Bob Diamond, Barclays’ chief executive, surprised many people when he gave a warm welcome to the report published in September by the Independent Commission on Banking (ICB). The ex-investment banker, who had spoken out against too much regulation in the 15 months of the report’s preparation, said it offered “the greater clarity that banks need to be able to operate with confidence”.
But little is clear from the Vickers report about what the future holds for investment banking in the UK. Plenty of questions still need answering and specific details hammered out before any legislation is passed and the proposals implemented, say analysts and bankers.
UK businesses are also unsure how the report will change their relationship with investment banks. “Most of our members find it difficult to think through what the implications are,” says John Grout, policy and technical director at the UK’s Association of Corporate Treasurers (ACT). “The reaction of most is probably bemusement.”
Funding costs to spike
Potentially the biggest impact will be on investment banks’ funding. The Vickers report estimates that financing costs for UK banks – both the ring-fenced and non-ring-fenced entities – could rise by as much as £4bn ($6.33bn) to £7bn annually.
The extra costs will likely hit investment banking arms hardest. This is partly because the report makes clear that non-ring-fenced firms should not expect state support, thus removing the implicit government guarantees they have enjoyed in the past and implying that they would be allowed to go bankrupt.
The ICB also proposed that senior unsecured bonds be included among the bail-in capital that will form part of banks’ primary loss-absorbing capacity of up to 20% of their risk-weighted assets. “Shareholders in financial institutions took significant losses in the recent crisis, and holders of bonds issued by non-financial companies do not expect to be bailed out if they suffer losses,” says the report. “In these cases it is well-understood that investors are buying risk-bearing instruments, for which they are getting a return. There is no reason why investors in bank debt should not also be exposed to loss.”
Eric Anstee, chief executive, City of London Group
Game changer
Although equity and subordinated debt would be wiped out first, the ability for UK authorities to impose losses on senior unsecured bonds in a bank resolution would have negative implications for holders of those bonds, say analysts. “It causes you to rethink core assumptions,” says Fiona Swaffield, managing director of banks equity research at RBC Capital Markets. “It basically changes the hierarchy and turns senior debt into loss-absorbing capital.”
The removal of implicit government guarantees could also lead to investment banks being downgraded by rating agencies, which would put more pressure on their funding costs. Analysts at research provider CreditSights say in response to the report that without recapitalisations the ratings of Lloyds Banking Group and Royal Bank of Scotland’s investment banking arms “could be several notches lower than the banks’ current ratings”.
Barclays and HSBC would also be affected, but to a lesser degree thanks to the smaller proportion their ring-fenced banks would make up of their overall balance sheets, says CreditSights.
UK banks’ senior bond spreads widened significantly in the run-up to the ICB’s publication. This suggests that investors have already decided that they will want to be paid more to hold senior unsecured UK bank bonds (although analysts caution that at least some of the widening was a result of wider market turmoil).
Deposits to the fore?
Investment banks could raise corporate deposits to boost their liquidity should senior debt prove too costly. But there is no certainty that they would want to. Corporate deposits are assumed to be far more volatile than retail deposits, particularly during a crisis when they can disappear rapidly. Moreover, Barclays Capital – the closest thing the UK currently has to a big standalone investment bank – funds itself almost entirely in wholesale markets. “Investment banks really shouldn’t be seeking that much deposit money,” says Pete Hahn, a lecturer in corporate finance at London’s Cass Business School. “Ultimately, they should be raising [wholesale] funding.”
Even if investment banks do try to raise corporate deposits – perhaps even competing for them with their ring-fenced siblings – they could struggle. The ACT’s Mr Grout says that while companies would be wary of the ICB’s proposal that corporate deposits in a ring-fenced institution be subordinated to insured retail deposits, this might not be enough to outweigh the effects of any downgrades suffered by investment banks. “If the institution is now said to be not quite as attractive as it was yesterday, you’ve got to respond to that,” he says. “Companies can be quite mechanical about this.”
It seems unlikely that UK investment banks could simply shift higher costs on to their clients. This is perhaps especially the case regarding blue-chip companies, most of which could turn to non-UK investment banks. “Will UK investment banks pass on their higher funding costs to their customers?” says Ms Swaffield. “It will be difficult for them to do that if foreign banks aren’t subject to the same restrictions.”
Woe for SMEs
Pete Hahn, lecturer in corporate finance, Cass Business School
Many critics of the ICB believe that small and medium-sized enterprises (SMEs) in the UK will be worst affected by the proposals. The report states that ring-fenced banks would not be able to execute derivatives transactions for their customers. But many fear that only for blue-chip companies would investment banks be willing to fill the void. “Small companies do not want to borrow from a ring-fenced bank on the one hand and have to deal with hedging currencies with somebody else on the other,” says Tim Ambler, a senior fellow at London Business School. “Small companies can’t deal with investment banks and investment banks won’t deal with them.”
Others add that the report will only exacerbate the problem of the Basel III framework’s requirement that banks set aside more capital when funding lower-rated companies, which SMEs almost by definition are. “We all know what is causing the problem at the SME level,” says Eric Anstee, chief executive of City of London Group, and investment company. “It’s the shrinkage of the balance sheets to cope with the Basel [regulations] and the risk-weighted asset calculations for capital.”
The report could thus accelerate the trend since 2009 of UK companies turning less to the loan market, which has traditionally been their main source of funding, and more to the bond market. This is all the more likely if banks’ funding costs remain higher than those of many of their corporate clients, a phenomenon that began after the 2007 crisis and has been exacerbated by the eurozone crisis and the Vickers report. “The longer that continues, the more incentive banks and their customers have to raise funds outside the banking system,” says Mr Hahn.
Others agree that investment banks would not necessarily mind if this was the case. “Further disintermediation could be to the benefit of investment banks,” says Ms Swaffield. “It may lead to them making more fee-based revenues and having to use their balance sheets less.”
Still too big to fail
A major concern of some of the report’s critics is that the UK’s big four banks may seek to move their headquarters outside the country. HSBC is reported to be considering a move to Hong Kong, while Barclays could feasibly relocate to New York.
But the costs of the ICB’s proposals would have to be substantial for them alone to lead banks to move their headquarters abroad. Analysts point out that any move by HSBC would be prompted more by it wanting to be nearer the Asian markets from which it derives the bulk of its profits than the Vickers report itself. The case of Barclays Capital, which has become more focused on the US following its takeover of Lehman Brothers’ North American operations, would be a similar one.
The ICB asserts that ring-fenced banks would be able to survive the bankruptcy of their investment banking sister companies. But most commentators believe the UK government would have to step in and save big non-ring-fenced entities, especially given the ramifications, still being felt today, of Lehman Brothers’ bankruptcy. “There’s nothing really in this report that leads one to believe that a failed investment bank would be able to collapse without that doing great damage through connectedness of the sort we saw with Lehman,” said Lord Myners, who was financial services secretary in the UK government from late 2008 until May 2010, at an ACT discussion in late September. “BarCap, under this model, if it separated from Barclays Bank Plc, would still be a bank of such international significance that its failure could not be absorbed and handled without huge economic consequences.”
The Vickers report is likely to have significant effects on investment banks. What those will be is, however, impossible to tell with so many of the main details and specific legislation yet to be decided on. But it is clear that there will be fundamental changes to investment banks’ funding models, competitiveness and profitability.
