Tuesday, July 5, 2011

ICB submission

Click "Read more" to see the full text of my submission to the Independent Commission on Banking

Greg Ford is editor and research manager at the think tank Re-Define. This submission represents his personal views.

Consultation question 1.1
Do you agree with the general position set out in this Interim Report?
I agree with much of the analysis but feel the ICB’s general position on reforming the UK banking sector does not go far enough.
I would prefer full separation of retail and investment banks, much higher equity capital in all banks, more balance sheet disclosure, and incentives on banks to self-shrink and self-resolve.
In addition, I believe the ICB should consider the use of leverage ratios instead of risk asset ratios as a primary tool for prudential regulation of banks. Other measures the ICB could consider or recommend for future assessment include the abolition of debt interest deductibility for tax purposes, a more purposive regulatory regime and a policy to position London as a global centre of excellence in sustainable finance.
Underlying my submission is a belief that banks and the financial system should not in general profit from public subsidy or moral hazard, should have as their primary objective the tasks of bringing capital into productive use and helping business to cope with risk, and should operate where possible in an undistorted, unsubsidised and competitive market.

Consultation question 2.1
Do you agree with the analysis set out in this chapter?
Yes, although I think paragraph 2.4 defines the functions of the financial system too narrowly.
Instead of “lending to households, businesses and governments”, I would prefer “bringing capital into productive use” as this recognises the benefit of allocating bank credit to where it can do the most economic good. This sorting process is a central function of capital markets and should be made more explicit in the ICB’s analysis.

Consultation question 3.1
Are there other reform initiatives, beyond those set out in Chapter 3 and Annex 5, which you consider it essential for the Commission to examine further?

There are four other areas of reform that I would like to bring to the ICB’s attention as it prepares its final report:

1.       risk weighting reform
2.       debt interest deductibility
3.       purposive regulation
4.       making London a centre of sustainable finance.

1 Risk weighting reform

“Recent history suggests that risk weights have done a poor job of assessing how much capital should be held against assets. …  These points argue against relying on a minimum capital ratio to RWAs alone.” (ICB interim report, 4.27 and 4.28)

Summary of idea

Risk weights proved themselves an ineffective tool for prudential regulation. They are a (i) flawed concept that (ii) failed to ensure enough loss-absorbing capital or flag problems in advance of the financial crisis, they have (iii) allowed banks to disguise historically high levels of total leverage, and (iv) have distorted the allocation of credit within the economy to perceived-as-low-risk investments at the expense of risk enterprise and economic growth.

The easiest way for the ICB to address these flaws would be to recommend a simple leverage ratio at a level high enough that the Basel commitments on risk assets become redundant.

Problems with risk weighting

(i) Flawed concept

Perceived risk is not the same as real risk. As Per Kurowski, former World Bank director, wrote recently in an open letter to new IMF boss Christine Lagarde[1]:

Currently the “capital requirements for banks” are set by discriminating between borrowers based on their “perceived risk of default”, mostly as perceived by the credit rating agencies. More perceived risk, more capital, and vice-versa.

But, this is not logical, given the fact that regulators need not concern themselves much with the risks that are perceived, but should concern themselves mostly with the risks that are not perceived.

There has never, ever been a financial crisis resulting from excessive lending to what is perceived as “risky”. Apart from cases when fraudulent behaviour was present, they have all resulted from excessive lending to what is perceived as “not-risky”. Just look at the current crisis, 100% caused by leveraging the perceived as "not-risky" and then discovering these, later, as being “very-risky”

And it is also not logical, given that those perceived as “risky” are already compensating the capital accounts of the banks by means of paying higher risk-adjusted interest rates.

Since crises arise only when supposedly-safe assets turn out to be dangerous and not the other way round, risk weighting by definition will not catch the next crisis. It is more likely to accelerate the next crisis, by incentivising banks to disguise risk. This happened with sub-prime and is happening again with sovereign debt. The head of Swiss Re’s investment office wrote in last week’s FT:
The explosion of sovereign debt in several advanced economies is one of the more visible issues and calls into question the wisdom of regulatory incentives that encourage investment in so-called “risk-free” assets, which we now know to be an illusion...
The incentives for investing into sovereign bonds are being increased exactly at a time when interest rates are still very low and rate volatility is set to increase, exposing financial markets to the risk of global capital misallocation.[2]
Rather than increasing bank safety, risk weighting appears to reward banks for disguising risks and for engaging in capital arbitrage instead of traditional risk assessment.

