Analysis: Are the banks crying wolf over reform?

Banks say the Vickers report reforms will prevent them lending and force them overseas. Does that stand up to scrutiny?

By Ian Dunt 

In the days preceding the publication of Sir John Vickers' report into banking reform, the sector unleashed its PR operation. Banks would move overseas, they argued. They would be unable to lend to consumers. Many of the apocalyptic suggestions were a crude last-ditch effort to halt reform, but there are reasons to believe that even if the Vickers report does no damage, it could still fail to prevent another banking bail-out


Sir John announced a "strong and flexible" ringfencing of banks' retail and investment functions. This would force banks, or part of banks, offering core services such as overdrafts and mortgages from engaging in risky trading in markets or derivatives, although they would obviously be able to hedge their retail risks. They would also be able to lend to large non-financial companies and would have their own capital, which would have to stay above a certain set limit.

Reformists believe that ringfencing – one of Vince Cable's personal crusades – gives a sound long-term framework for ensuring the supply of credit in the economy. It protects the bog-standard banking services normal people use from the madcap casino adventures of the investment sector. By forcing investors to make do without access to the capital from retail, they would be more careful in their risk-taking. Or so the argument goes.

The banking industry says otherwise. The threat that banks will move to Shanghai or Hong Kong, a predictable cornerstone of any bank PR operation, rings hollow. As Cable himself pointed out, even the US is unlikely to leave taxpayers liable to pay for bankers' behaviour to the extent they demand. Most other countries simply can't afford to.

An argument from the sector which may prove more effective is that this is a solution which is entirely disconnected from the problem. Universal banks such as HSBC and Deutsche, which provide retail and investment, actually scrapped through the crisis pretty well, while banks with a narrow focus, like Lehmans and Northern Rock, collapsed. They also argue that where risk is avoided, interest on savings is reduced. Traditionally, customers don't like this, which is why they flocked to these banks in the first place – many of them overseas, such as in Iceland. When those banks fail again, the government will probably find itself in the same position it was in three years ago – it will be politically impossible not to guarantee their customers' deposits.

Safety fund

A second Vickers proposal focuses on the need for banks to maintain enough capital to bear loss at the point of failure. Ringfenced banks are supposed to have 20% capital to protect them (equity of ten per cent buoyed with bonds and other capital). The largest ringfenced banks are expected to have at least 17% of equity and bonds together with an extra cushion of up to three per cent if there's additional concern about their stability.

Many commentators, including Bank of England governor Mervyn King and chairman of the Financial Services Authority Lord Turner, consider this a reasonable response to the crisis. While banks complain that it will increase the cost of capital and unsecured debt outside the ringfence, that is a consequence of returning risk to the investor rather than the taxpayer. Not only is this more just, but it is better for the economy in the long-term, because it introduces an element of discipline to risk taking.

While some analysts say that the real change which is needed is ultimately a cultural one about shareholders pushing for long term stability rather than short term gain, the two moves are not mutually exclusive and many would argue that the cultural change will more easily follow from capital regulation. It is possible, however, that the move will have an impact on lending, such as it is. It's also true that state-mandated capital reserves are easily outdone by financial firms because of their clumsy legal definitions of risk.

The timetable

Sir John has set a timetable of policy completion by the end of the year, legislation by the end of the parliament (in 2015) and full implementation by 2019. To some people, that seems overly generous. While Liberal Democrat ministers want to see as much done before the general election as possible, Sir John has his eye on the Basel III capital standards, which are set for 2019. Those standards are less radical than his proposals but provide a good international timetable, especially given concerns about the UK regulating itself out of competitiveness.

Sir John is relying on the idea that markets will operate according to the regulatory timetable once they see that policy is clear and the British government is certain to proceed, rather than at the exact point of implementation. That partly explains the briefings from the Treasury over the weekend stressing how supportive George Osborne was of what he had read. Sir John made it quite clear that the entire package had to be taken as a whole and early noises from the Treasury suggest that is precisely what will happen.