New UK banking regulation

The Vickers Report in the UK has made three main recommendations which the government will implement, it claims, pretty nearly in full. Firstly apologies to our many North American readers but the same may happen to you in due course so it is instructive to consider the consequences. Bear with me please because there will be knock-on effects in the global market. It may well be that some of these reforms also find their way into the Eurozone, possibly not a moment too late.  Despite the recent spats between leaders, wiser heads on both sides of the Channel do recognise the importance of London as a financial centre and it seems that Britain will have an observer role in the reconstruction of the Eurozone systems.

The biggest immediate effect over the pond will I suspect be the downsizing and probably removal of the Royal Bank of Scotland’s investment presence in the US as that bank, largely in public ownership, will be refocused on the UK according to the statement in the House of Commons this afternoon by the Chancellor of the Exchequer.

The main Vickers recommendations are

  1. to split their European retail banking assets, liabilities and services into separate subsidiaries in order to ‘ring-fence’ retail from investment banking,
  2. to promote retail deposits (savings) ahead of unsecured loans in case a bank goes bust which means that unsecured lenders will be more careful where they place their money in future and
  3. insist that the retail components of banks should be capitalised not at 7% as Basel 3 recommends nor at 10% as the UK Treasury had been suggesting but for the larger UK banks with an international presence, at 17-20% of their UK balance sheet.

The original Vickers’ recommendation for the larger banks was for 17-20% on all assets but this has been watered down to be only those which will affect the UK taxpayer. You can see the sense in that – if one of the giant UK banks goes under despite all this, you don’t want the UK taxpayer bailing out the deposits held overseas in other currencies and HSBC in particular argued this point on the basis that the majority of its business was overseas and it would mean raising an awful lot of (dead) money.

This will all be enacted in Parliament by 2015 and has to be completed by 2019.

It all sounds great but what does it mean and will it work?

Let’s start with the good news. Deposits will be protected ahead of unsecured creditors. This will reassure the former and keep the latter on their toes. The former are of course the ordinary people and businesses, the latter are those shady folk who float billions around the world all day.

Now the bad news.

First it means substantial money will have to be raised by the banks. They have already moved from the rather paltry few percent of capitalisation to approaching the 10% required. Along with trying to recover their losses (most banks were not of course nationalised), repaying loans from the government needed to avoid complete collapse in 2008, this has meant a substantial reduction in lending, only eased by the Bank of England printing money – ie doing what the private banks had been doing rather too willingly up to the crash. So this lending freeze will carry on at least for UK loans until the 17-20% is reached. Which means surely that the BoE will have to carry on pumping money in and/or the impending recession will be longer and worse.

Once all this has settled down, the penny will drop that lending in the UK will not be as profitable as lending elsewhere. Remember my calculations of why banks love to lend? The increase in capitalisation means that the effective yield to the bank (interest rate as they see it) is just about halved so your 4% 20 year mortgage is worth not 72% yield on the 10% required but a paltry 36% to them, an 8% car loan over 4 years will net only 145% yield.  Boo hoo. Champagne halved this year, chaps.  And next year…

Expect therefore banks with overseas operations to favour areas where they can still make a shed load which is better than half a shed load. Or banks will offer off-shore lending at a slightly lower interest rate where they can still clean up on profit. Nice one – all outside the regulatory control I expect.

Secondly I am rather puzzled about this ring-fencing. Where will the banks place their 20%? According to the recommendations, 10% should be in top-quality form such as shares and retained earnings, the rest in bonds that can easily be converted into equity. Now wait a minute – shares? What if the stock market goes south? Bonds? Which? And if they have to sell either in vast quantities (as would be the case), who will buy them at what price? If a bank goes down, the price of any backing asset will drop like a stone so what protection is that?  The ‘quality’ of any backing instruments will be verified by whom? The same ratings agencies that have let us down in the past?  Lastly, the banks clearly had problems before in finding sufficient good places to put their few percent before, so how in these days are they going to find secure repositories for substantially more, particularly as all other banks in the world will at least have to follow Basel 3?   Nothing seems to be said about this.

