Ahead of schedule, the final Report has just been published. This Final Report sets out the Commission’s recommendations on reforms to improve stability and competition in UK banking.  The context of this Final Report is striking, as set out in the conclusion of the Executive Summary. “The fact that the economy is currently weak is no reason to be distracted from this goal. It is strongly in the national economic interest to have much sounder banks than before. Postponement of reform would be a mistake, as would failure to provide certainty about its path.”

The Final Report commences thus:

The recommendations in this report aim to create a more stable and competitive basis for UK banking in the longer term. That means much more than greater resilience against future financial crises and removing risks from banks to the public finances. It also means a banking system that is effective and efficient at providing the basic banking services of safeguarding retail deposits, operating secure payments systems, efficiently channelling savings to productive investments, and managing financial risk. To those ends there should be vigorous competition among banks to deliver the services required by well-informed customers.

The international reform agenda – notably the Basel process and European Union (EU) initiatives – is running concurrently, but needs to be supported and enhanced by national measures, according to the Committee. Sir John Vickers and colleagues believe that mcro-prudential regulation by the new Financial Policy Committee should help curb aggregate financial volatility in the UK.

They comment specifically that improved supervision by the new Prudential Regulation Authority should avoid some shortcomings of regulation exposed by the recent crisis. The Commission’s view is that the right policy approach for UK banking stability requires both (i) greater capital and other loss-absorbing capacity; and (ii) structural reform.

The Committee notes that governments in the UK and elsewhere prevented banks from failing in 2008 because the alternative of allowing them to go bankrupt was regarded as intolerable. Under Basel III, banks will be required to have equity capital of at least 7% of risk-weighted assets by 2019, while risk weights have also been tightened.

The Committee believes that structural separation should make it easier and less costly to resolve banks that get into trouble.  They feel that one of the key benefits of separation is that it would make it easier for the authorities to require creditors of failing retail banks, failing wholesale/investment banks, or both, if necessary, to bear losses, instead of the taxpayer. Secondly they believe that structural separation should help insulate retail banking from external financial shocks, including by diminishing problems arising from globalisation in the banking sector. The Commission’s analysis of the costs and benefits of alternative structural reform options has concluded that the best policy approach is to require retail ring-fencing of UK banks, not total separation. They strikingly comment that:

The objective of such a ring-fence would be to isolate those banking activities where continuous provision of service is vital to the economy and to a bank’s customers. This would be in order to ensure, first, that such provision could not be threatened by activities that are incidental to it and, second, that such provision could be maintained in the event of the bank’s failure without government solvency support. This would require banks’ UK retail activities to be carried out in separate subsidiaries. The UK retail subsidiaries would be legally, economically and operationally separate from the rest of the banking groups to which they belonged. They would have distinct governance arrangements, and should have different cultures. The Commission believes that ring-fencing would achieve the principal stability benefits of full separation but at lower cost to the economy.

Governance

Since the development of the Combined Code in the City here in London, a huge amount of attention has been paid to effective corporate governance mechanisms such that the financial services industry and the general public can have complete faith in the banking sector. Effective ring-fencing also requires measures for independent governance to enforce the arm’s length relationship. The Commission’s view is that the board of the UK retail subsidiary should normally have a majority of independent directors, one of whom is the chair. For the sake of transparency, the Committee argues that subsidiary should make disclosures and reports as if it were an independently listed company.

The Final Report interestingly considers the effect of this structural reorganisation on corporate culture.

Though corporate culture cannot directly be regulated, the structural and governance arrangements proposed here should consolidate the foundations for long-term customer-oriented UK retail banking.

This tackles one fundamental issue in organisational change in management – that whilst you can radically alter the structure of a corporation, you may not be able to alter it fundamental make-up culturally, and its values and modus operandi continue as before. The combined effect of the Commission’s recommended reforms on structure and loss- absorbency can be explained in relation to the ‘too big to fail’ problem, i.e. that government is compelled to save big banks for fear of the consequences of not doing so.

UK competitiveness

The effect on the City as one of the leading global markets is discussed in great detail, unsurprisingly.

Vickers and colleagues do not wish to throw the baby out with the bathwater. They believe that these reforms, arguably the most substantial reforms in the banking industry in a lifetime, will ensure “the City’s international reputation as a place to do business.” UK competitiveness also features extremely prominently in the Commission’s remit, unsurprisingly. The Committee argue that recommendations in this Final Report will be positive for UK competitiveness overall by strengthening financial stability. The proportion of wholesale and investment banking activity in the City that would be directly affected by the proposed reforms would be relatively small, and the ability of UK banks to compete against foreign banks should be maintained by allowing, subject to important provisos, international regulatory standards to apply to their wholesale/investment banking activities. The proposed capital standards for ring-fenced banks, which have been calibrated partly with an eye to regulatory arbitrage possibilities, should not threaten competitiveness in retail banking either.

The consultation on the Interim Report has apparently indicated that a greatly improved switching system for personal and business current accounts could be introduced without undue cost. The Commission therefore recommends an early introduction of a redirection service for personal and SME current accounts which, among other things, transfers accounts within seven working days, provides seamless redirection for more than a year, and is free of risk and cost to customers. The threat of substitutes and barriers to entry have long been recognised by Prof Michael Porter from the Harvard Business School as being pivotal in analysing the competitive advantage of any entity in industry (although Porter’s original analysis emanated from American-based manufacturing industry.)

The relationship between competition and regulation

One of the reasons for long-standing problems of competition and consumer choice in banking and financial services more generally has been that competition has not been central to financial regulation. Sir John Vickers and his Committee for the first time considers this specific issue.

The current reform of the financial regulatory authorities, especially the creation of the FCA, presents an opportunity to change this, which in the Commission’s view should be seized. The issues of switching and transparency mentioned above are examples of where the FCA, with strong pro-competitive powers and duties, could make markets work much better for consumers. It could also do so by tackling barriers to the entry and growth of smaller banks.

The Interim Report also considered whether there was a case for the relevant authorities to refer any banking markets to the Competition Commission for independent investigation and possible use of its powers to implement remedies under competition law.

The final report instead conclude that such a reference is not recommended “before important current policy questions are resolved, but could well be called for depending how events turn out in the next few years.”

Conclusion

The final conclusion to the Executive Summary is extremely sobering: “Banks are at the heart of the financial system and hence of the market economy. The opportunity must be seized to establish a much more secure foundation for the UK banking system of the future.”

Quotations are provided from the Executive Summary of the Final Report of the Independent Commission on Banking published at 0615 on 12 September 2011.