Monday, 29 August 2011

Setting up banks to fail: retail ring-fencing revisited

In my quest for a blueprint for bank reform that would allow dinosaurs to die quietly without endangering people's lives and finances, I found myself re-reading the Independent Commission on Banking's (ICB) draft report yesterday.  I always find it interesting to return to something I haven't read for a while, as I nearly always find something that I missed before. This was no exception.

In fact I don't know how I missed it before. On re-reading the report it is very evident that the ICB's recommendations for increased capital and retail ring-fencing have little to do with keeping banks running safely and efficiently. They are intended to make it easier and safer for them to fail.

And they don't mean just investment banks, either. The aim of the retail ring-fence is to enable government to take over the running of essential banking services (payments, access to deposits, lending facilities) for ordinary people and small businesses in the event of ANY bank failure, whatever the cause. You see, the problem with running an integrated retail & investment banking model is not that one funds the other, or that one increases the risk of the other. It is that you can't easily separate functions that are essential to the smooth running of our economy from those that are not, nor from those that have global rather than domestic impact. That is the real reason why the Government found it necessary to bail out banks rather than allowing them to fail.

On that basis, I applaud the ICB's efforts. But they don't go far enough, and there is - as I have noted before - a cost, both financially and in terms of increased risk, particularly to retail customers. 

Let's look more closely at their recommendations and the reasons for them.

According to the ICB, "making the banking system safer requires a combined approach that:

••makes banks better able to absorb losses;••makes it easier and less costly to sort out banks that still get into trouble; and••curbs incentives for excessive risk taking."


And in recommending ring-fencing of retail banking as a solution, they say the following:

"Ring-fencing a bank’s UK retail banking activities could have several advantages. It would make it easier and less costly to sort out banks if they got into trouble, by allowing different parts of the bank to be treated in different ways. Vital retail operations could be kept running while commercial solutions – reorganisation or wind-down – were found for other operations. It would help shield UK retail activities from risks arising elsewhere within the bank or wider system, while preserving the possibility that they could be saved by the rest of the bank. And in combination with higher capital standards it could curtail taxpayer exposure and thereby sharpen commercial disciplines on risk taking."

See what I mean? Most of this is concerned with closing down failing banks. Only the reference to drawing on investment & wholesale banking to save retail operations, and the reduction of the taxpayers' guarantee to improve risk management, is about keeping them going.

Note that the above quotation mentioned the possibility of failing RETAIL operations being bailed out by wholesale and investment banking operations. This is not pie in the sky. Three of the four UK banks that failed did so because of serious losses in retail banking. It is essential that banks that have wholesale and investment operations can draw on them if necessary to support retail banking.  One of the reasons for the ICB's opposition (and mine) to full legal separation is that that would make it very much harder for banks to do this, and there would consequently be increased risk to RETAIL customers.

It is unfortunate that the way in which this report has been represented in the media and by politicians gives the impression that it is a blueprint for protecting "safe" retail banking from "risky" wholesale and investment banking. It is nothing of the kind, and hysterical demands for full legal separation to "prevent bankers gambling with our retail deposits" are a million miles removed from the careful analysis and balanced arguments in this report.  To quote the ICB again (my emphasis):

"...the Commission believes that there are practicable ways of distinguishing between retail banking and wholesale and investment banking. Both sorts of banking are risky and both are important, but they present somewhat different policy challenges."

I have previously written about the ICB's proposals for retail ring-fencing. As a model for banking in the future I still think it is seriously flawed, relying as it does on the integrity of bankers to keep risks manageable. The increased capital requirements overall and separate capital requirement for retail operations go some way towards mitigating this, but the fact remains that retail deposits will still be at risk.  And the existence of deposit insurance backstopped by the taxpayer will still encourage bankers to take excessive risks in lending, knowing that if it all goes wrong the taxpayer will cough up. 

However, as a model for ensuring that failed banks can be safely wound down and essential services maintained, I have to admit it has some merits. And since we are currently facing the possibility of a mammoth banking crisis due to sovereign debt writedown, imposition of a ring-fence in the short term would provide retail customers with some protection. But it doesn't go far enough. In particular, it is unacceptable that current accounts remain "at risk" in the same way as deposit accounts.  As I have noted in another place, these accounts are the lifeblood of our economy and people need constant access to them. Nothing is proposed either to ensure that these accounts cannot fail under ANY circumstances or to compensate people for contingent losses arising from lack of access to these accounts.  The FSCS scheme is utterly inadeqate as insurance for current accounts.  I would prefer to see current accounts separately ringfenced and treated as custodian accounts (i.e. off balance sheet), so that banks cannot use them to support any commercial activity.  And I would also like included in the ICB report discussion of appropriate measures to enable investment and wholesale operations to be safely resolved, losses mitigated and risks managed.  After all, large amounts of our savings pass through these operations. Global failure of investment banking could wreck our pensions, our ISAs and our endowments.

And finally....the ICB does not discuss funding of retail operations at all: it appears to assume that funds arise only from deposits, which is far from the truth.  There are strident calls for retail banks to be denied access to external funding sources such as the interbank market and bond issuance: many of these calls arise from a mistaken belief that retail banking deposits fund investment banking, so retail banks can't be short of cash, can they? Oh yes, they can. Most retail banks require external funding on a daily basis. Liquidity crises are possibly the most serious threat to retail banking.  How would liquidity be maintained in a ring-fenced model? As, despite my qualms, it seems likely that some form of ring fence will be imposed, I shall return to this in a subsequent post.

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