(ii) Insufficient capital, poor indicator of trouble

The bail-out is proof that the system of risk weighted capital requirements failed to ensure that banks had enough loss-absorbing capital to survive a banking crisis. Looking at only one area of difficulty, the Bank of England found that trading book losses were up to six times greater than pre-crisis trading book capital, and that overall capital ratios would have needed to be up to 2.5 percentage points higher to accommodate this model risk[3].

The Basel committee has since adjusted trading book requirements but this retrospective approach is not a long-term solution: it will always leave regulators one step behind the next crisis.  It also assumes that regulators can gauge future risk, something even the market struggles with.

This backward-looking system explains why most of the banks that got into trouble had adequate capital according to Basel rules at the time. Risk-weighted capital requirements turned out to be a poor indicator of trouble, leading the Bank’s Andrew Haldane to conclude:

“Regulatory capital ratios do about as well in predicting crises as a coin toss”[4]

(iii) Disguises high total leverage

Risk weighting has allowed banks to disguise high levels of absolute leverage by letting them reduce risk assets as a proportion of total assets while still complying with regulatory standards. Barclays’ total assets today are nearly four times its risk weighted assets. This means that despite holding a safe-sounding 10.8% in Core Tier 1 equity, well above the new Basel minimum, its entire shareholders equity would be wiped out by a 2.8% fall in total assets.[5]

As the ICB points out in Box 1 of its interim report, Basel III would still allow leverage of nearly 30x and a safety margin of only 3.5% of total assets, even assuming risk assets increased to half of total assets.

This is less than the rate of non-performing loans among UK banks after the crisis. A year after Lehman Brothers collapsed, non-performing loans at European banks jumped to an average of 4.9% of total loans, according to the IMF[6]. A year later in the UK, they reached 6.1% of total loans, according to PwC[7]. These are averages, so the figures at the worst hit banks could be much worse.

Apart from allowing too much absolute leverage, the risk weight regime has grown too complex to be useful. It allows banks to escape effective supervision, as most large banks set their own risk weightings using the Internal Ratings Based Approach. For a regulator to check a large bank’s risk weightings, it may have to assess several million separate calculations, the Bank of England has noted. The resulting freedom and subjectivity means that the same asset can be weighted anything from 30% to 189% by different banks, according to a recent spot check by the FSA.

The variation has given rise to calls for harmonisation of risk weighting methodology across banks and countries but this would only fix one symptom among many and would the bigger problem of resource misallocation unfixed.

(iv) Distorting the allocation of credit within the economy

Just as risk weighting helped to disguise large increases in overall bank leverage during the boom, it has forced rapid real economy deleveraging in the bust, hurting the most productive parts of the economy first. BBA data from 2007 to date shows that lending to private non-financial companies, which includes SMEs and businesses that lack credit ratings and therefore attract a high risk weight, fell off a cliff after the crisis, relative to other forms of lending (see chart).

This can be partly explained by falling demand but it does not explain why business lending fell so much more than other lending measures. Since banks set the terms in most lending markets, it cannot be ruled out that the drop off follows a deliberate policy of tightening terms in specific markets in order to economise on bank equity and preserve double digit returns on equity. Business loans typically attract high risk weights, while consumer credit and mortgages can access lower risk weights through securitisations. 

The most recent BBA data shows the trend continuing, with May 2011 lending to private non-financial companies falling £2.5bn, while mortgage lending was up £1.2bn.[8]

Newspapers have criticised banks on their front pages for failing to lend to SMEs but on other pages carried stories of acquisitions with debt financing measured in billions, such as Blackstone’s planned leveraged acquisition of a £1.4bn debt portfolio from RBS, the two secondary private equity buyouts from PAI to BC Partners of Gruppo Coin for €1.3bn and of SPIE to CDR for €2.1bn, and Apax Partners €1.2bn takeover of Takko from Advent International.

While banks have focussed on lending to relatively less productive sectors, such as real estate and LBO finance, they have dismantled the financial and branch infrastructure needed for traditional small business lending, despite the higher lending margins available. This is because the wide variation in gearing of different assets under the risk weight system has made capital intensity the dominant factor in lending decisions. The government’s aims of re-balancing the economy away from financial services while stimulating an SME-led jobs and growth recovery look unachievable as long as this bias continues.

Reforming risk weights

The case for reforming the risk weight regime is strong and has supporters from many quarters. However, there are strong barriers to reform and there is no consensus on what should replace the current system. This section looks at (i) the barriers and (ii) some proposals.

