LONDON, 12 September 2011 - Commenting on the Final Report issued by the Independent Commission on Banking (ICB) this morning, Emily Reid, partner in Hogan Lovells' Financial Institutions Group, said:
The key proposals are, as widely expected:
- as a compromise to full separation, ring fencing is still favoured but the scope of the ring fence has been clarified, giving banks some flexibility to choose what is in and what is out of the ring fence;
- increased equity capital requirements for ring fenced banks of 10% but also primary loss absorbency of 17% to 20%
- measures to increase competition - with some good news for Lloyds Banking Group bidders who already have UK networks to add to the planned branch disposals, given the recommendation that LBG reach agreement with the Government that the challenger will have at least 6% of the PCA market.
The ICB clearly sees these as important parts of a complete package resulting in a banking industry which operates better for consumers and businesses and, by reducing the risk of tax payer bail-out, for the UK economy.
Although simply stated, none of these proposals will be easy for banks to achieve. There must be a material risk that banks will be distracted from their core businesses by the need to focus simultaneously on layers of additional regulation and internal reorganisations. Banks will need to look at restructuring to meet the ring fencing requirements and at their products to meet the new demand for greater price/cost transparency (also to be a focus for the FCA). Assuming the Government accepts these recommendations, the sooner new legislation provides clarity the better.
Apart from the cost inherent in the reforms, there will be significant implementation cost as banks tackle the legal and operational implications of all the reforms.
It is vital to see the ICB's proposals in the context of wider financial reform. Both will require a significant investment by the Government and the FSA in knowledgeable and skilled teams who can work with the financial industry to bring about constructive change. Have banks have got away with it? The ICB has stuck to its guns. It has not been swayed by threats of HSBC and Barclays moving their headquarters to friendlier jurisdictions nor by queries as to the effectiveness of the ring-fencing proposals. Whether the banks get away with it will be a political issue. The Government will have to assess: how real bank threats to move overseas are; whether the banks' claims that ring-fencing will restrict the supply of credit to consumers and small businesses, so impeding the economic recovery are correct; and what is politically more relevant to re-election - a slower economic recovery or public anger that the banks got away with it?
- It appears the key issue is not if, but when and how.
'When' is largely a political issue; it requires the Government to assess:
- whether the banks' claims that ring-fencing will restrict the supply of credit to consumers and small businesses, so impeding the economic recovery are correct; and
- what is politically more relevant to re-election - a slower economic recovery or public anger that the banks got away with it?
'How' remains a big issue - not just in infrastructure and organisation but also in scope.
Where will the dividing lines fall The basic idea is that there will be three categories of business:
- “mandated services” - which must be within the ring fence (e.g. deposit taking for individuals and SMEs (and related overdrafts)
- “Prohibited services” – which cannot be within the ring fence. These are (in summary) activities which are likely to make the bank harder to resolve, directly increase its exposure to the global financial markets and/or involve risk taking which is extraneous to payment services or funding intermediation.
- Other services – i.e., anything which is not prohibited or mandated - which can be carried on inside or outside the ring fence
- How much infrastructure can universal banking groups continue to share?
The only restriction will be a requirement to ensure that the ring-fenced bank will continue to have access to the services necessary to carry on its activities even if other parts of the group fail.
What about the rest of Europe? European banks are free to provide services in the UK and could do so without the additional cost of the reforms required by the ICB. If that translates into higher savings and lower borrowing costs from the UK operation of an EU bank , UK banks could be at a competitive disadvantage from their European competitors:
- Would the UK Government remain on the hook for EU bank failures (like Iceland)?
- Would UK based banks find it even harder to generate the returns their shareholders expect as a cost of competing with non UK banks?
- The ICB are recommending retail bank equity capital at 10% but also primary loss absorbency of 17% to 20%. Delaying the requirement for higher capital to 2019 may assist banks already suffering higher cost as a result of ring-fencing.
- If there are more banks, there is less risk of any bank being too big to fail and, if there is a failure, fewer consumers and small businesses exposed to that risk.
- Neither the ICB nor the Government can legislate to increase competition (that has to be market driven) but they can support proposals which are designed to increase competition. This is the area where the ICB clearly intersects with wider reform and in particular the competition objectives of the Financial Conduct Authority (FCA) which the ICB suggests should be strengthened.
The ICB supports measures designed to make consumers drive part of the change. There are 3 limbs to this:
Increased price transparency to encourage shopping around and switching
- The ICB supports the addition of Foregone Interest Information to show how much consumers are paying in lost interest by lending their deposits to banks on no or low interest accounts in return for 'free banking'. (Unlikely to be of significant interest to consumers in a very low interest environment.)
- Any proposals for additional consumer information are likely to be met with some scepticism - see the TSC's reservations about the effectiveness of information as a means of consumer protection.
- This is an area where the FCA's proposals on product intervention may prove more effective - and banks are generally favouring simpler products and pricing to mitigate some of the problems they have experienced in recent years with regulatory and consumer challenges.
Improved switching mechanisms
- The difficulty here may be more one of perception than reality
- The industry supports the concept of portable bank account numbers but has persuaded the ICB that there are real concerns about feasibility. By 2013, however, the ICB is recommending that a redirection service should have been implemented.
Action by regulators to review potential barriers to entry
- Focus on prudential requirements and access to bank infrastructure especially payment systems.
- Increased price transparency to encourage shopping around and switching