Can the industry be made safer and more competitive?
Three years ago, it was all so different. In the Sidlaw auditorium of the Edinburgh International Conference Centre, 250 people had gathered for Scotland’s first Global Financial Services Conference, the culmination of a week of events celebrating the country’s pre-eminence in banking and investment. The Royal Bank of Scotland’s then chief executive Sir Fred Goodwin was not there, but then he considered his company above such collective back-slapping. Andy Hornby, his counterpart at HBOS, did speak, though, describing a business that delivered value to its customers and avoided risk.
“That went ok, didn’t it?” he murmured to colleagues afterwards. But he probably already knew that he and his peers were in trouble. HBOS’s exposure to America’s toxic sub-prime mortgage market was, at £430m, relatively small. The problem was the ratio – 177 per cent – of its loans to deposits. The bank had fuelled its growth in the mortgage market by borrowing from other banks instead of using deposited reserves. It faced a “funding gap”, a mismatch of obligations and available funds, which stood at £198bn. But the other banks, because of the sub-prime market, were no longer willing to lend.
With some insight, Hornby described the problem this way: “If you have ten bottles of water in front of you and you know one of them contains poison, you are unlikely to drink any of them.” Six months later, both he and Sir Fred had been sacked and their companies bailed out by the taxpayer.
“When the Titanic hit that iceberg, at first the crew didn’t think it was so bad. The ship’s hull was divided into watertight compartments, and not enough of them had been ripped open to sink the ship,” the New York Times’ columnist Paul Krugman observed in the autumn of that year. “But the flooding from the initial hole tipped the ship, and the compartments were open at the top, so that compartments that hadn’t been ripped open by the impact of the iceberg started filling up, tipping the ship even more, flooding more compartments … remind you of anything in the news lately?”
When the Scottish Government convenes its planned summit of banks and businesses sometime in the next few months, it will do so in a markedly different context. It will be held against the background of a savage realignment of the UK economy. There is the ongoing tension between the Coalition Government and Britain’s four biggest banks over executive bonuses and the amount they are lending to small and medium-sized businesses under their ‘Project Merlin’ agreement. And the forthcoming report of the Independent Commission on Banking (ICB) could recommend that some of the banks be broken-up.
Sir John Vickers, the ICB’s chairman, was in Edinburgh recently and picked up on the Krugman analogy: “When some of these enormous banks got into trouble, governments like ours had to save the whole lot. They were not in the form where you could separate out the retail bit and let market forces take care of, say, the international investment bit. If you think of a big bank like RBS, it didn’t have internal separations; it wasn’t like the Chinese junk with the compartments in the hold to stop the penetration of water sinking the whole thing. So governments had to intervene on an absolutely massive scale. And we are left with a situation where if we don’t cure this the taxpayer is going to remain very much on the hook.”
The option of a complete break-up of the banks was “not off the table”, said Sir John. But he and his four colleagues on the commission – “We are not just an independent commission; we are five very independent people” – have, in their interim report, so far stopped short of such a radical recommendation and are instead considering forms of “retail ring-fencing” under which retail banking operations would be carried out by a separate subsidiary within a wider group. This would require another of the commission’s main initial recommendations; a so-called equity ratio of at least 10 per cent (and preferably several per cent more), designed to absorb any unforeseen losses.
“The sub-prime crisis was a big economic shock in itself but look at the havoc it caused. Remember those early days of October 2008 when there were very real concerns that ordinary high-street bank services, like getting cash out of an ATM, were in jeopardy. How was it that those banks put the things that were absolutely imperative for economic and social life at risk? Part of it was that banks in the last decade had leveraged their balance sheet relative to shareholder equity. You had a very thin layer of equity and when those losses were experienced or even in prospect, not only did that thin layer vanish but the banks were structured in such a way that made it impossible for them to absorb the shocks.”
Sir John said that the commission was against single solutions: “Some would say you just have to pile up capital requirements. Others would say you have got to split up the banks. We think there is merit in both lines of argument, but we think it’s got to be a package, for all sorts of reasons. We also think a package is the best way to combine safety and the international competitiveness of UK-based banking. So we have proposals on loss absorbing capacity; we believe that UK retail banks need at least a 10 per cent equity cushion.
“Secondly, we’ve considered structure very carefully. Not off the table is the idea of a total split between retail and wholesale investment banking. How you define that is a big question. We have advanced the idea of retail ring fence which would essentially be a subsidiary model with self-standing capital requirements, loss absorbing debt requirements and governance. Nothing is going to be perfect in this world but we thing that ring fence plus the capital requirements would give massively better protection of the UK retail banking services that we all depend on.” The commission has also said that competition between banks should be increased by making it easier for customers to switch accounts.
Dr Irwin Stelzer, senior director and fellow of the Hudson Institute and an expert on financial regulation, said that there was a great deal to admire in the commission’s interim report: “It’s a very good piece of work because it sets out all of the data and issues clearly. If I had an overall objection, I think that there’s a point in the report where modesty and balance morph into timidity. I think that’s obvious in three areas. Ringfencing as an alternative to what the report calls structural radicalism. I’ll withhold judgment until I see the final details of ringfencing but my experience in regulation tells me that the regulatory authorities will never be able to cope with the banks’ ability to gain the system in defining the area of ringfencing and I worry that not enough thought is being given to the more radical solution.
“Second, there’s an overriding concern about going too far on capital requirements because of international competition. It seems to me that the financials sector in the UK has proved its ability to compete financially and I don’t see why being more adequately capitalised than, say, a bank in New York would somehow disadvantage a bank. While it would make the cost of capital higher, that’s the same thing as saying we can’t have carbon taxes because it would make production costs higher. I don’t know what the [per centage] number would be but I think the worry about competition is overdone.
