Summary and implications

After much guessing and the release of responses before the final report had even been published, the ICB, more colloquially known as the Vickers Committee, has issued its final report and recommendations.

The recommendations coming out of the ICB report have been widely reported:

  • Ring-fencing: Retail deposit-taking operations will need to be housed in so-called “ring-fenced” businesses, which will have their activities limited.
  • Competition: The Government and competition authorities are to keep the competitive state of the retail market and dominance of a few large incumbents under review and a number of steps to increase competition have been suggested.

Much of what was in the final report was heavily trailed in the press beforehand, so there were few surprises. However, the debate is far from over as the government moves towards implementing the recommendations – this is one piece of legislation where the devil truly will be in the detail.

What is ring-fencing about?

Listening to the members of ICB discussing the report, what is clear is that ring-fencing is not about making banks safer. As is acknowledged in the report, ring-fencing would not have prevented Northern Rock from failing.

What the ICB have tried to devise is a structure which removes, so far as possible, the government guarantee of banks’ liabilities, whether explicit or implicit, and make it easier to “resolve” banks which get into financial difficulty. The reality of the situation is that every government will stand behind retail deposits if a bank fails: failure to do so would result in a heavy defeat at the polls.

Accepting that a de facto government guarantee of retail deposits is a given, the ICB looked at what amounts to slimming down the operations of retail deposit-taking banks (referred to simply as “retail banks”) to their less risky activities and those which will be easier to resolve. They have also sought to take away the benefit of investment banks of being able to trade off the balance sheet of the retail bank. By not splitting the banks entirely, they are seeking to keep the perceived cost benefits of the so-called universal banks whilst putting in place Chinese walls to prevent cross-trading and the passing of risk onto the retail bank.

How will ring-fencing work?

The basic concept behind ring-fencing will involve isolating the “safer” aspects of banking with retail deposit-taking from the riskier investment banking activities. These retail activities will then be further enhanced by requiring the ring-fenced retail banks to hold higher levels of loss-absorbing capital – 17–20 per cent equity is suggested – which will bear the first tranche of losses in the event of a failure of the bank.

What this should deliver is a full payback to the Government if the bank fails: although the Government will pay depositors immediately, it should be able to make a swift and full recovery of the amounts out-laid in settling depositors’ claims.

The question as to what activities are deemed less risky, and therefore appropriate for retail banks to carry on, is a more vexing issue. What will definitely be permitted are loans to retail borrowers (household loans, mortgages etc.) and SMEs that are not “financial companies”. Loans to large corporates will be permitted, and banks will be free to carry on lending activities to large corporates from both their ring-fenced, retail operations and their wholesale and investment banking operations.

SMEs and smaller businesses operating in the financial sector will not be permitted to borrow from the retail banks however. As the list of financial companies includes insurance companies, broker-dealers, underwriters, pension funds, asset managers and hedge funds, many of which will not be large enough or have sufficient borrowing requirements to access the wholesale banking markets, the question as to where they will be able to get funding, and at what cost, is one which remains open.

What will the consequences of ring-fencing be?

The consequences of the ring-fencing proposals are perhaps the most difficult to understand.

The ICB Report contains a fairly detailed cost-benefit analysis of their proposals however, the analysis is largely at the macro-economic level: what is the implicit cost of the government guarantee of the banks verses the expected costs of implementing the proposals. This latter aspect focuses very much on the ICB’s expectation of the additional charge which banks will pass on to the wider economy, and shows little real impact.

A number of people however are questioning what the effect would be at the micro-economic level. That there will be significant private costs to the banks (and that those costs will be passed on to bank customers, is unquestionable. However, to reach the ICB’s position, a number of other factors need to remain constant, such as the impact on the overall economy if we lose international competitiveness.

For the wholesale and investment banking operations of universal banks, the removal of the implicit government guarantee (through the ring-fencing proposals) is expected to result in a “four notch” downgrade of their credit ratings (which will increase their costs of funding). The requirements for the new ring-fenced operations will result in lower returns on equity for investors in those operations. Some commentators have queried whether investors themselves will ultimately drive universal banks to separate so that they can have transparency on the returns on their investments, choosing how they want to place their exposure.

The ICB has also largely dismissed the effects of its ring-fencing proposals on the UK’s competiveness. Again, this is an area on which there are many conflicting views. Sadly, it is one call which we cannot afford to get wrong: London may be a, if not the, leading global financial centre but there are plenty of others chasing at our heels, desperate for any opportunity to steal business from us.

Over the coming months …

The ring-fencing proposals will be the key part of the report which are debated over the coming months as legislators seek to put the implementing legislation before parliament before the 2015 general election. There is sure to be a lot of wrangling over the detail, and doubtless many controversial issues will emerge.

As those debates get under way, it would be useful to bear in mind one aspect of the ring-fencing proposals which the ICB stresses in its report and which is emphasised by ICB members when they discuss its contents: the ICB has proposed the ring-fencing proposals as a single package. The ICB recommendations are of the whole package and only the whole package: they should not be viewed as a menu of options which can be tinkered with and added to, reduced or amended.

Banks will need to start planning ahead for implementation of the recommendations, even though the reforms would not come into full effect until 2019. The 2019 date was deliberately set so as to allow most term loan facilities to be refinanced into the right parts of the banks by implementation: those seeking seven year maturity loans in 2012 or five year maturity loans in 2015 beware!

And on competition?

Despite initial concerns, the ICB did not, in the end, recommend the disposal of additional Lloyds’ branches. Instead, the focus is on increasing competition through:

  • Favouring one of the “up-and-coming” banks as a buyer of the Lloyds branches to help create a new competitor to the incumbents who dominate the market;
  • Making it easier for customers to switch their bank accounts.

While the ICB do not believe that the retail banking market should be referred for a competition investigation at the moment, they have recommended that if clear indications of improved competition are not obvious by 2014/2015, the Government should, at that stage, refer the market for a competition review.