No More Bets: The Banking Reform Agenda and its Impact

This article seeks to examine the proposals for structural banking reform in the context of the range of ‘ex-ante’ and ‘ex-post’ measures that regulatory authorities can take to reduce the likelihood, and impact, of systemic banking failure. It goes on to explore the implications for the industry, including from measures looking to impose structural separation on banks such as the Independent Commission on Banking’s proposed ring fence and the Volcker Rule under the Dodd Frank Act, and ends by hazarding a prediction of what the industry may look like post implementation.

Introduction

The pernicious, contagious and far-reaching impact of the 2007-09 financial crisis on the economy of the United Kingdom is unprecedented.  Upwards of one trillion pounds – one thousand billion – has been spent on supporting the banking sector, either in direct or guaranteed loans and equity investment (1). That is close to two thirds of the annual output of the entire national economy. More than five years after the start of the crisis, signaled by the collapse in 2007 of the sub-prime mortgage market in the United States, the UK public finances are still reeling from this gargantuan package of state aid.

Unsurprising then, in response, is the cacophony of calls to fundamentally change the way the banking industry is organised. These voices, at first limited to the esoteric audiences of central bankers, regulatory authorities and banking industry professionals, are now filling the lexicon of ‘main street’.

The politicisation of the work of the 2011 Independent Commission on Banking (ICB) under the chair of Sir John Vickers, fanned by the publicity of the current Parliamentary Commission on Banking Standards, ensures that mere tinkering of capital, liquidity and depositor standards will not satiate the demands of those imploring ‘never again’. Wholesale change is the order of the day, and any one doubting the resolve of the mob to achieve this would do well to look at the carcasses of fallen parliamentarians and journalists similarly vilified.

This article seeks to examine the proposals for structural banking reform in the context of the range of ‘ex- ante’ and ‘ex-post’ measures that regulatory authorities can take to reduce the likelihood, and impact, of systemic banking failure (2). Note that it is the reduction, not the elimination, of the risk of failure that is at the centre of the reforms, extolling that never again will an industry predominantly owned by the private sector be underwritten by public guarantee. Thus the aim of containing bank collapse to within the financial industry rather than destabilising the outer economy is overriding, as is accepting the inevitability of the pendulum swing from banking boom to bust.

Upon considering the context of the reforms, we go on to explore the implications for the industry, including from measures looking to impose structural separation on banks such as the ICB’s proposed ring fence and the Volcker Rule under the Dodd Frank Act in the US, and ends by hazarding a prediction of what the industry may look like post implementation.

Gaming the State

Since the repeal of the Glass-Steagall Act at the end of the last century, the terms of the so-called contract between the state and banking have been stacked markedly in favour of the latter, seemingly on a basis of ‘heads we win, tails you lose’. The symbiotic relationship between the state and banks has clearly been in evidence for a lot longer than the Act’s introduction in 1933, notably as a means to finance the aggrandising pursuits of the sovereign since the early Middle Ages. In the modern era the benefit has swung decisively to the banks, and events since 1999 have accelerated this trend.

Whether through accident or by design, clear strategies were followed by banks that dramatically raised the stakes of the game prior to the 2007 crisis.

  1. Higher leverage fuelling balance sheet expansion. With no restriction on UK (and European) banks on simple leverage, banks’ assets grew to unprecedented levels prior to 2007 that, taken as a whole, amounted to nearly 600% of UK GDP (3).
  2. Swelling the proportion of trading-held assets. Valuation techniques that marked to (the) market created a virtuous circle of rising bank equity when the good times rolled, and a precipitous chasm when the music stopped.
  3. Business diversification. Ostensibly to allow the takeover of Travelers (retail bank) by Citibank (investment bank) in 1999, the repeal of Glass-Steagall heralded the rise of US and European banking conglomerates. Customer-centric ‘one stop shops’ pedaled retail deposit taking and home insurance alongside prime services provision and ‘casino’ proprietary trading. Balance sheet size, as a signal of illusionary strength, became the calling card of the major players
  4. More in evidence in the US, at least initially, were dangerous forays by banks into the origination of risky assets such as highly leveraged lending and sub-prime mortgages and their associated securitization. The asymmetric payoffs yielded high returns in the good times but spectacularly large losses in bad, adding to the sense of an unimagined, unmodelled and extra-ordinary perfect storm.

