Tuesday 9 October 2012


ZEITtruth…

MILIBAND IS RIGHT TO CALL FOR THE SEPARATION OF BANKS - IS THAT ENOUGH?

  Ed Miliband announced his candidacy for the next General Election at the Labour Party Conference last Tuesday, with a recrudescent performance in front of a packed house at Manchester Central.

  The details on policy were sketchy and largely absent from vast swathes of the hour long speech, but in some respects this is understandable. Miliband spoke for over an hour without using notes, showcasing a rarely-before-seen jocular style that surprised many detractors.

  One policy he did proclaim vociferously – and to a rapturous reception – was the intention to separate high street banks from “casino style operations” (investment banks to the less acerbic amongst us).

  Separating the high-street and investment arms of banks is hardly a new idea - with ‘ring-fencing’ of high street banks being advocated in the Vickers Report in September 2011. Since then, several banks have begun the process of ‘ring-fencing’ their retail operations, with some looking to complete this ahead of the scheduled date of 2019 proposed by Vickers (being the commencement date of Basel III). However, the impact of rating-agency concerns for the non-ring fenced investment banks – which will no longer be able to comfort creditors by evidencing a recourse to unsecured deposits - has predictably lead to a period of lobbying by the banking sector, resulting in what Labour has described as a watered-down version of ring fencing, where the fences themselves are allowed to be ‘looser’. But even if – as Miliband promised a Labour government would deliver – ring-fencing was sufficiently tightened and legislated upon; will this really be enough to effectively avoid the catastrophic failure of the finance sector in recent years? Will this really be enough to ensure that the tax-payer will never again be forced to pick up the bill for banking profligacy?

  So far, neither Labour nor the Coalition have proposed going beyond the recommendations of the Vickers Report. There have been signals from the government that any Banking Reform Bill would incorporate recommendations from the Wheatley Review published last week, which sought to deal with the rampant criminality exposed during the Libor scandal. Wheatley stressed the importance of making Libor manipulation a criminal offence and declared that the BBA should be stripped of their Libor setting role. Wheatley’s gambit extended little further than the Libor investigation, and with respect to more systemic reforms in the way investment banks conduct themselves, both the government and Labour are ominously silent.

  To date, ring-fencing the high-street arm of a bank is has been touted as the most sure-fire way to stave off the need for tax payers to bail out failed banks in future. It has been suggested that separating retail and investment banks will make it easier to isolate problems in the event that a bank fails, with any state-intervention being focussed on the retail operation where the principal beneficiaries would be ordinary members of the public.

  Ring-fencing the high-street arm of a bank from the investment side requires the ring-fenced entity to be a separate subsidiary company. There should be a separate board of directors and the company should display an operational independence from the non-ring fenced entity, such that it would be able to list on the London Stock Exchange in its own regard. Furthermore, transactions entered into between the ring-fenced and non-ring-fenced entity should be at arms-length. There is no restriction however on ring-fenced entities receiving funding from its non-ring fenced sibling, providing that the transaction is at an arms-length.

  According to the Vickers Report, the ring-fenced entity should be subject to a number of restrictions on the kind of service it can provide to its customers – bringing its activities more into line with those of a ‘traditional’ high street bank, whose purpose should extend little further than taking deposits and making loans. It was recommended that there be an express prohibition on the ring-fenced entity engaging into several types of ‘risky’ transaction, including derivative transactions, or transactions where the bank’s regulatory capital could be exposed to counter party risk. However, there is no mention on a restriction or curtailment in this kind of activity for the non-ring fenced entity. Instead, it is suggested that increased ‘loss-absorption’ requirements (which include a requirement to hold more capital and ‘bail-in’ bond which would be used in the event of a bank’s collapse) for non-ring fenced entities will create an incentive to ‘monitor’ risk more closely. But there is nothing in the Vickers Report, nor has anything been mentioned since by the Coalition or most recently by Labour, which indicates a move to limit the amount of high-risk transactions the non-ring fenced entity can enter into – the type of transaction that got us into this mess in the first place.

