Banking reform the right move

Published on by chris bowdler

The Independent Commission on Banking proposed important reforms to the structure of the UK banking industry this week, including higher capital ratios for the retail sections of universal banks, ring-fencing of those parts of a bank so that they can readily be separated from the parent company in the event of solvency problems, and greater competition in banking through scaling down the activities of very large retail banking groups such as Lloyds.

All of these measures will help in avoiding repetition of the banking crisis and state bail-out of the banks that started in 2008. Increased capital ratios will provide banks with a buffer against losses they might incur in the future as a result of risky investments that fail. Procedures for separating the retail and investment banking sections of universal banks will facilitate the winding up of insolvent investment banks with minimal disruption to retail banking; a higher probability of future insolvency is an important constraint on the risky activities of investment banks managers' and the institutional investors that fund them. Greater competition in the banking sector will reduce excess profits in retail banking that, under the previous regime, could be channelled to investment banking activities that later turned sour. In combination, these reforms should ensure that the UK banking system is more robust going forward.

Opponents of the reforms argue that they will impose costs on the UK financial services industry that will ultimately raise the price of finance for households and firms in the UK, and see many profitable businesses re-locate overseas, undermining an important driver of UK GDP and the overall tax base. However, I think there are several arguments for saying that the Vickers Commission called it right in the nature and scope of the reforms they have outlined.

The first, obvious point is that the effects of the banking crisis have been far-reaching and very detrimental, so some kind of reform is essential. The headline cost of the bail-out runs to roughly £80billion and has been a key factor in escalating the UK national debt. It is possible that in time this investment will return a profit, but even if we don't think of the £80billion as a deadweight loss, the medium-term consequences of raising debt to save the banks have been deleterious. The intervention increased public indebtedness at a time of some turmoil in global capital markets. Flight-to-safety by bond market investors was a key component in the argument for austerity presented by the coalition government, and the implementation of this fiscal tightening risks a serious Keynesian demand deficit at the macro level, a sharp increase in income inequality as a round of regressive measure takes hold, and under-investment in vital national assets such as the university system.

The fiscal pressures arising from the bail-out are arguably under-stated by the £80billion number. As commentators such as Robert Peston have noted, the loan guarantees and other measures put in place to support the bail-out run to more than £1trillion. This set of measures sustain the 'Too Big To Fail' (TBTF) label that attaches to many of Britain's biggest financial institutions. The consequence of TBTF is that the debt and equity that funds these organizations is priced inefficiently low, risking further moral hazard in investment, whilst the debt that funds the activities of the state is priced inefficiently high, putting at risk the important economic functions performed by governments.

The second main area in which the banking crisis has had extremely negative effects is the growth potential of the UK economy. The credit crunch was a major factor behind the deep recession from which the UK recently emerged. Like all recessions, the recent contraction necessitates rebalancing of the economy and shifts in the structure of production and the use of labour, all of which take time to achieve. During the transition, growth opportunities are sacrificed. Perhaps more importantly, whilst policy measures taken since the crisis and resulting recession, have reduced the cost of capital for large corporations, small businesses, critically dependent on bank lending, find investment capital and increments to credit lines hard to come by. This will surely stifle investment, enterprise and risk-taking in an important sector of the economy, in a way that will impede future economic growth. The impacts of the crisis not only on the debt of the nation, but also the evolution of the GDP from which that debt is serviced, both provide powerful arguments for reforming the banking sector to reduce the probability of a future crisis.

What of the other side of the argument, the claim that reforms will drive profitable banks overseas to the detriment of the UK economy? This is always a risk, but current circumstances suggest that the risk is small. Firstly, flight from the UK is likely only if regulation is excessive and not matched by reforms in other countries. The Swiss regulators, responsible for a major global banking sector, clobbered UBS with capital requirements far in excess of the Basel III thresholds, and the reforms proposed in the UK seem unlikely to raise costs in a way that will force banks to exit the country for other parts of Europe. The prospect of exit to North America or Asia remains, but for many organization such a move would be self-defeating. An important component of the reforms is that banks like Barclays will face limits to the amount of capital they can squeeze from their retail banking divisions to finance investment banking operations. By definition, the retail arm of Barclays cannot move to New York. Barclays Capital could move to New York, but it would then lack a local retail banking unit, and would face the same constraints on tapping profits from its UK retail operations as it would had it remained in London. So the case for saying that the reforms proposed in the UK risk the demise of the financial services industry seems weak. The importance of the reforms in preventing a repeat of the last four years seems overwhelming, and on this basis the proposals recently set out are an important step forward.


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