Is UK Banking Reform heading in the right direction?

Financial crises are like wars; the winners write the history. In the UK the winners are the Treasury and the Bank of England armed with the ultimate weapon of the public purse. There will be no public enquiry into the cause of the crisis or the performance of our public institutions responsible for financial system stability. All this matters because without learning from past mistakes we are condemned to repeat them.

The Chancellor announced in June 2010 an Independent Commission on Banking (ICB or Vickers Commission) to consider structural and non-structural reforms to the UK banking sector. In so doing, the ICB created a narrative to explain the crisis (reviewed here). In the years before the crisis bank executives and investors understood that the government would be compelled to save them from failing for fear of the wider repercussions to the economy and hence they took excessive risks and engaged in too little monitoring. This is a story of ‘too-big-to-fail’ causing the crisis.

The ICB’s recommendations received support across all political parties and authorities. The two most important recommendations to prevent a future systemic crisis relate to ‘ring-fencing’ retail bank operations from wholesale banking and requiring banks hold a higher share of ‘loss absorbing’ capital. The logic is that because retail bank services are vital to the economy, if a bank gets into trouble the ring-fenced retail part could be carved-out and continue operating while the rest of the bank is closed with losses absorbed by a larger class of investors and hence at less to the tax payer.

The fly-in-the-ointment came with the LIBOR rate-rigging scandal six months later. This market was at the heart of the transmission of the crisis but not mentioned by the ICB. In response the main political parties agreed to a Parliamentary Commission on Banking Standards (PCBS) to examine the shortfall in professional standards and culture in UK banking.

The first two PBCS reports cover the Financial Services (Banking Reform) Bill which implement most, but not all, of the ICB’s recommendations. Despite receiving accounts of how bankers have found ways around laws separating banking activities and the concern that the ring-fence will be eroded over time, the PCBS opted for two reserve powers to review the ring-fence (‘electrification’) rather than full separation. The PCBS supports ‘bail-in’ bonds as part of loss absorbing capital and the ICB recommendation of a 25 times leverage limit rather than 33 times preferred by the Government.

Whether these recommendations prevent another systemic crisis depends on whether they are based on the correct diagnosis. The ICB narrative certainly has convenient fall guys. But the idea that ‘too-big-to-fail’ encouraged bankers to deliberately take excessive risks is simply inconsistent with data showing bankers increased their personal exposure to the same risks (e.g. Cheng et al). It is also inconsistent with a psychological aversion to failure and the idea that the motive for mergers and risk taking was somehow kept secret from everyone outside of banking is inconceivable. The problem is that even if a government commits to closing banks in future, if the reasoning is based on a flawed diagnosis it will not be credible and prove ineffective when the time comes.

The PCBS’s third report published last week is a case study of the downfall of HBOS. For all the serious incompetence of senior managers and the FSA, there is little to suggest that those who ran HBOS even understood the risks they were taking rather than a deliberate play on being ‘too-big-to-fail’. It is consistent with reviews of other rescued banks which stress: management failure; internal agency problems; excessive return on equity targets; and, too complex to regulate e.g. UBS Report, Citi Report. The reports are indicative of moral hazard between those inside the banks and those outside rather than deliberately shifting of risks on to the state. The ICB and PCBS ring-fence in a bank holding company will simply invite other perhaps more subtle agency problems in future. And whether sanctioning banks to operate with a significant uninsured funding gap proves to be ‘loss absorbing’ in the next fog of the next systemic crisis remains to be seen.

The separation of banking activities has a long and distinguished history. As Professor Tobin pointed out, the key is to separate by function and not institution. In this UK this is complicated because we have a hybrid of retail and wholesale banks: Northern Rock, HBOS and Bradford &Bingley may have had retail assets but they were funded like wholesale banks (see mortgage funding here). To ignore the method of funding (as the ICB and PCBS do) is to ignore the innovation in finance over the past decade or more. It is no longer an asset allocation decision given deposit funding in place but a joint decision on asset quality and the method of funding.

A robust financial system requires deciding how ‘retail banks’ fund themselves beyond deposits. This requires distinguishing between those parts of the shadow banking system which directly fund real economy loans and therefore need to be brought within the regulatory perimeter. This financial crisis began in the shadows and almost destroyed the banking system (the same as in the Asia crisis). Only be dealing with the real issue can we hope to start solving the problem.