UK banking reform - Vickers report

I will open the blog with a regulatory topic - the ICB banking reform in the UK and its effects on competitiveness, growth and recovery of the UK economy.

In September 2011 the UK Independent Commission on Banking (ICB) announced its proposal of a banking reform that was to transform the British banking system and make it less vulnerable to outside shocks of liquidity and more responsive in their risk-taking behaviour. The initial concern that drove to the setting up of the ICB in 2010 was the notion that Britain will never again uphold a system in which a financial institution is considered too big to fail and that never again will the government have to bailout large banks at the taxpayers’ expense. The very essence of the Commission was to design a regulation that will reduce the likelihood of failure of important financial institutions and mitigate the effects on the economy of their possible defaults. The Commission was also supposed to tackle the problems of reducing systemic risk of the economy while keeping in perspective that it shouldn’t disturb the financial system from maintaining its main role of supporting the economy.

The Commission focused their report around two central issues: financial stability and competition of the banking system. Financial stability implies setting up a loss-absorbent position for the banks by increasing their capital requirements along with a structural reform of the universal banking system in the form of a ring-fence. A ring-fence implies partial separation of retail and investment branches of a bank so as to assure that the retail branch shouldn’t be responsible for its investment branch’s risky decisions and would be able to absorb the losses and protect the deposits of its clients. The partial separation means that in case of balance sheet problems incurred by either of the bank’s branches the other branch could still step in and provide the needed funds to absorb the losses and avoid another public bailout. The ring fence should discourage the banks from risky investments making them more robust and highly unlikely to fail. It will also make resolution simple in case of a bust of either branches and it won’t incur any cost to the taxpayers.

In addition to the ring-fence the banks are to be required to hold more equity than before primary to avoid imposing losses to the taxpayers. Higher capital requirements will lead to the creation of a ‘bail-in’ fund where the bank’s private creditors will be responsible to cover the losses. Instead of the international standard of 7% capital requirement the UK banks should hold a 10% capital, while the retail banks should hold another 7 to 10% in order to mitigate possible future losses. The intuition behind such higher capital standards claims they would have been enough to protect the banks if initiated before the crisis. 

The ring-fence proposal recognises the retail part of a bank as too important to fail and seeks to protect it from losses imposed by the bank’s other subsidiaries. The retail branch will also be discouraged from investing into risky assets by limiting the scope to where it may invest. Such a proposal is based on faulty assumptions. Firstly, there is no clear pattern that an investment part of a bank drove to illiquidity of the retail part (Northern Rock and Wachovia are clear counter examples since they were retail banks, while other universal banks had balance sheet problems in both branches). Secondly, higher capital standards and an incentive to invest into what the regulators perceive as safe assets will not increase stability or the resistance to future financial crises. The effect will be exactly the opposite – it will lead to an increase of systemic risk to the economy. The ring-fence will stiff lending and make credit more expensive on the domestic market. The perception of safety will be achieved for the retail banks, but it is only a question until when, since future threats to banks assets are impossible to predict. The only plausible argument in entailing a ring-fence is to satisfy the public’s desire to be strict to banks as they are found as the main culprit due to their over-extensive risk taking and greed. It is therefore not convincing how a ring-fence should impose more stability into the system. The causal relationship between a ring-fence and financial stability is not proven, it is merely a possibility.  

Although the Commission does anticipate effects of future liquidity crises and asset shocks as well as the effects on bank behaviour once the reform is implemented, it fails to recognize the immediate impact the reform will have on the economy. They have set 2019 as the deadline to when the banks should adapt to the new reform, but the impact on expectations of banks and investors is immediate. Rational expectations and confidence are formed today with regard to expectations of the future. The banks will anticipate higher future costs and capital requirements which could lead them to a possible credit contraction now. If the banks anticipate a more hostile environment in the future, they will be reluctant to support long term projects today. The Commission should have included in one of its Annexes the anticipated immediate reaction of the banks and the markets, especially concerning the delicate situation the UK economy is currently in.

The second crucial focus of the Commission, competitiveness of the banking industry, is somewhat in contrast with the ring-fencing and capital requirement propositions. In the domestic market, higher capital requirements will result in less credit and deposit creation which implies less money for businesses to invest. Higher costs for banks will make loans more expensive and interest rates higher in the UK, therefore discouraging investments. On the international front, there is no guarantee that British banks will increase their competitiveness, since the banks’ subsidiaries abroad will continue operating under the same standards as before. Perhaps the regulators had in mind that by making banks safer at home would boost their international credibility as they become a more confident lender. This sort of reasoning is questionable, as there are many factors that influence the performance of domestic banks abroad, where the situation in the domestic market contributes only a small part in evaluating this performance.

The Commission requires that banks start investing into safe assets, but it fails to recognize that this sort of behaviour and economic thinking initiated the balance sheet problems of the banks. It also fails to realize why the banks started lowering lending standards. The regulatory obligations set forth in the US and Europe were steering bank’s investments into ‘safe’ assets such as mortgage based securities (MBSs) and were creating adverse demand on the housing market. The banks lowered lending standards because of an artificially created demand pushing them to invest into mortgage based securities. This drove the banks into issuing more and more mortgage loans to risky borrowers, as they needed to respond to the rising demand for MBSs. Filling up banks’ assets with risky securities wasn’t caused by competition but a lack of competition combined with overprotective regulatory confinements. The banks didn’t undertake risky investments due to greed and misbehaviour; they were simply following what the regulators enforced. The regulators had only the best intentions but made mistakes in evaluating the full consequences of their actions – the main one being what will happen if the mortgage based securities were to suddenly default. The only way for that to happen was for the housing market to crash simultaneously across the nation, which is exactly what happened. The housing bubble burst led to a series of defaults of MBSs, leaving all the banks that complied with government regulations with ‘toxic’ assets. The regulators are again repeating the same mistake. They feel they have the wisdom to repair the system and point out to obvious mistakes no one else before them was smart enough to observe. However, they omit to realize the following:

"The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design."

F.A. Hayek, The Fatal Conceit

Steering investment decisions of banks and imposing capital restrictions isn’t a way to boost confidence and will not result in a safer and more stable system. Regulators have designed reforms in the past that were supposed to protect the economy against adverse banking crises and defaults, but crises still occur, despite all their promising efforts.

I don’t mean to create a pessimistic forecast over the newly designed proposal but I would suggest caution in implementing the reform in this stage of the recovery. A vital task in this stage is to start up economic growth by restoring investor confidence. This will depend on many factors, mostly on resolving the Greek default issue and recoveries of the euro zone and the US, both huge UK trading partners. All the actions of the government and all newly legislated policies should therefore be focused on reducing uncertainty and enabling long term credible promises, such as the Treasury growth plan. While many countries chose short term fixes, Britain chose a long term path to recovery and restoring financial stability. It should stick to that path, not amend it along the way at any signal of poor performance of the economy. It takes time for the reforms to kick in. The UK is in a good position regarding its near future; it hosts the Olympic Games in the summer of 2012, which will bring in a huge inflow of foreign currency and assets into the country. An event such as that one will spur optimism back to the consumers and send a credible signal to the investors that the UK is capable of servicing its liabilities even with deep budget cuts. By roughly the same time, upon observing the new budget proposal the investors will receive a signal that the government is sticking to their long term path and will adjust their expectations accordingly. This will create incentives for businesses to start investing again and for consumers to start spending again as they will realize that the tax cuts are sustainable and that they shouldn’t expect any future tax increases that will stiff spending due to rising deficits. Reducing regulatory confinements to businesses is also a step in a right direction in reducing uncertainty. The ICB Report isn’t of such effect, at least not at the moment.