Will the Suggestions of the Vickers Commision be Taken Seriously?

Ronan Jack, 20 April 2011

Categories: Finance | Politics |

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In recent years, we have seen a massive financial meltdown due to over-lending, over-borrowing and poor regulation. The Government believes that the current system of financial regulation is fundamentally flawed and needs to be replaced with a framework that promotes responsible and sustainable banking, where regulators have greater powers to curb unsustainable lending practices and we take action to promote more competition in the banking sector. In addition, we recognise that much more needs to be done to protect taxpayers from financial malpractice and to help the public manage their own debts.

Above is the first paragraph of the coalition agreement that forms the basis of the current government. It was placed first in recognition of the importance of the issue.

There are different strands in the Government's approach to this. There was Project Merlin, previously discussed on News Unspun. The ineffectiveness of this initiative was strongly criticised by Lord Oakeshott, former City financier and Lib Dem Treasury spokesman, as he resigned his post. Part of Project Merlin was about tackling excessive bonuses. Barclays boss Bob Diamond showed what this delivered as he assured the Treasury Select Committee that restraint was being shown in pay and bonuses, while subsequently accepting a bonus of £6.5m.

The Select Committee itself is another strand which looks at what should be done about the banks. However, the head of the British Bankers' Association, Angela Knight, who has previously told us to get off bankers' backs, refused to attend the committee.

Following these gestures of contempt shown by the banking world, will the third strand, the Vickers Commission, be taken any more seriously?

The Vickers Commission

The Independent Commission on Banking, or the Vickers Commission, was established in June 2010 against a backdrop of concern and anger at the way banks had spiralled out of control. Their actions had led directly to the global financial crisis, the taxpayer had bailed them out to the tune of billions. In December 2010, the National Audit Office estimated the taxpayers' exposure to be £512bn, and direct investment £124bn . The exposure has gone down from a year previously, but could rise again. This is the setting described in the coalition agreement quoted above. The Commission has just released an interim report, the final version being due in September.

The interim report provides four main recommendations: banks should ringfence their more speculative activities, rather than split into wholly separate commercial and investment banks; they should keep more capital as a safeguard against market turbulence - 10% of their capital base rather than the 7% required under the Basel III standards; switching between banks should be easier for customers; and Lloyds should sell some of its branches.

Reactions to the report

The Telegraph called it a "radical shake-up", though the text of the story didn't seem to reflect the headline too well. Most other comment is unfavourable; a fudge which "will do nothing to puncture the arrogant complacency of the banking system" (Daily Mail) ; "No sign of the revolution we were promised” (Guardian) ; a "cop-out" (Michael Meacher) ; "Intellectual mush" (Independent) . The Financial Times, whose chief economic correspondent was one of the five Commission members, is less critical, calling it a sensible path towards reform and an agenda for debate rather than a set of answers. A further FT article claimed that the report was tougher than critics were supposing, and the banks should not feel they were off the hook.

The banks have also been critical of the report, warning that their costs will rise and will have to be passed on to customers (it is not clear whether they considered finding the money from bonuses instead), and repeating the dark mutterings about leaving the country, like petulant children.

One of the most telling reactions is what happens in the stock market. If the proposals looked as though they would seriously curtail banks' activities, shares would fall. In January, it was thought that the report would propose a radical reform of banking; shares slid. Last week though, with the release of the interim report, bank shares rose and Barclays and RBS added £1bn to their value.

This strongly suggests that the markets think banks are going to face little disturbance, and that the measures proposed are not going to curtail their activities. The banks must make a show of being upset, in case people think the report has been too soft on them, but the bottom line is that this set of proposals has added a large amount of value to the banks' share prices.

Problems with the report

What are the problems with the report? Much of it is quite sound. It covers a lot of ground, delves into a lot of material, reviews what is happening in other countries, and makes recommendations which can create a better buffer against market upheaval, making banks better able to fend for themselves before turning so quickly to the government for assistance.

