Safeguarding the banking sector: Lessons learned from fallout

8 Min Read

As a response to the fallout caused by the financial crisis in the past years, the Independent Commission on Banking was tasked in June 2010 by the UK government to consider reforms to the UK banking sector.

The move was a bid "to promote financial stability and competition, and to make recommendations to the government by the end of September 2011."

The Independent Commission on Banking published its Interim Report earlier this month, and a specially convened Lafferty Group webcast was organized to discuss the report directly after its publication. Lafferty Group is a banking think tank with operations in Egypt.

The report asked how to make the system safer for the future? And a lot of the answers can be useful for Egypt’s banking sector, which has already undergone years of reform with more in the pipeline as more Basel requirements come into the fold.

According to the report, one essential part of the answer is better macroeconomic — including ‘macro-prudential’ — policy so that there are fewer and smaller shocks to the system.

“Making the banking system safer requires a combined approach that makes banks better able to absorb losses, makes it easier and less costly to sort out banks that still get into trouble; and curbs incentives for excessive risk taking,” the report said.

It adds that these inter-related goals ensure that the more bank owners and creditors stand to lose when things go awry, the stronger their incentives are to monitor risks in the first place. This expands their capacity to shoulder losses without damage to others when risks go bad.

Bruce Packard, head of financial research at Seymour Pierce Stockbrokers London, said “This whole thing started in 2007, if you think about the history of financial crisis over the last few decades we’ve had some sort of blow up every five years. Since this one started in 2007, were due another crisis in 2012.”

“The next crisis will prove if the credit markets believe that the investment banking subsidiaries will be allowed to fail and the retail depositors will be protected. At the moment credit markets think this is fine and banks will be able to arbitrage they feel that this really doesn’t make any difference to their business model.”

The commission said that instead of traditional “too big to fail” rhetoric, larger banks may in fact be “too big to save” due to the effect of crises on public finances, impacting output and employment. Being so large gives these banks an unwarranted competitive advantage over other institutions, and will encourage too much risk taking once market conditions normalize.

The commission agreed that the 10 percent equity baseline should become the international standard for systemically important banks, and that it should apply to large UK retail banking operations in any event.

“The capital standards applied to the wholesale and investment banking businesses of UK banks need not exceed international standards provided that those businesses have credible resolution plans so that they can fail without risk to the UK taxpayer,” said the report.

Turning to the structural aspect of reform, the Commission questions whether there should be a form of separation between UK retail banking and wholesale and investment banking. It said that “ring-fencing a bank’s UK retail banking activities could have several advantages.”

For the commission, it would make “it easier and less costly to sort out banks if they got into trouble, by allowing different parts of the bank to be treated in different ways. Vital retail operations could be kept running while commercial solutions — reorganization or wind-down — were found for other operations.”

According to the report, “it would help shield UK retail activities from risks arising elsewhere within the bank or wider system, while preserving the possibility that they could be saved by the rest of the bank. And in combination with higher capital standards it could curtail taxpayer exposure and thereby sharpen commercial disciplines on risk taking.”

As to the form that separation might take, the report suggests a balance between the benefits to society of making banks safer and the costs that this entails — choosing ring fencing over full separation.

“While full separation may provide the strongest firewall to protect retail banking services from contagion effects of external shocks; it would lose some benefits of universal banking. On the other hand, it is doubtful that separability of operational systems, though desirable for effective resolvability, would itself be enough,” the report said.

Abdul Rahman, professor of economics and finance at the University of Ottowa, said, “If I agree that there are economies of scope between investment banking operations and retail banking, there is a great demand on bank directors to insuring that these so-called economies of scope are obtained in a way that does lead to inefficient transfer pricing between the different groups.”

“I haven’t seen much thought about this in the report but there is a significant responsibility now on board directors in insuring that these objectives that are spelled out in these recommendations are met,” he added.

Peter Suraparu, executive vice president of the American Trust and Savings Bank, compared the findings of the report with what happened in the US with the Dodd-Frank Act.

“It is interesting for us here in the US having gone through a rather significant round of banking reform ourselves over the past 12-18 months through the Dodd-Frank act, which actually addressed some of the issues which the Vicars report is attempting to this morning.”

“Dodd- Frank actually created a consumer financial protection bureau here in the US which is still in its formative stages but should be fully operation by midsummer, and those directives that the Dodd Frank act gave to the bureau mirror what the Vicar’s report is attempting to do with the separation of virtual separation of retail banking from other elements of universal banking.

“When you look at ring fencing would be effective, I think there has to be recognition that retail deposits are a significant driver of overall bank profitability and must be recognized for that.”

“Whether there is fear internal transfer pricing being applied or whether the government can provide protection to continue the flow of retail deposits into the banking system, as soon as soon as consumer feel unsafe in delivering their deposits to their local banks that’s when the music may begging to end for the banking system in any country.”



Share This Article
Leave a comment