  The ring-fenced entity, under the Vickers Report recommendations, is also required to maintain a loss-absorption provision, equating to between 10 and 17 per cent of risk-weighted assets - depending on the size of the bank. This is actually not a huge departure from the capital requirement ratio that Basel II had required all banks to keep; meaning that the ring-fenced entity can still lend money way beyond the value of deposits it takes. Yes, it may only lend the money for activities and services that fall within a stricter remit than the non-ring fenced banks, but there is still an incentive for it to acquire additional funding beyond its deposit base – though how it would do so is presently unclear.

  Though the ring-fenced bank is prohibited from operating in the secondary credit and debt markets, there has been no suggestion of a restriction from it seeking finance in a primary fashion from investment (or non-ring fenced) banks. This leaves us with a problem, one which resonates throughout the ‘reformed’ system and is yet to be addressed by either Labour or the Coalition. If the risk-loving and ultimately contagion-inducing activities of investment arms of banks are left relatively unabated, is it really possible to protect the ring-fenced sector?

  The Vickers Report stated that the banking activities that would comprise the ring-fenced sector presently account for between a sixth and a third of the £6 trillion UK banking market; the vast majority of market share is attributed to investment banks. It seems optimistic that merely securing and safe guarding a diminutive portion of the market will serve as effective mitigation preventing the entire system from collapsing. Furthermore, if the non-ring fenced system did collapse, it is highly unlikely that the ring-fenced sector could remain immune to its effects.

  Firstly, ring-fenced banks are likely to need funding – and presently there has been no mention that they will not be able to obtain this in a primary sense from a non-ring-fenced bank. Therefore, were it to be the counterparty on a loan with an investment bank typically engaging in ‘risky’ transactions, consumers’ deposits are still subject to a certain amount of undue risk, albeit once removed.

  Additionally, ring-fencing itself, is a complicated and perilous activity. The Vickers Report recommended that the ring-fenced bank should be a separate subsidiary company, but there is no mention of how the shares in the subsidiary should be held. Again, if it is permissible (and to date there has been little to suggest the contrary) for a non-ring fenced bank to hold a shareholding in its ring-fenced subsidiary, we are again presented with the possibility that the depositors of the ring-fenced banks could be exposed to undue amounts of risk – if the activities of the investment arm are left unchecked.

  The key point in all of this is that unless the risk-loving propensity of investment banks is not systematically tackled, it will persist; simply compartmentalising this gluttony for risk will not eradicate the widespread impact of its consequences.  Vickers suggested that the increased ‘risk-absorption’ requirements put on non-ring fenced banks would effectively lead to a curtailment in risk taking activity; but this proposition displays a certain amount of naivety. Investment bankers and shareholders of investment banks are loath to increases in costs or reductions in their bonuses and dividends. The increased costs associated with implementing a greater amount ‘risk absorption’ capital will inevitably lead traders and bankers to work any available capital even harder; meaning greater risk will need to be undertaken in order to generate the kind of profits they had become accustomed to in a ‘pre-reform’ environment.

  There has been much talk about the need to create high-street banks with a different ‘culture’ to their investment counterparts. But, effectively mitigating against contagion requires a change to the ‘culture’ of investment banks themselves.

  A year on from the publication of the Vickers Report – and following a woeful litany of subsequent scandals – the need for banking reform is greater than ever. Despite Ed Miliband proclaiming the need to split high-street from investment banks (and rightly so), there has been no mention of a detailed attempt to curb the risk-loving activities of the investment banks themselves. Separating banking arms will simply compartmentalise the toxicity of high risk, rather than effectively reduce or eradicate it. Obviously there is an imperative for banks and other investment entities to engage in risk in order to make a profit, but in the days before the bubble burst, traders and bankers took on unacceptable levels of risk.  If the high-risk transactions that investment-banks previously engaged in (and presently still do so in a largely unfettered manner) are left untouched by restriction or regulation - the risk of contagion still remains. Though a banking separation may cause the retail banking sector to become one-step removed from its more brazenly-avaricious sibling, it will never be impervious to the consequences of its licentiousness - unless such licentiousness is in fact curtailed. The lack of circumspection on this matter from all parties shows ominous signs for the future and once again, it could be that ordinary members of the public are left to pay for myopic policy making.

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