While I was on holidays, the Independent Commission on Banking in the UK brought out its Final Report on reforms to the British banking system. The Commission was chaired by the noted economist Sir John Vickers. Overall, the report is pretty good and should be compulsory reading for politicians and banking regulators in Australia. We could do a lot worse than to follow its recommendations.
As Professor Vickers noted when he released the report, the report aims to:
create a more stable and competitive basis for UK banking for the long term (page 1).
Its recommendations fall into three groups:
- Increased liquidity requirements for banks;
- Ring-fencing retail banking from wholesale and investment banking activities; and
- Increasing competition by reducing customer switching costs.
The first of these groups is really just enhanced Basel reforms.
The third group of recommendations relates to redirection of accounts. Joshua has talked about this before. The report (p.17):
[R]ecommends the early introduction of a redirection service for personal and SME current accounts which, among other things, transfers accounts within seven working days, provides seamless redirection for more than a year, and is free of risk and cost to customers. This should boost confidence in the ease of switching and enhance the competitive pressure exerted on banks through customer choice.
The report does not recommend account number portability but only because:
[I]ts costs and incremental benefits are uncertain relative to redirection (p.17).
In other words, it thinks redirection will do the job but is happy to be convinced otherwise, particularly as technology makes account number portability easier over time.
The second group of recommendations relate to ring fencing:
[R]ing-fenced banks would take retail deposits, provide payments services and supply credit to households and businesses (p.35).
The purpose of the retail ring-fence is to isolate those banking activities where continuous provision of service is vital to the economy and to a bank’s customers in order to ensure, first, that this provision is not threatened as a result of activities which are incidental to it and, second, that such provision can be maintained in the event of the bank’s failure without government solvency support. A retail ring-fence should be designed to achieve the following objectives at the lowest possible cost to the economy:
- make it easier to sort out both ring-fenced banks and non-ring-fenced banks which get into trouble, without the provision of taxpayer-funded solvency support;
- insulate vital banking services on which households and SMEs depend from problems elsewhere in the financial system; and
- curtail government guarantees, reducing the risk to the public finances and making it less likely that banks will run excessive risks in the first place (p.35)
The report’s recommendations stop short of structural separation for retail banking. In other words, the report strongly supports restricting the activities of retail banks in order to put appropriate limits on their risk. But it argues that this can be done ‘within’ a single bank, by ‘ring fencing’ rather than requiring retail banks to be structurally separated (i.e. different corporate entities) from other banking activities.
The report canvasses some of the arguments against ring fencing and in favour of structural separation. For example:
[R]ing-fencing does not go far enough because only total separation prevents contagion;
[R]ing-fencing is impractical and would be circumvented (p.24. see also p.63).
I think these arguments against ring fencing are basically correct. As someone who has had experience with ring-fenced utilities, anything less than structural separation creates internal conflicts of interest in the relevant company that undermine separation. This has been an issue in telecommunications for the past two decades, and is a reason why structural separation is a key part of the NBN project.
The Vickers’ Report, however, argues that ring fencing is good enough. Maybe I am biased but I am not sure that their hearts are really in their counter-arguments. Rather I suspect that the report chooses ring fencing over structural separation for legal reasons:
[F]ull separation would give rise to legal obstacles which are not applicable to ring-fencing because European law places particular constraints on the degree to which ownership of companies can be controlled (p.65).
So maybe full separation is just too hard in the context of the EU.
As is pretty clear, overall I like the Vickers’ report. In part this is because its recommendations are pretty close to my own suggestions for banking reform in Australia. See here and here. However, the key problem with the report is its starting point. It notes (p.15) that:
The probability of government intervention being needed should be much reduced by greater loss-absorbency and curtailed risk-taking incentives. The form of intervention, if still needed, should involve resolution, not financial rescue. If, in the last resort, public funds had to be deployed, the scale of any such support should be greatly diminished by the proposed reforms.
