l The focus is to make banks more stable, the UK banking system more competitive and to reduce the costs to the economy and taxpayers of any remaining bank failures. The banking sector must be returned to normal market forces.
l Enhanced competition is needed between UK banks to reduce concentration and offer consumers more choice. Barriers to entry should be reduced.
THE NEED FOR REFORM
l Banks, by their nature, hold more debt than equity than other firms, so are more susceptible to failure if a small portion of their assets goes bad.
l Banks tend to fail in tandem so one failure can harm others. Their liquidity and funding are vulnerable to drops in confidence in financial institutions.
l Failure of systemically important financial institutions can damage economies by disrupting payments and lending. These costs are not fully borne by the bank – so banks take on more risk than is good for economies.
l Governments have felt compelled to bail out banks. This constitutes a government guarantee, which undercuts market discipline and encourages risk-taking.
l Senior debtholders should have borne losses in the crisis but bailouts ensured they generally took no losses.
l The UK market is highly concentrated after the crisis. SME banking and personal current accounts are the most concentrated. Barriers to entry are high.
CURRENT REFORM INITIATIVES
l Regulators such as the Basel Committee and Financial Stability Board have been active since the crisis. Basel III is the global standard but countries such as Switzerland are going further.
l The UK’s Financial Services Authority will set out its plans to wind down failed banks; the FSB is coordinating cross-border cooperation.
l EU reforms to create three new financial super-regulators will enhance oversight, as will the splitting of the FSA into two new agencies.
REFORM OPTIONS: FINANCIAL STABILITY
l Increasing bank’s loss-absorbing capacity and simplifying their structures would reduce their systemic risk. However, it may raise their cost of capital and funding and hence the cost to consumers would also go up.
l A bank failure is less damaging if it can absorb losses, rather than passing them on via a bailout. Both equity and debt liabilities can be loss-absorbing.
l The ICB believes the Basel III seven per cent capital ratio is too low and a ten per cent ratio is necessary for systemically important financial institutions. This assumes banks issue loss-absorbing convertible capital (co-cos) in addition to equity.
l Aspects of co-cos, such as price and how to avoid contagion, must still be resolved. Bail-in debt also needs clarity on which debts could be converted.
l Depositors should take preference over senior bondholders to ensure they are the last to take losses.
l Ring-fencing retail banks would make it easier to limit a universal bank’s failure and make banks less reliant on guarantees. It would also allow regulators to intervene in parts of a bank to protect depositors, rather than bail out the entire institution as in the last crisis.
l It is not a given that universal banks are safer. They cause problems such as contagion and allow greater risk taking.
l Full separation was considered but would lead to higher costs; operational subsidisation would still require different arms of the business to be restructured in a crisis.
l The Volcker Rule would be unlikely to have a significant impact in the UK.
REFORM OPTIONS: STRUCTURAL REFORM
l Despite disposals of Lloyds Bank and RBS branches and assets to compensate for their government bailouts, concentration in the UK’s retail banking sector is higher than before the crisis.
l The Lloyds HBOS merger should not be fully reversed as it would waste the vast investment into integrating the businesses over the past two years.
l But Lloyds’ disposal of assets needs to be “substantially enhanced” with a full competition commission inquiry to follow if this cannot be achieved.
l Forcing further RBS divestments would be too costly and disruptive given that it has already agreed a deal with Santander for the sale of 318 branches.
l It should be easier for customers to switch personal accounts, but the danger of missing payments must be addressed.
Automatic redirection of debit and credit payments would be an improvement; full account number portability ideal.