The Independent Commission on Banking’s proposals fall into three categories.
1. Making banks safer. Banks should hold more equity capital relative to their risk-weighted assets, and systemically important banks should hold more than others. UK retail operations should be carried out by separately capitalized subsidiaries, so as to firewall them from riskier investment activity.
2. Resolving distressed banks. Banks should have ‘living wills’, explaining how they can be wound up without risk to the taxpayer. They should also hold minimum amounts of contingent capital – debt that converts to equity if capital ratios fall below a predetermined level. Compulsory debt-for-equity swaps should be used to recapitalize banks that cease to be going concerns, and ordinary depositors should be given priority over other unsecured creditors if a bank fails.
3. Increasing competition. Lloyds Banking Group should be forced to divest more assets and liabilities, portable account numbers should be introduced so that people can switch between banks more easily, and the new Financial Conduct Authority should make competition its major focus.
In some respects, these recommendations are commendable. The proposed approach to resolving distressed banks is eminently sensible. The other suggestions are practical and implementable. Crucially, the measures advocated are unlikely to put Britain’s financial services industry at a competitive disadvantage globally.
But do the Commission’s proposals succeed on their own criteria? Would they make the UK banking system safer and more competitive? Arguably, the answer is ‘not much’ since the Commission has failed to adequately deal with the fundamental flaw at the heart of our banking system.
Government guarantees subsidize risk taking and encourage shareholders, bondholders and depositors to abdicate responsibility. This can never be counterbalanced by regulatory oversight, no matter how well designed. Banks must believe that they will never be bailed out again, and depositors, bondholders and shareholders must be convinced that their investments are their concern. Otherwise, banks have no incentive to be ‘safe’. In this respect, the Commission has not gone far enough.
The same failing has important implications for competition. A banking system without government guarantees would be far more competitive: incompetent banks would lose business to competitors or market entrants, rather than being propped up by the state, and banks would compete on risk quality in order to attract depositors.
In short, ensuring that banks obey the basic rules of capitalism is the surest way to fulfill both the Commission’s key objectives: stability and competition.
Published on LexisNexis.