Expect international banks to set up off-shore operations providing ‘products’, pay the ratings agencies their loot to AAA-rate them, dump their 20%s in these ‘vehicles’ and carry on playing as they have been doing with impunity so far. Why?  Because they can, because it’s more profitable and no ordinary audit trail will be able to follow the money.  Not a lot will have changed. I would have thought that the best place – in fact the only place – for such money is with the central bank and for Sterling, the 20%s should be deposited with the Bank of England. End of.

And what about non-UK banks operating in the UK? Does this mean the same for them too? There are a lot of them. Will they need to obey the same regulations? What if the EU passes different standards? Which will they obey? And if the UK standards are stiffer, will they complain to the EU and take their ball away? It seems to be party time for the lawyers.

Of course some people are saying – why wait until 2019? Apart from the legislative delay (and expect some rearguard action from the banks’ friends), it does mean that this reduction in lending will be over 4 years (or if they realise the game is up and start immediately, over 8 years) which is more manageable. During which time of course the banks are still vulnerable, particularly to events in Eurozone.

Lastly, as was shown in these columns recently, these banks are among the biggest financial organisations in the world and are all intimately connected with cross-board ownership. It is very difficult to control such institutions because they control us.

I don’t object in principle to the Vickers’ report but do find it rather difficult to see that it will do much good at all particularly in a global economy where assets can be moved so quickly.   The Three Taxes proposals made recently would be a better – or additional – way of regulation, much lighter and more difficult to evade, reduce central bank liability, reduce market volatility and benefit businesses and consumers much more visibly.

21 thoughts on “New UK banking regulation”

  1. This just adds to my belief that no amount of regulation or requirement will be good enough. Banks will do as you said, lend less and go to places were they can make a shed load vs an half a shed.

    1. You’re probably right but it does mean the mind should concentrate on how to control banks in a manner which they can’t circumvent. It really shouldn’t be beyond the wit of wo/man to do this!

      Let’s hope so because the world is not in a good place just at the moment!

      1. Legislation that the banks can’t cirumvent has been drawn up by the group positive money
        In brief:
        It prevents new bank lending from creating new money, ensuring that there will be a stable money supply
        It ensures that banks that fail can be shut down, rather than having to be bailed out at the expense of the taxpayer
        It democratises the investment priorities of banks by requiring them to disclose to customers how their money will actually be invested
        It separates the payments system and the lending side of a bank’s business, so that poor investment practice by a bank doesn’t threaten the payments system for the whole economy
        It limits the power of the Bank of England in manipulating the economy
        It ensures, as much as possible, that money is created in an open, transparent manner and that this power to create money is sheltered from abuse
        It takes the power to create money out of the hands of both vote seeking politicians and profit-seeking bankers.

        1. Richard

          Many thanks for your comments. I will be returning to the banking problems in these columns over the next few weeks but meanwhile, thank you for pointing out the PositiveMoney proposals. I have been aware of them for some time and some of the aims are indeed good. I have reservations about the capitalisation levels demanded by Vickers – they will lead to a substantial long-term reduction in UK lending vis-a-vis our international competitors. I have reservations about other PM proposals in two contexts:

          a) by placing the control of money supply in bureacratic hands, it risks provoking a very long recession. There is nothing intrinsically wrong with creating money – as I said elsewhere it is a necessary response to entropy. Creating money enables us to have symphony orchestras for example – why else would we have such things which do no ‘good’ at all? Other of course than to delight their audiences but that has no immediate effect on the economy.

          b) The rest of the world will not follow this lead. Indeed there will be a large dose of schadenfreude if the UK does adopt it as other economies will ‘grow’ – maybe on a house of sand but for some that sand will be firmed up. Meanwhile the UK will have dug a large hole for itself by trying to return to the gold standard, albeit modified to include electronic funds. Fractional reserve banking enables growth. It just needs controlling and I don’t think that a central bureacracy is the way to control it – we’ve been there before in other parts of the world.

          The present draconian cuts imposed by the UK goverment are an attempt to be more macho than the next guy to cut the deficit so that the UK retains its ‘AAA’ rating when all around do not. But an AAA rating is only that useful when you are heavily in debt (as we are primarily because of the banks). If there are other ways of reducing this debt that do not hit innocent people, that route should be tried.

