Whatever Vickers Recommends, Banking Can Never Be a Risk Free Activity

Memories in the world of banking are notoriously short. It was just three years ago this month with the collapse of Lehman Brothers that the global financial system came close to imploding. As time has passed, recollections of this near-catastrophe have rapidly dimmed and the international momentum for fundamental reform has stalled.

Nevertheless the City of London’s size and global reach continues to make the UK economy especially vulnerable to turbulence in the financial markets. This is the backdrop to Sir John Vickers’ Independent Commission on Banking (ICB) report, which will be published next Tuesday [12 September].

The ICB has been charged by the Coalition with proposing structural and non-structural changes to make Britain’s banks safer. In the absence of international action, we have decided to go it alone and Vickers seems set to opt for a ring fencing of high street banking from investment banking. It is worth stressing that irrespective of the hugely interconnected community of global finance, if enacted, these proposals will only apply to banks domiciled in the UK. Moreover, there is nothing in the ICB report that will challenge the more pressing public concern about banks’ profits or bankers’ remuneration.

I fear that its work also flies in the face of the two overriding insights of this financial crisis. Since time immemorial everything in banking has hinged upon confidence. Talk about ‘safe’ levels of capital is in the final analysis just that – talk. Raising capital thresholds up to and beyond 10% (as proposed successively by the Basel 3 Accords and in the ICB’s interim report) will act only to make the UK banking sector less internationally competitive. Splitting the banks will leave them short of capital and risks cutting off cashflow to the SME sector that it so desperately requires at this stage of the economic cycle, thereby triggering a renewed credit crunch.

Fundamentally banking is a daily confidence trick – the only institutions truly safe are those which hold on to every last penny of their depositors’ cash. As we saw with Northern Rock in 2007 no bank can survive without confidence. Once it is forced to deny that it is in trouble, the game is up and nothing short of an explicit government guarantee to depositors will save it. The ICB report, however, is predicated on the notion that sufficient safeguards can protect against such a collapse in confidence. Yet contagion is not a rational process. If there is a belief in the banking sector that the travails of any particular institution will spill over to others invariably this becomes a self-fulfilling prophecy.

The Vickers’ template for ringfencing banking activities is based on an outdated and simplistic division between what amounts to wholesale and retail banking. There are numerous transmission mechanisms between the two that make a hard and fast split between high street and ‘casino’ investment banking difficult to achieve.

The coalition government’s goals are laudable. Ideally incentives for excessive risk-taking should be curbed and the process for sorting out banks which get into difficulties should be streamlined substantially to reduce potential liabilities to the taxpayer.

However, banking is a global business. Even the perennially activist EU Commission recognises that it can do nothing if, following implementation of Vickers’ proposals, banks simply redomiciled to the EU and set up subsidiaries in the UK. This raises the more fundamental question – if only UK banks are obliged to sign up to the Vickers reforms then surely the contagion risk from any future global financial crisis will be exactly the same? Small additional amounts of capital being held in a dwindling number of British banks is unlikely to make any difference when the next crisis is in full flow.

The benefits of breaking up the banks are probably being oversold in any event. In practical terms will this much heralded split make banks better at absorbing losses? A failing investment bank which falls outside the ringfence is still likely to share its name or at least reputation goodwill with the retail bank from which it has been cast asunder. Does anyone seriously believe that there will not also be a run on the retail bank and huge potential liabilities falling back to the taxpayer via the depositors’ compensation scheme? Ringfencing may sound like a neat solution designed by the ICB to ensure banks’ support. In truth it is a hopeless fudge – when put to the test it will surely fail.

If we go down this route we would need to enforce a full, legal separation splitting UK banks and create a divided domestic financial sector unique in the developed world. This cannot be in the interests of the UK’s financial services sector. Similarly the impact on likely profitability would act to increase the incentive for greater risk taking.

History shows that tougher regulation in the banking sector is a driver for new, innovative and riskier off-balance sheet vehicles – indeed the explosive expansion in hedge funds over the past decade came about in the aftermath of imposing new regulatory measures following the collapse of Enron and WorldCom.

Before the coalition government becomes too enthusiastic in its endorsement of everything that Vickers and the ICB propose it should be careful what it wishes for. The potential of a renewed credit crunch if lending dries up, choking off hopes of renewed economic growth in order that stringent capital requirements are met, coupled with an outflow of capital from the UK if our banking system goes out on a limb, makes for a miserable prospect.

No one should envy George Osborne as he navigates his way through the recommendations of a Report he commissioned himself. The political pressure from the Liberal Democrat wing of the coalition could hardly be more intense. Following Vince Cable’s vindication (as he would see it) over Murdoch and the BSkyB bid, the rhetoric, outlook and interests of his Party favour the Vickers recommendations being instituted in full and without delay. The national interest may not be served so easily.