Banking Commission: Retail banking must be ring-fenced
The Independent Commission on Banking (ICB) set up by the Treasury has come up with reform proposals for the banking industry in the UK that will anger and worry both the banks and the banks' sternest critics.
The central recommendation of its interim report - which is arguably the most important response in the UK to date to the financial crisis of 2007-8 that triggered the worst recession since the 1930s - is that a protective firewall should be put around the British retail banking operations of big universal banks, such as HSBC, Barclays and Royal Bank of Scotland.
Customers' deposits, business lending and the transmission of money would be ring-fenced within the universal banks as new subsidiaries, endowed with increased capital resources to protect against losses.
Also, the ICB wants Lloyds to be ordered to sell "assets and liabilities" in addition to those that the European Commission is already obliging Lloyds to sell, to reduce its substantial market share in personal banking. If implemented, this would force Lloyds to sell more branches on top of the 600 it is already auctioning.
The big banks will claim that putting their retail banks into subsidiaries would impose significant extra costs on them - because it would force them to raise and retain more capital (which is expensive), and it would increase what they pay to borrow. Their fear is that these incremental costs would put them at a disadvantage compared with their international competitors.
However the ICB says that the banks have exaggerated the size of this new financial burden. It calculates that the extra costs would be a good deal less than the £12bn to £15bn a year estimated by the consultants Oliver Wyman in a report prepared for the banks.
Perhaps more importantly, the commission is convinced that the social benefits of the reform - in respect of reducing the likelihood of destabilising financial shocks that increase unemployment and cut growth - would significantly outweigh the costs.
The commission has also taken steps to reassure the government that it doesn't have a great deal to fear from getting tough with the banks and implementing the change: on its analysis, even if big banks such as HSBC or Barclays were to move their respective head offices abroad in protest at the reforms, the loss of tax revenue and the damage to the success of the City of London would be limited.
The interim report says: "The commission's view is that the reforms of the kind contemplated...would support the competitiveness of the economy and would be likely to have a broadly neutral effect on financial services".
Perhaps because of that, some will claim that the commission has been too timid - in that it has rejected more radical alternatives, such as breaking up the banks, imposing formal limits on their size, prohibiting them from using depositors' cash to make loans, or massively narrowing the range of their permitted activities.
The thinking behind the ring-fencing recommendation is that if the wholesale or investment banking arm of a universal bank were to go bad, the retail operation - which looks after our savings, lends to business and moves money around - would not be tainted.
And if in the event it was the universal bank's retail banking side that ran into difficulties, rather than the wholesale or investment arm, then in theory it would be cheaper and easier for taxpayers to rescue the retail bank as a ring-fenced, separable subsidiary: there would be no need for taxpayers to bail out the entire giant universal bank, as British taxpayers were forced to do in 2008 in the case of Royal Bank of Scotland.
That said, the commission has not been prescriptive about precisely which of the banks' assets and liabilities would be defined as "retail" and then ring-fenced: it wants to encourage a debate to determine the categories of deposits and business lending that should be moved, along with the money transmission networks, behind the new firewall.
There are a number of other proposals:
1) The retail banking subsidiaries of the universal banks and any other large retail banks in the UK, such as Lloyds and Santander, would have to hold equity capital, to absorb potential losses, equivalent to 10% of their respective loans and investments - which is 3 percentage points greater than the new international minimum of the so-called Basel lll accord.
2) Wholesale banks operating in the UK would not have to hold more capital than the international norm (which is likely to rise this year, as regulators on the Basel Committee and the Financial Stability Board review how much capital banks should hold to cover the risks of their trading activities).
3) A universal bank would be able to move capital from its retail arm to its wholesale arm (and back again), so long as the separate subsidiaries never let their capital ratios fall below the new minimums. This, in theory, would preserve some of the benefits for a universal bank of being a universal bank.
4) The commission regrets that Lloyds was able to acquire a huge 30% market share in current accounts through the rescue takeover bid of HBOS at the end of 2008 - but it does not recommend that Lloyds should now be forced to divest HBOS.
