Monday, 11 April 2011

The ICB interim report: leaving us in a dangerous situation.

April 11th has for months been a significant date in the diaries of bankers. This morning the Independent Commission on Banking (ICB) released its interim report, a sort of preview of the final recommendations it will present to the government in September with the aim to improve stability and competition in UK banking. 

It was not just the banking sector eagerly anticipating todays report, I have been excited about it for weeks(!), and have thoroughly enjoyed a day in a warm and sweaty office reading the report in detail with the Positive Money team.

After threats that the banks will pack up and leave the UK*, and cries that the commission's recommendations would destroy profits, meaning that nationalised RBS and Lloyds might sell at a loss to the tax payer, the markets proved optimistic this morning in response to the report as shares in Barclays, RBS and Lloyds rose by 3.28%, 2.49%, and 0.72%, respectively. Unfortunately for the public, the outcome of the market is not determined by investors with long term outlooks aligned with the welfare of society, and in contrast to the banks, our evaluation of the report was critical. 

I just want to remind you how important the influence this commission has on the government to reform the banking sector is. In the words of the commission...
" The UK was severely affected by the crisis. National output in 2010 was 4.5% below its pre-recession peak. Unemployment has risen by more than 800,000 since 2007. The  public finances have deteriorated sharply, and the 2009/10 deficit exceeded 10% GDP. There is evidence to suggest that some of the output loss economies suffer during crises is permanent. Work by the Basel Committee on Banking Supervision suggests that the cost of banking crises may exceed 60% of pre-crisis GDP. More than 80% of RBS and more than 40% of Lloyds are in state ownership as a result of the Government bail-out of the banking system."
So what does the ICB propose? 
1) Increased Competition
Competition was part of the commission's remit, and so had to be addressed. Indeed, increasing competitive pressures in the UK banking sector, which is concentrated in the hands of The Big Four (RBS, HSBC, Barclays and Lloyds TSB) is no bad thing. If we suspect that a lack of competition is allowing these firms to keep costs up, then increasing competition promises to benefit consumers by decreasing the cost of borrowing and increasing returns on savings. Providing information to help consumers choose the best bank for them, another proposal, is of course also welcome. These proposals, however, are fairly irrelevant to dealing with a financial crisis.

Crucially, the report does not address the unique lack of competitive pressure that the banking sector faces as a whole. The government promises to insure all deposits up to the value of £50,000 should a bank fail to repay a saver, and we have seen that the government bails out failing banks at huge cost to the tax payer. The possibility of external support boosts banks ratings by the ratings agencies at no cost to themselves. Haldane (2010) estimates that the government guarantee reduced bank funding costs by £57bn per year from 2007-2009. No other industry or service sector receives this kind of support, or subsidy, which fundamentally buffers it from true competitive pressures. When any other firm goes bankrupt they exit the market leaving more room for companies with the best skills and ideas to grow. The result is that banks can behave recklessly by taking on excessive risk; if they are lucky they will make high returns, and if they mess up they know that the government will help out.

2) Increased Capital Requirements

In their analysis of the recent crisis, the report describes the "explosion of leverage" in the run up to the crisis as key to explaining why the banks were so vulnerable. Just before the crisis banks lent up to 50 times the amount of capital they actually had! Increased capital requirements are being called for internationally by regulatory bodies to reduce the extent of leverage banks can take on, and reduce how hard they can fall in a crisis. Specifically, the report suggests that retail banks hold capital equal to 10% of their loans and investments, and that wholesale banks should meet the slightly lower capital requirement of 7% (in line with the Basel III accord). I think the most we can say is that these small adjustments might make the banking system slightly "less brittle"; the commission estimates that it "would allow total assets [in the wholesale banks] to be almost 30 times equity capital. And so banks could only withstand a 3.5% fall in the value of their assets before wiping out this capital." 

This leaves their final proposal to make the banking system more stable...

3) Ring-fencing

The idea behind ring-fencing is to stop risky investment activities from pulling down the retail activities (where you and I hold out current accounts) of banks by ensuring that they are each supported by their own separate pools of capital. The separation has been described as a firewall because it is not permanent, it is only activated in times of need, and only if it does not pull down the other part of the bank down too. Ben Curtis from Positive Money explains it well in a piece he wrote for Liberal Conspiracy today: "The two arms of the bank would to still be able to bail each other out in difficult times, but neither would be able to bring the other half down in a crisis."

Firstly, this proposal demands more from the regulators than they have shown to be capable of (the regulators embarrassingly failed to foresee the recent crisis): how will they know when the special circumstances in which the firewalls need to be activated hold? Secondly, because of a lack of information and transparency regulators will have to rely on what the banks tell them. This means that should the retail activities of a bank go under, the bank manager has an incentive to tell the government that their investment arm is not strong enough to bail it out. The government will then be likely to bail out the failing retail activities, and the bank's investment activities will be protected at a cost to the tax payer. Thirdly, the commission mention that even if banking crises can be contained to certain arms of bank activities, the market response could be so negative that the crisis could spread to other areas.

I listened with great esteem to Liam Halligan's damning crtique of the report on PM (radio 4). (He is currently chief economist at Prosperity Capital Management, and a highly regarded financial journalist.) He describes the ring-fencing proposal as an elegant political compromise, when what we need is leadership to get us out of a dangerous situation. You can listen here (from about 18 mins).

In sum, the commission's report provides a disappointing preview of a selection of weak and ineffective recommendations that they will make in September. I think the report betrays a bias towards the banks and the status quo, and also an ignorance by not taking seriously more 'radical' proposals. Oh, but that is for another post... I'm sleepy xx

* There is an interesting table on p.202 of the report that breaks down the amount of tax we would lose should banks move their operations from the UK, as some threaten to. Of the total £55bn the government received in taxes in 2009/10, the commission estimates that only £3bn face the "lowest hurdle to departure" and that £30 - 36 bn would be "hard-to-impossible to leave". Should we be so concerned by their threats?

UPDATE: You can watch Ben Dyson's summary of Positive Money's reading of the ICB report here.

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