Why the Vickers ringfence is no panacea
November 20, 2012
The City of London’s size and global reach continues to make the UK economy especially vulnerable to turbulence in the financial markets. In a bid to reduce that vulnerability and avert future crises, the UK’s coalition government, soon after taking the reins in 2010, tasked an Independent Commission on Banking with proposing reforms to Britain’s banking system.
Last autumn the Commission, under the chairmanship of Sir John Vickers, released its much anticipated final report, its centrepiece a plan to ringfence domiciled banks’ retail arms from their investment ones. Based on the notion that ‘less risky’ retail operations required protection from the ‘casino excesses’ of investment banking, the reforms aimed to reduce the burden on the British taxpayer in the event of banking failure. To the relief of many in the financial fraternity, the reforms fell short of a return to full-blown Glass-Stegall, the US legislation which had separated commercial and investment banking for seven decades until 1999. In addition, the big banks would now need to raise capital and loans equivalent to 20% of the part of their balance sheet for which UK taxpayers would be liable in a crisis.
The coalition government was swift to accept the Vickers recommendations without reservation, giving British banks until 2019 to install their ringfence. Yet a year on from this blanket acceptance by the coalition, the question about the separation of banks’ retail and investment arms has still not been successfully settled here in the UK.
Fears have been raised that the Vickers reforms will tie up £ billions in additional capital and impose upon banks a requirement to overhaul compliance and corporate affairs, a burden that will be met by the public in higher interest rates and a sharp reduction in the amounts banks are willing to lend. One of the causes of the paralysing strategic uncertainty that has enveloped the UK’s big banks is the mixed messages from the Treasury and central Bank alike over the dual requirements to recapitalise (and thereby reduce risks of future taxpayer bailouts) whilst being ready to lend to credit-starved UK Plc as if it were 2007 all over again.
Meanwhile, as the government prepares to legislate for Vickers in a Banking Reform Bill scheduled to be considered by the UK parliament early in the New Year, at EU-level, the Liikanen Report has recommended to the European Commission a similar, Vickers-style ringfencing of retail from investment banking. This has given a small crumb of comfort that the UK may not now be going down this path alone. However Liikanen’s proposals are sufficiently different from Vickers’ to heap further uncertainty upon financial services providers here in the City of London. Since there is likely to be precious little consensus between the EU, UK and US authorities any time soon as to whether the structure of banking is best under Liikanen, Vickers or Volcker, how should banks now prepare? Once again, the cost of uncertainty will be borne by the consumer and the wider economy, not to mention heavy job losses in the financial services sector. In this regard, it is important to nail the understandable public misconception that it has been “business as usual” in the City since 2008. Over the past two years volumes of business have collapsed, state financial support has been largely withdrawn and there has been a huge jobs cull. Couple this with falling salaries and bonuses for the vast majority of workers and it has been bad news all round, as Treasury receipts from financial services have plunged to a new norm.
Aside from the issue of commercial uncertainty, there are question marks over whether the ringfence will actually work. I believe the Vickers template is based on an outdated and simplistic division between what amounts to wholesale and retail banking. There are numerous transmission mechanisms between the two that make a hard and fast split between high street and ‘casino’ investment banking difficult to achieve.
The Vickers model also implicitly assumes that retail banking is ‘risk free’. Part of the genesis for the 2008 financial crisis, however, lay in the lending of money by retail banks to poorly-risk-assessed clients, particularly in the US. After all Northern Rock, whose decline famously sent the balloon up for what was to come in the UK, did not have an investment arm.
In practical terms, it is questionable whether the much-heralded split will make banks better at absorbing losses. A failing investment bank which falls outside the ringfence is still likely to share its name or at least reputational goodwill with the retail bank from which it has been cast asunder. Does anyone seriously believe that there will not also be a run on the retail bank and huge potential liabilities falling back to the taxpayer via the depositors’ compensation scheme?
Unilateral British action over bank regulation also risks diminishing the competitiveness of domestic financial services since non-domiciled banks would be able to escape the ringfence. This raises the more fundamental question – if only UK banks are obliged to sign up to the Vickers reforms then surely the contagion risk from any future global financial crisis will be exactly the same? Small additional amounts of capital being held in a dwindling number of British banks are unlikely to make any difference when the next crisis is in full flow. In any event, what is to stop banks simply redomiciling to the EU and setting up subsidiaries in the UK?
Historically the City of London has benefited from arbitrage with Wall Street from withholding tax under President Kennedy (which precipitated the creation of the Eurodollar and Eurobond markets) to Big Bang in the mid-1980s and the effects of Sarbanes-Oxley (2002) in the aftermath of the Enron and Worldcom scandals. If the UK is to prevent its competitors benefiting from unilateral British action along Vickers lines, it must continue to press for international agreement on the future landscape of the financial services world.
There is a danger now that the UK Treasury and EU regulators are viewing ringfencing as a panacea – and are selling it as such to the general public. Instead, in light of the pitfalls of the ringfence options, the UK Treasury should be open-minded to looking beyond the Vickers recommendation – both to accelerate the long-stop timing (currently set at 2019) and also examine whether a fully fledged breaking up of investment banks from retail banks might prove more practicable, publicly acceptable and long-standing than the ringfence provisions that the Vickers Commission has proposed. In this vein, it might prove more effective to look at an alternative dual system when it comes to ordinary deposit accounts, allowing those who desire a risk-free place to store their money to place it in savings banks, while those willing to take more of a risk can have an account with a fractional reserve bank, as used to be the case in the UK until the mid-1980s.
The UK’s coalition government has faced an unenviable task in reforming Britain’s banking system without placing the UK’s vital financial services sector at a competitive disadvantage. It has been brave in wholeheartedly accepting the Independent Commission on Banking’s reforms. But before it becomes too enthusiastic in its endorsement of everything Vickers, it should be careful what it wishes for. There is the real potential of a renewed credit crunch if lending dries up. We would then see the choking off of hopes for renewed economic growth in order that stringent capital requirements are met, coupled with an outflow of capital from the UK. In short, I fear that if the UK financial services system goes out on a limb over an unworkable banking ringfence, we risk a perilous prospect ahead for the real economy.