The effect of these developments was to create an industry-wide belief in a new paradigm of virtually risk free transactions, so efficient – apparently – was the market in transferring risk from a single point of origination through to a multitude of credit underwriters. And happily watching in the back ground was, in the UK, a New Labour government repeating the mantra of ‘no more boom and bust’ and a regulatory authority, the Financial Services Authority, praising the virtues of industry self-regulation.

The music stops

The hubris came to an abrupt halt from September 2007 with a series of government funded bail outs of banking and financial institutions across the western world. Other than for, notably, Lehman Brothers, the gaming of the state was complete; more than a decade of privately held gain, lost in a couple of years with the losses unwittingly subsidised by the tax payer. The size of the implicit guarantee for the five biggest UK banks between 2007 and 2009 has been estimated at £50bn – roughly equal to the same banks’ annual profits prior to the crisis (4).

The crushing sense of injustice, inflamed by frequent exhibitions of culturally endemic arrogance and disdain within the banking industry as well as further evidence of malpractice (around payment protection insurance (PPI), Libor fixing and derivative mis-selling for example) has elevated banker bashing to a national pastime. And it has united erudite, apolitical central bankers and academics alike to the cause of banking reform, reform that addresses the problem of moral hazard – gaming the state – and the notion that banks are ‘too important to fail’.

Broadly speaking, the reform can be divided into two approaches. On the one hand, measures that reduce the likelihood of banks failing in the first place (so called ex ante or before the event measures). And on the other, those that explicitly accept that banks can and should fail – if market forces so dictate – and therefore seek to contain the fall out ex post, such that the broader national and international economy – the economic system – can continue to operate.

Before or after the event?

To reduce the probability of failure, regulators can impose stringent capital and liquidity requirements on financial institutions that are related to the risks on their solvency and cash flow that they are taking. In effect, these force banks to build a bulwark against future adverse events. But rather like Canute and a flooding tide, neither eliminates the need for catastrophe insurance from the state should the worst happen. And neither delivers the surgical strike of retribution that is seen to be required to cleanse the industry from current malpractise. Basle II, the capital adequacy regime introduced across the G7 leading economies from 2006 (but not pointedly by the US), did nothing to prevent large scale capital injections being required to shore up the industry in the eye of the 2007-09 storm, even when capital ratios of some banks were reporting compliance (5).
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Subsequent measures to recalibrate risk weights and to preclude certain internal risk models under Basle ‘version 3’ – to be implemented from 2013 – do not do enough to dispel the notion that an industry within an industry has grown up purely motivated by the aim to outfox the regulators through evasion strategies such as shadow banking and regulatory arbitrage.

The focus thus turns to more fundamental questions that are posed by the second approach: how do we stop banks from becoming too important to fail? And how do we stop the state being gamed by banks and bankers?

At the heart of measures underpinning this approach is a distinction between the different activities that banks undertake. The banking system provides two crucial services to the wider economy: the function that allows people and businesses to make payments for goods and services; and the function that holds deposits for people and businesses that can be used to fund others’ investment needs. Other activities, including speculative, proprietary bets on the direction of markets in often arcane and esoteric financial products, are distinctly non-essential. In drawing this distinction then, we are introducing the idea of a separation between essential banking utilities and non-essential speculative ‘casinos’.

Banking utilities – providing payment services and deposit-backed investments for the use of the economy – would enjoy prudential oversight from the financial regulator and in extremis government protection in the event of failure. To some extent, this is what we have already seen with the extension of deposit insurance to cover 100% of deposits (up to £85,000) after the Northern Rock bank run in 2007. And with the Special Resolution Regime introduced in 2009 that gives the Bank of England, as ‘resolution authority’, powers to break up failing banks and transfer essential services to another vehicle – whether to a private sector purchaser or to a bridge bank (6).

Banking casinos at a time of failure by contrast would be left to the mercy of market forces, with no government backing or guarantee, just a (dis)-orderly queue of creditors, bond holders, share holders and other unsecured creditors picking over the bones of remaining assets. And that harsh reality, it is argued, will deter investors from allowing banks to speculate in the first place by raising the cost of their capital and apportioning that cost to where it should be felt; to the banks themselves, explicitly and directly, rather than to the taxpayer, implicitly and indirectly.

