Two and a half years have now passed since the British banking sector stood on the brink of total collapse.  The economy has shrunk, unemployment has soared, and now we face years of austerity under the Coalition’s programme for cutting the massive debts that the last Labour government was forced to take on to rescue the banks.  In this week’s long-awaited Interim Report of the Independent Commission on Banking, published on 11 April, Sir John Vickers and his colleagues have set out policy recommendations intended to ensure that we never face the same sort of systemic crisis again.  There now follows a period of consultation before the final report appears in September. 

Given its remit and membership, the Commission was never going to propose radical reforms.  The Interim Report, although it addresses complex issues at times, is minimalist in its intent and narrowly focused in execution.  The Commission explicitly examines two main issues: how to make our financial system more stable, and how to ensure that the markets for banking services are more competitive.  In proposing structural changes, the Commission has tried to steer a middle course between those who want minimal change – that is, the banks themselves – and their critics who want more.  The response has not surprisingly been lukewarm from both camps, but as bank shares rose in value on the stock market, it has been the more radical reformers who have been most vocal in their criticism.  Needless to say, proposals coming from socialists and greens, such as public ownership, a return to the mutual model, or a financial transactions tax, have been completely excluded.

Evidently, the overall concern of the Commission is the long-term health of UK capitalism, rather than any moves towards a more democratic, just and sustainable economic system;  and for British capitalism, the question of financial stability is especially salient.  British banks and the City of London as a whole, together with their counterparts in New York, pioneered the financial deregulation and globalisation of the 1980s, and thereafter the excessive lending and risk-taking of the last two decades. Compared to the world’s other major economies, the UK’s success in developing a globally-competitive financial sector left our economy much more exposed when the crash came.  The Commission gives a good example of this: at the time of the big bail-outs of late 2008, the US bank Citigroup had total assets amounting to 16% of US gross domestic product, while the equivalent figure for the UK’s |Royal Bank of Scotland was a massive 99%. This is the main reason why in 2009 and 2010 the UK’s government deficit rose so sharply by comparison with most other countries.

Reserve ratios and bank capital

In the mainstream debate on reform there is general agreement that financial stability needs to be addressed at two levels: that of individual banks, and that of the financial system as a whole.  In a capitalist economy, individual banks need to maintain reserves of capital to deal with fluctuations in their own deposits, loans and repayments: bigger reserves means more security, but limits the volume of lending, thereby cutting into profits. 

In the run-up to the crash, many banks cut their reserves to the bone, believing that they could always raise extra money in the form of short-term borrowing if the need arose.  The Commission thus broadly agrees with the Basel III recommendations of the Bank for International Settlements for higher minimum capital ratios, although it recommends a minimum of 10% rather than 7%; interestingly the Bank of England has suggested as much as 15%.  They also support the policies being developed internationally to measure and monitor the system-wide risks of contagion, where one bank collapse triggers further collapses.

But as so often, the devil lies in the detail.  The complexity of that detail is clear from a December 2010 report from the Bank for International Settlements in Geneva, with the catchy title “Basel III: International framework for liquidity risk measurement, standards and monitoring”.  The only people who can make complete sense of this document are finance specialists with strong mathematical and analytical skills.  Unfortunately, these were precisely the people who figured out how to get round the old Basel II rules, and played a major part in bringing about the 2008 crisis.

The stability of a bank also depends on how its long-term capital has been raised.  Like any capitalist business, banks can issue equity (shares) or debt (loan stock, also called bonds).  Whereas debt takes the form of a contract under which the agreed interest must be paid out regardless of the bank’s earnings, the dividends paid to equity holders are decided by the bank itself, and therefore fluctuate in line with its earnings.  If interest rates are low, as they were in 2000-07, loans are a cheaper way to raise money, and as long as that money generates high earnings, the holders of equity enjoy high dividends and hopefully big capital gains too as the share price rises. 

But when earnings collapse, the equity holders may lose not only their dividend income, but also find that the market value of their shares is wiped out, as bondholders have priority over shareholders.  The emergence of this conflict of interest between the two is an important reason why bankruptcies are so messy and expensive, although they are a bonanza for the lawyers and accountants.  For this reason, the IBC also broadly supports international proposals to bridge the gap between bondholders and shareholders by getting banks “to issue a new type of bond known as ‘contingent capital’ that either converts into equity in times of crisis, or can be partially written-down in value.  But in exchange for the greater risk, the bondholders would demand a higher rate of interest, which banks don’t like paying.

Retail vs investment banking: to split or not to split?

Most of the public debate on the IBC’s Interim Report has focused not on these very technical issues, but on the question of the riskiness of bank lending.  This depends greatly on the sort of borrower.  Historically, banking services have been divided into two branches, retail banking and investment banking.  In retail banking, the borrowers are businesses and households needing loans that are either short-term, like overdrafts, or if long-term, firmly secured, like mortgages on domestic property.  Lending is financed primarily by short-term deposits of the self-same households and businesses.  For an individual retail-only bank to get into difficulties, it has to engage in obviously stupid activities, as Northern Rock did in offering 125% mortgages at a time when house prices were exceptionally high in relation to household incomes.

