Will Vickers do the trick?

by Dr. Ros Altmann

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So now we have the Vickers Commission Report, can we relax about the banking system? Certainly not. Banks seem to have almost welcomed the report, which surely in itself suggests the proposals are not tough enough!

What’s the problem?

The ICB’s remit was to promote financial stability and increase competition among UK banks. Following the 2008 crisis, it was clear that the banking system had been allowed to grow too freely and had ended up with so much power that it could effectively hold the rest of the economy to ransom. Government felt forced to step in to rescue banks, rather than let them fail.

Bank lending had mushroomed out of control and investment banking had become so complex and globally interconnected that, following the collapse of Lehman Brothers, failure of a major financial institution seemed too dangerous to contemplate.

Investment banking arms had gambled billions of pounds of depositors’ money on future market movements, had entered into esoteric financial instruments whose risks they did not fully understand, had parcelled up risky loans and sold them as almost riskless to unsuspecting investors, or to each other. Sophisticated risk models turned out to be fatally flawed.

The City had been run under so-called ‘light-touch’ regulation, which was basically more like ‘hands-off’. Bank management had endorsed and encouraged the creation of all kinds of financial inventions that seemed to bring in great profits. Short-term trading or speculation was rewarded with huge bonuses, lending to borrowers who could never repay was itself considered hugely profitable and investment bankers or salesmen were richly rewarded for selling these loans, regardless of the risk. The retail banking operations were bound up with these risky investment banking divisions, so if things went wrong on the investment side, depositors’ money was on the line and the banks did not have sufficient capital to absorb the large-scale losses.

The ICB Recommendations

Vickers’ verdict is that banks must in future ringfence their retail operations (for individuals and small or medium size companies) from their investment banking side, each having their own independent boards with more independent directors, and they must hold far more capital. This is designed to ensure that, if investment products go wrong, if trading suffers huge losses, or if risk is misjudged by trading or broking divisions, ordinary investors’ deposits are not put at risk. It should be the investment bankers’ capital that is on the line, rather than retail depositors. As Mervyn King has rightly observed , Western banks have acted like casinos, ‘making bets with other people’s money’ while ‘not understanding the nature of the risks they were taking’. This is not supposed to be allowed to happen again.

In order to shore up the strength of the retail side of UK banks, Vickers says the retail banking arms must meet more stringent capital, liquidity and funding rules on a stand-alone basis in future, with equity capital of at least 10 per cent of risk-weighted assets. This is stricter than Basel III which requires only 7 per cent. The banks will also need an overall minimum capital buffer of 17-20 per cent.

Will these recommendations do the trick?

These measures are designed to promote financial stability by ensuring that taxpayers will no longer be ‘on the hook’ to bale out bankers’ bad decisions about investment risk.

These are all commendable goals, but the sad reality is that banks have been given until 2019 to implement these changes, so they are hardly much comfort for the foreseeable future. It is difficult to understand why the banks are being given so long to change their practices. The Commission appears to have bowed to the banking lobby which has frightened them into believing that acting quickly could damage economic growth and increase the costs of banking for business or individual customers. Banks have also continually threatened to move offshore if measures are too harsh.

We should not have to wait till 2019. These changes should happen far sooner. By 2019, it is highly likely that another full-blown banking crisis will have happened and taxpayers could suffer again as they will not have the benefit of better protection.

Until there is more capital and better separation of investment banking from retail deposit-taking, British taxpayers are still at risk of having to save the banking system once more. By doing so, we are still destroying capitalism, because capitalism thrives on the taking of risk being rewarded – but also that those who take risk and fail suffer the losses. With banking, however, it’s heads they win and tails we lose, so they can gamble as much as they like, get rewarded for when it goes right, but when it goes very wrong they rely on taxpayers to pick up the tab.

Costs and rewards

The ICB Report estimates that the costs of separating the casino side from the retail side could be £4billion-£7billion a year. It has been pointed out that, coincidentally, the investment bankers at the big five UK banks paid themselves £7billion in bonuses last year – so surely these changes could be implemented quickly and without additional cost to customers – as long as bonuses were scrapped! In fact, the ICB could and should have made recommendations to better align bankers’ pay with reality, but it ducked that issue. Rewards of such massive size, paid to those who gamble with other people’s money, have led to poor decisions in the past and there are signs that past mistakes may be being repeated.

As long as both retail and investment banking take place under one ‘universal bank’, the retail depositors’ money is going to be used to take giant risks. We need a return to ‘Glass-Steagall’-style separation quickly. Again, to quote Mervyn King ‘allowing large banks to combine High Street retail banking and risky investment banking strategies, and then providing an implicit state guarantee�creates a banking system which contains the seeds of its own destruction.’

Criticisms of the proposals

Many have tried to argue that separation of retail and investment banking is not the answer – that there is no proof that this will work, that it will be difficult to decide which activities stay within which part of the fence. They claim that Lehmans had no retail side and Northern Rock was only a retail bank, so this is the wrong solution. However, the latest scandal with UBS losing billions due to one rogue trader, again reinforces the need for urgent action to protect pedestrian banking from high-octane trading. The reality is that the high-risk investment banking operations, sliced and diced sub-prime loans and complex financial derivatives were all part of the problem of the banking implosion and it is vital to find a way to separate the taxpayer-guaranteed retail banks from the rest of the banks’ arsenal. This is particularly vital in the UK because of the size of our banks – which have been allowed to grow far too large. The balance sheets of our top ten banks amount to over 4 times our nation’s annual GDP (the equivalent figure for the US top ten banks is ‘only’ two thirds of one year’s GDP).

In fact, I believe the banks are not too big to fail, they are too big to save. Taxpayers cannot really afford to bale them out and, in fact, doing so last time has caused huge problems which are only jus beginning to be recognised. By paying such a high price for the shares of RBS and Lloyds, we are locked into situation where taxpayers cannot dictate bank policy in the national interest, even though they are largely nationally owned.

What about the customer interests – we need a different type of bank

Banks are not doing enough to help growth, because they are desperate to deal with their own debts. If banks are so important to growth, why are they failing to lend to small businesses, continually increasing charges and interest rates and riding roughshod over customer interests? Vickers does not really help address these issues. Yes, we need more competition in banking but the best way to achieve that might be to have a major bank taken into public ownership and run in the social interest, rather than for profit. This bank could then lend to businesses on better terms, offer better and fairer deals to customers and ensure that ordinary depositors’ interests are a higher priority. I fear, however, there is little chance of this happening. We only have to look at the precedent of National Savings and Investments, who run an astonishingly efficient retail banking operation, managing millions of accounts, paying on time and not ripping customers off. They have been forced to withdrawn their offerings because they were proving ‘too popular’ with ordinary investors and providing too much competition for banks and building societies.

Conclusion

So overall, the ICB has some good recommendations, but it has not gone far enough. It is certainly true that we need more independent directors and customer groups represented on the boards of banks, plus a separation of retain from investment banking. However, the glacial pace of change means that financial stability is still at risk from our banks. The political establishment and economic policymakers are still being held to ransom and allowing such a long lead time to 2019 may mean changes not happening at all. The Report has not dealt with the remuneration structures that produce dangerous incentives to reward risk and ignore customer interests. Taxpayers must hope and pray that things don’t go wrong again. If they do, we know who will still pick up the tab.