By Simon Miller

Next month, the Independent Commission on Banking (ICB) releases its finished report into the industry and one issue that has caused more debate than others is the principle of ring-fencing retail banking.

The issue is not a new one. In the States, the separation between investment banks and retail operations was originally enshrined in law through the Glass-Steagall act of 1933.

However, since the Big Bang, and the full repeal of Glass-Steagall in
1999, the split between investment and retail divisions has blurred with the
cross-subsidisation being blamed for the collapse of several banks.

But is this an accurate reflection of events leading up to the financial crisis?

Although it is true that there were some high profile casualties in the States, it could be argued that, at least in UK, the banks that got themselves in the most trouble did not have investment divisions. Northern Rock and Bradford & Bingley were high-street operations, whilst RBS had pursued an aggressive expansion policy which led to the disastrous purchase of ABN Amro. One other troubled and State-owned bank Lloyds was a paragon of virtue in terms of retail and investment performances and balance sheets until the previous government persuaded it to pick up the remains
of Halifax.

Those banks that survived the crisis, HSBC and Barclays for example, have aggressive investment divisions, indeed Barclays went for the profitable part of Lehmans following its demise.

In a briefing note, law firm Freshfields partner Will Lawes commented: “Just as there was no single, fundamental cause of the financial crisis or a common reason why banks in the UK and elsewhere failed, no-one should pretend there is a regulatory silver bullet that will ensure that never again will there be a bank failure in the UK.”

In its original submission to the commission, Barclays pointed out: “There is little empirical evidence to suggest that structural change would enhance financial stability, not least because the cross-border nature of banking risk makes it very difficult for risk to be isolated in, or contained by, national boundaries. The costs of such structural change to customers and the wider economy are certain and high, and the implementation risks are material.”

Indeed the Futures and Options Association (FOA) warned the committee against “knee-jerk” reactions.

“In general terms, the FOA believes that the crisis was caused inter alia by the excess to which certain aspects of the investment banking model were taken, largely through failures in risk management and corporate governance, by some banks and by the regulatory failure to focus adequately on macro-prudential and economic issues. The FOA believes therefore that a cautious approach needs to be adopted towards assuming that there is an inherent failure in the investment banking model itself,” the association wrote in its submission.

So if there was no single cause for the financial crisis, and those banks that have investment division are seemingly surviving without ring-fencing the retail-side of banks, why has this split been suggested?

The ICB’s interim report into banking, published in April, said that in the
build-up to the crisis, lenders and borrowers took on excessive and
ill-understood risks, and banks operated with excessive leverage and inadequate liquidity.

It added: “Regulation permitted the ratio of their assets to their capital base to grow far too high – to twice normal levels – and they could not access market funding when they needed it. When the crisis hit, bank balance sheets proved poor at absorbing losses, and the complexity of many failing institutions made it impossible efficiently to ‘resolve’ them – i.e. sort out which parts of them should fail and which should continue and how.”

So why look at “breaking up the banks”?

There has been a great amount of political capital gathered at the expense of the financial sector. Be it “fat cat” bonuses or bailouts, it has not been a great few years for banks.

In addition, the scenes of queues of people waiting outside their branches of Northern Rock embedded an image that the pursuit of wealth by investment bankers had come at the expense of the ordinary man in the street – “Casino banking”, as the current business secretary Vince Cable described it back in 2008.

For the ICB, in deciding between either turning retail and wholesale and investment banking into wholly separate firms, or to take a laissez-faire attitude towards structure as long as there were high capital requirements, the commission decided on a complementary combination of the two.

Aside from holding a minimum 10 per cent in capital requirement, the
commission was concerned about the death of universal banking if retail banking was fundamentally split from the rest of the bank.

Instead retail banking operations would be carried out by a separate subsidiary within the wider group.

