Splitting the banks

Banks need structural reform as well as tighter regulation and we should be careful to distinguish between the economic impact to the country of reform and the effect on the banks themselves. Those are the main core conclusions of the final report of the Independent Commission on Banking, which was published today. The ICB builds on its provisional recommendations made in its earlier interim report. The final report should be seen as a minimum and every politician facing industry lobbying should have it to hand. It contains useful analysis of the economic impact of the banks as well as detail on its proposed reforms.

The ICB believes that separation of banking activities is vital to protect the taxpayer, retail depositors, and the UK economy. It does not believe that formal, legal, separation of banking into retail banks and investment banks is necessary. I disagree with it here because I believe any reform which relies on regulatory policing will be subject to erosion over time. Nevertheless, the ICB instead proposes that retail banking operations of larger banking groups should be ringfenced and operate as separate entities with their own boards, independent directors, culture, and capital ratios. Large UK retail banks should each hold equity capital of at least 10 per cent of risk-weighted assets (protecting against losses).  The ICB also proposes that ‘retail and other activities of large UK banking groups should both have primary loss-absorbing capacity of at least 17-20 per cent’.

The ICB is trying to address the ‘too big to fail’ problem ie when government has to act to save large banks because the consequences of not doing appear too great (as happened in the recent financial crisis when government had to act). Ringfencing should give retail investors some protection and problems will be easier to sort out; with larger capital ratios banks will be able to absorb more losses before any risk to the public finances; resolving a failing bank will be easier; and if problems do occur, the reforms are expected to ‘limit the spread of contagion through the UK banking system. This reduces the likelihood of triggering a system-wide crisis.’ The proposals are designed to complement other reforms being implemented (eg Basel III).

The ICB notes that the European sovereign debt crisis has shown that not only can banks put a country’s fiscal position at risk, but an unsustainable fiscal position can put banks at risk: ‘This shows starkly the close inter-relationship between the stability of banks and the soundness of public finances, and further strengthens the case for reforms to make the UK banking system more resilient.’

Worth a read is chapter five, on the economic impact of banking. The ICB stresses that while its reforms may cost individual banking groups, ‘it does not necessarily follow that there would be an equivalent – or indeed any – cost to the economy as a whole.’ Section 5.8 looks at the cost of financial crises. The median estimate in a Basel Committee study it quotes is 63 per cent of annual GDP, with financial crises occurring every 20-25 years. As the ICB notes, ‘…a financial crisis occurring every twenty years or so, costing 63 per cent of GDP, is equivalent to losing about three per cent of GDP a year. Put another way, if the level of GDP were the only thing that mattered, it would be worth paying an insurance premium of 3 per cent of GDP per annum if doing so would eliminate a five per cent annual chance of an event causing damage equivalent to 60 per cent of GDP on average.’

The point here is that financial crises cost (the estimate varies but the cost can be as high as 163 per cent of GDP). So far, UK GDP has been hit by around 25 per cent cumulatively. The cost of insuring against this is high (I recommended a ‘Financial Leverage Insurance Premium’ in a Progress article in spring 2008). Structural reform lowers the cost, in the ICB’s view.  There are other costs, too, to bear in mind, for example, the costs of volatile GDP and of unemployment.

We can choose. If we want to, we could levy banking to insure against the cost of the next financial crisis (or we could levy the taxpayer and subsidise the banks as, in effect, happened this time).  Or we can adopt structural reforms.  With the Christian Socialist Movement I have advocated complete separation of banking (an associated Early Day Motion attracted the support of many MPs including Vince Cable). I hold to that view; indeed there is a case for saying that if such a ringfence is required why not just separate? Yet this is an important set of recommendations (including on depositor protection and competition) and should form the baseline of bank reform. Labour, and the government, should follow the ICB’s recommendation that legislation be passed as soon as possible. We should also be wary of arguments for moving the reform deadline beyond 2019, which, of course, is itself still many years away.

 This article was first published on the Progress website on 12 September 2011.