The banks are complaining that the requirement to hold more capital would be costly. The report explains that under the Basel III requirement to hold equity capital equivalent to 7% of their assets, this could still mean (depending on the risk weighting attaching to those assets) that their capital would be wiped out if asset values fell by a small percentage. That is the case for requiring greater capital holdings, and the banks' objections are unlikely to carry much weight, bearing in mind the collapse in asset values we saw in the recent financial crisis.

Predictably, Lloyds are unhappy about being told to sell off some branches. And the bankers are saying that having portable bank account numbers to make it easier to switch accounts would be expensive and unnecessary. Both arguments appear purely self-interested.

More fundamental criticism has come from the New Economics Foundation, which points out that the Commission appears to say that banks use deposit to provide loans to businesses and consumers, whereas in fact banks create money as debt, out of nothing, rather than lending out real money from savers. The people on the Commission must know this, including as they do two bankers as well as Martin Wolf, the respected financial journalist.

This is not a minor point of detail. What follows from this is that money is mostly created by private banks, not by the government. In creating this new money, the banks add to their own wealth, because they have created a debt to themselves without actually forgoing anything or creating anything of value in the real world. As a result, they continue to extend credit, create debt, and enhance their own wealth. That is why private debt has exploded. Banks have a direct financial interest in creating more debt. This is not widely understood, and most people probably think that banks lend out real money which has been deposited with them; and also think that the money supply grows mainly because the government prints more money. Both of these assumptions are untrue.

Ann Pettifor explains that the level of public debt in the UK is 58% of gross domestic product (GDP), the level of private debt is 450% of GDP. We are endlessly told that public debt is unsustainable, but the real problem is the extent of private debt. The Commission does not tackle the role of the banks in actively promoting unsustainable levels of private debt. It is a massive failing, which Pettifor describes as "a fundamental flaw in analysis and approach, [which] dooms the commission to obscurity".

Similarly, there is little discussion of the role of the "shadow" banking sector, the network of special purpose vehicles, hedge funds and other financial intermediaries which are used by banks but which remain outside of regulation. Its existence is recognised, and Appendix II sets out a description of it. Again, this is not a trivial oversight. The shadow banking system was almost twice the size of the traditional banking sector in 2008, according to the Federal Reserve Bank (FRB). Banks use the shadow sector to evade regulation.

Although many elements of the shadow system have shrunk in the global crisis, it remains larger than the traditional banking sector, and has an enormous effect on the economy. It is the elephant in the room, and the Vickers Commission opts not to talk about it. In the view of Gillian Tett of the Financial Times, the failure to scrutinise the role of this sector during the financial collapse "was a striking, terrible omission". Tett is quite right, and the Commission makes the same mistake.

What next?

Between now and the final report, there will be a lot more lobbying. The banks will seek to water down even the tepid recommendations made in the interim report. For those who share Ann Pettifor's view that the report is "a huge missed opportunity; a betrayal, some might say", there is also the chance to press politicians to take the issue more seriously, and in particular, to demand that the casual arrogance shown by bankers on the bonus issue is not allowed to sweep this larger and more important issue under the carpet. One starting point would be to ask MPs if they have read Gillian Tate's article on the shadow banking sector; if they are content that it remain unregulated; and what they propose to do to ensure that it is addressed. We have hit this particular iceberg once already, and once is more than enough.

Banks are always trying to escape regulation, including by moving to softer jurisdictions, setting up subsidiaries in tax havens, using the shadow sector to evade regulatory control, and devising transactions which are so complex they become impenetrable to regulators. These things directly contribute to rising levels of private debt, instability in the financial sector, and the recent crisis. The UK cannot control this alone, and global action is needed, but the Vickers Commission is one opportunity to address some of the weaknesses in the system. That opportunity will be lost if the final report echoes this draft.

Categories in which this article appears: Finance | Politics |

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