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The final report of the Independent Commission on Banking from Sir John Vickers



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.

 

Not The News Of The World



There is a concept in large professions such as law that no single person is more important than the profession. Many analyses have been written about the relationship between Tony Blair and his Party, and indeed subsequently between Gordon Brown and the same Party, and the concept has arisen that Tony Blair was more popular than Labour, making him such a formidable ‘election winning machine’. The electability of the Leader has always been cited by New Labourites as being pivotal to Labour’s ultimate electoral success, and I believe that this die-hard group of members within Labour still feel this today, with their eye on 2015.

This week was a ‘game changer’ for Ed for various complicated reasons. Having been stuck ‘on loop’ with the traditional Labour bust-up with the Unions, it seemed unlikely that Ed would be able to make a new, innovative step in Labour. A quantum leap. Thankfully, the Right seemed to resent that the group representing ‘It’s the Sun that won it’ had been caught up in such a robust scandal. Rewind – the Right seemed to resent the fact that the Left seemed to be enjoying it so much. What about Tony Blair’s transatlantic flight to court Rupert Murdoch once?

What about Ed Miliband and Douglas Alexander meeting Rupert Murdoch only the other week? Rupert Murdoch, more than the Left, is more symbolic of the corporate in US and UK life, and it is this maximization of shareholder profit which is about to come under enormous scrutiny in David Cameron’s single term of government. The NHS Health and Social Care Bill is (potentially) fundamentally flawed because it edges towards NHS institution becoming private limited companies, with legal corporate legal liability, with the function of maximizing shareholder profit, and becoming subject to the intense regulation of competition, insolvency, and employment law disciplines, but a few.

History has shown that, when corporate scandals of any description, such as ENRON, they have a lasting impact, because they force management analysts to examine how a toxic organizational culture has arisen, and how corporates must have a strong grasp on the triple bottom line ‘people, planet and profit’ (i.e. they must mean it), to survive. This is not however the same as a belief that pursuing profit is fundamentally wrong. This, so-called “corporate social responsibility”, can directly impact on their financial success, as investors can powerfully make a financial decision to go elsewhere. In the case of News International, investors can decide to shop around, but the genuine question is whether other entities are simply better at hiding their own brand of toxicity. The danger would of course be for the Left to conflate the toxicity of News of the World (“NOTW”) (evidenced, arguably, by the Management Board of News International deciding to dump NOTW in its last edition this Sunday) with any toxicity of the Conservative brand. A noteworthy success of David Cameron has been to detoxify his own brand.

You can often tell a lot about a leader by its followers in management analysis, but people are more interested in leadership than followership (reflected in fact in the relative numbers of books written on the subject on Amazon). The fact that David Cameron promoted Andy Coulson, after he had left News of the World, at a time when John Prescott had warned of there existing some ‘unfinished business’, is at best an error of judgment. A minority of people feel that he has handled the News International scandal well, and it should be of no shame to him that he personally gets well with Rebekah Wade and Andy Coulson. People are not so superficial to think that this impacts on running the country, but the corollary in business is whether a corporate should be able to make large profits at any cost.  Interestingly, the Independent ran a story earlier this week suggesting that Directors could be negligent in spotting illegal phone-hacking activity through s.79 Regulation of Investigatory Powers Act [2000] (article by Andreas Whittam-Smith dated 7 July 2011, quoted by @charonqc on his blog).

In the far-from real world, the New York Times gave a glowing description of Rebekah Brooks’ leadership qualities today. In traditional MBA territory, Ed Miliband has in fact shown excellent leadership. He demonstrated risk-taking behaviour, in being the first to dare to break from the fetters of ‘It’s the Sun that Won it’. He showed emotional intelligence in agreeing to a discussion of the matter with David Cameron next Wednesday, and he also displayed cognitive intelligence in being able to analyse a case for regulation of the journalism profession this morning. He has inspired followers, but indeed books can be justifiably written about whether the followers are actually ‘susceptible’. This notion of susceptibility can arise from the view that David Cameron did not in any sense win the election, but Gordon Brown (predictably) lost it, and a lot of people (including a vast majority of English Labour supporters, but rarely social Liberal Democrat voters) feel they’re biding time until 2015. The severity of the situation has meant that people are not too concerned about whether Ed Miliband looks like Gromit the Dog, but feel that there is something toxic about the culture in some parts of the News International, from the past, if the allegations are to be believed.