          More specifically re PM proposals:

          It prevents new bank lending from creating new money, ensuring that there will be a stable money supply

          This is placing an awful lot of trust in the BoE and its ability to monitor and control the economy. To whom is the BoE accountable and what happens if that accountability is called in? Yes it means that foolish banks won’t be able to create money but it also means that sensible banks won’t be able to lend if they happen to have run out of the stuff. Or some shadow market will develop of spare money and a bidding war opens to get it. Then the less scrupulous banks prepared to pay rather more for the money will be able to lend at elevated interest rates – which means that otherwise excellent projects will be hijacked by the bank prepared to pay more for some shadow money. Or the bank that wants to lend on a sensible project will have to go on bended knees to the BoE for money. Or they may end up trying to borrow in another currency but having to exchange it for sterling and in which case, where does the exchanged sterling come from? I can’t begin to imagine the bureaucracy involved, electronic or not, in any of these operations. And what happens if a lot of sensible projects are mounted at a similar time. We will be back to credit control with avengance and the people that suffer then are always the small businesses and individuals because they don’t have the ear of the high and mighty. My Funny Money Tax proposal is a tax paid to the Central Bank for the ‘right’ to print the money based simply on the difference between the actual (sterling) deposits with the Central Bank and the total (sterling) book. As such it represents an insurance payment coupled with draconian confiscation powers over the directors to stop them being too foolish. But if one bank won’t help, another may see the benefit. The reward of course is that the lending bank sees a very high yield on the reserve it uses to generate the funds.

          It ensures that banks that fail can be shut down, rather than having to be bailed out at the expense of the taxpayer

          That’s a good thing – they are just like any other business then.

          It democratises the investment priorities of banks by requiring them to disclose to customers how their money will actually be invested

          In other words an extended Credit Union? I am not sure that political concepts can healthily be incorporated into finance which will have to be international unless you want a Continental system as espoused by Napoleon. The best way is a coherent a-political system of taxes – political only in the sense that they are established within a single legislative identity (ie a currency zone). Most people don’t care where the money is invested anyway – they just want the best rate of return. People are greedy and fall for Ponzi schemes all the time.

          It separates the payments system and the lending side of a bank’s business, so that poor investment practice by a bank doesn’t threaten the payments system for the whole economy

          Well the ‘ring-fencing’ proposed should do this and I don’t in principle object to it either.

          It limits the power of the Bank of England in manipulating the economy

          But surely either the BoE or the politicians must have power. Otherwise an upturn in the economy is at best at risk of being stifled or at worst generates a recession.

          It ensures, as much as possible, that money is created in an open, transparent manner and that this power to create money is sheltered from abuse

          That’s not a bad thing but could be done within the present framework.

          It takes the power to create money out of the hands of both vote seeking politicians and profit-seeking bankers.

          Politicians are always looking for votes and bankers for profit. But not all policicians and not all bankers are bad. Some of each genuinely want to improve the world and see their trade as enabling this improvement. Do we throw those (perhaps few) babies out with the bathwater?

          We need to find a smooth way of transitioning from the present system to a system where the banks serve the people and the economy. The Three Taxes proposals would do that I feel – the Excess Interest Tax could also raise a lot of money that would help restore public finances in particular. And by setting the tax rates fairly low to start with, the transition could be controlled.

          1. John, I really like your ideas on taxation, in particular the funny money and excess interest tax. However I still feel that the legal right for banks to create money out of thin air through lending is fundamentally unfair and needs to be dealt with. I’m sure you’re aware of the arguments but some of the reasons I feel it’s unfair follow:
            Banks are able to undercut lenders who don’t have the same money creating privilege
            They inflate the money supply causing inflation and make all of us pay the bill
            The system means that new money is only really available as debt
            Debt has to repaid plus interest which the banks may or may not decide to spend back into the economy where people can earn it to pay off what they owe

            The positive money proposals deal with the issue of money as debt which the taxes do not.

            There are many reasons why it’s not a good idea to create money as debt. An important one is that it requires continual economic growth at any human or environmental cost no matter how unsustainable it might be. Growth is good but not when it destroys the planet we live on.

