Independent Commission on Banking

Ulster-bank The Independent Commission on Banking has called for ring-fencing of retail banking operations to protect the public from future banking crises. Stephen Dineen outlines the main recommendations.

The Independent Commission on Banking report published in September called for a ring-fencing of retail operations and new rules on loss absorption so as to minimise the exposure of the taxpayer, but the Government has given a deadline of 2019 to implement the changes.

Chaired by Sir John Vickers, former Chief Economist the Bank of England, the commission produced proposals in three main strands: structural reforms to banks; new rules on loss absorption; and proposals on how to increase competition within the sector.

Structural reforms recommended would see deposits and provisions of overdrafts of ordinary individuals and SMEs into a ring-fenced entity along with other banking services such as deposits from other customers and lending to large companies outside the financial sector. The ring-fence would comprise between one sixth and one third of the aggregate balance sheet of UK banks (over £6 trillion, according to the report).

The governance of retail subsidiaries should be made more independent, by way of boards having a majority of independent directors, one of whom would be chair. Global wholesale and investment banking, it recommended, should be kept outside the ring-fence.

Complete separation of retail banking from other activities is not entailed, the commission pointed out. It said, however, that benefits from the diversification of earnings would be retained for shareholders and creditors; capital could be injected into retail subsidiaries if needed; and there would be provision for “one-stop relationships for customers” wanting both retail and investment banking services.

Loss absorption

Stating that the obligations of the Basel III standards “do not go far enough” for UK banks of national importance, Vickers and his colleagues made several recommendations on ensuring adequate loss absorbency:

• large UK retail banks should have equity capital of at least 10 per cent of risk-weighted assets;

• retail and other activities of large UK banking groups should have a primary loss-absorbing capacity of at least 17-20 per cent (including long- term unsecured debt that regulators could require to bear losses in resolution, also possibly contingent capital, known as ‘cocos’); and

• depositor preference for deposits insured by the Financial Services Compensation Scheme, leading to them ranking higher than unsecured debt if it came to insolvency.

The combined effect of these reforms, the commission stated, would be to give customers who have no ready alternatives “some protection from problems elsewhere in the international financial system.”

Greater loss absorbing capacity meaning that “banks of all kinds can sustain bigger losses without causing wider problems,” and a curtailment of risks to the public finances “if they nevertheless do get into trouble.” It would also facilitate resolution, curb incentives to run excessive risks from the outset and help limit the spread of contagion through the UK’s banking system. No structural change would mean “substantially higher capital requirements than those recommended here would be necessary to achieve the same degree of expected stability.”

There was much debate on the report’s implications if the recommendations are implemented. Given the additional capital requirements being sought, the Commission said implementation should be completed by the start of 2019. It claimed UK banks will be able to compete against foreign banks by allowing international regulatory standards to apply to their wholesale and investment banking activities.

The report also dealt with the need to increase competition between banks and the perceived “too big to fail” issue which the commission says gives larger banks an advantage. It called for:

• a substantial enhancement of the divesture of Lloyds’ assets and liabilities;

• the introduction of a redirection service for personal and SME accounts to allow, among other things, accounts be transferred within seven days and seamless redirection for more than a year risk-free and cost-free to customers; and

• strengthening of the proposed wording of the duties and objectives of the Financial Conduct Authority so it can achieve aims such as tackling barriers to the entry and growth of smaller banks.

The report cited the 2010 Office of Fair Trading finding that Northern Ireland and Scottish banks had significant barriers in attracting new customers as they are often wary of switching to unfamiliar brands.

In its analysis of what happened to the UK’s banking system, the commission said there was a double failure of banks’ ability to bear losses. They had too little equity capital in relation to risks they were running. Leverage ratios of assets to equity capital had reached twice the historical norms, and this was allowed to happen because there was no restriction on leverage but on limits on the ratio of capital to ‘risk-weighted’ assets. When “the thin layer of equity capital was eroded,” it stated, “banks’ debt proved poor at absorbing losses.” While the debt holders might have borne substantial losses in insolvency, fears of the wider consequences forced governments to make taxpayers bear the contingent liabilities of bank failures.

Reaction

The Chancellor has said the Government welcomed the recommendations in principle and that reforms will be legislated for during this Parliament, with a deadline of 2019 for the banking system.

SDLP MP Mark Durkan welcomed the report saying that “without a safeguard for the retail side, massive losses on the speculative side could once again threaten retail depositors.” He said such a scenario would again mean taxpayers having to pump tens of billions of pounds to rescue such a combined bank. Alliance MP Naomi Long also welcomed the report but pointed out that the availability of lending for business and competition in personal banking is being affected by the Irish banking system.

Long asked the Chancellor how the report’s recommendations will inform discussions with the Irish Government on matters of competition, personal banking and lending to businesses in the North. The Chancellor said he and his colleagues are in constant discussion with the Irish authorities about the Republic’s banks.

The British Bankers’ Association, which had been critical of the scope of the ring- fence proposed in the commission’s interim report in April, said the final report covers the same issues as those in the sweeping reforms already brought in by the Government, the EU and at a global level: “It is vital that the full impact any further reforms will have on the economy, the recovery and banks’ ability to support their customers in the UK is understood.”

19,400 people were employed in Northern Ireland in the financial services sector in 2008, with the sector’s output valued at £1.4 billion to the local economy (4.9 per cent of gross value added).

Main points

• Ring-fencing of retail banking: deposits and overdraft provisions of ordinary individuals and SMEs, deposits from other customers and lending to large companies outside the financial sector

• Economic independence for retail subsidiaries: independent directors and chair forming a majority of the board of retail banks

• Equity capital of at least 10 per cent of risk-weighted assets in large UK retail banks

• Primary loss-making capacity of at least 17-20 per cent

• Financial Services Compensation Scheme-insured deposits ranking higher than unsecured debt in cases of insolvency

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