In other words the starting point for the report is the avoidance of government bailouts in the banking sector. As readers of this Blog will know, in my opinion, this is not quite the right way to think about the problem.
First, given that government intervention is inevitable if a retail bank has solvency problems, my view is that the insurance relationship between the government and the retail banking sector needs to be explicit. This would include the payment of an explicit insurance premium from each bank to the government.
Second, given that the government cannot (politically) refuse to provide the insurance to the retail banking sector, the activities of the sector need to be limited, taking the perspective of ‘optimal insurance’.
This approach leads to exactly the first two reforms of the Vicker’s Report. The government needs to set appropriate liquidity requirements for retail banks to limit the risk of insolvency. The government must also limit the activities of retail banks and the only practical way to do this is structural separation. Retail banks that have government insurance cannot engage in certain activities that are viewed as too risky by the government insurer.
While an ‘insurance’ approach leads to similar conclusions to the Vickers’ report, there are subtle differences. An insurance approach is likely to lead to a similar activity split as in the report. However, an insurance approach is likely to be more open to institutions ‘outside the fence’ (in Vickers’ terminology) engaging in some of the same activities as the retail banks, so long as:
- It is explicit and clear to the relevant customers that their activities are NOT insured and
- The volume of the relevant activities is not so significant that the government would be forced by political pressure to intervene in the relevant institution, despite its ‘lack of insurance’, if the institution hit liquidity problems.
In contrast, the Vickers’ report has to define ‘mandated services’. In other words, it defines a group of services that can only be provided by ring-fenced retail banks and cannot be provided by other institutions (see p.38). This seems to go too far. There have been deposit-taking institutions that have collapsed, failed and disappeared in the past. There is no need to regulate such institutions out of existence so long as the government can let them fail and their customers know that this is the risk they are taking when they deposit their money with these institutions. Undoubtedly this will mean limiting the activities of institutions that are not insured but it should allow more consumer choice than an outright ‘ban’ on activities.
An insurance approach also takes the political sting out of bank failure. The aim is not to prevent failure but to control risk. If, despite appropriate risk control, a retail bank does fail, then the government, as insurer, will intervene. This is not a political decision, it is a business decision based on the insurance relationship. So long as the retail bank has been paying the appropriate insurance premium, a bail out is not an abuse of taxpayer funds but simply a relationship between the bank and the relevant government insurance operations.
Finally, the insurance approach limits claims by banks that the interventions are costing them profits and harming consumers. An insurance approach makes it explicit that a variety of activities may still occur in institutions that are not insured (although they may be subject to other prudential regulation). But the restrictions on retail banks are simply an economic quid pro quo for the insurance coverage they receive. Their profits may be lower but only because they are now forced to pay the financial burden of the risks of their activities. As the report notes (p.10):
[I]t would be a consequence of risk returning to where it should be….
By making the government insurance of retail banks explicit, a key point of contention in the Vickers’ report is simplified. The report finds it difficult to define the range of prohibited activities. Which activities are ‘too risky’ for retail banks? (e.g. paragraph 3.21). An insurance approach looks at these ‘borderline’ activities with regards to the relevant premium. If a retail bank wishes to undertake an activity, how does that alter its risk and how does this alter the insurance premium that the bank pays to the government? Under an insurance approach, separated retail banks may face three classes of activities:
- Those that are unambiguously allowed;
- Those that are unambiguously banned; and
- Those that a bank may choose to undertake if it pays an explicit additional insurance premium to the government to cover the additional risk of these activities.
Of course, if it is difficult to properly evaluate the additional risk, the third group of activities may be small. But it provides the financial system with a potentially useful level of flexibility while retaining the key principle – that the retail banks pay for the risk they create.
So overall I give the Vickers’ report an A-minus. It loses a half grade for compromising on structural separation. And it loses half a grade because it essentially reaches the right solutions from the wrong starting point.
Australia’s politicians and regulators could do a lot worse than to consider the recommendations for our own banking system.