            In response to the comments on positive money’s draft legislation, I am perhaps not the best person to respond as was not involved in drafting them and have only been really interested in this area for a year or two now. However I will make a few points

            a) The quantity of money in the money supply is controlled by banks when they create money by making loans and “destroy” money by accepting repayments and also by the government when it mints coins and prints notes which it sells to the banks with the profits being paid into the treasury. There is also quantitative easing. As I understand it implementation of positive money’s proposals would involve a gradual increase of bank reserve limits up to 100%. Money would then be created by the BoE and paid into the treasury to fill the gap. How much is created is determined by how much is needed to fix inflation at 0 or a set level slightly above 0. I.e. how the quantity of money in the money supply changes is determined by economic indicators and not by politicians or the banks. If the economy grows by 2%, 2% more money is printed to prevent deflation or an amount slightly larger to keep inflation at a fixed low rate.

            You have a valid point about banks not being able to lend as much but part of the importance of bank lending is because it is currently the only real way to access new money. Here new money is spent into the economy debt free by the treasury in the form of public services or tax cuts.
            There are also a number of peer to peer lending / crowdfunding companies which potentially are be able to fill any gaps left by the loss of fractioanl reserve bank lending. E.g. Zopa, Ratesetter, Crowdcube and Civilised Money.

            b) The proposals are not about returning to a gold standard. The pound has value in the UK because among other things it is accepted as taxes. It doesn’t have to be redeemable for a fixed quantity of precious metal.

            c) The independent institution that determines how much money is created is like any public institution such as the law courts and is essentially accountable to the people as the BoE ultimately is now.

            d) The question of the global context is a complex one but I don’t see why it would stop the UK from growing. Investors should be attracted by the stability conferred by this legislation.

            e) Banks are still able to lend money, they just like the rest of us have to have it to do so.

            f) The declaring where your deposits are invested is more of a transparency issue than a political one. There will still be people who want to get the best return for their money even if it involves funding landmine production. But by requiring banks to declare where they invest your money people will have more choice and we’ll likely see things that people like do better than those they don’t like.

            The taxes you propose are an excellent place to start but the system needs a fundamental overhaul. I believe the positive money legislation is capable of doing that successfully and with minimal disruption.

          2. Richard

            Thanks for your long and thoughtful message. I will reply on Tuesday week in a post rather than another essay! There are a number of Positive Money proposals that I like and some that I think are impracticable but I do understand and agree with the motivation. We need to improve the financial systems.

            It is rather disappointing that the problems were not envisaged by the Financial Services Authority prior to 2007/8 and I don’t think the Vickers’ report tackles the problem properly either. And in the FSA’s defence, neither did the SEC in the US nor the ECB or any other authority predict the disaster that occurred, let alone the ratings agencies which are of course paid by the ‘owners’ of the ‘products’.

            There are a lot of things to sort out. My big concern – not only for the UK – is that we have all gone down the scorched earth policy which hits the victims and not the perpetrators of the crime.

            Oh dear – nearly another essay!

  2. Interesting. I must say I haven’t felt much of this where we live in Canada. We have had good regulation with banks for a long time and people are relatively happy. No major issues. When stuff changed in the US last year, many Canadian banks bought up US firms as assets but this didn’t affect us consumers.

    1. Yup Canada has certainly done a lot better than other countries.

      But I hope the Canadian banks didn’t enter the US banks on their asset sheets at 100%! There is a sad history of firms – not just banks and not just in the US – containing nasties in the broom cupboards. When the chips are down, the owners or receivers of a failing business will do whatever they can to offload the business without too many qualms.

    1. Yup JP – while the US is teetering about, only just having averted a national shutdown, it is possible that politicians have not had their eye on the banking ball. I don’t know enough of what is happening with the SEC etc to comment but over here. these changes are unstoppable whatever their effect.

      So governments and central banks, having been caught partying with their trousers down and the lights out, are running round like headless chickens particularly in the EU.

      It is all a macho stance to avoid having a national credit rating cut. Now since that will mean an increase in interest charges on the national debt, I understand it although the usual reservations about ratings agencies remain of course. But surely there are other – and better – ways of solving the problems of managing the banks, reducing the debt without such a scorched-earth policy.

      There is some merit in the Vickers report but I am concerned that it will not have the desired effect. So we will be back where we are now in a few generations time – say about 2050…

      We should not despair, just act!

    1. Yup.

      If everyone else follows Basel 3 (7% capitalisation) and the UK ploughs its own macho line of carefully bolting the door after the banking horse has bolted, expect relative lending in the UK to shrivel (banks will lend where they have to put up less money) and the economy will stop.