(i) Barriers to reform

The first barrier is that countries running budgets deficits such as the UK and US benefit from the zero-weighting of their sovereign debt. The Treasury will naturally be wary of actions that might disrupt the gilt market or raise national borrowing costs. Risk weight reform would therefore need an impact assessment and a careful transition plan. Any increase in national borrowing costs caused by banks demanding a higher return on sovereign debt will be offset by the likely fall in national borrowing costs as banks are weaned off state subsidies, including the subsidy that state-guaranteed banks earn when lending to the government via zero-weighted gilts.

Secondly, bank shareholders and staff benefit substantially from the higher leverage and freedom possible under the risk weighting system and will resist any reform strongly, for example by demanding global implementation or threatening to leave the UK. Counter-arguments include that the UK’s financial sector could end up attracting more capital under risk weight reform if it were seen as developing an expertise in undistorted credit assessment and if its capital were seen as correctly priced, self-sufficient and not linked to the UK’s fiscal health. Arguments about unilateral implementation should be no different from the “Swiss finish” or the ICB’s ringfencing proposals.

Thirdly, the reform could interact with other developments that impact bank treasuries, such as the growing reliance of banks on secured repo funding or higher margin requirements for OTC derivatives as they are brought on-exchange. A transition plan would therefore need to coordinate with other reforms.

Fourthly, many senior regulators and academics including at central banks have spent years refining the risk-weight system and may feel they have a vested interest in its survival. A public debate could help to challenge views in this area. The academic case for reform has already been well made by Martin Hellwig of the Max Planck Institute in his July 2010 paper “Capital Regulation after the Crisis: Business as Usual?”[9], the business case by James Ferguson of Arbuthnot Securities[10], former World Bank director Per Kurowski has been campaigning for risk weight reform for years through his blog[11], ThomsonReuters blogger Felix Salmon and the Economist have both advocated it in recent articles[12]. It would be very helpful if the ICB also endorsed this as an area for discussion.

Fifth, abandoning risk weights may encourage banks to pile into risky assets in pursuit of higher interest margins, with possible adverse consequences for systemic risk. But as long as they do so within a prudent overall leverage ratio, and as long as there is sufficient balance sheet disclosure for regulators and the market to assess risk and the formation of bubbles, this should not make banks any more dangerous than they are now. In fact, instead of being incentivised to accept risk and then hide it, as now, they would be incentivised to become more expert at assessing credit risk on their own (ie without Credit Ratings Agencies) and matching it with appropriate collateral and interest rate conditions.
If this measure were accompanied by better balance sheet disclosure, banks would be kept in line by their own investors. This process would encourage the market for bank capital to evolve to allow investors to choose between banks with higher and lower risk lending strategies, a development that would improve diversity.

(ii) Alternatives to the current risk weight regime

A transition away from risk weights to an alternative system would be difficult in the short term, especially during the Eurozone sovereign crisis, but in the longer term could have profound benefits for the stability and function of the financial sector and the economy as a whole.

There seem to be two approaches suggested so far. One is to aim for the eventual abolition of risk weights in favour of a simple leverage ratio for prudential purposes, accompanied by a switch from Basel-led risk assessment to old fashioned risk and reward credit assessment, all subject to investor discipline backed by balance sheet disclosure. The transition could be done by lifting risk weights as a proportion of total assets until they reach 100%, or by lowering leverage ratios until risk asset based ratios become redundant, which might be less confrontational to the Basel committee. Changes would need to be implemented gradually to avoid over-rapid balance sheet restructuring and integrated with new rules on collateral etc. 
The other approach is to retain risk weights but adapt them to reflect macroeconomic, social and environmental and other policy risks. This raises interesting political questions about how best to use regulators to implement policy goals outside of their core area.
Here is a sample of proposals for risk weight reform from different ends of the political spectrum:
Right wing think tank Reform favours leaving credit assessment to the market and adjusting capital requirements only for macro or idiosyncratic risk:
Regulation and government guarantees have not, in the historical long term, made banks one iota safer. They have merely mollycoddled and confused. Fifty or even twenty five years ago all almost certainly had higher capital levels; not because regulators demanded it, but because the market did.
Regulators should be able, more precisely, to adjust banks’ capital requirements to the stage of the economic and credit cycle (i.e. build up capital in the good times) or to the strategy of an individual bank (i.e. requiring more capital to cover new probably illiquid types of investment which are not yet “in the rules”).[13]
James Ferguson, chief strategist at Arbuthnot Securities, wrote that risk weighting is a flawed concept and suggests more power for regulators to probe banks’ capital decisions:
There’s a logic flaw at the very heart of the whole RWA concept… Taken to its logical conclusion, the capital to risk-weighted asset ratio should, therefore, be very high (perhaps even 100%) yet the BIS and US minimum requirement is 8%. Capital should equal the likely loss in the event of default, so why such a low ratio was acceptable has never been adequately explained.
Regulators should be impelled to explain why they support banks capital and risk-weighting decisions and be encouraged to offer alternatives capital ratios under differing assumptions[14]
Friends of the Earth has written that risk weights distort capital allocation and proposes that social and environmental criteria be included in risk weights, with capital surcharges used to punish behaviour with negative externalities:
The Basel Capital Accord… favoured global financial conglomerates and their financial innovations at the expense of other traditional financial actors.[15]
Banks should be required to integrate social and environmental sustainability criteria in their credit risk assessment system. Specific and penal capital requirements should be considered for banks providing credit to companies grossly violating environmental and human rights standards, as well as for banks financing other investors that invest in such companies, such as private equity funds. Banks exposed to, or financing, commodity, credit and foreign exchange derivatives trades, as well as any kind of OTC derivatives, which have no hedging purposes and stimulate excessive financial speculation, could be required to hold specific and penal capital requirements, especially in times of high volatility and high prices.[16]
Whatever the preferred option, there is a case for risk weighting to answer. The ICB should use its final report to acknowledge this and either propose reforms to the way risk weights are used or recommend a detailed follow up investigation by another body.

