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Banking Reform – The Great Challenge

Submitted by on 26 Jul 2011 – 11:30

John ThursoJohn Thurso MP, Liberal Democrat Member, Treasury Select Committee

Banking reform and the deliberations of the Vickers Commission has been a central topic of debate for most of this year. The commission’s interim report naming ring fencing of retail operations as the lead choice, followed by the Chancellor’s endorsement in his Mansion House speech, has concentrated debate around that concept. Not surprisingly the big universal banks are lining up along a spectrum from distinctly lukewarm to downright hostile. However the question of why do we need banks and what are they for, has been bypassed. Before we rush headlong into change perhaps an answer to that basic question is needed. We need to separate what we require from banks to help industry and commerce create wealth on the one hand, from hosting financial institutions and markets on the other. And we need to understand what activities assist long term growth and which act as a barrier.

City supporters point to the size and scope of the financial services industry in the UK, and to the jobs it supports and the revenue delivered in tax, as justification for leaving the banks alone. Come down heavily on banks- so the argument goes – and they will up sticks and move, London will cease to be a good location for overseas operators and we will all be losers as the tax revenue dries up. However this ignores a few fundamental facts. First – could big universal banks domiciled in the UK move elsewhere. For the foreseeable future not a chance. Just as we would not allow a foreign bank of real size to move here because the country cannot afford the risk, so there is no country that could afford to accept one of ours. They are stuck here and we are stuck with them. Second – much of the revenue in the city comes from foreign banks who want to have operations in London because it is a convenient to be here and because their employees like the cosmopolitan offering and quality of life. These can move and it is these that we need to be careful with. We need to make a regulatory distinction between those who operate here but go home to die and those whose balance sheets are based here and who we therefore implicitly underwrite.

As Vickers makes clear modern banking is a complex business and interconnected across the spectrum. However it is still possible to say that bank functions fall broadly under one of three general categories: retail and commercial, capital markets, and investment and advisory. Most of the failings of the crash are seen in terms of systemic risk brought on by “nice” retail banking being polluted by “nasty” investment banking. However it is more complex. In fact “nice” retail banking has helped to water down true investment banking and has stopped a proper relationship between risk and reward, and reward to capital that should be the hallmarks of good investment banking. As part of the reform packages there should be scope for a return to the partnership model investment bank unsullied by a retail operation but in which the partners have unlimited liability. This model is still the only one which makes partners really think long term and worry about risk from a personal perspective. What we want from investment banking is an operation that enhances wealth creation and helps companies in commerce and industry grow through understanding and taking appropriate risk. The stand alone investment bank is more likely to deliver that long term than the polyglot universal bank.

By contrast we need retail and commercial banks to provide the lubricant for general commerce, a payment system, personal finance, and lending to business. This must be a different skill set and should have low risk and consequently not offer much scope for transaction based rewards. Notwithstanding Merlin they are currently failing. A large part of that stems from the need to rebuild balance sheets which is more easily done by capital and investment operations than retail and commercial. As a result SMEs are failing to get the finance they need because in the competition for available funds they will always be the less attractive.

There is a role for universal banks, but not too many of them. We need more specialists in each of the disciplines. So perhaps the single most important changes we can make going forward is to increase the opportunity of smaller institutions in all disciplines to get started whist increasing the cost and ease of creating big Bank Corps. Vickers final report cannot therefore be seen as a take it or leave it. The core decisions of what we want from our banks are in part a political choice and that will need ministerial engagement. We are also part way through creating a completely new regulatory architecture. The effectiveness of the PRA and the FSC going forward will be a key consideration on how regulation of banks should evolve. However the one goal that must be achieved is a proper alignment of risk and reward. If only that comes out of Vickers it will have achieved its purpose.