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Economics

Ringfencing retail banks – just rearranging deckchairs on the Titanic

The 363 page ICB report implies more rules, more regulation, substantial taxpayer costs in drafting, implementing and overseeing.  Will this approach work to protect the taxpayer from future bailouts?

I would make three comments:

  1. the establishment of this Commission has received insufficient recognition for what it is – a formal acknowledgment that our present bank regulatory triumvirate of the FSA, Bank of England and HM Treasury has failed dismally to date and cannot be relied upon to protect us in the future.
  2. The substantial increase and regulatory cost implied by the Report (it must be noted that this is only a report; draft legislation is not yet available) will have the unintended effect of erecting even greater barriers to entry for competitor banks.  This will in turn provide no incentive to our banks to address their culture of entitlement, of high and unwarranted compensation, of disdain bordering on aggression towards customers.
  3. Having skimmed through its 363 pages, I sense the ICB is unaware of the kernel of the problem: deeply flawed accounting standards and treatments of transactions leading to falsification of profits and capital.  RBS for certain, and perhaps other major UK banks, are insolvent.  Their liabilities exceed their assets and capital, properly measured and reported.  RBS cannot continue as a going concern, and it at least should simply be put through an orderly liquidation process rather than conferred the respect that the ICB proposals imply.

In the context of ‘respect’, I would say that I have considerable respect for the ICB.  Martin Taylor, in particular, strikes me from his media appearances as understanding the severity of the crisis and the task he shares with the four others.  It is not my place to make apologies on his behalf, but others have commented on the framing of the terms of reference limiting the scope of their responses.

Sadly, however, the measures will fail to achieve their objectives, primarily because the doctors do not appear to understand the cause of the illness.

Early in the Executive Summary (page 10) the ICB refers to one advantage of ringfencing as being to protect retail banks from “external financial shocks”.   This implies that the 2008 crisis was caused by such external factors.  But the crisis that began in 2007 and continues to this day was not a function of “external financial shocks”; it was a crisis stemming from the insolvency of the banks, as even the Bank of England now accept[1].

IFRS accounting rules, despite the 2009 MTM reforms still allow or encourage banks:

  • to “mark up” to market assets whose prices they can claim have risen, thus reporting a profit despite no actual transaction;
  • to transfer assets whose market values have fallen (such as Greek sovereign debt)[2] between “accounting classifications” (e.g. onto the “Held to Maturity” book) to avoid recognising losses;
  • to pay bonuses despite such banks being loss-making under UK Company Law accounting standards – in other words to operate as Ponzi schemes – and furthermore not to deduct promised bonuses from reported profits.

Retail banks “should have different cultures” the ICB Report pleads (page 11).  Dream on.  Regulators cannot influence cultures. Only markets, shareholders and the threat of job losses, as feared by workers in insolvent companies outside of the banking sector, will.

I mention shareholders, but when the shareholders are the public sector they seem to impose no such corrective influence.  There has been not a whimper of concern from these shareholders in response to the staggering contents of both MP Steve Baker’s and Cobden Partners’ Press Releases of May 15th and 17th exposing RBS’ overstatement of its 2010 profit and capital by about £25bn.

Further, the concept of the ring fence implies that, in a crisis, the investment banking bit can be cut off and allowed to fail, yet exceptions to the ring fence[3] are permitted for banking services that involve an exposure to the sister investment bank.  This is not a ring fence, and if this rule survives, expect substantial gaming.

The ICB will counter that they are providing the regulators with sharper teeth.  The regulators will not use them.  Why should they?  As Professor Kevin Dowd points out[4], in 2009 after presiding over the worst financial crisis in living memory, FSA staffers were paid record bonuses after submitting to their pay committees testimonials from the banks they were supposed to have been scrutinising.


[1] “Right through the crisis from the very beginning …an awful lot of people wanted to believe that it was a crisis of liquidity” Sir Mervyn King said.  “It wasn’t, it isn’t.  And until we accept that we will never find an answer to it.  It was a crisis based on solvency.” Financial Times, 24th June 2011.

[2] Step by step guide how to do this provided by Barclays Capital’s Equity Research team July 2011

[3] ICB Report page 235, footnote 6

[4]Alchemists of Loss

5 comments to Ringfencing retail banks – just rearranging deckchairs on the Titanic

  • 1.It is assumed that the risk lies more with investment banking than domestic lending: this is only true if an economic recovery is assumed. If the economy tanks, which is looking increasingly likely, this is not true.
    2. Investment banking is more profitable for capital employed than domestic banking. Increasing capital requirements for domestic banking will merely shift the business commitment away from domestic lending, reducing credit availability.
    3. Splitting the banks infers that we rescue the ring-fenced domestic banking and let the investment bank go hang in a systemic crisis. That option does not in reality exist.

    Thank goodness nothing will be done on this for a long time, certainly not before the upcoming tests faced by the global banking system.

  • Bob

    Gordon, I believe the “kernel” of the problem, or the “cause of the illness” as you put it in your excellent article is the ability of the banks to create money. This is the root cause of the Global crisis. Until we all understand this and act on it, very little will be achieved. In 2009 they created the same amount of money in loans as the BOE did in QE.
    Please see http://www.legalforgery.com/. This is what our national banks are doing and we must get it under control.

  • Simon Bennett

    I can’t see the point of these proposals since as far as I have heard the ring-fencing will not be put in place until 2019. I am fairly sure that the entire banking system will implode well before then, so the whole exercise is therefore a complete waste of time and energy.

  • I had a quick look at the “legal forgery” work referred to by Bob above. The basic idea in that work, namely that fractional reserve banking be abolished, is part and parcel of the submission to the ICB by Prof. R.A.Werner, Positive Money and the New Economics Foundation.

    As to ring-fencing, there is a serious lack of any simple clear principle in the ICB report as to what goes on which side of the fence (2.27). For example they say that deposits from, and loans to large enterprises should be on the retail side of the fence. That doen’t sound like “retail” to me. Plus loans to “financial” firms cannot be made by banks’ retail divisions. I can see lawyers earning huge fees in squabbles over the definiton of the word “financial”.

    Moreover, ring-fencing retail activities is illogical in that some retail customers will want to have a flutter and expose themselves to risky investments, and why not? But of course they are not entitled to taxpayer support if it all goes wrong.

    Second, and conversely, a proportion of non-retail customers, e.g. large commercial enterprises will want specific sums of money to be 100% safe. And if that’s what they want, there is no harm in that, as long as they don’t expect to get a commercial rate of interest on their money.

    In contrast to that, the “fence positioning” advocated by the above Werner submission is simple and clear. Customers, large or small, can go for 100% safety, in which case their money is NOT used in a commercial manner. It is deposited at the Bank of England and thus earns little or no interest. Alternatively, they can let their money be invested in commerce. That means a higher rate of interest, but there is no taxpayer funded rescue if it goes wrong: it is not the job of taxpayers to subsidise commerce.

  • Bob

    Ralph,
    Very supportive of Posative money’s objectives. Unfortunately the ICB has not picked up on the seniorage of money in their work, or chosen to ignore it. http://www.legalforgery.com/ web site offers a solution to controlling the banks printing money by registering it with the BOE, which is far simpler and easier than what is proposed by PM.