2 Debt interest deductibility

The tax preference for debt over equity funding has contributed to excessive leverage and fragility in the capital structures of many firms and acted as a tool for transferring wealth from taxpayers to financial engineers, especially in private equity. As Lord Turner has pointed out, it has also contributed to confusion between the private interests of banks and the public interests of society in any discussion of what is the socially optimal level of bank capital.

Equalising the tax treatment of debt and equity could fund a corporation tax decrease to 17%, according to calculations by Andrew Lillico at the Policy Exchange[17], which could spur corporate investment.

Commentators have been calling for this reform for some time, with the FT’s John Plender writing last year:

A failure to address this very large distortion, which affects most of the larger developed economies, means the tax system is at odds with policy initiatives that seek to promote financial stability. It is a fundamental and destabilising flaw in the post-crisis financial architecture.

Such a far-reaching move may need international coordination (it would certainly be opposed by the industry on level-playing-field grounds) but placing it on the ICBs agenda would be a good first step, especially as part of a discussion about socially optimal levels of bank equity.

3 Purposive regulation

If the calls from Lord Myners and others for a Royal Commission into the causes of the financial crisis are successful[19], the investigators should look at the general level of dysfunction in the financial industry, of which the 2008 crisis was merely the culmination (see appendix Re-Define doc “That other financial crisis”). 

One proposal that an enquiry could examine is to create a new power for regulators to investigate financial dysfunction.

The recession will end up costing far more than the 2008 crisis because parts of the financial system have evolved in a way that leaves them unable to perform their core economic functions of resource allocation and risk management, among other things.

Where an industry area has obviously failed - as with SME lending, PPI, or under-performing pensions - intervention is easy to justify. But where it merely bumps along without crisis, incurring hidden economic costs and possibly storing up hidden risks while contributing little economic value, regulators have no general right to act outside of competition, consumer and certain other areas of law.

The idea of purposive regulation is to expand a regulator’s scope to include monitoring the underlying economic function of the firms it is regulating. It could work by creating a power for regulators to investigate evidence of market dysfunction such as high prices or wages and then act or make recommendations based on the cause (eg poor regulation, tax distortions, macro-liquidity, market structure, oligopoly, agency incentives, information flows etc).

If the rules and structures that emerge from this approach fell outside the regulator’s direct powers it could still make recommendations to other bodies, such as the competition commission or legislators. The outcome would tend to realign the City with the needs of the real economy and provide London with a competitive advantage over financial centres in Asia and elsewhere, since customers would be more protected from market capture.

The approach could lean against practices that impose costs without bringing economic benefits, such as high frequency trading or dividend tax arbitrage. It would entitle regulators to ask basic questions such as “who benefits from this activity and who bears the cost” and to correct market failures early on. 

Examples of areas where purposive regulation could make an immediate impact include the possible restoration of the broker/jobber distinction in capital markets, supported by different regulatory regimes and pay structures to remove conflicts of interest between client and trader, as argued recently by the FT’s John Gapper.[20]

4 London as a centre of sustainable finance

Part of this approach could include replacing any duty to promote London with a duty to promote sustainable finance in London.

Bodies such as the CityUK, the ICB and the FSA (under its outgoing mandate), have duties to consider or promote the competitiveness of London as an international financial centre.  This controversial requirement is a kind of extreme financial mercantilism that disregards external costs even when they fall on the UK. It is frequently used by the bank lobby to fight reforms.

