Sir John Vickers

The UK government is expected to announce this month that it will implement in full the far-reaching reforms proposed by the Independent Commission on Banking. What will this mean for the UK banking sector?

Policy-makers and regulators around the world have been working overtime to improve the stability of their countries’ financial systems, make their banks safer, and make it easier to sort out banks that get into trouble. But few have been as radical as the UK in their proposals.


Summary of the ICB recommendations

The Independent Commission on Banking, led by Sir John Vickers, consulted widely with banks and other interested parties and made three main recommendations.

1. It recommends that banks’ domestic "retail banking activities should be structurally separated, by a ring-fence, from wholesale and investment banking activities". Domestic means anything within the European Economic Area. Structural separation would “insulate vital UK retail banking services from global financial shocks”; make it easier and less costly “to sort out banks” that got into trouble; and still allow the global wholesale and investment banking activities of UK banks to follow international standards and remain competitive.

2. It proposes that banks should have “more equity capital and loss-absorbing debt” beyond what has so far been internationally agreed in Basel III. In particular, the ring-fenced banks should have equity capital of at least 10% of risk-weighted assets and corresponding limits on overall leverage; and the entire business of banks (the wholesale and investment elements, as well as the ring-fenced retail activities) should have primary loss-absorbing capacity – equity plus long-term unsecured debt (bail-in bonds) that readily bears the loss at the point of failure – equivalent to 17% to 20% of risk-weighted assets.

3. It proposes measures to improve competition, including:

• That Lloyds Banking Group should sell a sizeable part of its business, large enough to lead “to the emergence of a strong challenger bank”.

• That a system be introduced to make it easier for personal and small business customers to switch banks. 

• That competition be made central to financial regulation by giving the new Financial Conduct Authority a duty to promote effective competition.

The commission proposed that the reforms should come into effect no later than 2019, the Basel III deadline.

The Independent Commission on Banking (ICB), set up by the country's coalition government last year and led by former chief economist of the Bank of England Sir John Vickers, is a case in point. In its final report published in September it recommended that the domestic retail banking operations of UK banks be ring-fenced from the more risky wholesale and investment banking activities; that higher levels of capital be held; and that more competition be encouraged (see box). The UK treasury is expected to accept its recommendations in full this month.

HSBC doubts

So what do bankers think? They are hugely fearful that the regulations will put them at a disadvantage to international competitors. The UK banks with large international operations – HSBC, Barclays and Standard Chartered – are the most concerned and worry that capital measures may be applied to their global rather than their domestic balance sheets. Reports have circulated that they may end up relocating elsewhere.

The issue raised its head again in November when HSBC CEO Stuart Gulliver was fairly forthright publically about the extra costs that might be imposed. Later in an interview with The Banker (a fuller version of which will appear in our January issue), he said: "The [ICB] issue for us is the primary loss-absorbing capacity [ICB recommendation is for bail-in bonds on top of 10% equity capital to take total capital to 17% to 20%]. We have an asset-deposit ratio of 75 [compared with one of 160 for some UK banks], which is very conservative, and because we have high core Tier 1 equity, we don’t really have any bonds. We don’t need them. The only bonds we have are in the US and supporting Household [HSBC's US subprime business] so are not able to be bailed in in the UK.

"If this were applied globally to our $2700bn balance sheet funded with deposits, we would have to leverage up the balance sheet by issuing $55bn of bonds and using the funds to buy gilts. The carrying cost of this is about 400 basis points [bps] assuming the bonds would be deeply subordinated because of depositor preference – so they would probably be 300bps over where we issue senior debt – and assuming a 100bps carrying cost on gilts. That works out at about $2bn." 

Barclays' tentative support

Barclays CEO Bob Diamond is more circumspect. At an Institute of International Finance conference in Washington, DC, in September, he said: “I think with this report, what Sir John and his team have been able to do is lift a cloud off of the UK to some extent in that we now know where it is going. The focus is on allowing the international components [of banks to develop]. Certainly for Barclays it is important for us to operate on a level playing field with our US and German and other international competitors.”

“Because of my passion and belief that recovery and resolution can happen without a ring-fence this would not have been my first choice. My first choice would have been operational subsidiarisation, resolution and recovery. But we can live with this and we can make it work.”

Interestingly, the chairman of this panel debate in which Mr Diamond took part was Peter Sands, CEO of Standard Chartered, who asked about the same issue worrying Mr Gulliver – the loss-absorbing bonds. But Mr Diamond failed to be drawn on this only repeating that he believes it is workable.

Mr Sands wrote in a newspaper article before the final report was published: “Imposing structural change on banks is a blunt instrument that will almost certainly have unintended consequences. The last thing the UK needs right now is a raft of measures that make it even harder for banks to support economic recovery and job creation." However, the ICB's recommendations will soon become a reality and the UK's banks will have to adapt accordingly, even if they are eligible for exemptions within some areas of the new rulings. 

BBA response

Angela Knight, chief executive of the British Bankers’ Association (BBA), says that while the ICB's intentions are “worthy”, she has reservations about some of the action proposed.

On ring-fencing, Ms Knight says it would come at the cost of “upping organisational complexity". "With a ring-fence in place, the bank loses the benefits of diversification," she believes, which can actually work against financial stability, reinforcing the tendency of retail and small business lending to be procyclical in nature. Ring-fenced UK banks would be at a disadvantage to those from other countries that would be able to provide cheaper retail and wholesale banking services into the UK from outside without the constraints of a ring-fence.

