Let’s deal with Vickers’ better proposals first. The chancellor would be right to implement bail-in procedures and depositor preference. It is essential to have a legal framework in which banks can be wound up without bringing down the rest of the financial system. It is difficult to see that being possible without banks’ bondholders having their capital turned into equity in the event of a bank failure. Furthermore, if depositors are to be insured, then taxpayers will end up bailing out bondholders unless their capital is clearly at risk before depositors start to lose money – this was the Irish experience.
The government is also likely to accept the proposed ring-fence between investment banking and deposit-taking banks as proposed by Vickers. This would be a mistake. As the final version of the Vickers report hinted, ring-fencing is not really justified by Vince Cable’s argument that the supposedly “risky casino” part of a bank can bring down the “safe”, retail deposit bank that has been run in the style of Mr Mainwaring. Northern Rock was a retail bank; Lehman was an investment bank; neither AIG nor Goldman Sachs took deposits. All these institutions posed a systemic risk, but not because of contagion from investment banking to deposit taking. Indeed, in some circumstances a well-capitalised investment bank may be able to save an ailing deposit-taking subsidiary.
The better reason for some form of investment banking and retail banking separation is to ensure that banks can be more easily wound up if they fail – because they are less complex. This may be true, but it is not obvious that the division proposed by Vickers will be helpful in this respect. If I set up “Booth Bank”: a small bank taking deposits, making mortgage loans and diversifying risk by buying securitised mortgages, it may have to divide its activities into subsidiaries. This would actually increase the risk and make the bank no easier to wind up if it failed. This is an extreme case, but drawing the lines for the ring-fence will be difficult. As Europe Economics’s Andrew Lilico has said: “These Vickers proposals are a sledge hammer that misses the nut.”
What could be done instead? The best thing would be to move to a system of regulation based on one over-riding principle instead of the setting of detailed capital requirements and corporate structures. The Bank of England could be given, as its primary statutory objective in this area, a duty to ensure that failed banks could be wound up without significantly disrupting the financial system and without cost to the taxpayer. The Bank could then impose remedies on a bank if it was not satisfied that it could fulfil its duties. For one bank, it may be a greater number of international deposit-taking subsidiaries; for another it may be a detailed “living will” to deal with a specific set of complex contracts. Any bank that refused the remedy would lose the right to lender of last resort facilities and deposit insurance. We need to get back to legal frameworks that are based on coherent economic principles rather than trying to control every aspect of the activities of financial firms.
We should also make deposit-holders bear more risk. Certainly, there should be a class of uninsured deposits or a range of other investment instruments available to the retail investor which would not receive government protection and which would have higher returns and higher risks.
Unfortunately, much of this would not be possible under EU law. Indeed, the EU may make Vickers itself ineffective because it is not possible under EU law to force banks to ring-fence UK deposit business. We have recently seen proposals for a Eurozone banking union. These proposals are internally coherent but entirely miss the point of the crisis. But, if the Eurozone countries want a banking union, the chancellor should let them have it. In return, he should demand repeal of single market regulation that has centralised political power and undermined free trade – especially in financial services. The chancellor should promote his alternative vision of free-trade with the world and sensible banking regulation at home.
Philip Booth is editorial and programme director at the Institute of Economic Affairs.