The government is now considering how far to include a similar duty in future regulatory legislation. This presents an opportunity to replace the duty to promote London at all costs with a duty to promote sustainable finance in London.

By positioning the City as a centre for sustainable finance - meaning finance whose returns can be sustained over the longer term by the real economy growth it facilitates - the City could attract more stable capital inflows and wind down its involvement with the type of leveraged, speculative trading and extractive financial engineering that characterise the City today.

In employment terms, this may mean replacing, for example, derivative traders moving to Asia with new specialists in London who could become world leaders in green finance, GDP bonds, execution only trading, venture and growth capital, traditional risk lending etc.

This back-to-basics approach would be attractive to politicians and provide an alternative strategy for a financial industry facing tougher regulation and foreign competition.

Consultation question 4.1 and 4.2
Should systemically important banks be required to hold more equity than Basel III requirements? If so, how much?
Should UK retail banks be required to hold more equity than Basel III requirements? If so, how much?

The ICB should recommend far higher equity capital for both systemically risky and retail banks.
The proposed 10% ratio of tangible common equity to risk assets represents only 2-3% of total assets, assuming the proportion of risk assets to total assets currently typical among UK banks. The proposed rate is lower than the average rate of non-performing loans among European banks following the crisis, which ran at 6.1% of total assets in 2009, according to PwC.[21]
Barclays’ £392bn of risk assets are only a quarter of its £1,492bn total assets, according to its last interim statement. Barclays could satisfy the ICB's requirement with only £39bn of core Tier 1 equity, still only 2.6% of its balance sheet. The headline 10% ratio is therefore an optical illusion, providing only a fraction of the protection needed.
It seems sensible that the ICB should aim at least for the 17-20% level recommended by David Miles[22], a level calculated to be socially optimal given the high economic costs of bank crises.
The industry’s argument that this is costly and damaging for the real economy have been comprehensively dismissed by Stamford academic Anat Admati in the 2011 paper “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive”[23], which, among other things, analyses the deliberate confusion created by banks between the private interest of banks and the public interest.
Admati writes that banks could easily build capital on their own through retained earnings and mandatory equity issuance. In her view:
Bank equity is not socially expensive, and high leverage is not necessary for banks to perform all their socially valuable functions.
FSA Chairman Lord Turner summarised Admati and Miles, saying:
The costs of higher bank equity requirements are lower and the economic benefits considerably higher than many participants in this debate – from the banking industry but also from public authorities – have in the past assumed.[24]
The IMF and bank lobby both argue that higher equity capital would mean reducing dividends, raising lending margins or deleveraging, all of which harm the economy. But their argument misses the most obvious solution – that banks simply issue new equity. In a May 2011 working paper [25], the IMF excluded equity issuance from its model on the feeble grounds that it felt banks would view the “dilution of existing shareholder rights as a last resort measure". The ICB should not accept reasoning based only on bank preferences.
Institutional investors have lobbied against higher bank capital to avoid dilution and loss of dividend income. This is fair comment but should be seen in the context of a longer transition plan. The short term outlook of many institutional fund managers (often incentivised on a quarterly or annual basis) has become such a barrier to long-term planning that the government has set up the Kay Review to look at investment in UK equity markets and its impact on the long-term performance and governance of UK quoted companies.  Institutional investors should see higher bank capital as a longer term opportunity to invest in bank debt and equity at much better risk-adjusted returns than are currently available, assuming fewer bank crises over the longer term.  
The CBI and industry have also objected to higher bank capital in case it reduces bank lending[26]. This should be seen in the light of other reforms that could increase business lending, such as risk weight reform (see section 3.1 above) and mandatory new equity issuance at banks.
The obvious way of implementing higher capital without hurting lending is to require bankers to be paid in new equity when their remuneration is above a certain level, eg a certain multiple of average earnings, until the desired capital has been built.
Over time, this could transfer bank ownership gradually to bank staff, moving banks closer to the partnership style of ownership that many had before becoming joint stock companies. Bank culture and risk management are likely to improve as a result.
Alternatively, mandatory equity issuance could be designed to include dividends so the balance of ownership between existing shareholders and staff does not change.
A further twist would be if bank staff with especially high risk profiles, such as traders, were paid with double or treble liability equity, as suggested by economist Axel Leijonhufvud in the recent Good Banking summit in London. This would lower the bank’s funding costs, while other equity holders and taxpayers would benefit from a reduction in asymmetric risk-taking at their expense.
Bankers including Jamie Dimon have warned that excessive capital regulation could force banks to shed assets, triggering another spiral of deleveraging and tipping the economy back into recession.
This need not be the case. 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 any urgent need to shrink balance sheets. Basel III capital ratios will not fully apply until 2019, so there is plenty of time. Of course, banks would not do this voluntarily, but that is why we have regulators.
A transitionary risk-weighting regime could also help minimise the economic impact of a move to higher capital by reducing the equity required for small and medium business lending relative to lower risk-weighted lending (see section 3.1).
A final comment is that global SIFI surcharges, as agreed by the BIS recently, must be set at punitively high levels to counter the increased subsidy that banks would gain from G-SIFI status with its guarantee of a bail-out.

