Ringing the changes

Hannah Langworth reports on what the government has in store for the banking industry

In early October 2008, key share prices in the UK reported their largest daily fall in over 20 years. Global investment bank Lehman Brothers had recently collapsed into what would develop into a long and messy insolvency procedure. The - previously almost invisible - cracks in the global banking system first exposed by turbulence in the US mortgage market in the spring of 2007 were turning into wide fissures. By the end of the first week of October, fears for the stability of some of the UK's leading and, until now, most trusted high street banks were so acute that the government was forced to pass emergency legislation to allow it to prop up these institutions with taxpayer funds - £17 billion for the Lloyds Banking Group, including HBOS and £20 billion for the Royal Bank of Scotland Group, meaning taxpayers would own 40 per cent of Lloyds and a huge 60 per cent of RBS.

As part of the response to these events, an Independent Commission on Banking (the ICB) was established by the new coalition government shortly after the 2010 general election. It was asked to consider why these events happened and what reforms should be made to the UK's banking system to ensure nothing similar, or worse, could occur in the future. The ICB's report, which became known as the "Vickers report" after commission chair economist John Vickers, came out last summer, and this June saw the publication of the coalition government's response - a summary of its own reflections on the 2008 meltdown and the changes it proposes to implement.

Rule of three

This "white paper" on the issue generally follows the recommendations set out in the Vickers report. There are three main strands to the proposed reforms. First, the government agrees with the ICB that the retail operations of major high street banks should be ring-fenced from their investment banking activities. What this proposal essentially means is that banks which hold the deposits of ordinary individuals and small to medium businesses should not be allowed to use that money to engage in risky transactions such as trading in the financial markets, working with derivatives products, and purchasing large slices of new issues of shares or debt products. It's hoped that this measure will insulate these funds from the significant risks that banks' activities had exposed them to by autumn 2008 which forced the government to intervene. The move is broadly comparable to the less restrictive US Volcker Rule which, rather than formally separating banks' retail and investment banking divisions, simply limits the way in which banks can deal with their retail deposits.

The government's proposal for how ring-fencing should work departs, however, in some significant ways from the ICB's suggestions in this area. Smaller banks - those with less than £25 billion of deposits - are to be exempt altogether. Furthermore, the retail sides of the banks which are subject to ring-fencing are to be allowed to carry out some investment banking activity. In particular, the report mentions that retail arms will be able to sell simple derivatives products to their small and medium business clients to help them manage business risks.

The second strand to the proposed reforms is a rise in the amount of capital banks are required to hold in reserve. The increase, it's hoped, will mean that steps such as emergency injections of government funds into high street banks can be avoided in the future. The move is very much in line with international efforts to increase the stability of the banking system globally - the Basel III accord issued by a committee made up of representatives from ten key financial powers recommended that 3 per cent of banks' assets should be held as a safety cushion. But note that while the ICB recommended that this requirement should be raised to 4 per cent for British banks, the government is happy to stick to the lower Basel level.

The final element of the proposed reforms is a series of measures intended to increase competition in the UK's banking sector in the hope that doing so will both make individual institutions stronger and also ensure the UK continues to be a global leader in the provision of financial services. These include dividing up HBOS and the Lloyds Banking Group, both currently under the Lloyds umbrella, into two separate players, and steps to make it easier for consumer to compare and switch between the services provided by different banks.

Bottom up

Responses to the white paper, and views on whether the measures will ensure a brighter future for the banking industry, have been mixed. ICB Chair John Vickers and shadow chancellor Ed Balls both criticised the departures the government has made from the ICB's recommendations, claiming they marked a watering-down of important reforms. However, the British Banking Association (the BBA), a representative umbrella body for the UK's banks and financial services firms, feels that in some ways the proposed reforms are overly onerous. Angela Knight, the BBA's chief executive, commented that, in general, the reforms could lead to increased costs and operational difficulties for banks and could put the UK's banking industry at a competitive disadvantage in some areas. More specifically, she pointed out that the ring-fencing restrictions would have a significant impact on the ability of banks' retail banking arms to provide everyday services to individuals and businesses: "For instance it would make it very difficult for a bank to provide a small or medium-sized business customer with some straightforward services - such as foreign exchange, or protection against volatility of costs in the import of raw materials or exports of their product. It would make it difficult if not impossible for a bank to offer to a customer a fixed rate mortgage."

Knight also made the point that the increased capital restrictions proposed in the Vickers report and in the white paper could restrict the UK's economic growth in the coming years: "In simplistic terms, if a bank has got to hold more cash and more capital, that is money it cannot also lend." The difficult balancing act between stability in the financial services sector and fostering economic growth is arguably the key issue for UK economic policymakers at the moment. It underlies the Vickers report and the white paper and other ongoing initiatives towards banking reform, as chancellor George Osborne recognised in his annual Mansion House after dinner speech made shortly after the white paper's publication. Referring to what he has dubbed in the past "the British dilemma", he reiterated the government's intention of "protecting British taxpayers in a way that does not make the UK uncompetitive as a home of global banks". As the drinks flowed, Osborne explained he felt that that through the measures outlined in the white paper, together with other initiatives such as the recently announced Bank of England business stimulus packages, "the government has sought to keep the British economy safe in the storm, while sharpening our competitive edge for the future". Whether he and his colleagues have mixed the right cocktail to achieve this aim, only time will tell.