Sir John Vickers, chair of the Independent Commission on Banking (ICB), stuck to his guns in insisting that his ring-fence proposal is the best way to ensure Britain’s banks are more stable and do not require costly bailouts if they fail.
His main argument is that a ring-fence will make it easier to resolve banks that get into trouble – that is, to wind them up in an orderly way. The ICB also claims that a ring-fence will insulate vital domestic retail services from “global shocks” that originate in investment banks that are plugged in to international markets.
Under the plan outlined, banks would have a large degree of discretion over which activities they place in their ring-fenced arm, but any deposit-taking services or overdraft facilities offered to consumers and small and medium-sized enterprises (SMEs) will have to be included.
Other types of activity will be strictly banned from the ring-fenced bank. Anything not integral to the provision of payments services to customers within the European Economic Area (EEA) or to intermediation between savers and borrowers in non-financial sectors, or which increases exposure to global markets will be prohibited.
That covers: services to non-EEA customers; services resulting in exposure to financial institutions; “trading book” activities; trading related to secondary market activities, including loan and security purchases; and derivatives trading, except when managing the retail bank’s own risk.
Another set of operations will be allowed on either side of the fence. These include the wholesale funding of retail operations – within limits – and loaning out consumer and SME deposits to larger corporates.
However, despite the flexibility over what is allowed on either side of the fence, its interactions with its group’s investment banking arm are strictly proscribed. The retail and investment banks will not be allowed to cross-sell products to one another’s customers and must interact as if they were third parties, limiting their exposure to one another. Each subsidiary must be run at “arm’s length” from the other.
These new rules are “principle driven”. That means they aim to apply general rules to all products and operations – but will also result in negotiations on the exact structures banks can adopt.
The core principle is: only ring-fenced banks will be able to take on vital services where any interruption in service has “significant economic costs”, or where customers are “not well-equipped to plan for such an interruption”.
The retail bank must also have its own board and no director will be allowed on both the board of the retail bank and that of the universal or investment bank. This is an attempt to ensure that the “culture” of each is be very different.
However, the Commission says that ring-fencing is better than full separation because it means that investors will still be able to benefit from diversified income streams.
Despite all the wrangling over timelines, Vickers is fairly clear: the legislation should be passed soon, but banks should be given until 2019 to implement the changes.
HIGHER CAPACITY TO ABSORB LOSSES
The ICB says that banks do not hold sufficient capital to protect themselves in a crisis. Moreover, many of their creditors are not required to take losses in the event of a bankruptcy, which means that taxpayers end up footing the bill.
Basel III, the collection of international regulations governing capital requirements, comes into force in 2019. But it mandates only a certain level of common equity as a capital cushion, set at 9.5 per cent of banks’ risk-weighted assets (RWA) for globally significant banks. The Commission instead recommends an equity capital ratio requirement of ten per cent.
However, this is not enough, the ICB argues. A far larger proportion of banks’ creditors need to be on the hook for losses if a lender fails. Otherwise, taxpayers end up picking up the tab.
In order to solve this problem, a far higher proportion of banks’ debt needs to be able to absorb losses. The ICB sets a minimum level of 17-20 per cent of RWAs that must be loss-absorbing.
However, most of banks’ senior long-term debt will already qualify to fulfill this requirement because regulators are gaining more powers to impose losses on senior bondholders, turning normal bonds into “bail-in bonds”, whereby holders see the value of their asset written down during the wind-down of a bank. If the bank’s assets decline in value and it needs to use its capital buffer, these bondholders quickly lose their money as the bank pays higher-priority liabilities. That means a higher proportion of their debt will become “loss-absorbing” and in practice means that very little extra issuance will be necessary.
Other capital types can also contribute to the higher requirement, for example, contingent convertible bonds, or “cocos”. Cocos are a form of debt which is converted into equity when a certain agreed trigger point is reached, rather than being written down or converted by regulators.
Regulatory discretion will play a large part in determining the size and content of each bank’s buffer. For example banks with poor resolution procedures may be forced to hold more capital in case of a resolution, to protect depositors and the taxpayer from its weak plan.
The ICB also calls for lower leverage of assets to equity capital. During the crisis leverage boomed to around 40 times; Basel III will impose a limit of 33 times; the ICB wants the limit to fall to 24.6.