This would still allow capital transfers but the capital requirement should ensure that banks would be constrained in how much money they could transfer. Essentially, deposits would be safe from a mythical grab by the investment arm. In the event of a crash, the separation of that arm from the rest of the body could be done with more ease than previous regimes – the so-called “living wills”.

But what effect would this have on banks?

The more cynical would claim that banks would be very pleased with the recommendations of the interim report. Indeed, Paul Mumford, senior investment director at Cavendish Asset Management, commented at the time of the report that “the ICB’s bark has proved much worse than its bite and its recommendations won’t seriously damage the competiveness of the sector.”

However, for some banks with large wholesale business, the recommendations could still see them most at risk from the commission’s final report.

After the interim report was published, Goldman Sachs analysts estimated that Barclays and RBS were most at risk due to their large UK wholesale businesses.

But Goldman said that for all the banks “the overall effect of the likely recommendations is manageable, on our estimates”.

However, there are other dangers to banks aside from the straight
structural changes.

Ratings agency Moody’s warns that ring-fencing the retail side would have negative outcomes for bondholders of affected banks.

In a briefing note Moody’s says: “By distancing banking activities which are outside the ring-fenced entity from those which the UK authorities are
likely to deem systemically important, this measure is intended to broaden the authorities’ options for resolving the non-systemic entities. It will therefore have negative implications for the bondholders of these non-systemic entities, as they will be less likely to benefit from government support.”

Moody’s says the final report must have greater clarity on which assets will be allocated to the ring-fenced operations and on the allocation of existing debt between entities, as well as detail on the capital and funding profile of each institution, before it could assess the full impact on bond holders.

Moody’s vice president Elisabeth Rudman wrote in the note: “However, we consider the principle of ring-fencing to be negative for existing bondholders if, as we expect, they are largely placed outside the ring-fenced entity”.

With this, and a likely reduction in assumptions of systemic support included in the senior debt ratings of UK banks, Moody’s estimates that Barclays would be hit the most with an Aa3negative and C/A3 stable, while RBS (Aa3 under review for possible downgrade; C-/Baa2 stable) and HSBC (Aa2 negative; C+/A2 negative) would complete the top three as they have UK retail banking and wholesale banking activities within the same legal entity.

Indeed, the British Bankers’ Association (BBA) believes that the impact on business and the economy had not been assessed.

In its submission before the final report, the BBA warns that there was widespread concern in both banking and business circles that the costs and possible consequences of the ICB’s proposals have not been worked through.

The report is due on 15 September but with ferocious lobbying from all sides of the political arena, what is the likelihood that the initial recommendations remain the same?

Many were surprised when Chancellor of the Exchequer George Osborne supported the principle of ring-fencing retail banks, in addition to living wills, but politically there have been growing noises from members of the coalition and left-wing think tanks that the ICB doesn’t go far enough.

In a letter to the Observer on 3 July, members of the Liberal Democrats joined Labour MPs and Green party members in warning that the proposals did not go far enough.

“Ring-fencing retail and investment banking through “Chinese walls”, as endorsed by the chancellor, George Osborne, will not produce a banking system that is safe. If companies can continue to move capital between retail and investment banking, the latter could still endanger the former.
“As a first step, full separation of banking functions is needed to insulate the taxpayer against failure. Full separation would provide depositors with institutions they can trust,” the letter states.

However, there are concerns that the City is already being weighed under by a raft of regulations and that this could provide the final straw.

The FOA, in its submission to the commission, pointed out that, in political terms, the US had rejected a move back towards the Glass-Steagall act – preferring instead to push back Volker and the “push out” provisions in Dodd-Frank.

In addition it appears that the Eurozone has also accepted the notion of universal banking with no plans to separate retail from investment banking.

It warned that if the UK went alone, it would “almost certainly add to bank disenchantment with the UK as an international location of choice, not just in terms of those who are already based here, but also other non-UK financial institutions which may be looking for jurisdictions in which to base their non-domestic business”.

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