Debate on UK Bank Reform Misses the Point

Last Friday, the debate on UK bank reform burst into life, after Ed Miliband boomed that British banks have been “an incredibly poor servant of the real economy”. Labour, the party’s youthful leader told us, will “turn the tide”.

The UK’s five largest banks are “too powerful” and should be forced to give up “significant numbers” of branches, said Mililand. He’s right, given that the big-five still hold 85pc of personal accounts. “On day one” of the next Labour government, Miliband promised, steps would be taken to create two new “Challenger” banks to take on the existing “big five” and boost competition on the High Street.

All this, of course, is nothing but populist button-pushing. The public is rightly upset, not only about the role our out-of-control banks played in this ghastly sub-prime crisis, sparking the worst recession since the 1930s. There’s also near-constant outrage about the multi-million pound bonuses still trousered by the lucky banking few, including those at the top of partly state-owned outfits like Royal Bank of Scotland and Lloyds.

Last autumn, Miliband pledged to freeze household energy prices, another proposal tapping public discontent. That pushed “the cost of living crisis” to the top of the political agenda and the Tories, despite signs of economic recovery, have struggled to change that.

George Osborne responded last week by signaling the minimum wage could rise – from today’s £6.31, possibly up to £7 by 2015. The Chancellor’s move, though, was itself largely a spoiler, coming just a day before the Labour leader’s “day of reckoning speech” attacking the UK’s banks.

There is much about Miliband’s bank plans, just as with his energy-price ideas, which is financially illiterate and could be considered reckless. I’m no defender of the banking status quo (far from it) but caps on market share will encourage the dumping of poorer customers. And telling the new Competition and Markets Authority, the successor to the Office of Fair Trading, what to do is just wrong. The OFT was independent, which is why its judgments were trusted. Banking competition will come if business conditions are right and vested interests are tackled to lower barriers to entry. Miliband’s plan to “instruct” the CMA to conclude that we need two new state-run banks is nuts.

Enough of that, as the main point I want to make is that under cover of this Punch and Judy politics, this tit-for-tat trading of vague proposals, a highly significant banking policy shift happened last week which I haven’t heard mentioned by a single mainstream politician. It will heavily impact the conduct of Western banks and, in my view, make another collapse more likely.

Events in Basel are never likely to hit the UK headlines. Yet they should, because early last week, during a meeting of central bankers and regulators in the sleeply Swiss town, the international standard for the so-called leverage ratio, the main measure of any banks’ financial strength, was quietly but significantly weakened.

This move came after intense lobbying by deep-pocketed global investment banks. Once the deal was done, City firms wrote to their clients with news of “a series of victories”, a “better than expected outcome” and “a significant relaxation” in the post sub-prime regulatory regime.

Share in Barclays spiked 3pc the day after this news from Basel. Deutsche Bank rose 5pc. Compare that to the market’s response to Miliband’s anti-bank blast. The Labour leader’s scary rhetoric meant UK bank shares fell while he was speaking, but they quickly made up lost ground. Most ended the week with their share price up, not only due to what happened in Basel earlier in the week, but because investors soon realized Miliband’s plans are largely unworkable bluster.

The leverage – or loan exposure, for a given amount of capital – of Western banks has been rising steadily for more than a hundred years. At the end of the 19th century, British and American banks would typically hold capital equivalent to around 25-35pc of their loans. Such banks could absorb losses up to a quarter or a third of their outstanding loans, then, and remain solvent.

By the time of the sub-prime collapse, banks were far more complex, with massive (and often very risky) investment portfolios intertwined with their normal deposit-taking and lending activities.

Light-touch regulation throughout the 1990s and, especially, the early 2000s had allowed universal banks – combining retail banking and investment activities, functions previously kept separate – to build huge businesses based on their now unbridled ability to “lever-up”. The big banks borrowed against ordinary firms’ and households’ deposits and made reckless investments, knowing that their massive size, political connections and, above all, their holding of voters’ deposits, meant they’d be bailed-out.

By the time of the credit-crunch in 2008, then, RBS had capital reserves so meager it could cover just over 2pc of its loans and investments. So their leverage ratio was 2pc. This wasn’t unusual – with UK banks in general holding capital equivalent to less than 3pc of their loan and investment exposure at the time that global markets collapsed in the autumn of 2008. Banks like a leverage ratio in the low single digits, of course, as it allows them o make more profits, which are then channeled into executive pay.

Despite widespread calls for a higher UK leverage ratio from the likes of the Parliamentary Commission on Banking, the Government’s ears seem closed. Ministers, instead, are applying the deeply flawed Basel rules. While it makes sense to set rules globally, as the Basel seeks to do, the resulting capital adequacy measures are in terms of “risk-weighted assets”, allowing banks to continue making wildly optimistic assumptions about current and future losses. As a result, they can hold less capital, increasing the chances of another disastrous collapse – with all the bank bail-outs and related economic and fiscal damage that entails.

So what just happened in Basel? Well, far from imposing a leverage ratio of 5pc, 10pc or even 15pc, the committee continues to propose a leverage ratio of just 3pc – that’s right, only slightly above that displayed by the UK banking industry just before the last collapse.

At the same time, technical changes related to the “netting” of derivatives and the treatment of off-balance sheet items will now allow banks further to reduce the capital they’re required to hold for a given loan/investment exposure. It’s precisely what the bankers wanted.

American lawmakers have proposed banking rules that, while still far too weak, are slightly tougher than the Basel regime. This latest news from will give US banks ammunition to “seek a level playing field” and dilute their current safeguards too.

The UK has adopted the Basel rules, such as they are, earlier than most. Yet given our grossly-bloated banking sector, with a combined balance sheet equal to five times our annual GDP, we have the most to lose from changes such as these, which allow our already precarious banking sector to behavior in a manner which is even more risky.

Some claim a higher leverage ratio would curtail lending to credit-worthy firms and households. Really? Hundreds of billions of pounds have been sprayed on our banking sector in the name of “quantitative easing” – and still, loans remain scarce.

Our regulatory response to the sub-prime debacle is not only inadequate, but actually makes the problem of “too-big-to-fail” even worse. Her Majesty’s Opposition should be focused on that reality, rather than making populist, irresponsible proposals that will do nothing to help the electorate.

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