Hugo Radice: The key questions we must ask about the future of our banks

TWO-and-a-half years have now passed since the British banking sector stood on the brink of collapse. In this week’s long-awaited Interim Report of the Independent Commission on Banking, Sir John Vickers and his colleagues have at last set out policy recommendations intended to ensure that we never again face the same sort of system-wide crisis.

The report focuses on two main issues: how to make our financial system more stable, and how to ensure that the markets for banking services are more competitive. In proposing structural changes, the commission has tried to steer a middle course between those who want minimal change – that is, the banks themselves – and their critics, who have long urged major reforms.

The response from both camps has, not surprisingly, been lukewarm but as bank shares rose in value on the day of publication, it has been the radical reformers who have been most vocal in their criticism.

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Financial stability needs to be addressed at two levels: that of individual banks, and that of the financial system as a whole. Individual banks need to maintain reserves of capital to deal with fluctuations in their own deposits, loans and repayments: bigger reserves mean more security, but lower income from lending. The commission broadly agrees with the Basel III recommendations of the Bank for International Settlements (BIS) for higher minimum capital ratios, although they sensibly propose a 10 per cent minimum for large retail banks rather than the seven per cent proposed by the BIS. They also support the policies being developed internationally to measure and monitor the system-wide risks of contagion, where one bank collapse triggers further casualties.

Much more controversial is the question of regulating the activities of individual banks, and whether the British Government – that is, taxpayers – should guarantee their depositors and creditors. The sheer size, complexity and interdependence of the biggest banks meant that in the 2008 crisis, they were seen as “too big to fail”, and were rescued at vast public expense.

However, the riskiness of banking varies greatly. Retail banking is mostly low-risk, taking deposits from businesses and households, and making loans that are either short-term, like overdrafts, or if long-term, firmly secured, like mortgages on domestic property. Investment banks, on the other hand, traditionally provided long-term funding to businesses and governments, mainly by issuing securities that are bought by long-term investors.

But since the deregulation of the 1980s, they have made much of their profits through trading securities, currencies and other assets, and through the development of new forms of financial asset like mortgage-backed securities and credit derivatives. Such activities are inherently much more risky than those of retail banking, but bring much greater potential rewards in terms of profits.

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When times were good and confidence was high, banks underestimated these risks, and increased their lending to 30 or more times their available reserves. Some, like Northern Rock, made the cardinal mistake of funding long-term lending by short-term borrowing, which then dried up as the money markets at last became aware of the impending crunch in 2007. To address this problem, the commission is recommending that banks wanting to operate both retail and investment banking should build a “firewall” between the two, ensuring that the capital required to secure their retail lending is not invested in high-risk activities.

Their critics claim that such firewalls are easily circumvented, and argue instead that the two types of banking should be organised as entirely separate businesses. Investors can then put their money in either type, depending on their attitude to risk, but meanwhile retail depositors, and the economy as a whole, will be safeguarded.

Naturally, the giant multipurpose banks like Barclays object strongly, because it would stop them deploying low-cost deposits in high-return risky lending and trading. They threaten to move their operations abroad, but London’s huge advantages of location, culture and language make this very unlikely. Given the immense difficulties facing any government that tries to regulate the internal operations of banks, the right answer here is surely to require full separation of “utility” retail banks from “casino” investment banks, with only the former benefiting from Government guarantees.

The commission’s other main aim is to improve competitiveness in retail banking. On the face of it, their proposals for requiring more transparency in the description of financial products, and making it easier for customers to transfer between banks, will bring real benefits to the millions who feel they have been tricked into buying credit insurance and other products of little or no value. But more competition may just mean more advertising and more marketing – paid for by customers – without any greater efficiency and customer satisfaction.

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Their proposal that Lloyds be required to sell off more of their branches than the 600 required by the European Union competition authorities is also not obviously beneficial: those who rely on their local branch for day-to-day transactions would be forced to change their bank, while it would be irrelevant for the growing number who bank online. What most of us want is a bank, any bank, that just gets on with providing efficiently the limited range of services that we require.

In the coming months, the commission will surely find that in trying to stay the middle of the road, they risk being run over in both directions: by banks who want less change, and radical reformers who want more. But it is vital that we do not forget the important issues that lie outside the commission’s remit.

In particular, we need to consider whether it is healthy for the UK economy to continue to specialise globally to such an extent in the provision of financial services. If not, then rebalancing towards greater production, and greater export of goods and non-financial services, will require a raft of new policies across education, industry and planning – not to mention the financing of new activities as they develop.

Hugo Radice is a Life Fellow in the school of politics and international studies, University of Leeds.