      Even when the 20% capitalisation is reached, lending will still be relatively depressed. Hopefully we will remember to switch off the lights before we all bail out. Unless of course our wonderful coalition of the incompetents manages to persuade everyone else to do the same…. 😛

      Happy 2012!

      PS This is the government which has said that it won’t consider a financial transactions tax unless everyone else does. How cute.

  3. John,

    1. Re our banks devoting more of their efforts to making shed loads of money abroad if we regulate banks more strictly than elsewhere – who cares? The assets and liabilities of banks in the UK have expanded something like ten-fold in real terms over the last twenty years, which makes me suspect they are too big for their boots. Plus there is Lord Turner’s point about them being “socially useless”.

    Our aim should be to have an OPTIMUM sized bank sector. If other countries want a bloated and socially useless bank sector they are welcomed to it.

    2. Re the much vaunted ring fence, I see Vickers & Co could not even decide whether deposits by and loans to large firms should be inside or outside the fence. Do Vickers & Co have any idea what they are on about?

    Plus this casts doubt on your claim that the ring fence will bring security. I.e. if loans to businesses (never mind large businesses) are inside the fence, there is nothing to stop banks using depositors’ money to lend to dodgy businesses. Of course IN THEORY they cannot lend to what Vickers called “financial companies” – or words to that effect. But banks will easily work their way round that restriction.

    3. Strikes me that much the best suggestion in the Werner / Pos Money / New Economics Foundation submission to Vickers was the idea that depositors must be made to choose between safe accounts and accounts where their money is loaned on to businesses, mortgagors, etc. That renders unnecessary a huge amount of regulation.

    I.e. if someone wants to take a flutter and have their money invested by their bank, and it all goes belly up, there is no reason for the taxpayer to come to the rescue: any more than there is good reason for the taxpayer to rescue me if I invest directly in some business that goes belly up.

    4. Re Miss T’s comment about Canada above: quite right. In the 1930s I believe Canada did not have one single bank failure, while the U.S. had hundreds.

    1. Ralph

      Thank you for your comment. I did suggest that the ring fencing was very artificial and easily circumvented by the banks but your note about large firms’ deposits and loans adds an additional reason to doubt the efficacy of that proposal. I was not aware of this issue so thanks for that information.

      I will be posting next week (on Tuesday) on these problems rather than adding another essay in the comments, as I said in response to Richard above. 😛

    1. I’m sure there are. Regulation needs to be effective and well thought out rather than the piecemeal Vickers type approach.

      I also think the additional capital requirements on British banks’ European operations will extend the UK recession while the rest of the world is hopefully recovering.

  4. John, I think you’ve misunderstood the capital requirements. Tier 1 capital is made up of shareholders’ funds and retained earnings, Tier 2 includes hybrid debt/equity instruments and provisions (sorry, this is a REALLY simplistic summary but you get the general idea). These shares and hybrid instruments are ISSUED by the bank, not purchased – i.e. sit on the liabilities side of the balance sheet. The capital regulations don’t determine in what form share capital should be held, only how much there should be in relation to risk weighted assets. I think you would have to look at liquidity requirements to see some regulation of the form in which banks should hold their capital base – and currently banks are required to hold a significant proportion as very safe liquid assets such as gilts.

    Yes, if a bank gets into trouble its share price will drop, but that isn’t a problem. The share capital is paid up, so if the share price collapses the shareholders are wiped, but the share capital itself isn’t. It therefore acts as a buffer to absorb losses on the bank’s asset base, protecting depositors, bondholders and taxpayers.

  5. Frances – thanks for the clarification.

    Doesn’t the point remain that if the market falls substantially, any provisions – even gilts – which may need to be realised to cover bad debt may also fall? Imagine a melt-down where no-one will buy an instrument at its face value but only at half the value.

    Then if a customer goes into a bank that has assets on its balance sheet but no spare cash and wants to withdraw their money, where does that come from if they don’t sell one of their assets which they then find doesn’t give them as much money as it says in the accounts.

    Or are they just retained on the balance sheet to show that the bank is not theoretically bust, in which case it is all hypothetical.

    Either you have a loss to cover and need to sell something or you are just papering over the cracks by claiming something on the balance sheet.

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