One reason for this is that the ICB does not believe the process of risk-weighting of assets is flawless because it requires banks to make their own calculations about the riskiness of their balance sheets. To counter the weightings of risk being imperfect, the ICB wants an un-weighted leverage cap too.
British banks will face tougher regulations than foreign competitors after ICB.
Aware of the international picture, the ICB implies that the fear of regulatory arbitrage stopped it raising capital requirements further, but claims that the structural reforms it recommends will make banks safer anyway.
Overall, the ICB believes increased stability should boost London’s reputation as a financial services centre. It also says that because retail banks tend to focus on domestic markets, the impact on those operations will be limited.
It is worth noting that this is not the ICB’s overriding concern however. It is more concerned with “public interest” and the removal of implied government support for banks that get into trouble.
The ICB could run into difficulties with CRD IV, the EU’s directive implementing Basel III. In an effort to harmonise rules, it could in theory prevent the UK from increasing capital requirements above Basel III’s. However, European Commissioner Michel Barnier has indicated that goldplating the rules will probably be allowed.
COSTS FOR BANKS
Banks face costs of around £6bn, according to the report, which says analysts’ estimates range from £2bn to £10bn. These come both from increased funding costs and from reorganising the banks’ structures due to the ring-fence requirement.
Funding costs will rise as the current implicit government guarantee is withdrawn. The ICB emphasises that this is a cost to the bank rather than to the economy as a whole, however, reflecting a more accurate pricing of risk and a shift of the burden onto investors rather than taxpayers.
Investment banks’ funding costs are expected to rise more than the ring-fenced banks’ because they will not have easy access to retail deposits for funding, which are generally cheaper than wholesale debt.
The main emphasis, though is that the costs are lower than those faced by banks and the economy as a whole as a result of a financial crisis – which the ICB hopes will now become less likely to occur.
Higher capital ratios should make banks stronger and therefore more stable, the ICB hopes. The sector as a whole should benefit too, with “systemic” risks specifically targeted.
Regulators will, under the proposed changes, receive the power to impose higher capital and bail-in requirements on the largest and most interconnected banks. Further, with a ring-fence in place, other sections of a large bank can collapse without as much impact on their own or other banks’ retail operations, according to the ICB’s analysis.
Vickers has maintained his view that long-standing problems exist in personal current accounts (PCAs), services to SMEs and market dominance.
A large part of the reforms will therefore aim to make PCA switching simpler for individuals and SMEs. The new system will see all credits and debits to and from the old account automatically redirected for a year following the switch.
The ICB has backed down on requiring Lloyds to sell more branches to boost the competitive position of the buyer. But it asks the Treasury to get Lloyds to agree to sell to a viable challenger entity.
VERDICT | THE RING-FENCE
ICB chair Sir John Vickers (pictured) believes that his proposal for a ring-fence around retail banks will deliver safer domestic lenders. But his commission has not shown how. The ICB suggests both that a ring-fence will make it easier to wind up a failing bank and that it will make it easier to save the part that’s truly vital to consumers. But both cannot be true: if the aim is to get taxpayers off the hook, no part of a bank should have to be saved during a crisis, whether it is inside or outside Vickers’ ring-fence.
VERDICT | UK PLC
Since the ICB’s recommendations on loss-absorbing capital are mostly in line with international requirements and don’t require much new capital issuance, they are unlikely to have a big impact on UK banks’ competitiveness. But the ring-fence requirement will hit the profitability of universal banks at a time when they are struggling to build up their capital bases and deliver better returns to investors who have been hit by equity losses and sparse dividends. UK banks will be the only lenders subject to these structural rules, putting them at a disadvantage. Banks also say that Vickers’ analysis radically underestimates the costs of the proposal. Despite this, it could have been worse: the ring-fence is somewhat flexible and allows them to transfer capital between subsidiaries.
VERDICT | COMPETITION
The Commission’s new position on competition is a marked shift from the views it expressed in its interim report. Most notably, it has performed a U-turn on its recommendation that Lloyds be required to sell more than the 632 branches that are currently on the block. Instead, it has made a vague recommendation that the Treasury seek agreement with Lloyds to make sure the sale creates a “viable challenger” bank.
In effect, the ICB says, that means a bank with at least six per cent of the personal current account market. Lloyds believes that, in effect, the proposal will have little impact on the sale. Instead, the ICB has refocused on transparency of fees and ease of switching accounts, both of which are likely to have a greater impact on consumer choice.