5) To promote greater competition, Lloyds should be forced to dispose of a greater "package of assets and liabilities" than it is currently being required to do by the European Commission. Unlike the rest of the proposals in the interim report, this recommendation will require an almost immediate decision by the chancellor of the Exchequer - because Lloyds has already started to sell the 600 branches, current accounts and mortgage accounts it is obliged to offload, and it would be very difficult for it to sell another bit of its operations at a later date (see below for more on this).
6) The implicit charges and costs to customers of current accounts should be set out in a much clearer and more comprehensible way, and there should be a deadline of perhaps seven days imposed on banks for transferring over customer information when someone moves his or her current account to a new bank.
7) The new Financial Conduct Authority being created by the government to protect consumers of financial services should have "a clear primary duty to promote effective competition" - which will please MPs on the Treasury Select Committee, who have already called for this.
8) In the longer term, a new automated system for shifting a current account from one bank to another should be created. And it should perhaps be possible for current account customers to keep their account numbers when they move banks, in the way that mobile phone customers can keep their phone numbers when they change suppliers.
So where do we go from here?
There will now be an intense and passionate debate, between banks, politicians, regulators and assorted campaigners, about whether the commission has been too tough or too soft. The commission is scheduled to produce final recommendations in September - and the government will only then have to decide whether to implement those recommendations.
On paper, the commission has been less bold than the Lib Dem Business Secretary, Vince Cable, would have wanted when he was in opposition. It will be interesting and important to see whether Mr Cable's views on bank reform have been mellowed by his participation in government.
As for HSBC or Barclays, it is not clear that they would gain much by carrying out their sotto voce threats to move their respective HQs abroad - since this would not protect them from the requirement to increase the equity capital they hold in their British retail banking operations to 10% of assets.
And unless they were to move their new head offices to another part of the European Union (and I've discussed in earlier posts why emigration to Paris, Frankfurt or Luxembourg is unlikely), they probably couldn't dodge the requirement to put their UK retail operations into new subsidiaries (because British regulators have the power to insist on subsidiarisation for all banks except those from another part of the EU).
Now because Santander has its head office in Spain, it may be that it will be seen to have an unfair advantage over RBS, Barclays or HSBC. But I understand Santander already operates through a subsidiary in the UK as Santander UK (I will let you know if I am wrong about this).
Anyway, if George Osborne is persuaded by the commission's argument, he can probably implement its proposals with little risk that the banks can exact revenge on him by stomping out of the UK in a huff (of course some of you would probably quite like them to do that in any case).
On the other hand, Mr Osborne doesn't have to make up his mind for a while - except on one issue. If he thinks the commission is correct that, for the good of competition, Lloyds has to slim down more, then more-or-less straight away he has to order Lloyds to postpone the disposal of 600 branches.
The reason is that Lloyds - under its new chief executive Antonio Horta-Orsorio - has recently accelerated that sale, presumably because it spotted there was a risk that it would be ordered to do more. And Lloyds would find it difficult to sell a second lump of assets for a decent price so soon after the first.
If Lloyds and its shareholders - which include taxpayers with 43% - are to get the best possible price for selling a chunk of its business, far better for the sale to be in one big lump than two small ones.
In that context, you may be amused that the commission gave Lloyds advance notice a month ago of this one recommendation (but none of the others).
Interestingly, Lloyds did not feel it needed to tell its shareholders what the commission wanted - and nor has it manifested any conspicuous inclination to slow down the auction of the smaller lump of its business it was already obliged to sell.
So will the banking commission's proposals split the coalition, pitting the Lib Dems - supposedly more radical on bank reform - against the Tories?
Probably not - because the commission seems to have framed its recommendations with more than half an eye on what each party said it wanted before the election.
Both Lib Dems and Tories can claim the commission is offering something similar to what they wanted.
Lib Dems can and probably will say that ring-fencing retail banking is close to splitting retail from investment banking.
As for Tories, they proposed a form of America's so-called Volcker rule. And the interim report says: "The Volcker rule shares a common motivation with the retail ring-fence in that it aims to curtail government guarantees."
In other words, the commissioner is presenting his retail ring-fence as a kind of Volcker rule for Britain.
PS - Lloyds tells me that the commission made what it saw as a flaky proposal to it a few weeks ago: to hive off some assets into a new nationalised bank.
Lloyds claims it was not given a workable recommendation to dispose of more assets and liabilities - which is why it decided not to tell its shareholders about the conversation with the commission.