Independent Banking Commission offers Disappointing Half-Time Report

John Vickers, Chairman of the Independent Banking Commission gave a half-time report on Saturday 22nd January. Overall it’s not very encouraging and looks as though the Commission is aiming for strengthened capital requirements as its main cure-all. Radical changes in banking practice are not on the bill.

Due to present a final report to the Chancellor at the end of September on how to make the banking system safer and improve competition between banks, the Commission has already indicated that the new international rules on how much capital and liquid resources banks should hold, known as Basel III, are not strong enough. This is, in the Commission’s view, especially true of what are known as systemically important banks – the big ones such as Barclays, HSBC and Royal Bank of Scotland.

Radical reform of banking practice was given a nod but rejected. Vickers offered the cautious view that excessive costs to the economy would be caused by the imposition of what he referred to as narrow banking, in which banks that look after our deposits would be banned from lending our cash to businesses or individuals. He said:

“Some versions of ’narrow banking’ would eliminate most risk by requiring deposits to be fully backed by government bonds. But that would shift lending – including to personal and SME customers – elsewhere, and it is very doubtful that the implicit government guarantee would be confined to narrow banking. What sort of institutions would have loans on their books under narrow banking? Maybe mutual funds – a kind of mass securitisation. But to ban the funding of ordinary credit by deposits could have considerable economic cost.

“While the ICB is unlikely to favour radical forms of narrow or limited purpose banking, their aims deserve recognition. In particular, they seek by structural reform and much higher capital and/or liquidity requirements to limit (or make redundant) the government guarantee of risky activities, so that they can be left to the market. Second, they note the useful risk-bearing role that non-banks can play. As we have seen, however, depending on their linkages with banks both directly and through pro-cyclical market effects non- (or shadow) banks can amplify, as well as absorb, risks to the core banking system.”

Other points from the ICB Chairman’s speech include these views:

• It’s unfair that big banks, especially retail banks, can raise money more cheaply because their creditors believe that the state will always rescue them if they run into difficulties. As Vickers puts it:

“Systemically important institutions now have an implicit guarantee for risk taking activities, particularly those related to and/or inseparable from retail banking. The distortion, which is also a distortion to competition with other institutions, should be neutralised or contained.”

• A main task of the Commission is to propose reforms which would make creditors and investors responsible for all the costs of a banking failure at the same time ensuring continuation of money transmission, savers’ access to deposits and the provision of credit to households and small businesses.

• There needs to be a change to the tax system which perversely makes it cheaper to fund a company with debt rather than with equity. Equity holders absorb any losses but interest on debt is tax deductible giving banks a big incentive to minimize their holdings of equity.

• The arguments of the big universal banks that they are safer combining retail and investment banking than they would be if their functions were separated does not impress the Commission.

Overall it seems clear that at this point the Commission is thinking that higher capital requirements, especially for the systemically important banks, are the answer to the problem of instability in the banking system.

It looks as though the Commission would also like to see some sort of arrangement that separates the retail and investment banking activities of big banks, but it seems to be looking for solutions that fall short of de-mergers.

The question now is how can we change the Commission’s thinking on more radical reforms to banking practice?