Current resolution measures – such as the Special Resolution Regime – though do not offer an effective solution in the face of the failure of a large and complex international firm. This is precisely the type of firm that at the moment enjoys retail funding guarantees coupled with the legal and commercial freedom to use that funding for risky and speculative activities that are underpinned by the tax payer (such as the four banks that dominate the retail and commercial banking market in the UK). Curtailing that freedom through structural separation enforced by statute is what the body of opinion built up around the Vickers’ ICB report is aiming to achieve.

The ICB ring fence

The ICB is proposing a series of activities that need to be protected through the setting up a ring fence between one part of a bank and another. Those that are in need of protection – within the ring fence – relate to the utilitarian functions of taking deposits and providing lending to individuals and to small and medium sized businesses. Such functions could also be extended to larger companies, with the proviso that none of the ring-fenced entity’s activities include those of ‘investment banking’, so defined as proprietary trading, market making, dealing in securities and underwriting securities.

Proposals offered up by the Liikanen Group to address structural reform of the EU banking sector in October 2012 broaden the remit of the ring fenced bank to include some hedging and underwriting services along side deposit taking and lending, but like ICB proprietary trading, market making and securities dealing are also prohibited. Under both, some activities can be conducted by either entity such as larger company deposit taking and lending.

Whether ‘putting a fence around a deer park’ or ‘trying to cage the wild animals’ – both amount to the same thing in the end, as the ICB put it (7) – the clear conclusion is that banks will have no choice but to implement structural separation. Legally, under ICB and Liikanen, the ring fenced bank can be owned by a wider banking group that conducts prohibited (within the ring fence) activities, but independence from the wider group must be guaranteed. This guarantee is three-fold; (i) the ring fenced entity should meet capital and liquidity requirements on a stand alone basis; (ii) its relationship with the rest of the group must be conducted on a third party basis; and (iii) it should have independent governance and make disclosures as if it were independently listed. We shall come on to considering the implications for banks from these proposals later in this paper.

Full separation

The sanction of full separation – the so called ‘electrification’ of the ring fence – has been proposed if the reality of independence does not match the intent, and the objective of separation through ring-fencing is threatened. Other proposals, including the Volcker Rule that is being implemented through the Dodd-Frank Act in the US, target full structural separation from the outset. In other words, certain activities are required to take place in completely separate organizations, not just in different subsidiaries of the same group. Retail deposit taking services cannot be in the same corporate group as an entity which undertakes investment banking proprietary trading for example. And Volcker prohibits proprietary trading and investment in hedge funds or private equity funds from taking place in the banking group, although the range of activities that can take place under his reforms within the separated entity is broader than ICB or Liikanen, extending to activities that are customer-related (including under-writing and market making).

Differences exist within these proposals over the precise extent of structural separation, whether through a ring fence splitting an organization or through full separation that creates an entirely new entity. What they share however is an overriding aim to minimize, if not eliminate, the implicit, state backed guarantee for non- essential banking activities. Instead, the full weight of regulatory supervision and government support is directed towards those singular services that are in the economic interest of the state. Separation may also have the less tangible but culturally significant effect of reversing, or at least stemming, the contamination of retail banking with the vices of investment banking, vices based on greed, self-interest and distrust. And as a wider consequence, perhaps, of reducing the probability of banks’ utilities from failing in the first place through introducing better corporate governance (as an ultimate ex ante measure).

The groundswell of public and private sector opinion on the need to reform the organization of the banking industry in the aftermath of the 2007-09 financial crisis, and its lingering, toxic effect on the wider economy, ensures that structural separation of the banking industry is inevitable. The remaining questions are when, not if, and where the exact boundary of separation – and how severe – will lie.

In the UK, the Government has pledged to complete all legislation for ring fencing before the end of the current Parliament in 2015 and to implement the ring fence before the ICB’s recommended deadline of 2019. In the US, the Volker rule is targeted for mid 2014.

Impact

The implementation of separation – in the form of a ring fence – will impact heavily on big banks’ balance sheets. The quality and quantity of capital will have to increase on both sides of the ring fence as banks guarantee independence from one to the other. And as Tier 1 capital ratios relative to risk weighted assets and to balance sheet leverage are bolstered. The resulting reduction in profitability (return on equity) will have to be accepted and mitigated, perhaps through greater risk being run in the entity outside the ring fence (assuming investors allow).

