Westminster Report indicates HBOS and Lloyds merger a mistake


by George Kerevan

THE waiting is over.  The Coalition Government’s Independent Commission on Banking (ICB) has revealed its interim conclusions on how to stop the next big meltdown in UK financial services – in a dense, academic 200 pages.  Not unexpectedly, there were lots of leaks, the ICB has gone for the middle way.  The interim ICB report reads very much like a victory for the City of London in its bid to fend off tight regulation.

The extreme reform option was to split the big, “universal” banks into two separate institutions: one dealing with customers’ deposits and typical high street loans, and the other dealing with more risky (but far more profitable) trading on a bank’s own account, on the financial markets.  It was own-account trading on the markets that led to the credit crunch in 2008.

The danger in the “extreme” option is that it would chase London-based universal banks elsewhere.  HSBC and Barclays have already dropped heavy hints about switching their head offices to New York or Hong Kong.  So the ICB’s other option was to tell British banks to hold a bit more capital in reserve against a rainy day, and hope that the G-20 negotiations to reform global banking supervision would sort things out eventually.

Waiting for an international solution could take forever.  So the ICB, chaired by John Vickers, an Oxford academic, has proposed a halfway house in which British-licensed banks remain in fact but form separate subsidiaries for retail and trading operations inside the UK.  The theory is that if the trading subsidiary gets into trouble, the retail arm (which has your deposits) will remain solvent.  Or, should the latter get into difficulties, at least it will be small enough for the government to bail out without crippling the taxpayer.

Will the ICB compromise work?  One problem is that it is not so easy to decide what is retail business and what is proprietary trading. The interim report itself says that around 30 per cent of bank activity could be assessed either way.  Expect the banks to fight to keep as much business as possible out of the retail pot.  This is because the ICB wants the new retail subsidiaries to hold 10 per cent of their assets idle in shareholders’ capital that can be used to meet potential debts.

Why does this 10 per cent rule matter?  Essentially banks get the money they lend to customers from two sources – from depositors, or by borrowing cash from other banks.  These days, ordinary punters don’t save very much with banks.  So banks get most of their lending money by borrowing from other banks.  When this financial “pass the parcel” stalled in 2008, the global economy imploded.

The ICB’s 10 per cent equity rule would mean the new retail subsidiaries would have to rely more on deposits to fund their activities, and less on funds borrowed from other banks.  This is because borrowing on the inter-bank market would require them automatically to hold extra equity.

The upside is that this makes retail banking less risky.  We will not see a repeat of the HBOS disaster, in which that bank literally “bought” a majority share of the UK mortgage market by borrowing from other banks and then using the money to lend to home buyers who were incapable of keeping up their repayments.

The downside is that it might restrict the growth in the volume of mortgages and consumer credit.  This could prove unpopular with the voters, not to say the banks, who will find their profits cut.  The danger is that the whole move to split retail and investment banking could unravel if the Coalition government surrenders to the City.

There is an obvious solution.  If you ring-fence retail banking and make it hold tight capital reserves, you limit lending to the rise in deposits.  Another way of saying this is that you limit lending to the growth of savings.  There is nothing wrong with that per se, as long as the government promotes savings through the correct mix of fiscal and monetary policy.  But if your economic growth model is based on rising consumer debt, ring-fencing retail banks will not work.

There are countries with tight bank regulation that also focus on encouraging savings and investment.  Sweden is one.  Sweden did not suffer much from the credit crunch and its economy is now growing at over 8 per cent per annum – the highest on record.

The interim ICB report will now go to the banks for detailed consultation, with the final report due in September.  Expect the banks to claim that creating retail subsidiaries will force them to put up the cost of borrowing to customers.  This is dubious.  Actually banks will be forced to seek more depositors, which is good for the ordinary punter.

In fact, banks have gotten off a lot lighter than they might have expected because the ICB is still letting them transfer capital and liquidity between their UK retail arms and their investment banking business – so the fire wall between the retail and trading activities is hardly made of asbestos.  It means ordinary depositors can still end up with their money funding risky bank trading.  In capitalist America, however, they have passed legislation that prohibits deposit-taking banks from conducting any proprietary trading.

The one surprise in the interim report – given its Establishment panel – is its poke at Lloyds Banking Group, which the commission suggests should be ordered to sell hundreds more high street branches in addition to the 600 already on the block.  The aim is to promote more competition between banks – LBG controls around 30 per cent of UK current accounts.

The ICB stops short of recommending the unwinding of the 2008 takeover of HBOS by Lloyds, the panic, shotgun marriage promoted by Gordon Brown and Alistair Darling when HBOS came close to insolvency.  However, John Vickers correctly criticises the deal: “There is cause for regret that the [Labour] government in 2008 amended competition law to facilitate the Lloyds TSB/HBOS merger.”

One anomaly in the ICB recommendations is that the new rules on retail subsidiaries will not necessarily apply to EU banks.  A bank incorporated in one member state is entitled to set up branches in another member state using its home license.  The ICB thinks this is a marginal problem.  But what if an EU bank buys the nationalised RBS network when it eventually comes up for sale? 

The ICB is right to put increased competition at the heart of its reforms.  A start would be to ensure RBS is returned to Scottish control, or at least any Treasury profits from the sale are used to fund a new Scottish investment bank.  The job of banking reform has only just begun.