Consultation question 4.3
Do you agree that bank debt should be made more loss-absorbing using some or all of contingent capital, bail-inable debt and/or depositor preference? If so, which of these tools do you support and how should they be designed?
Bail-ins, cocos, depositor preference and bank resolution are all welcome but significant problems exist with each, making them less effective than a simple combination of structural separation and socially optimal (ie much higher than now) levels of equity capital.
The “bailing in” of bank creditors barely happened in the last crisis for reasons of complexity that have since become worse. Complex inter-bank relationships exist from treasury to repos to swaps and derivatives, syndicated lending, structured credit, equity finance, trading, collateral and custodial arrangements etc. These areas are not known for their transparency and fear of contamination will always risk a domino effect if a bank is left to fail, unless structural and strong equity capital remedies are adopted.
Secondly, not all types of debt can be bailed in. There is little point bailing in central banks or holders of secured repos and other secured debt, while unsecured creditors would likely challenge any bail-in, especially in cross-border cases. These all make bail-ins slow, difficult and less effective at stopping contagion than a bail-out with public money.

CoCos are an interesting source of loss-absorbing capital. Andy Haldane calculated
[27] that if half the bonuses and dividends paid in the run up to the crisis had been in contingent capital instead of cash, UK banks would already have had the £70bn in extra loss-absorbing capital they needed to raise as a result of the crisis.
The ICB’s interim report was lukewarm on CoCos because they are vulnerable to speculative attack and might be difficult to sell.  But if banks were forced to part-pay their high rollers and shareholders in CoCos that might help while reducing moral hazard by forcing bank staff to “eat their own cooking” if things turned out badly, to use Andrew Haldane’s words.
An even better solution than CoCos, however, would be to pay staff bonuses in new equity until David Miles-levels have been raised.

Resolution plans are also worthwhile and the European Union and FSB are working on these now. However, the politics of cross-border burden sharing seen in the Eurozone crisis suggest there is much work to do before they will offer a reliable source of protection.  For now, structural separation and higher equity seem much safer tools for addressing the too-big-to-fail problem.

Consultation question 4.4
In relation to structural reforms to promote stability, do you agree that the Commission should focus its work on a UK retail ring-fence?
No, I think full structural separation is a simpler, more effective and fairer solution.
Ringfencing will continue the state subsidy for bank capital, something considered inappropriate in most other industries. The subsidy is measured in tens of billions, depending on methodology, and helps to fund the bonus culture, as RBS chief executive Stephen Hester admitted to the Treasury Select Committee recently.

Ringfencing will let investment banks profit directly from government-backed retail deposit insurance, to the extent that surplus capital moves over the wall. The more capital crosses the wall, the greater the subsidy and the greater the inter-connection between bank subsidiaries, which will further increase the chances of rescue and therefore the subsidy.
The subsidy is not free to taxpayers. Cheaper bank capital means more expensive government debt, as the ratings agencies have made very clear in countries with over-developed bank sectors such as Ireland, and with Greece.
There is a further cost from ringfencing in credit misallocation. The best way to turn retail deposits into small business loans – the area where they might produce the most economic growth and employment - 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 economically productive. This further reduces the case for allowing subsidised bank capital across the ringfence wall.
One argument for leaving the banks alone is that separation of any kind would decrease the value of state owned bank RBS, denying taxpayers a profit when this rescued lender is sold back to the market. This argument fails to compare the huge value of RBS to the economy as a functioning bank with its relatively limited value as a one-off asset for sale.
A second argument is that ringfencing would increase the cost of credit to large corporates if they were excluded from the retail part of the bank, as they could no longer access the subsidised, retail deposit-backed credit that universal banks now offer. This is true, but neither a ringfence nor complete separation would stop the government from providing capital subsidies to large corporates directly, if that is what an elected government chooses to do. In fact, this would be a more targeted and democratically accountable way of subsidising big business than using banks as opaque intermediaries.
A third is that cutting off investment banks from subsidised capital would encourage them to adopt riskier behaviour to maintain their current double digits returns on equity.  Such a danger would recede quickly if the ICB were to recommend higher equity capital.
Both ringfencing and separation would make the state guarantee of retail banks explicit, which brings dangers for retail banks too, as Jeremy Warner of the Telegraph wrote:
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.[28]
This makes it even more important for the ICB to recommend a low leverage ratio for retail banks to shut down any risk weight-driven arbitrages. It should also impose tough restrictions on retail bank activities: the government guarantee should come with strings attached.

