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Friday, 18 October 2013

Banking reform five years on

Adam Bennett (Senior Member, St Antony's College, Oxford)

On Monday, October 14, PEFM’s Michaelmas term seminar series got off to a flying start with an extremely interesting presentation by Professor Sir John Vickers, Warden of All Souls College and former Chairman of the Independent Commission on Banking (ICB).  Professor Vickers summarized and explained some of the key findings of the ICB (which were published in September 2011), elements of which have since been incorporated into the Financial Service (Banking Reform) Bill currently progressing through Parliament, and outlined the features of ongoing deliberations. While his presentation can be followed on PEFM’s forthcoming Podcast of the seminar, what follows is an attempt to extract the essence of his message.
The findings of the ICB started from the fundamental presumption (shared by most policy-makers and academic experts) that the financial services provided by retail (as opposed to investment) banking are so essential for the operation of an advanced economy that a collapse of the retail banking system is something that policymakers must avoid at all costs. These essential services include facilitating payments, taking deposits (providing a store of wealth), and supplying credit. Because of the risk of contagion, there is a strong case, according to Professor Vickers, for guaranteeing most if not all deposits, whether themselves small or large, or located in banks small or large (which de facto applied during the current global financial crisis almost everywhere except Cyprus). While an implicit or explicit guarantee – a subsidy which is not costless to provide (as the huge build-up of government debt during the crisis has proven) - may raise social welfare when confined to retail banks, it can be problematic if retail and investment banking are combined. This is because investment banking – which may add value to the economy but is not essential – is inherently more risky than retail banking. The extension of the official guarantee to investment banking that results from the combination can both encourage excessive risk taking in investment banking and contaminate the balance sheets of the all-important retail banks. For this reason, the ICB recommended “ring-fencing” retail banking from investment banking – choking off all possible channels of contamination from the latter to the former while not precluding joint ownership. The ICB did not go as far as to argue for a full Glass-Steagall style separation, preferring to allow a market solution to ownership in the context of ring-fencing. There was a close analogy with the US requirement for groups to hold retail banking activities in a separate affiliate.  The Parliamentary Committee on Banking Standards, which convened after the ICB, has recommended “electrifying” this fence—reserving powers to force separation if needed.

Strengthening the structure of banking is only part of the solution, however, as ring-fenced retail banking would still involve risk, if less so than investment banking. Retail banks thereby need adequate “loss-absorbing” buffers to reduce the risk of bank failure (i.e., asset values falling below deposit liabilities) to an acceptable minimum. For this reason, banks must hold capital. But how much? It is instructive to consider the level of capital that banks in the USA and UK relied on during the late nineteenth century, where equity to asset ratios were observed in the range of 10-25 percent. There is no evidence that capital ratios this high impaired economic growth during this period (as some have argued would happen if such ratios were reimposed). By the last two decades of the 20th Century, however, with banks leveraging their equity by a factor of 20 times, this capital ratio had fallen to around 5 percent, falling to as low as half that in the build-up to the crisis in 2008 when median leverage approached 50 times. Clearly, it didn’t need much asset impairment to tip the system into insolvency. Professor Vickers commended the intentions of the Basle III accord to raise the required ratio of equity to risk-weighted assets to 7.5 percent, or 9.5 percent for globally systemic important banks (GSIBs), and an (unweighted) leverage maximum of 33 percent. But he felt that this did not go far enough. The ICB recommended that the ratio should be 10 percent with a leverage maximum of 25 percent. The ICB also recommended that ways be found to more effectively “bail-in” bank bond financing, so that this is treated more like equity (and thereby subject to potential loss) than like bank deposits. Professor Vickers would have preferred even tougher requirements but he recognized that the choice had to reflect the constraints imposed by the need to (i) avoid forcing banks to increase capital ratios too much during a recession (thereby risking reduced lending and perpetuating the recession), and (ii) avoid creating perverse incentives for regulatory arbitrage (either between banks and non-banks or geographically).

This summary does not do justice to the many and complex subjects that Professor Vickers discussed, including the parallel initiatives that are being developed elsewhere in the world. But I hope it gives a flavour of the some of the fundamental issues that Professor Vickers (with the ICB) grappled with, as well as those which are the subject of continuing debate. His presentation provoked many interesting and wide-ranging questions from the audience, including whether there would be in practice any difference between bullet-proof ring-fencing and Glass-Steagall, whether the world would be safer with banks being 100 percent equity financed (a-la-Kotlikoff), whether criminal liability could be strengthened to help avert improper risk-taking, whether there should be limits to remuneration, and why bankers were paid so much anyway. Questions will always outnumber answers on the subject of banking reform, which as one member of the audience implied, will go on forever, albeit in phases. Hopefully, we will converge toward a solution of this current phase in the not too distant future, allowing the world to learn from one of the gravest financial crises in history, and so move on.

1 comment:

  1. A very interesting feature was Sir John Vickers' perspective on substantially strengthening the regulatory framework while paying due regard to the competitive position of London in global business. The EU's Liikanen report has a strong family resemblance to the IBC recommendations, with the twist of allowing retail banks to do underwriting. But it is not yet clear what the EU will do with Liikanen...