Last week, the Parliamentary Commission on Banking Standards published a significant report. It followed on from John Vickers’ Independent Commission on Banking. Both were set up to solve the ‘too big to fail’ problem in banks. You’d be forgiven for having missed them, though their proposals – to legally ring fence certain banks – will have a far reaching impact on us all. As I was reading last week’s report, I was reminded of Aesop’s fable about unintended consequences; The Maids and the Rooster.
Aesop tells of an old widow that kept some maid servants, who she’d wake for work each day when her rooster crowed. The maids eventually grew tired of the toil, and decided their problems would disappear if they killed the rooster, whose crowing caused their mistress to wake them. But with her rooster dead, their mistress was no longer able to tell the time, and so would wake the servants for work even earlier.Beware the law of unintended consequences.
The proposals set out by these banking committees will have major intended, and unintended consequences. Whether you continue to get your current account for free, how much your mortgage costs, the interest you pay on a car loan, and even broader economic growth, will all be impacted by these changes.
A basic, and sound premise underpins all of this. Banks, for all their faults provide society with a few critical functions which can’t be disrupted. They allow people to deposit money electronically into their accounts, and withdraw this money as needed. That which is not immediately needed is then lent out so other people can buy houses, or new businesses can start up. Depositors receive interest, lenders pay interest. The system works, for the most part. Let’s call this retail banking.
Modern banks, however, also provide a lot of other services, of variable social utility. For example, British Airways’ bank will provide it with a derivative allowing the cost of jet fuel to be locked in at a given price for the year ahead. After all, an airline is in the business of flying planes, not of gambling on the price of oil. But that same bank could structure a different derivative that lets you bet which companies on a stock exchange might fail in any given year. There may be some social utility to such a product, but if there is, it is less clear to most. Let’s call this investment banking.
Most large banks typically provide both retail and investment banking services. The financial crisis demonstrated that some banks became so large, selling so many mortgages, loans, and derivatives all at once that their potential collapse could have brought down the entire UK economy. This, in simple terms, is why the UK tax payer now owns 82% of RBS, and 40% of Lloyds. A similar story unfolded across Europe and the USA, as banks deemed too big to fail were bailed out by governments.
As a result of these experiences, politicians around the world have been rushing to separate ‘socially useful’ retail banking, from the ‘less useful’ and infinitely less popular investment banking. The consensus they’ve struck upon is to force retail banking into legally ring-fenced entities. So the retail arms of Barclays, RBS, Lloyds and others will be isolated from any form of investment banking. This would protect the critical services we rely on from the risks generated in the ‘casino’, and in the event the bank did get into trouble, these critical services could be sold off to another bank. This is what our committees have concluded.
The intention of these reforms is sound, and their apparent simplicity is appealing. However in their current form they are ill thought out, and creaking under the weight of unintended consequences. Consequences we will all have to bear.
Take for example the idea of a retail bank that only takes deposits and extends loans. This is not a particularly profitable model, and in many cases tends to lose money for the banks that provide it. Banks in a ring fence would need to be investable propositions, and so to cover costs and remain self sufficient from their investment banks, charges will likely be introduced for holding an account. Get ready for that.
We may not like the idea of a bank being ‘too big to fail’, but whilst only some of them actually require a tax payer bailout, all of them benefit from this implicit government guarantee. So when they borrow on the financial markets, the cost of that funding is less than it otherwise would be. Some of this discount is passed on to customers in the form of cheaper interest rates. When banks in the ring fence are no longer deemed too big to fail, their borrowing costs will rise, as the implicit state guarantee falls away. Under a separate clause, they will also be prevented from trading with other financial institutions outside the ring fence. This combined increase in funding costs will, we can safely assume, be passed on to customers.
Such an action may alleviate the too big to fail problem, but it will come at a cost. Expect that low mortgage rate to start creeping up, and those overdraft rates you’ve been sitting on to rise further.
An even more serious consequence might be the effect on businesses, which may find themselves pushed into the ‘shadow banking’ sector. Once banks are ring-fenced, manufacturers and retailers will still be able to do things like make deposits and use overdrafts. But a lot of the services they have come to depend on in the modern economy will not be available to them at their ring fenced banks. The BA example was just one common type of derivative that businesses use to manage risk. Take Dixons as another example. Those Samsung TVs and Sony DVD players they sell will most likely come from a Chinese factory, and be paid for in Renminbi. When you buy your TV in the UK, you pay for it in pound sterling. Dixons will need a large scale facility to swap your pounds into Renminbi on a daily basis to keep the supply chain going. And they will have to do this in dozens of currencies simultaneously. They will use a derivative product to do this. And a different type of derivative to lock in the exchange rate at a given price. If they don’t, fluctuations in exchange rates risk wiping out their profit margins.
When these ‘investment banking’ services are removed from the ring fenced banks, manufacturers will have to look elsewhere for them. The obvious place is the shadow banking sector, where less regulated hedge funds and the like will be able to provide these services. Moving substantial banking operations into the shadow banking sector is certainly not the intended consequence of these reforms.
Many other unintended consequences will arise from this. In normal times, such radical proposals are amended or sometimes watered down to limit their impact. However the subject of too big to fail is so politically charged that parliament is unlikely to yield on these proposals.
There is certainly a groundswell in favour of tough reforms. The Parliamentary Commission on Banking Standards, which published the report last week, includes a former Chancellor, a former head of the Treasury Select Committee, and the incoming Arch Bishop of Canterbury. So it carries weight. And the MPs who will legislate for the bill appear onside. An Ipsos Mori poll showed 60% of cross party backbenchers intend to support the tough proposals. All three party leaders support the idea of a ring fence, and the Lib Dems in particular will want to make their mark on this flagship policy.
Significant change is afoot. As well as the plans being drawn up in the UK, legislators in the US are putting in comparable reforms as part of the Dodd Frank Act. In the EU, the Liikanen Review has recommended a similar approach.
The political will to end the too big to fail problem is to be welcomed. However the plans in their current state are ill considered, and carry many unintended consequences. These are likely to have an impact on all of us.