The chancellor George Osborne has spoken about what he calls the “British dilemma” that strong financial services benefit the UK as long as they don’t bankrupt it. His backing of ringfencing goes part-way to solving that dilemma but this should not stop the ICB from going all the way in its final recommendations. A clean, structural remedy that could be implemented decisively and forgotten about is far preferable to a behavioural remedy with blurred definitions that invites never-ending regulation and continuous arbitrage.
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 and the ancient spirit of the City of London. It would help investment banks to end their period of regulatory uncertainty and build sustainable, self-sufficient business models that the public and industry could support.
If enforced separation proves politically difficult after Mr Osborne’s public support for ringfencing, the ICB could consider creating incentives for universal banks to break themselves up, probably using capital surcharges or balance sheet taxes.

Consultation question 4.8
Do you agree with the Commission’s assessment of the impact on the competitiveness of the City and the UK economy of the reforms? Can you provide further data and analysis in this area?
See “London as a centre of sustainable finance”, above.

That Other financial crisis
Sony Kapoor, Re-Define Managing Director
A crisis can manifest itself in the form of a short and intense burst or it can unfold over a long time. While the present financial crisis has been spectacular in its speed and apparent size, a much bigger more insidious and harmful financial crisis has been brewing.
Making cost estimates for the financial crisis is fashionable, in particular if your number is higher than others that went before. From the direct cost of bailing financial institutions to the total estimated costs that include the deterioration of fiscal balances and the opportunity costs from lost growth estimates vary from 1%-2% of GDP to 25% of GDP or more.
While these calculations are no doubt important for public policy I believe that this approach to measuring the seriousness of problems afflicting the financial sector is limited. An excessive focus on this approach can lead to serious policy mistakes and lost opportunities.
It would not be too unfair to say that the primary, if not sole, focus of the extensive regulatory reform agenda in the EU and beyond is crisis avoidance. We have catalogued the various causes of the crisis on a piecemeal basis and are trying to use a tick mark approach to ensure most of these are addressed.
We have embarked upon the biggest most ambitious program of reform of the financial sector without having ever asked basic questions such as 1) what the financial sector is meant to do 2) whether it was doing this job well and 3) if this was not the case then what corrective measures could be applied using the window of opportunity provided by the crisis.
We have crisis myopia where the single minded focus on the crisis has crowded out any positive vision of what a good financial sector ought to look like. It has prevented us from pausing to map out what the supposedly well-functioning financial sector that is supposed to emerge from this reform process ought to look like.
The reform process in the EU is being led with some zeal by teams of people drafting detailed regulations with little time for the big questions or the vision thing. They are obsessed with making sure that what led to the crisis does not happen again.
The real costs of a malfunctioning financial system
The implicit underpinning of this approach is that all was well before the crisis. That if only we are able to prevent the recurrence of another crisis, the economy would prosper and finance would be doing its job.
the real long-term costs of a malfunctioning financial system have arisen not during war-time (the financial crash) but during peace time when the financial sector was apparently working well. I believe that these costs are far bigger and far more serious than even the high end estimates of the costs of the crisis.
These costs arise when the financial sector fails in its assigned role of supporting real sustainable growth in the economy through 1) facilitating price discovery 2) ensuring the efficient mobilization and allocation of resources 3) providing opportunities for effective risk sharing 4) acting as a shock absorber for the real economy 5) and the provision of access to suitable credit, savings and investment products for economic actors.
For example, a financial system that impeded proper price discovery can send erroneous price signals to the economy and lead to suboptimal investments. These have a large opportunity cost.
Problems with the time-horizon of financial sector actors and misaligned incentives can cause the financial sector to misallocate resources away from high return investments into wasteful investments that have a lower economic return.
The financial sector can and does, often as a result of implicit public subsidy and the asymmetry of information push risk away from entities most competent to handle and absorb it towards public entities as well as unsophisticated economic actors least capable of managing and absorbing such risks.
The real economy is cyclical and has strong inertia so the virtual financial sector which can at least on paper adjust faster has a significant shock absorption capacity. At least that is the theory. In reality, the financial sector has often acted as an amplifier and even a source of shocks to the real economy imposing significant economic costs.
The financial sector is supposed to increase welfare through improving access to credit, savings and investment products for economic actors. However, the financial market remains far from complete, many economic actors still lack access to financial product and appropriate products are often not matched with the right economic actors. All of these reduce potential economic welfare.
Suffice to say that the economic and welfare costs of a malfunctioning financial system are much larger than even the largest cost estimates that show up in a crisis. Most of the time, a sub-optimal financial system will simply chug along imposing large opportunity costs on the economy without necessarily blowing up.
Instead of waiting for the financial sector to blow up again, we urgently need to use the current spate of financial sector reforms and regulations being enacted in the EU to rejig the design of the financial system so it fulfils the tasks expected of it and to improve its functioning. The political window of opportunity for financial reform will close soon again.

