are believed to pose no risk to the battered UK taxpayers.

Finally, the government plans to exempt banks with mandated deposits of less than £25bn from the obligation to set up a ringfenced retail bank.

I have little quarrel with this last idea.

But the suggested waiver for foreign subsidiaries is acceptable if and only if the burden of proving that they pose no risk to the UK taxpayer be on the bank, not on the regulator, since the bank is always the better-informed party and also the one with the bigger incentive to downplay the risks.

Again, the notion that certain derivatives may be offered by the ringfenced bank is acceptable if and only if these do not expose the latter to market risk and do not create an obstacle to the resolvability of the bank in desperate times.

The white paper offers a long list of safeguards. I hope they work.

I fear this blurred line will be breached repeatedly under pressure from the banks until the fence is almost totally permeable.

Above all, the decision to accept the ICB’s recommendation for raising the loss-absorbing capacity of globally significant banks, while rejecting an equivalent rise in their required equity, may be a serious error.

First, this makes almost everything depend on risk-weighted capital: a fallible, even intellectually fraudulent, concept, as the ICB’s final report pointed out.

Thus, between 2004 and 2008, the estimated riskiness of UK-headquartered banks’ portfolios collapsed precisely when, as we now know, in the light of events, their true riskiness was soaring.

Second, it leaves these institutions horribly undercapitalised: nobody but a banker can believe that allowing vast – and vastly important – financial institutions to operate with true leverage of 33 to 1 makes sense.

A 4 percent equity requirement may not seem much, but it is a third better than 3 percent. Personally, I would like to see 10 per cent as an ultimate objective.

But at least I would have wanted the UK government to indicate a stronger push for more equity than is currently proposed.

In the end, the ability to bail-in debt in a crisis is uncertain. For that reason, the best cushion is old-fashioned equity.

As Sir John said on Thursday: “The white paper proposals are far-reaching but on some points – such as limits on the leverage of big banks – we believe they should go further.” He is right.

There is still time for the government to change its mind on this point.

Let it do so.