The Case For Regulation: How To Tame The Banking Sector

Deregulation of the financial sector is widely accepted as one of the contributors to the recent banking crisis that reached a peak in 2008. The repeal of the Glass-Steagall Act in 1999 permitted the formation of one-stop super banks. Many institutions held and traded enormous portfolios of complex financial securities, the risks of which were not even sufficiently understood, let alone adequately provided for. During this time there was a degree of uncertainty between the FSA and the Bank of England over whose responsibility it was to regulate the banks. Things got out of hand. 

Then again, over-regulation was also a contributing factor. As explained in more detail in a previous article, the government’s involvement in the banking sector to guarantee deposits for individuals, and the central bank’s involvement as a lender of last resort, creates an environment which incentivises excessive lending and debt creation.

However one weighs up the factors, it is generally accepted that the banking industry will always require regulation, or at least for some time to come, and many urge that strict rules should be put in place as soon as possible to prevent any of the calamities of the financial crisis from reoccurring. 

This article discusses the merits and limitations of the new bank regulations proposed in the UK and gives some thoughts about an alternative solution. 

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The main objectives of the regulations proposed in the UK since the onset of the financial crisis have been twofold: to protect ordinary retail depositors from any potential losses taken by the failure of financial institutions, and to ensure that the taxpayer never again has to step in to rescue the banking sector. 

The government is supposedly considering the implementation of regulations proposed in an paper by the Independent Commission on Banking, commonly known as the Vickers report, which details three main recommendations to achieve this: 1) Ringfencing: in that the investment banking arm of any financial institution, and any activities that involve trading of OTC secondary market instruments, derivatives or global market services, must essentially be run as a separate organisation, outside of the impervious “ringfence” in which lies the retail ‘high-street’ banking business. This would protect you and me by ensuring our savings are ‘ringfenced,’ and hence protected if the riskier operations of the bank were to fail. 2) Loss absorbance: by increasing the capital requirements of banks, in order to ensure that they are able to take large losses without compromising their ability to cover their liabilities. This would protect the taxpayer, again you and me, from having to bail out the banks if things turned sour. 3) Competition: by breaking down barriers to entry in the industry, and increasing the ease with which people can make decisions and move their money around to take advantage of the best deal available. This would also aid you and me, in the long run, by creating more choice and better prices for the general public.

The banks, as an industry group, have received their fair share of resentment over the past few years and many politicians and organisations have suggested different regulations and reforms. Some also call for the power for regulators to delay asset purchases, and block them if necessary, to ensure that risky takeovers are not executed without independent and transparent due diligence. Proposals from Europe have also included bans on short selling and certain derivative trading that permit ‘bets’ on the negative outlook of governments or private institutions.

For the UK banking sector, the aspect of competition is of upmost importance. The market is somewhat oligopolistic, in that the majority of the industry is controlled by a small number of large firms. During the financial crisis, HBOS was bought by Lloyd Banking group and Alliance & Leicester, Abbey National and Bradford & Bingley were bought up by Santander. 

At the time of the report, the largest four banks accounted for 77% of personal current accounts and 85% of SME current accounts (small/medium enterprises). The government has since then sold Northern Rock, albeit at a loss, to Virgin Money, thereby creating another potentially significant competitor. The concentration of supply is bad for the consumer in any industry, and therefore splitting up the banking sector to promote healthy competition is a crucial addition to any regulatory plan.

The two main proposals put forward in the Vickers report (ringfencing and loss absorbance) have noble intentions, in that they seek to protect the savings of ordinary retail depositors and protect the taxpayer, and they will certainly achieve these goals to a certain extent. However, this plan begs two questions. Firstly, will the costs of implementing such reforms to the banking sector negatively affect UK banks relative to the rest of the world? And secondly, and most importantly, whereas these measures are focused on shielding us against potential bank losses, shouldn’t we instead be trying to fix the underlying problem in order to prevent these banks from taking any such big losses in the first place? 

The first question about the costs of regulation to the banking sector, will be covered in a future article on this blog. Watch this space.

In response to the second question, many of the ‘solutions’ proposed are not actually solutions to the problem at all, but measures to combat the symptoms and effects of the problem. Until now, those in favour of more government regulation in the banking sector have been thinking thus:

- We bailed out the banks in order to protect ordinary people with savings in the bank; good, but we also bailed out a lot of rich bankers and bond holders in the process; not so good. So by splitting the investment banking businesses from the retail banking businesses, risky trading activities can still continue but we ordinary folk will be protected from it; problem solved. 

- Most banks did not have enough equity capital to survive a big loss and many still don’t; this is bad. Therefore we should raise capital requirements; problem solved. 

- Big asset purchases were made without due diligence on the risk being taken (a classic example being RBS’s takeover of ABN Amro in 2007); this is bad. So in future let’s block takeovers until our accountants can do their own due diligence; problem solved.

These regulations do nothing to tackle the underlying problem. They seek to protect us somewhat from future shocks to the system, but they clearly do nothing to prevent these shocks from happening in the first place.

If we can create a banking system whereby the risks of excessive leveraging, complex securities trading and high yield investments and mergers are borne by none but who would accept such risk, then none of these regulations would be necessary.

The underlying problem is that people don’t understand the risk of their investments. This applies to both bankers and ordinary people like you and me who use banking services.

The bank managers certainly did not understand the risk of their investments. They undertook positions in foreign stocks and derivative financial products beyond their expertise and the potential financial gain blinded them to the need to accurately quantify the inherent risks involved.

