George Osborne sounded the death knell for enforced full bank separation this week at the Mansion House dinner, when he gave full – and premature – backing to the ICB’s interim recommendation for retail ringfencing.
It was bad news for taxpayers and the economy, but all is not lost. There are three steps the ICB can still take.
But first, a quick look at why ringfencing is not as good as full structural separation.
Ringfencing will continue a large part of the state subsidy for bank capital, not something one can imagine Osborne choosing to do in any other sector. The subsidy works by artificially lowering banks’ cost of capital and is worth tens of billions of pounds to the banks each year (up to £100bn at its peak after the crisis, according to the Bank of England). It helps fund the bonus culture, as RBS chief executive Stephen Hester admitted to the Treasury Select Committee recently.
Full structural separation would have denied investment banks the benefits of government-backed retail deposit insurance but ringfencing will let some slip through, since it allows surplus capital to cross the wall, subject to a 10% capital minimum. The more capital crosses the wall, the more the subsidy. And as this increases retail and investment banks will be more intertwined, which increases the subsidy even more as it makes a rescue more likely and further lowers the cost of capital.
While this is good for bankers, the costs will still fall on taxpayers and the wider economy. There is both a direct cost as the subsidy to bank capital increases the government's own cost of borrowing, and an indirect cost as retail-backed credit is gobbled up by the financial industry instead of being deployed where it can create the most jobs and growth.
Osborne and the ICB are aware of the subsidy but still back the ringfence, citing some of the industry's favourite arguments to do so.
One of these is that universal banks can use retail despoits to economise on equity, which lets them pump more credit into the economy. For the economy to really benefit, though, this credit must be used in the right way. Ideally, it would be available directly to businesses, especially the small and medium sized firms that create most of the country’s employment. Applying it to real estate securitisations, leveraged trading and various other investment bank businesses is less fruitful - for the economy at least - and can even be disastrous, as with sub-prime.
The best way to turn retail deposits into small business loans is to leave them in a retail bank that actually lends to small businesses. If surplus retail capital is transferred into investment banks it is likely to end up backing assets with low risk weights that are by definition less productive.
Osborne has pinned his career to the recovery of the economy but appears blind to these points. Instead, no doubt after strong lobbying, he is giving a thumb’s up to the ringfenced, but still universal, bank model, as if the long period of financial stability when retail and investment banking were kept entirely separate never happened. Those hoping for a return to Glass-Steagal will be sorely disappointed.
Just in case he changes his mind, a transition to separate banking need not be too painful. Bankers like Jamie Dimon like to warn that excessive regulations will force banks to shed assets, triggering another spiral of deleveraging and price falls and tipping the economy back into recession. This is a real risk but only if the transition is mismanaged.
For example, standalone investment banks that retain earnings or pay their higher-earning staff in new equity for a year or two could quickly build up capital, removing the need to reduce balance sheets in a hurry. Basel III capital ratios will not fully apply until 2019, so there's plenty of time. Of course, banks would not do this voluntarily, but that is why we have regulators.
Osborne made much of what he called the “British dilemma”, namely that strong financial services benefit the UK but might also bankrupt it. His response of mild intervention seems aimed at keeping the banks in the UK and on his side if the economy turns down. A braver response would be a radical, structural overhaul of the sector in which financial firms are regulated according to the real function we want them to perform, backed by a responsible transition plan.
Making investment banks rely on their own unsubsidised capital - as they did before the advent of Basel, deposit insurance and universal banking - would be the ultimate expression of free market capitalism, quite a legacy for a Conservative chancellor. If the free market gurus are right, the lack of subsidy should make the UK’s investment banks the best in the world.
More of a worry is that ringfencing makes the state guarantee of retail banks explicit. As Jeremy Warner of the Telegraph has written: "If everything within the ringfence is deemed utterly safe and guaranteed by taxpayers, it won’t be long before bankers find ways of exploiting this public subsidy with ever more high-risk forms of conventional lending."
This makes it even more important that the ICB recommends a low leverage ratio for retail banks. Suggestions of 10% of risk assets will not help if retail banks switch into lower risk assets such as sovereign debt and AAA bonds, unless they are either banned from such loans, quite a prescriptive remedy, or have a tough total asset ratio enforced. The government guarantee should come with strings attached.
However, it is hard to imagine Osborne changing course on ringfencing now - the coalition has flip-flopped on too many other things - but that shouldn’t stop the ICB from taking the few steps still left open to it.
• developing the most robust retail ringfence imaginable. The tougher the better: if it leads some banks to break themselves up voluntarily, so much the better;
• toughening its stance on capital ratios (see previous post);
• introducing leverage ratios as the main prudential control on banks. More on that to follow…