The UK's Independent Commission on Banking published its interim report earlier today. (Be warned: it's 200 pages long and it crashed my computer when I tried to download it). For a one-line appraisal of the contents we need look no further than the stock market, where shares in several of the major UK clearing banks are trading higher.
The Commission's Chairman, Sir John Vickers, has already had to defend himself against accusations that he "bottled it" (his term, not mine) by not recommending a full separation of retail banking from investment banking. Instead, the Commission wants to see retail operations of each bank placed in a separate subsidiary, which would have to hold capital of at least 10% of its assets, above the current requirement of 7%. In the event of another financial crisis this capital cushion would protect the retail operations, while leaving the investment side of the banks open to collapse, all without imposing costs on the taxpayer.
Even though this approach would allow the banks to remain "universal", which they claim is advantageous to them, their initial reaction is not positive. They warn that raising the additional capital needed to ringfence the retail operations would be expensive, and these costs would have to be passed on to customers. (Well, we certainly couldn't expect the banks to pay any of the costs of keeping themselves safe, could we?) They also complain that the higher costs could place them at a significant competitive disadvantage against foreign rivals.
These are entirely predictable objections that are unlikely to carry much weight with either politicians or the public. There are, however, other concerns regarding the Commission's proposals that merit closer scrutiny, namely, who decides what goes inside the retail ringfence; and is the Commission even focusing on the right problem?
Let's look at the definition of "retail" first. The liability side is fairly simple: all personal deposits and all company current accounts presumably count as retail. The asset side is more complicated, because the whole purpose of the exercise is to avoid the kind of "black swan" credit events that triggered the financial crisis. Extreme versions of the "utility banking" approach would allow retail depositors' funds to be used only for the purchase of entirely riskless assets (i.e. government debt), but this is too restrictive to be practicable. But what else do you include? All mortgages and personal borrowings? Or only those made in accordance with certain preset criteria -- so no NINJA mortgages, for example? Or do you insist that all assets on the retail side meet certain credit rating criteria -- and in that case, how much do you really trust the ratings agencies, given their past failings? These are important questions; getting the demarcation line between retail and wholesale assets wrong would impose higher costs on banks and their customers without ensuring the protection against failure that the whole exercise is supposed to achieve.
And then there's the bigger question: is the Commission perhaps looking at the wrong question in the first place? Apologists for "universal banking" like to point out that Northern Rock, the UK's biggest failure, was a purely retail bank, while Lehman Brothers in the US was purely an investment bank. This is a nonsense argument. RBS, undoubtedly a universal bank, was only saved from failure by the taxpayer, and there can be little doubt that if it had toppled, others would have followed. RBS didn't survive because it was a universal bank, but because it was deemed to be too big to fail.
Northern Rock wasn't too big to fail, but neither was it purely a retail bank. It's true that its assets were mainly mortgage loans, but its deposit gathering was inadequate to fund the asset portfolio it was able to generate, so it was a heavy user of securitisation on the liability side of the balance sheet. The higher capital ratios that the Independent Commission is suggesting might have provided some additional protection, but they would almost certainly have been inadequate to save it from the consequences of its flawed business model once the global crisis hit.
And that's where the case against allowing banks to become too large can really be made. With a relatively small number of banks, the systemic risks posed when even one of them "goes rogue" can quicly become unmanageable. Given the well-known herd instincts of the banks, of course, it's never just one bank that goes rogue, as the near-death experience of RBS (and HBOS, rushed into a shotgun marriage with Lloyds) clearly shows. A larger number of smaller (but NB -- not tiny) banks, with differing business models and less potential to wreck the system through contagion, may be at least as important as higher capital ratios in protecting depositors and taxpayers from future financial crises.
The Commission's final report is due in September, and then the Government has to decide what it wants to do about it, if anything. The best way to make money out of all this? Invest in a lobbying firm.
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