On the proposed increase in primary loss-absorbing capacity for the entire bank to 17% to 20% of risk-weighted assets, Ms Knight is also critical. She notes that this is more or less double the standard set by Basel III, and while it may make the system more stable it would be at a high cost of capital, a cost that would be passed on to customers in the form of higher prices. If banks decided not to, or could not, raise the additional equity and debt required, they would have to de-leverage and reduce lending.

RBS's mixed feelings

Stephen Hester, chief executive of RBS, declared at a conference in October that the bank was “supportive” of the commission’s proposals on capital, and that its recommendations on competition seemed to be “workable and manageable”. However, RBS was “critical of the ring-fence”, which put the ICB proposals as a whole “at the tough end of where the range might have been”.

“These proposals, and in particular the ring-fence, will be significantly negative to all those banks affected in terms of funding cost [and] in terms of capital held…and therefore a significant drag on return on equity,” says Mr Hester.

The heads of Britain’s five biggest banks gave evidence on the ICB report to the House of Lords Economic Affairs Committee in October. Here, Barclays’ Mr Diamond said he was against ring-fencing because it would add costs to UK banking and would not provide any additional safety to the higher capital and liquidity requirements already proposed in Basel III. Douglas Flint, HSBC chairman, told the committee he was worried that the ICB recommendations, if implemented, could reduce the attractiveness of UK banks for investors.

These proposals, and in particular the ring-fence, will be significantly negative to all those banks affected in terms of funding cost [and] in terms of capital held…and therefore a significant drag on return on equity

Stephen Hester

Building societies' view

Building societies – mutual organisations owned by their customers – take a more positive view. Andrew Gall, an economist at the Building Societies Association, says his members like the ring-fencing idea, especially as it is partly based on long-standing building society legislation which prevents societies operating outside certain boundaries.

“The ring-fence should not have huge ramifications for building societies because they have, in effect, already operated within a ring-fence for many years,” says Mr Gall. “We hope the ring-fence will reduce the implicit government subsidy to the largest and most complex banking groups so we are able to compete on a more equal basis.”

As for the ICB’s recommendations on the core Tier 1 capital ratio for ring-fenced banks, the BSA is “pleased to see that there is a sliding scale so the smaller institutions would not have to hold more than the Basel III minimum”. Only the largest institutions would have to hold 10% of their risk-weighted assets (the 7% Basel III minimum plus a 3% ring-fence buffer), and among building societies only Nationwide falls into that category.

The smaller institutions, which includes all other societies, would only need to hold the 7% Basel III minimum. Medium-sized institutions would fall somewhere in between the 7% and 10% ratio, depending on the size of their risk-weighted assets as a proportion of UK gross domestic product, and only the Co-operative Bank among BSA members falls into that category.

However, the BSA is worried about the ICB’s proposed leverage ratio, which is the amount of capital that institutions would have to hold as a proportion of their unweighted assets. The ratio proposed would be 3% of core Tier 1 capital (as in Basel III), and up to 4.06% for larger institutions. As it takes no account of the riskiness of assets, it could be detrimental to building societies because they have large volumes of low risk-weighted assets such as mortgages.

Andy Caton, corporate development director of Yorkshire Building Society, supports the proposal to put a limit on ring-fenced banks’ wholesale funding. “Building societies already have a legislative cap of 50% on wholesale funding, and individual societies agree caps with the regulator that are a lot lower, so we think similar restrictions on ring-fenced banks are a sensible idea,” he says. “On a standalone basis they will have to act much more as we do by raising retail deposits to fund retail lending.”

This could, though, have a negative consequence for building societies. Starved of wholesale funds, newly ring-fenced banks are likely to compete more aggressively for retail deposits and offer better rates, "which could lead to disorderly behaviour on the retail deposit market", says Mr Caton.

Objective viewpoints

David Strachan, co-head of the Deloitte Centre for Regulatory Strategy, and until this year director of financial stability at the Financial Services Authority, believes the UK government will implement the report’s high-level recommendations in full.

He envisages some difficulties. First, the higher capital requirements for ring-fenced banks may be above the maximum permitted by the Capital Requirements Regulation IV, which transposes Basel III into EU law. Second, creating a ring-fence could cause "significant operational disruption and complexity", says Mr Strachan. "The logistics, practicalities and legal complexities of moving activities, customers and businesses to the right place would be a major undertaking."

Third, the ICB was clear that the prime driver of the ring-fence is less to do with making banks safer and more to do with resolving them should they fail. “I can see how that works in relation to a ring-fenced bank, but the big unanswered question for me is the resolvability of what is outside the ring-fence – in other words, the complex cross-border investment banking business. The ring-fence does not deal with that issue at all. If the ultimate objective is to get to a position where a bank is allowed to fail, and can fail in an orderly fashion, it strikes me that we are still a long way from that objective. The Financial Stability Board’s latest paper on effective resolution is a step in the right direction,” says Mr Strachan.

Cynthia Chan, senior director, financial institutions, at Fitch Ratings, notes that the “pragmatic approach” taken by the ICB, coupled with the long implementation timeframe, means “there are no immediate rating implications”. However, the reforms will significantly weaken implicit government support for all banks, which will probably impact ratings longer term.

The only “surprise” for Ms Chan was the recommendation that all banks should have primary loss-absorbency capacity (equity plus long-term unsecured debt) of 17% to 20%. The debt element would have to be re-financed every three to five years, “which could create a refinancing cliff”.

Ms Chan says the ICB goes beyond banking resolution reforms being considered by other countries. A Fitch survey of European fixed-income investors, for example, showed that they do not believe other countries will follow the UK’s example.

Whether the ICB recommendations are being sensible, or over cautious, only time will tell.


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