Regulation to the rescue? 5 problems with ring-fencing, Basel III, and competition in the banking sector

Length: 6 minutes

Technical Read 

On Wednesday 4th July, I was invited to speak at the Westminster Business Forum as part of the event ‘Building a resilient UK financial sector – next steps for prudential regulation, structural reform and mitigating risks’. The panel I was asked to join was Preparing for the impact of the banking ring-fence and Basel III – effectiveness of reforms, and implications for firms’ competitiveness and liquidity.

Unsurprisingly, there is celebration within the banking sector that it will manage to meet the ring-fencing (separating retail banking from investment banking) deadline of January 1st 2019. And from the Bank of England that Basel III has been finalised. But are these reforms really tackling the core issues and problems with banking? I don’t necessarily think so.

This is what I outlined:

5 PROBLEMS WITH RING-FENCING 

1. Ring-fencing in the UK has been interpreted in many different ways by different banks. This has created more complexity and will make banks more difficult to regulate – some have described them as mutant banks! There is a strong argument why more and more complexity in an already complex system will not necessarily have the desired results. Andy Haldane spoke about this in a 2012 speech he gave entitled ‘the dog and the frisbee.’

2. Ring-fencing has always to some extent been about a false logic that retail banking is safe, with investment the risky side. But the 2007/8 crisis emanated from the retail arm in the first place, e.g. Northern Rock and mortgage lending.

3. Investment arms can become exposed to bad loans in the retail section of other banks anyway, through securitisation. Lehman Brothers had no retail activities but was the first major bank to go bust in 2008. Therefore some contamination of bad loans across the system is still possible, even if ring-fencing rules out contamination within one bank

4. The proposals have been watered down over time by the sector’s engagement and lobbying efforts. Banks ‘scored a victory’ in 2015 in that they will be able to transfer capital from retail arms to other divisions so long as the retail arm meets its own rules on capital. Profits from capital can still fund speculation in the retail arm. Regulators have ‘gone as far as they could to make life easier for the banks within the framework of the law.’

5. Since the reforms were introduced, they have been ‘overtaken by other rules’ e.g. higher capital requirements, international resolution rules, recapitalisation regime (bail-in). This has to some extent resulted in the British banking system becoming ‘over-engineered’ which might not actually result in increased resilience.

Ring-fencing and the ‘electrified ring-fence’ that was discussed at length through the independent commission on banking and Vickers commission may not cut it in terms of what we need it to do to make banks work in the interests of people, businesses, and our society.

5 PROBLEMS WITH BASEL III REGULATION

1. A key problem is the way risks are calculated. The amount of capital that banks need to hold is calculated against their risk weighted assets i.e. banks are required to hold more capital against riskier assets. This is backward looking: securities that have been risky in the past are assumed to be risky in the future and securities that have been safe in the past are assumed safe in the future, which is not necessarily the case. What happened with the 07/8 financial crisis serves as an example: banks invested in highly rated debt backed by lousy mortgages, which were thought of as risk-free or relatively risk-free assets, based on ratings that deteriorated over time. Rating agencies rated asset-backed securities as safe until the whole market collapsed. They thought that pooling of loans reduced the risk. As we know, mortgages were a key part of the 2008 crisis, but mortgages or securitised mortgages were thought of as risk-free or relatively risk-free assets, based on their ratings. Because they were considered less risky, banks all invested in them, and then all dumped them at the same time.

2. Basel III introduces a leverage ratio, so banks must hold 3% of total assets in capital. Many commentators have welcomed the leverage ratio but pointed out that it is held far too low to have any significant effect. Proposals have ranged from 10% to over 30%. Professor David Miles presented some modelling showing banks should hold at least 20% equity capital.

3. As with previous Basel rules, capital requirements do not fully constrain bank lending. As banks profit from making loans and profits can be retained, their capital can increase as long as loans are repaid. Higher capital allows for more lending, creating a reinforcing cycle. Banks can raise additional capital through new share issues, increasing their ability to lend. Due to securitisation, banks can package assets/loans and sell them off, freeing up capital and allowing for an increase in lending.

4. One major issue with our current banking system is that credit is primarily directed towards pre-existing assets, mortgages and financial intermediation, and not the productive parts of the economy. This hasn’t really changed since the crash – in fact it has got a bit worse.  Basel III won’t help correct that – in fact it is biased against lending to small and medium firms.

5. Basel III favours big banking groups as they are better able to absorb the costs of regulations – this might make them more prominent in certain markets, leading to higher degrees of concentration – exacerbating the ‘too big to fail’ problem as highlighted by the IMF.

5 PROBLEMS WITH COMPETITION IN THE BANKING SECTOR

1. Many people have drawn attention to our problem in the UK with competition in banking. In fact, at the Westminster Business Forum Charlie Elphicke MP pointed out that the industry is an oligopoly: 5 ‘too big to fail’ banks dominate with 85% of market share.

2. Policymakers at the Treasury treat the international competitiveness of our financial sector in the global market with greater reverence than domestic competition to serve the needs of our economy: people,  businesses, the productive UK economy.

3. The Competition and Markets Authority investigation into retail banking was disappointing, because it didn’t examine a key problem, which is that not only do we have few banks, but they are all the same type of bank – shareholder-owned, ‘too big to fail’ banks.  We need to have new types of bank in terms of ownership, geography, specialisation, and size: stakeholder, investment, regional, green focus, SME focus.

4. The government is selling the remainder of publicly owned shares in RBS at a loss to the taxpayer – this is a mistake. It should consider longer-term options to make the bank work for us.

5. Banks serve multiple functions: they make loans, but they also give people access to payment services. Still, 2 million people in the UK are without a bank account, and cannot partake of the convenience of electronic payments. Considering how we make the payments market and banking market serve the needs of citizens and the UK economy as a whole is the place to start.

As always, the Forum featured a question on the likelihood of another financial crash. It is a shame people always think we need a crash to instigate a new conversation about what is wrong with banking. Still, there is likely to be one somewhere in the world soon. Perhaps then we’ll see reforms that reach the core of the issue with our faulty banking sector.