Competition-wise, retail banks that don’t have the organisational and commercial complexity of the large universal banks that are in the firing line of ICB and other proposals should enjoy a more even playing field, competing like-for-like. Regulatory capital and liquidity arbitrage across retail, commercial and investment banking domains within the one universal organisation will not, at least in theory, be possible. Additionally, the concentration of banking services amongst the ‘cartel’ of the big four in the UK should be broken decisively, as the barriers to entry are lowered. One consumer focused change under ICB will be to make current account switching much more bearable through porting direct debits and standing orders, significantly increasing the 3.8% of customers that currently switch their accounts per year. 

Currently, some economies of scale are achieved by banks through harmonising their (internal) services provision across business domains – often motivated by the ideal of seamless customer service, and universally by the aim of cost efficiency – that is supported by technology-based infrastructure.  So centralised systems supporting payment transactions, regardless of client size and type; cross-business exposure management; consolidated financial and risk management reporting and disclosure; corporate treasury and treasury sales functions spanning the organisations’ balance sheet; inter-company transactions for legal, tax, risk, and revenue-generating purposes; and IT support centres and network-based technology that transcend geographical and business barriers; procurement discounts through volume purchasing. All these support-related areas will be torn up through separation, and will have to be reformed – and therefore duplicated – on both sides of the divide.

Banks that offer these services to their clients – externally and for profit, rather than inwardly-orientated as the cost of doing business – as a result of holding client assets will be particularly affected. Payment services will only be able to be offered by a ring fenced entity, and whilst that entity can provide such services to organisations that sit outside the ring fence, whether part of the same holding company (or group) or external to it, they will be subject to tight, regulatory-backed safeguards.  

The one off cost of implementing the ring fence has been estimated at between £1.5bn and £2.5bn (through the effort to legally restructure for example), and in a range of between £1.7bn and £4.4bn per year on an ongoing basis (as the consequence of running separate IT platforms year on year for example) (8).

These figures exclude the additional funding costs seen by some as a consequence of removing the implicit guarantee and the opportunity costs of not generating the type and amount of revenue the banks had done prior to separation.

Conclusion

The universal banks’ dominance within their own market and in relation to the broader economic system of the state is being fundamentally challenged. The rules of engagement are being re-written. Lower risk, lower return, lower barriers to entry, reduced concentration, less volatility, and never again a situation where the national economy is held to ransom by a single, albeit vital, industry.

The resolution to the recent financial problems in Cyprus may prove to be the start of the process that unwinds moral hazard and the implicit guarantee where by bond holders, share holders and depositors (over a certain threshold) pay for the mistakes of the bank they have invested in. And of course in this situation, rather than in countless prior examples (bar Lehman Brothers), the banks in question, Laiki Bank and Bank of Cyprus, have been allowed to fail. Whether the nerves of the regulator and Central Bank would sufficiently hold for a bank the size of HBOS or Barclays failing in the UK has been in doubt previously. Through measures such as structural separation, enforced by way of a ring fence, that doubt will be removed going forward. 
 

(1) Mervyn King, Governor of the Bank of England. Speech to Scottish Business Organisations, Edinburgh, Tuesday 20 October 2009.

(2) Andrew. G. Haldane, Executive Director, Financial Stability, Bank of England, and Piergiorgio Alessandri. “Banking on the State”, a paper based on a presentation delivered at the Federal Reserve Bank of Chicago 12th Annual International Banking Conference on “The International Financial Crisis: Have the Rules of Finance Changed?”, Chicago, 25 September 2009.

(3) Haldane and Alessandri, op cit. Source: Sheppard, D.K (1971) and Bank of England.

(4) Andrew. G. Haldane, Executive Director, Financial Stability, Bank of England. Speech ‘The $100bn question’, 30 March 2010. From House of Lords and House of Commons Parliamentary Commission on Banking Standards, First Report of Session 2012-2013. Published on 21st December 2012.

(5) Professor John Kay, ‘Narrow Banking: The Reform of Banking Regulation’ (2009).

(6) A Bridge Bank is a temporary bank set up as a subsidiary of the Bank of England that keeps the essential parts running while leaving the remainder to enter a modified form of insolvency. House of Lords and House of Commons Parliamentary Commission on Banking Standards, Page 19, op cit.

(7) House of Lords and House of Commons Parliamentary Commission on Banking Standards, Page 28, op cit.

(8) House of Lords and House of Commons Parliamentary Commission on Banking Standards, Page 25, op cit.

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