Vickers: 8 reasons why the banks' arguments are wrong

It’s only a week to go before Sir John Vickers publishes the ICB’s final report on bank reform and the debate is heating up spectacularly. The banking lobby has gone into spin overdrive and is pumping out arguments against change in various newspapers, on the BBA blog and behind closed doors to government officials, including David Cameron it seems.  At the same time, a few brave City figures like David Pitt-Wilson are putting the other side of the argument.

An unfortunate side-effect of this activity has been to anchor the public debate firmly around the ICB's remedy of ringfencing, which was already a compromise on the original proposal of structural separation. This shift is partly a result of George Osbourne's  Mansion House speech in June (see earlier post) and partly a result of recent bank lobbying. Like it or not, it means we are now discussing whether to compromise on a compromise. 

Luckily, the arguments against separation and against ringfencing are nearly identical and can be rebutted just as easily. In the article below, replace "inside or outside the ringfence" with "utility or casino bank" and the arguments work just as same.

If the anti-ringfence arguments are sufficiently discredited when the ICB launches its report on Monday it will be much easier to move the debate back to separation, although the politics still look pretty challenging.

It is surprising that any politician would want to resist a set of relatively mild bank reforms after the biggest financial crisis for 80 years and a deep recession. The fact that David Cameron is having reform jitters shows just how good the industry is at talking people round in private. Whether it can do so in public and avoid either ringfencing or separation will depend on the quality of its arguments, so let's see how many of them stand up.

Here are eight arguments against bank reform culled from the weekend press and eight rebuttals.

Bank argument:  Higher equity and ringfencing (or alternatively, the separation of "utility" from "casino" banks), will increase the cost of bank capital and this will hurt the economy.

Rebuttal: Higher equity capital requirements should in fact reduce the aggregate cost of equity and debt funding for banks because it reduces their overall long-term risk (the so-called Modigliani-Miller theorem).

In addition, higher equity buffers increase systemic stability, which further reduces risk and bank funding costs.

Transitioning to higher equity would not have to cause deleveraging in the real economy if banks are made to move slowly by retaining earnings and deleveraging their wholesale assets first.

Banks inside the retail ringfence (or "utility" banks under a full separation scenario) will have an explicit state guarantee and a slightly higher capital requirement, which should make their cost of funding lower than now. This will benefit the economy because most SME lending is done through retail banks. It will also make it easier for retail banks to fund themselves in the wholesale markets if they need to, as their risk profile will be better.

Banks outside the ringfence (or "casino banks" under full separation) will have a higher cost of capital as their subsidy is removed, but this will have limited impact on the real economy because the majority of investment bank assets are non-productive, meaning they are mostly financial or property -related. The different funding costs at retail and investment banks are likely to cause capital to move from the financial into the real economy.

The current subsidy to banks creates hidden “tail risk” for the UK’s sovereign rating. Removing the public subsidy from investment banks through any reform will reduce the chance of a speculative attack on UK government debt if the economy deteriorates, as most economists now predict it will.

Bank argument:  UK banks will face a competitive threat as will the future of London.

Rebuttal: The best way to protect London’s long-term future is to improve the stability and function of its banks, not to subordinate these qualities to profitability or short-run returns on equity.

Bank argument:  The global economy needs global banks.

Rebuttal: Ringfencing will not prevent banks from offering international corporate banking services. Global corporates managed fine in the stable era of Glass-Steagall and are likely to benefit if ringfencing reduces “financial bundling”, which drives a lot of excess bank profits.

Bank argument:  Corporates will move their accounts to foreign banks if ringfencing or separation pushes up lending costs.

Rebuttal: Corporate lending should become cheaper if this relatively uncomplicated activity is left inside the ringfence (or "utility" bank) because it will be expressly guaranteed and better capitalised than now. However, if it is outside (or in a "casino" bank), commercial lenders will need to become more competitive by offering a better service and lowering their own funding costs through safer, higher equity funding. If banks are unwilling to do this, or they do it but they still lose corporate lending business, that means, by definition, that the business they are losing was only won in the first place because of the UK taxpayer subsidy to bank capital. Since the benefit of this subsidy falls privately and often abroad but the cost is public (and very high if it ever endangers the UK’s sovereign rating), losing this business may well be a net gain for UK taxpayers. In any case, if public subsidies are to be provided for corporate borrowing they should be explicit and targetted.

Bank argument:  Banks will move abroad, eg HSBC to France.

Rebuttal: Healthy democracies do not make policy by blackmail, but if banks want to move they must first find a host country that is free from sovereign exposure, willing to risk its sovereign rating and willing to subsidise the bank’s capital. Good luck to them.

Bank argument:  The bulk of UK bank assets are foreign anyway. The UK’s domestic bank sector is no bigger than that of Spain or Norway.

Rebuttal: This is irrelevant. UK taxpayers can be on the hook for the overseas assets of UK domiciled banks just as they are for domestic assets, as we saw with Lloyds/HBOS and RBS.

Bank argument:  Ringfencing will destroy the value of taxpayer stakes in RBS and Lloyds.

Rebuttal: On average, banking crises cost the economy around 3% of GDP, or more than £40bn each year, according to the Independent Commission on Banking. The combined equity value of RBS and Lloyds is around £35bn, less than a single year of this burden. Ringfencing would help RBS and Lloyds to lend more to the real economy leading to higher tax revenues, and the value of the taxpayers' stakes would likely recover in the longer run anyway, once the banks were recapitalised and rehabilited.
 

Bank argument:  Universal banks are more resilient in a crisis.

Rebuttal: In fact the opposite is true; a universal bank only needs one rogue unit to get into trouble and the entire business can become insolvent. The more units a bank has, the greater the chance that one of these units will get into trouble. And the bigger the overall bank, the greater the systemic damage if this happens. This is exactly what happened with RBS and AIG.  As in many areas, systems made up of lots of different units are generally more resilient than those with fewer, similar units.