However, an inquiry through the Inquiries Act [2oo5], and the various criminal cases, seem like a sensible way for the law to progress. David Cameron’s (and, now, by association, Nick Clegg’s) challenge is to try to ‘nudge’ a sentiment of members in the public being inspired enough to consider he will contribute in clearing up the mess. The ultimate challenge for Rupert Murdoch to survive through these challenges, and for Jeremy Hunt to avoid referring it to the Competition Commission which many believe he is still able to; and, of course, for the re-branding of a newspaper on Sunday to go smoothly. Whether ‘ringfencing’ will be sufficient is anyone’s guess, but we’ve actually been here before.

 

@legalaware is a full-time MBA student at BPP Business School, St Mary Axe, The City, London. This article is not to be taken as representative the views of the BPP Legal Awareness Society, nor of BPP University College.

 

The reform of the banking industry. Are firewalls and ringfencing the answer?



Tomorrow the Independent Banking Commission headed by Sir John Vickers will publish its interim report. The Commission of five economists and bankers, chaired by former Bank of England chief economist John Vickers, was tasked with considering a full-scale break-up of banks – something Liberal Democrats had called for in their election manifesto. Regulation holds the key to successful functioning of the financial services or banking industry. The main argument made until now for completely breaking up the banks is that it is unfair that ordinary retail customers should be put at risk by the investment banking arms. That is likely to be true, in that when a consumer bank – Northern Rock – adopted an investment bank style of financing in the shape of aggressive securitisation it failed horribly. This report due to be published tomorrow will not support the total break-up of Britain’s biggest banks, according to the BBC. Instead it will favour ring-fencing their risky investment banking operations, so they do not jeopardise the savings of ordinary depositors.

Most of the big “Wall Street banks” have long come off the critical list, repaid the US government every cent invested or borrowed, and are happily paying dividends. Conversely, in the UK, Northern Rock, Royal  Bank of Scotland and Lloyds Banking Group soldier on, largely on the back of the UK government. The new ‘firewall’ arrangement is intended to eliminate the possibility of losses at the investment banks being borne by the public purse. Customers’ deposits, business lending and the transmission of money would be ring-fenced within the universal banks as new subsidiaries, endowed with increased capital resources to protect against losses.

Markets are likely to see the ring-fenced investment banks as riskier credits, making it more expensive for them to borrow and undercutting their profits. Rating agencies will be looking carefully at the report to understand how it affects the chance of banks being rescued by the government in future financial crises. One of the most famous agencies, Moody’s, said on Thursday that it will review ratings for 19 UK banks this year in light of the tougher regulatory environment, with many likely to face large downgrades. What happens to banking regulation will have worldwide implications for our relative competitive advantage, say, for example, compared to New York or Shanghai.

The ring-fencing may mean that rating agencies give investment banks separate – and lower – credit ratings than their parent banks. The buzzword is banking circles now is “subsidiarization”— the idea that banks can address regulators’ concerns by creating legal firewalls between their different businesses that stop short of full separation. Santander already operates a subsidiary structure along these lines: all its major units are separate legal entities, independently regulated and with responsibility for their own capital and funding. HSBC also largely follows this pattern. Since these have been two of the most successful banks in the world through the crisis, this models are understandably attracting increasing attention as a possible solution.

However, subsidiarization is not the complete answer to the regulators’ dilemma. For example, a subsidiary structure would have enabled U.K. regulators to stop Lehman Brothers transferring large quantities of cash to the U.S. the night before it went into administration. Similarly, U.K. regulators would have been able to ring-fence the operations of Icelandic banks active in the U.K. before the crisis by forcing them to hold their own capital and liquidity. Instead, they collapsed with their parents, with disastrous consequences for the U.K. economy. Not surprisingly, regulators are keen on subidiarization as part of their efforts to force banks to maintain so-called living wills to help ensure an orderly wind-up. Any regulation has to be correctly thought through this time around.

For example, the Wall Street Journal has previously remarked (link to the article here),

“[It is considered not atogether clear] subsidiarization provides the kind of firewall between different parts of a bank needed to protect taxpayers in the parent country. After all, HSBC operates a subsidiary structure, but that did not stop it funneling billions of dollars into its troubled U.S. unit, Household, rather than allowing it to go bust. At the time, HSBC argued persuasively that allowing Household’s bondholders to bear the losses from the unit’s disastrous subprime lending would have calamitous consequences for its own credit rating. Santander argues that its decision to write down the value of its Argentinian unit to zero during that country’s devaluation crisis early in the decade shows it was willing to cut a troubled subsidiary adrift. But ultimately, it never took this step—no bank could easily survive such a breach of trust. But because banks would retain the ability to deploy their capital across the range of their activities according to the returns they perceive to be available at any particular moment, the increase in their costs of doing business would not be – in their view – prohibitive.”

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