Neither did we, the banks’ customers, understand the risk of our investments. In fact, most people don’t even consider a bank account as being an investment at all, though it really is. If these banks are in fact private organisations, then their decisions to take on risks are up to their respective management, and will therefore differ from one another, meaning that some banks are riskier than others. So if a manager wants to endanger its own organisation by taking on big risks, that’s their business and not ours, right? Well, unfortunately not; the nature of banks is such that, they have lots and lots of stakeholders, in that everyone with a bank account, has a stake in the company’s future. Bad management decisions can potentially affect millions of people that have accounts with the bank. For this reason it is necessary to make sure that you only put your money in a bank that you trust. However, this is easier said than done. In order to have trust in a bank you would need to have sufficient knowledge about the company's long term goals and sufficient confidence in the reliability and competence of the bank's management. 

"Your money is safe with us"

The success of any bank depends on trust; it always has and always will. The first bankers were goldsmiths. Back when gold and silver were traded as currency, smiths would assay coins and take deposits for safeguarding purposes, and so naturally they expanded their businesses into financial services. At this time in history, I put it to you, one would not entrust their gold to a smith, unless they had full confidence that it would be kept safe. One certainly wouldn’t permit the smith to lend that gold on to a third party. Therefore, bankers only built up their business by maintaining absolute trust with their customers.

Banking has obviously moved on leaps and bounds since then, most significantly in the following three ways. 1) Modern currency and banking laws permit paper and digital money to be traded instead of precious metals. 2) Banks can take the majority of the money you deposit and lend it on to other people. 3) People don’t need to consider the trustworthiness of their bank anymore, because the government guarantees its credibility.

Points one and two make storing your money in a bank a much more complex and risky activity than it was previously. Point three means that this risk is no longer conceived by the vast majority of the banks’ customers.

Nowadays everybody has a bank account. Absolutely everyone in the UK with any sizable amount of cash has a deposit in a bank. Banking has become such an integral part of our society that most people believe that the money in their bank account is risk free. Indeed the government even ‘guarantees’ the savings of each and every one of us via the Financial Services Compensation Scheme.

Although free from the investment risk and other risks that may come with a portfolio of stocks and bonds etc, a bank account is nonetheless still an investment, and every investment is exposed to the systemic risk of the economy and the human risk of bad financial decision making by the bank's management. Even the government guarantee itself is subject to the risk that the government may go bust, and all currency is subject to the inflationary risk of voluntary government devaluation via money printing, not to mention any other outside risks like war or natural disasters etc.

It is about time that we began to educate people about the risks of putting money in the bank, so that people think more carefully about what they do with their money. A more suitable form of regulation would have the objective of making people understand that banks are (or at least should be) private enterprises, and that all businesses can go bust. Now obviously the majority of people have neither the time nor the ability to do their own comprehensive analyses of banks in order to make informed decisions about where to put their money. So such an approach will initially have to come from the government.

This would involve: 1) dropping the government guarantees on public money and all Bank of England guarantees on bank liabilities. All banks would therefore be totally independent privately-owned institutions. 2) total transparency for all the banks’ financial affairs and agreed investment/growth strategy, with constant risk monitoring, to be managed, initially, by the government.

The government could feasibly begin to educate the public through a simple numeric or colour-coded system to symbolise the riskiness of all bank accounts. This could be similar to the AAA, AA, AB systems used by existing rating agencies, and could be simplified into broader bands to suit the general public. It would apply to all deposit accounts, savings bonds and investment funds. These measures would ensure that everyone begins to understand that by giving money to the bank, you have surrendered ownership of that money for a deposit note (which nowadays is a digital bank balance) and that nobody’s money is ever completely and absolutely 100% safe. Every bank account has a risk.

This would have several huge effects on the banking sector. Firstly, it would change the face of banking. It would reward prudent banks, and punish the big risk-taking banks. Given the information about the inherent risks of banking, and the government's strict new no-bailouts policy, people would start to value greatly the knowledge that their money was safe. This way, the accounts of small banks with very prudent investment strategies would be given relatively ‘safe’ government ratings and would see their popularity grow, and therefore so would the bank's deposits and profits. It would reinstate the concept of trust into the business and bring back the traditional more personal aspect of entrusting your money with a person, or a group of people, that you know and trust with your money. The current system, with a constant government back stop, and the central banks as a lender of last resort, punishes prudent banks and instead rewards the more profligate ones that attain higher returns for their customers, albeit through risky exposures. Even worse, it creates an illusion to the common man, that all banks are the same. So long as we have these government/taxpayer guarantees, banks will always be competing by offering higher returns rather than by offering higher security. 

Additionally, admittedly and unavoidably, it would cause a little bit of temporary chaos. Some people would be shocked to find out that there was in fact a small risk attached to having a bank account and no doubt there would be a number of especially prudent people who would withdraw their money and stash it under their mattress for a while until they could find a suitably extra-safe bank. This temporary wobble to the banking system would be a long awaited and wholly necessary change that would see the race for banks to alter their image to one of security and could even see the rise of several small banks as people take flight from the larger ones.

This ratings system would require constant up to date reevaluation of the capital positions of banks and their exposure to market risks, a job that would be initially done by government regulators, accountable to parliament. Such a system could have online government information sources for those that want more detail, and over time, even more complex investments would be coded in the same way to encourage people to compare their bank accounts with more risky investments, not least for a sense of proportion. Once stable, this work could feasibly be passed on to private ratings agencies, so long as the government regulators continued to monitor the balance of power in the industry and any factors or special interests that may compromise impartiality. Other non-competition-damaging regulatory measures could also be introduced such as prioritising retail account holders in insolvency processes.

It would take a great deal of change in the established way of thinking for those in power to give in to such reforms, but understand that with the current state of affairs, as talked about in a previous article, something has to give, and the longer we remain closed off from the ‘less mainstream’ ideas, the more likely it appears that our current financial system will slip into the brink.