UK Banking Reform: Saving the patient?
Director of Financial Services
The banking industry is currently facing the most wide-reaching, radical shake-up in its centuries-long history. Since the financial crisis hit in 07/08, British policymakers have moved with speed to put in place new structures that will ensure that such a calamity – which we couldn't afford again anyhow - doesn't repeat itself.
Yet there is something of a knee-jerk nature to the response. Whilst we've put tremendous effort into publically shaming bankers and the banking industry for its crimes - restricting their ability to lend to the point that the economy now bounces along the bottom - less thought has been given to examining consumer behaviour, the aptitudes required for senior banking posts, or just how we go about sanitising the riskier banking activities that created such leveraged risk in the first place.
The current draft of the Bill on Banking Reforms, which recommends ring-fencing the riskier activities of the banking sector away from the staid savings and deposits business, risks unnecessarily amputating the patient in order to save him. Can such ring-fenced banks make money in the long-term in a persistent low interest rate environment? Will the ‘electrification’ of the fence create an overly punitive, anti-business regime?
Aside from these general concerns, however, the Bill also contains provisions prohibiting ring-fenced banks from having non-EEA branches or subsidiary operations. This could have dramatic, and negative, unintended consequences, not just for the Crown Dependencies and other non-EEA locations, but for the UK economy too.
It is important to stress the importance of these jurisdictions to the UK in terms of providing liquidity. To borrow from The Foot Report (2009), ‘[the Crown Dependencies and Overseas Territories] make a significant contribution to the liquidity of the UK market... together, they provided net financing to banks of $332.5 billion in the second quarter of 2009, largely accounted for by the ‘up-streaming’ to UK head office of deposits, collected by UK banks in Crown Dependencies’
This was not simply UK residents' money that would have found its way back in any case; for example around three quarters (74 per cent) of the money collected in the Isle of Man was non-UK (either local or international) in September 2012. UK residents are not the only people who want to hold Sterling – it is a store of wealth and many who operate internationally want to hold it in stable economies outside of the UK. If they suddenly cannot, they may well just switch to another, more accommodating currency, with the attendant negative effects on the Pound this would have.
Put simply, had the Crown Dependencies not been around in the crisis to provide that liquidity, the taxpayer tab could have been significantly higher. They form an important function within the economic ecosystem.
HM Treasury has indicated that it will consider allowing ring-fenced banks to have non-EEA operations on a case-by-case basis. The challenge for Crown Dependencies now is thus to demonstrate how the proposals could be extended to the location such that the resulting regime is deemed equivalent to the UK’s, allowing the current beneficial symbiosis to continue.
Yet there are additional problems plaguing the legislation. For instance, the introduction of a preferred creditor scheme will have the consequence that some customers of banks – ring-fenced or not – will pay for the total protection of those within the FSCS whilst not enjoying such protection themselves. The provisions are such that, in the case that the FSCS pays out to qualifying customers in times of distress, the resulting debt to the state becomes a preferred creditor in any liquidation regime. The consequence being that the return for larger depositors and corporates in such a scenario will be reduced, in some cases substantially. Is this fair? Will such investors look favourably on a model that elevates risk at the same time as dampening returns?
The solution lies in creating a regime that successfully matches risk appetite with higher risk, and avoids moral hazard. Easier said than done, and there are clear arguments in favour of the UK’s current approach.
But in the Isle of Man we suspect there is a third way, and that more scrutiny is needed to avoid the disaster of unintended consequences. Ideally, those with capital should also benefit from any future regime, not just pay for it.
Find out more about the Isle of Man's financial services sector.