“And third, this go-slow approach to competition, where we have to wait and see whether we can make switching for customers easier; again, I think it’s not sufficiently radical. I don’t see why we can’t set a firm date for a bank and say you have interoperability by this date or you can’t take on new accounts. [There needs to be] some incentive to move on in this score rather than wait until they are dragged kicking and screaming into an era of technology where switching is easier.”
But, according to Angela Knight, chief executive of the British Bankers’ Association, she said there was a danger that the consequences of actions were still not fully understood: “Trying to establish the right balance between stability and security, between ensuring long-term economic growth, between doing what we need to do in the retail space but also making sure that the UK continues to be an international trading – putting all that together is not easy. I think there are three things that need to be focused on; creating a more secure financial system and ensuring that the taxpayer doesn’t need to step in; international consistency because business has a choice where it goes; and ensuring that any changes meet the requirements of the UK, especially as it recovers.
“The banking industry in the UK agrees entirely that a bank should be able to be wound up regardless of size, that depositors should be protected and that the flow of finance in the economy be maintained and without recourse to the taxpayer. The report touches on ringfencing, but right now, the industry is engaged in putting in place what are known as recovery and resolution plans. These are being undertaken under the auspices of the Bank of England and are well-advanced. They are about maintaining services and about ensuring depositors are protected.
“But they are doing it in a way that does not bring to the fore the questions that come hard on the heels of ringfencing, such as whether it is the most optimal model, is it sustainable and what the cost would be. Looking forward, there has to be some very clear analysis so that there’s not just an automatic jump in one direction or another. Above a desire solely to be bold, there needs to be full knowledge of what do these various options mean in practice, what are the costs and indeed, what are their consequences. Understanding what the various options mean is absolutely vital and we hope that the ICB will be giving some real thought in that area before it comes out with its final response.”
The political pressures on the banks remain. Last week, the UK business secretary Vince Cable said they would face higher taxes if they did not increase lending to SMEs. Cable also told the Business Innovation and Skills Select Committee of MPs that he was pressing banks for evidence that executive pay was linked to lending, as had been pledged under Project Merlin. Signed in February after months of prevarication, Merlin involved promises by banks to lend £190bn to businesses and reduce the size of their bonuses.
Cable spoke as the heads of Britain’s four major banks – Royal Bank of Scotland, Lloyds Banking Group, HSBC and Barclays, all signatories to Project Merlin – appeared before the Treasury Select Committee to discuss the proposals by the independent banking commission. He restated his case that a separation of retail banks from “casino” investment banks was “desirable for the real economy” but said the Government was waiting for the final report by Sir John in September before reaching conclusions on the future shape of the industry.
Cable said that there was a “serious problem” with lending to small businesses and that was greater than the banks were prepared to acknowledge. He said that if in a year’s time the banks had not kept their side of the Merlin deal, the Government would be “absolved” of its promises not to alter the tax regime. “The Chancellor and Prime Minister have made it clear that if we don’t get results, they have said we should take further action with tax on banks,” Cable said. “Clearly we do have the option of approaching the taxing of profits, or bonuses or balance sheets in a different way.” He added: “It is hard to imagine we could penalise individual banks.”
Banks tend to argue that there is a reduced demand for loans because of the fragile economic conditions, while small businesses argue that the banks are restricting supply. The first update on Merlin published in May showed that the industry was missing its commitments. The shortfall was in lending to small and medium-sized businesses, which was £2bn short of targets set by the Treasury, rather than to large businesses. Cable said: “We can debate how much is lack of demand and how much is supply. We believe there is an issue with the supply and cost of finance and it is inhibiting recovery. If it’s not dealt with, it will inhibit recovery as we move into more rapid growth.”
Asked if Merlin was producing any change in behaviour, Cable said that small business lending was now discussed at a board level each month at Lloyds, which is 41 per cent owned by the taxpayer after being bailed out in October 2008. He said Lloyds was leading the way “in cultural change”. He also appeared to indicate that Santander was living up to its pledges. As well as the “stick” of higher taxes, Cable said executive pay could also be affected – but said he was disappointed by the evidence of links between pay and lending.
For its part, the Scottish Government, while it does not have powers of financial regulation, has said it will actively support the creation and entry of new retail banks offering services throughout Scotland. To increase diversity, it will also support the expansion of social banking. And as well as hosting the summit of banks and businesses “to help deliver investment and support”, the SNP administration has said it will campaign for Scottish representation in the Financial Services Authority and on the Bank of England’s Monetary Policy Committee. Later this month, RBS Group chairman Sir Philip Hampton and chief executive Stephen Hester, will host a reception in the Scottish Parliament to underline “the importance of Scotland to RBS.”
Last week, Chancellor George Osborne said the UK banking sector was “on the mend”. He announced that the Treasury was changing the rules of the Credit Guarantee Scheme (CGS) to allow banks to reduce their participation in the scheme ahead of schedule. The move, he said, demonstrated that the sector is returning to a stable footing and will allow banks to start reducing their reliance on the taxpayer, while they return to normal market financing. The changes to the scheme will allow institutions that have issued guaranteed debt under the scheme to buy back and cancel the debt before the debt was scheduled to mature.
“That the Government is able to do this shows that the UK banking sector is clearly on the mend. It is in everyone’s interest that banks return to stability and that as they do they are able to lessen the amount that they depend upon the taxpayer,” said Osborne, “We do, though, need to go further. The Government will push forward with reform to financial services within the UK and make sure that we put in place a stronger and more reliable regulation to ensure that we do not put the taxpayer in this situation again.”