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UK Independent Banking Commission Report Rules Out Radical Reform with Focus on Competition

UK Independent Banking Commission Report Rules Out Radical Reform with Focus on Competition – But Months of Hard Lobbying to Come   


Date: 11 April 2011

Initial comments by Dr Richard Reid
 

  • Ring-fencing of domestic retail activity and certain kinds of "key" business lending - one implementation issue will be how 'key business areas' are defined
  • Proposed bail-in mechanism does carry some risks in the form of disruptive market triggers - these bail-ins may be most effective during a relatively short restructuring process, as opposed to an early warning system of failing institutions
  • Central thrust of introducing more competitiveness should be handled with caution, as aggressive competition between financial institutions may have been a factor in the growth of leverage in the run up to this crisis
  • UK government could argue at IMF/G20 meetings later this week that this Independent Banking Commission report creates useful precedent for dealing with extra capital charges/efficient wind down procedures for Sifis. Continental  Europe may be pleased to see the universal bank model getting support in the UK

Certainty is usually seen as a key factor in the pursuit of financial and economic stability. Even if the changes to be faced are onerous, businesses usually argue that it is better to know sooner rather than later what new rules are that they will be playing under. Although the UK's Independent Commission on Banking (ICB) seems in the Interim Report to have ruled out (for now) some of the more radical reforms floated for restructuring the banks, there are still months of discussions ahead between the industry and the authorities across a range of issues in order to hammer out the details. Hence, the result of the Commission's deliberations will not be fully manifested for some time. No doubt the ICB will hold the threat of more thoroughgoing restructuring as a stick to encourage the banks to cooperate. On the other hand, history and experience suggests that extended periods of consultation and implementation lead more to evolutionary change rather than revolutionary change. Indeed, it seems that some of the leading banks are already engaged in intense discussions with the regulators over what offers the best options for the way forward. Decisions by major banking institutions about where to locate their headquarters are more likely to be influenced by longer term assessments of market growth and business strategy than by these recommendations. Realistically, it is almost impossible to provide a regulatory and supervisory structure which will entirely protect depositors and tax payers from the costs of a major financial crisis. These proposed measures may mitigate against the frequency and depth of crises, but will not prevent them from happening altogether, nor will they completely remove the role of the taxpayer in any future financial meltdown.

It's probably also worth remembering that the ICB was charged with examining the structure of the banking system to reduce risk, address moral hazard, minimise the likelihood and costs (especially to tax payer) of failure, and promoting competition. But all of this is to be done with due consideration for "The competitiveness of the UK financial and professional services sectors and the wider UK economy; and ...Risks to the fiscal position of the Government". (quote from ICB remit).  These last points suggest that the ICB will have to underpin a fully functioning financial system able to provide financial intermediation both for growth and for facilitating the financing of the budget deficit.

In the near term certainty may also be obscured by domestic politics. Although the Coalition government will back the Commission's findings as heading in the right direction, there may be strains within the Coalition about what the final report should recommend. The UK was one of the few countries in the world which was actively considering the breakup of the larger banks. With this looking unlikely now, the upcoming IMF/G20 meetings later this week are likely to concentrate more on how to deal with making systemically important institutions safer in combination with more efficient wind down schemes.  One key issue here under the Basel process is what kind of extra capital charge should be levied for a big institution here and maybe the UK will argue the ICB is setting a precedent in this field.  Note however that 'continental Europe' has long had a successful universal bank model mixing retail and investment banking, and therefore is 1) unlikely to pay much head to the report, or 2) if it does, will likely see British moves as a source of future comparative advantage for the Continent. Other regions are more likely to play 'wait and see' on implementation and judge the effectiveness of proposals in limiting consumer costs of failure come the next crisis.

It appears that the ICB is not favouring the full separation of investment banking from retail banking model or the narrow banking model. Although these would have been severe measures and had therefore caused great concern within the industry, most analysts had not considered that these proposals were likely to have been recommended. Less disruptive but also quite substantial moves such as functional or geographic separation of businesses lines also do not seem to have found favour. Perhaps in all of these cases the ICB were conscious of the perceived need not to undermine the industry or the UK's competitive position. However ring-fencing of key business areas does look to be a preferred option, as well as some form of operational subsidiarisation. The first of these will focus on domestic retail activity and certain kinds of "key" business lending. What key business areas are could be one area where discretion in implementation will be an issue. Operational subsidiarisation is aimed at allowing the banks and regulators to be sure of having mechanisms in place to deal with problems promptly during a crisis. The ICB also recommends that a further capital charge of 3% should be held to ensure the security of the essential elements of domestic banking activity, although as long as this cushion is maintained, capital can move between the retail business and the investment banking business - in both directions. "Moreover, full separation would remove all intra-banking diversification benefits and so eliminate the possibility that one part of the group could save another part" ICB Interim Report, para 4.85.

The banks will argue that this extra charge on retail business raises the risk of higher charges to retail customers. This would be an unwelcome prospect for the government.

Both the ring fencing and the operational approach are linked to the aims of protecting domestic financial services and to allow the authorities a clear framework for maintaining these operations during the process of winding down a failing institution. Also as part of efficient resolution mechanisms in which creditors of the banks will share in the costs of failure (to ease tax payer burden), the ICB has indicated its liking for bail-in measures. Although favoured by many as a way of ensuring a greater element of market discipline over banks' activities, the bail in mechanism does carry some risks in the form of the scope for disruptive market triggers. These bail-ins may have the most effective application during a relatively short restructuring process as opposed to an early warning system of failing institutions. ( Click here to see a recent comment by the ICFR on the IMF's concerns about the wisdom of publishing a list of  "at-risk" systemically important financial institutions).

Given that the  Commission appears to be steering away from a radical overhaul of the structure of the big institutions, since some institutions have become so big relative to the size of the economy, it looks like a central thrust of the final Report will be to promote competition in the UK financial market place. Introducing more competitiveness should be handled with some caution however, as many would argue that aggressive competition between financial institutions may have been a factor in the growth of leverage in the run up to this crisis. The focus of competition seems to be to provide greater transparency in charges for retail services and greater ease (less cost) in switching retail services between providers. There are already plans in train to redistribute bank branches in the UK, and this effort is likely to be intensified. It seems the industry may already be working with the authorities to demonstrate their willingness and determination to address the Commission's concerns in this field.