U.K. ring-fences bad bank policy

After her presentation to the Economic Club in Toronto Monday, Julie Dickson, the Superintendent of Financial Institutions, faced one key issue in questions from the audience: Do bank regulatory reforms in foreign jurisdictions extend beyond that called for in international forums such as the Basel Committee and Financial Stability Board?

The United States has gone furthest in regulatory zeal with the passage of the Dodd-Frank legislation. But the U.K. is also exercising its regulatory muscle. A report by an independent U.K. Commission on Banking - the Vickers report - will, if implemented, fundamentally restructure U.K. banking operations in a way that will disrupt its business models and create significant costs without any real benefit.

Ms. Dickson didn't get into the specifics of the U.S. or U.K. reforms, noting that these new initiatives will do little to improve supervision, which she sees as the key to be better financial system. Canada certainly would be wise to avoid the U.K.'s extreme turn.

The Vickers report calls for U.K. bank retail activities to be carried out in separate subsidiaries that would be legally, economically and operationally separate from the rest of the banking group to which they belong. This would ring-fence a bank's retail operations serving individuals and small businesses from wholesale activities such as investment banking. Despite being designed for retail operations, the ring-fenced bank would be permitted to accept wholesale deposits and engage in corporate lending. Capital requirements for the ring-fenced bank would be set at a higher level than that currently proposed in international standards.

The ring-fencing recommendation has laudable objectives, including curtailing government guarantees and facilitating resolution of troubled banks without government solvency support (in other words, some form of bailout). However, the whole concept - based on some financial services being vital while others are not - is fundamentally flawed. The report characterizes retail services in deposit-taking, payments and lending as vital to both customers and the economy, and in need of protection from problems elsewhere in the financial system. The ring-fence's purpose would be to ensure the provision of these services without government solvency support in the event of the banking group's failure.

However, if the banking group as a whole is failing because of its wholesale activities, it is naïve to think that depositors and other creditors will not lose confidence in the ring-fenced portion of the bank. Hence, even if the ring-fenced bank remains solvent, it would likely still fail with the rest of the bank as creditors flee. Even if this was not the case, the U.K. government may nevertheless elect to provide solvency support if there is sufficient concern that the failure of the bank's wholesale operations presents systemic risks to the broader financial system and economy. For instance, if eurozone banks had ring-fences in place, it would not prevent the calls now being made for capital injections into European banks.

Despite high capital requirements, the ring-fenced bank is easily capable of failing on its own. The proposed ringfence unfortunately adds to the risk of failure. Because the ring-fenced bank performs services characterized as vital, this could give rise to an expectation that government support would materialize if the ring-fenced bank finds itself in difficulty. This expectation would encourage more risk-taking by the ringfenced bank, which would be under pressure to generate returns while deal-ing with high capital requirements.

Additionally, the restrictions on the activities of the ring-fenced bank would prevent it from engaging in some activities that are relatively less risky and which could diversify earnings. For example, the Vickers report states that while ring-fenced banks should be able to lend to corporations, underwriting the issuance of debt securities, which is a market transaction rather than direct intermediation between savers and borrowers, would be prohibited. Yet in an underwriting arrangement, income would be fee-based, and the business less risky than a loan as debt would be taken on only for a temporary period to facilitate the transaction.

The Vickers recommendations add to other government actions with negative consequences for solvency and stability of the U.K. banking system. The worst so far has been this year's introduction of a bank tax applied to balance sheet items, effectively deteriorating the bank's capital in both good times and bad. U.K. authorities have also engaged in political interference in bank lending practices by arm-twisting the major banks into commitments to lend more to small and medium-sized enterprises, and to provide support for regional growth.

According to a recent Bloomberg article, Hong Kong's Chief Executive has stated that Hong Kong would absolutely welcome London-based banks if they decided to move their headquarters to the former British colony, an overture that Canada should be making as well.