The UK’s Independent Banking Commission has proposed that conglomerate banks in the UK should ringfence retail banking operations. The aim is to reduce the subsidy to large investment banks and the related risk exposures to taxpayers that arise from the belief that such banks are “too big to fail”.
The effect of these proposals is that the taxpayer would still be expected to protect depositors, and perhaps other bank creditors, from the consequences of banks’ bad lending but would be spared the losses from the banks’ inept gambling. This would be reassuring for those who bailed out RBS and UBS, though little consolation for those who bailed out HBOS and Anglo-Irish Bank. The issue is how to make the ringfence effective.
What activities are appropriate to a retail bank? A retail bank takes deposits from its customers and lends to businesses and households, and maintains liquidity to meet withdrawals. In short, it performs the traditional functions of a bank.
However, even the most boring bank needs a treasury operation to manage day-to-day funding requirements. Still, there is a large difference between a treasury that services the work of retail bankers and a treasury that hopes to derive a stream of profits from speculative trading in capital markets. The transition from the former model to the latter created UK banks whose balance sheets are many times larger than their loans or deposits.
As HSBC has pointed out in its submissions, international accounting standards already require a distinction between banking activities and trading activities. In principle this is right. But banks have demonstrated how flexible a distinction based on inference of motive can be: bad assets – which can be held at book value – are said to be intended to be held to maturity, while profits from good assets are marked to market.
The core problem is that banks have no intention of abiding by the spirit, rather than the letter, of any regulatory rules. Indeed they have developed profitable business in regulatory arbitrage – selling instruments that avoid regulatory burdens by changing the form of the transaction but not the substance. So rules have to be direct and simple.
A suitable requirement might be that a high proportion – 90 per cent or more – of a retail bank’s assets be in residential mortgages, government stock or loans to non-financial businesses. The latter really means SMEs, since the treasury operations of many large corporations are effectively internal banks. Such a rule helps solve a further difficulty: how to stop the ringfence being as permeable as, say, a Chinese wall.
In the absence of restriction, the retail bank could simply lend all its funds to the investment banking arm of the group; when the investment bank fails, the retail bank then has no assets. Treating such intra-group loans as third party exposures, as the commission proposes, would block that stratagem; but strict limitation on acceptable retail bank assets is needed to prohibit more complex transactions with similar practical effect. Limits on the retail bank’s dealings in derivatives are also necessary, since modern financial innovation allows almost any desired exposure to be written as a derivative contract. It is hard to see why a retail bank needs to trade any derivatives on its own account other than interest rate swaps.
These measures might be reinforced by a statutory duty on the directors of the retail bank to protect its deposits. The purpose is to use the threat of personal liability to force them to face the conflicts of interest inherent in a complex holding company structure. If it proved difficult to find directors willing to take on such a responsibility, that would tell us the separation was not working.
If the ringfencing of retail banking were effective, it would be a big step towards a financial system more resilient to crises. The sanguine reaction of banks and markets to the proposal suggests they do not believe such measures will make much difference. It is up to the commission to prove them wrong.