[1] http://subprimeregulations.blogspot.com/2011/07/letter-from-citizen-to-mme-christine.html
[3] January 2011 speech “Capital Discipline” p.6 http://www.bankofengland.co.uk/publications/speeches/2011/speech484.pdf
[4] Haldane, “Capital Discipline”
[5]  £392bn risk assets/£1,492 total assets x 10.8% Core Tier 1 = 2.8%, source Barclays Q1 2011 Interim Statement 
[6] IMF Global Financial Stability Report 2010, table 9 http://www.imf.org/external/pubs/ft/gfsr/2010/02/index.htm
[7] PwC European outlook for non-core and non-performing loan portfolios 2011 http://www.ukmediacentre.pwc.com/imagelibrary/downloadMedia.ashx?MediaDetailsID=1914
[9] http://www.coll.mpg.de/pdf_dat/2010_31online.pdf
[10] “The Gathering Storm”, Chapter 1 What Went Wrong?
[11] http://subprimeregulations.blogspot.com/
[12] http://blogs.reuters.com/felix-salmon/2010/09/15/the-biggest-weakness-of-basel-iii/ and  http://www.economist.com/blogs/freeexchange/2010/09/basel_iii
[13] Nicholas Boys Smith, “A Dangerous Consensus”, Sep 2009 http://www.reform.co.uk/Research/ResearchArticles/tabid/82/smid/378/ArticleID/932/reftab/82/t/A%20dangerous%20consensus/Default.aspx
[14] “The Gathering Storm”, Chapter 1 What Went Wrong?
[15] “In 2011 European decision makers can make banks sustainable” http://www.foeeurope.org/finance/sustainablebanks-2011.pdf
[16] “Seven steps to make banks sustainable” http://www.foeeurope.org/finance/sustainableCRD-2011.pdf
[18]It is time to stop punishing prudence”, John Plender FT, 25 march 2010 http://www.ft.com/cms/s/0/ad563496-37af-11df-88c6-00144feabdc0.html#axzz1R7V80Bec
[19] Sir John must take his chance to repair the banks”, Paul Myners and Neal Lawson, 3 July 2011 http://www.ft.com/cms/s/0/747d7652-a5a4-11e0-83b2-00144feabdc0.html#axzz1R7V80Bec
[20] “The price of Wall Street’s black box” 22 June 2011 http://www.ft.com/cms/s/0/fe7aaec6-9d00-11e0-8678-00144feabdc0.html#axzz1RDrHp74o
[21] PwC European outlook for non-core and non-performing loan portfolios 2011 http://www.ukmediacentre.pwc.com/imagelibrary/downloadMedia.ashx?MediaDetailsID=1914
[22] External MPC Unit Discussion Paper No. 31 “Optimal bank capital” Jan 2011 http://www.bankofengland.co.uk/publications/externalmpcpapers/extmpcpaper0031.pdf
[23] http://www.coll.mpg.de/pdf_dat/2010_42online.pdf
[24] March 2011 speech, “Leverage, Maturity Transformation and Financial Stability: Challenges Beyond Basel III” http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2011/0316_at.shtml
[25] “Macroeconomic Costs of Higher Bank Capital and Liquidity Requirements” http://www.imf.org/external/pubs/ft/wp/2011/wp11103.pdf
[26] http://www.cbi.org.uk/ndbs/press.nsf/0363c1f07c6ca12a8025671c00381cc7/63f05d3426953b97802578c3004ccefe/$FILE/CBI%20response%20to%20the%20ICB%20interim%20report%20-%20July%202011.pdf
[27] “Capital Discipline” Jan 2011 http://www.bankofengland.co.uk/publications/speeches/2011/speech484.pdf

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