Investment banking, on the other hand, traditionally provided long-term funding to businesses and governments, mainly by issuing securities that are bought by long-term investors; they also acted as financial advisors to big corporations, especially in mergers and takeovers.  Before the deregulation of the 1980s, not only were investment banks separate from retail banks, but in addition the day-to-day markets in securities were provided by independent stockbrokers.  After deregulation, investment banks could use their retail activities as a source of cheap funds which could then be deployed in riskier, high-return activities.  In addition, they started making much of their profits through trading in securities, currencies and commodities, and through the development of new forms of financial asset such as credit derivatives.  Such activities are inherently much more risky than those obtained by lending, but bring much greater potential rewards in terms of profits.

The problem is that when times are good, money is cheap and confidence is high, banks underestimate the risks they face.  In the run-up to the crash many increased their lending to 30, 40 or more times their available reserves.  Even a retail bank like Northern Rock could do this.  Using so-called ‘special investment vehicles’, Northern Rock got most of its lending off its own balance sheet by selling the loans on to investors.  However, they made the cardinal mistake of funding long-term lending by short-term borrowing, which then dried up as the money markets at last became aware of the impending crunch. 

More generally it is the investment banks that have taken on the greatest risks, which has led to the widespread demand for a radical return to the old separation between retail and investment banking.  Here, the Commission is instead recommending that banks wanting to operate both retail and investment banking should build a ‘firewall’ between the two, ensuring that the capital required to secure their retail lending is not invested in high-risk activities. Their critics claim that such firewalls are easily circumvented, and argue instead that the two types of banking should be organised as entirely separate businesses.  Investors can then put their money in either type, depending on their attitude to risk, but meanwhile the households and businesses that make retail deposits will be safeguarded. 

Naturally, the giant multipurpose banks like Barclays object strongly to the whole idea of separating the two types of activity, because it would stop them deploying low-cost deposits in high-return risky lending and trading.  They threaten to move their operations abroad, but London’s huge advantages of location, culture and language make this very unlikely.  Given the immense difficulties facing any government that tries to regulate the internal operations of banks, if the aim is to make capitalist finance more secure the right answer is surely to require full separation of ‘utility’ retail banks from ‘casino’ investment banks, with only the former benefiting from government guarantees.

Competitiveness in retail banking

The Commission’s other main aim is to improve competitiveness in retail banking.  On the face of it, their proposals for requiring more transparency in the description of financial products, and making it easier for customers to transfer between banks, will bring real benefits to the millions of us who feel we have been tricked into buying credit insurance and other products of little or no value.  But more competition may just mean more advertising and more marketing – paid for by customers – without any greater efficiency and customer satisfaction.  Even the routine processes of retail banking require a large and complex infrastructure, not to mention appropriately skilled staff, which would be daunting for newcomers to match, so it is not clear how many new banks, if any, would actually be set up.  Most likely is that foreign banks would begin by buying existing small companies – probably from among the remaining mutual building societies – and then slowly build up from there.

The Commission’s proposal that Lloyds be required to sell off more of their branches than the 600 required by the European Union competition authorities is also not obviously beneficial.  It is true that new firms might buy these additional branches, and might find ways to provide a cheaper or better service.  On the other hand, those who rely for day-to-day transactions on a local branch that suddenly changes ownership would be forced to either change their bank, or face the inconvenience of going to a different branch.  In addition, it would be irrelevant for the growing number who bank online.  What most of us want is a bank, any bank, that just gets on with providing efficiently the limited range of services that we require.

Broadening the debate

In the coming months, the Commission will surely find that in trying to stay in the middle of the road, they risk being run over in both directions: by banks who want less change, and radical reformers who want more.  If the banks resist change, we will find out just how far the rhetoric of Osborne, Cable and others in the coalition government will in practice dare to oppose the most powerful financial interests in the country.  For behind the present crop of bonus-hungry bankers lies the long history of the City, which for centuries has always won out when its interests were threatened, whether by the state, by industrialists looking for lower-cost finance, or indeed by the organised working class seeking to improve their living standards and the public provision of social goods. 

In recent years, we have seen how not only New Labour under Blair and Brown, but even a one-time socialist like Ken Livingston as Mayor of London, found themselves drawn inexorably into the City’s embrace.  Making money apparently out of nothing, financial services can all too easily be seen as a milch cow, yielding a stream of tax revenues that can fund whatever bread and circuses a supposedly progressive government deigns to provide to the public at large.

At the same time, we need to place the issue of finance firmly in a global context.  Is it healthy for the UK economy to continue to specialise globally to such an extent in the provision of financial services?  If not, then rebalancing towards greater production and export of goods and non-financial services, will require a raft of new policies across education, industry and planning – not to mention the financing of new activities as they develop.

But these broader debates, about the role of finance and the City of London in the UK economy and the wider world, have no place in the work of the Independent Commission on Banking.  That is the real problem.

Hugo Radice is a Life Fellow at the School of Politics and International Studies at the University of Leeds.