Parliamentary Commission on Banking Standards: NIESR’s Assessment

Last week’s official response to the Parliamentary Commission on Banking Standards’ (PCBS) five hundred page Final Report is another milestone along the UK’s financial reform process. Since this follows two earlier commissions on essentially the same subject, a certain amount of reform fatigue is inevitable.[1] Yet this stuff really matters. No less authority than two Nobel laureates, from quite different specialisations, (Robert Merton and Douglass North) come to the conclusion that the infrastructure of financial systems is perhaps the key to understanding economic development.

Because the Final Report has over one hundred recommendations, only the Commission’s main recommendations are considered in this post. The context for the Commission is described here. A second post on what we believe would be a better strategy will follow.

The coherence of all reports depends on understanding the question being asked. Each commission starts off with a reasonable preamble about why banking is important to an economy.[2] But then the issue of how we maintain our role as a world financial centre soon slips into the mix. The implicit assumption is that these two objectives are complementary. This need not be the case. Many other countries have perfectly good financial systems which are not dominated by global mega-banks. It is simply not necessary that three quarters of the credit to UK households and firms is supplied by systemically important global banks. Conflating the two objectives can lead to compromises which lead to inefficient outcomes.[3]

Let’s start with the good news. The PCBS report has individual responsibility front and centre of its recommendations. The existing Approved Persons Regime is finally recognised as no more than a gateway and the Government accepts the PCBS’ recommendations to introduce a Senior Persons Regime to assign key responsibilities and a Licensing Regime where staff are contractually required to adhere to a set of Banking Standards. Its effectiveness will inevitably depend on the precise standards, enforceability and sanctions. The PCBS and Government hope for an industry-led unified “professional body”, but seem doubtful this will ever happen.

Kenneth Arrow eloquently described how ethics can complement competition.[4] This is known in finance from the eleventh century Maghribi traders to the London Stock Exchange (“my word  is my bond”). See my earlier paper on trust. For codes to be effective, they must be in the interests of a body of agents with restricted entry and a particular credibility problem to solve. Where contracts are incomplete and property rights ill defined, the natural domain of the City, there is a case for reducing some regulations to create space for codes to emerge. This is not simply de-regulation, but removing safety nets.[5] A corollary is this requires full separation from retail banks.

The Vickers Commission introduced the idea of ring-fencing (small) retail and wholesale activities. Despite very clear evidence to the PCBS that ring-fencing would prove ineffective, the PCBS settled on “electrifying” or tightening the ring-fence. If the ring fence really is “electrified” then why not go for full separation? The only possible answer could be that a bank holding company would benefit from diversified income streams. Yet the most credible analysis shows that there is a diversification discount rather than a premium as governance issues more than offset any diversification gains (see IMF Study). The compromise of “electrifying” an abstract ring-fence is as absurd as it sounds and merely passes the buck for others to deal with.

The PCBS recommended a leverage ratio of 4% (up from 3% in the Vickers report), and that the Financial Policy Committee use the ratio as a macro-prudential tool with immediate effect. The Government rejected this recommendation. The PCBS also recommended that the Bank of England report to Parliament on the extent to which the shortcomings of Basle II have been addressed on Basle III. It is important to put this all into context. UK banks had an average 4% leverage ratio on the eve of the crisis and the minimum capital requirement in Basle III would not have saved any of the banks which failed. The Government is mistaken in rejecting the higher leverage ratio, but the increase is so small it is hard to believe it make a meaningful impact.

An area of agreement across all commissions and the Government is for more competition. The FCA will have a “proactive role” in promoting competition and the Government accepts that the PRA has a secondary objective of competition. Yet the proposals under discussion are almost surreal, namely, the portability of current accounts, which simply had nothing to do with the crisis (and may make runs even more likely). Nor is it clear how lowering entry standards or having lots of smaller but similar banks will make the system any better. Stability requires a diversified banking system, but this is not discussed. The fate of challenger banks such as Northern Rock, Anglo Irish and now Co-op Bank warrants a more thoughtful approach. Three of the most resilient financial systems (Australia, Canada and Singapore) deliberately operate oligopolistic banking markets.

Finally, we come to the most ridiculous PCBS recommendation that the that the lack of transparency, opaque fee structure and complex transactions in the wholesale markets should NOT be an area of concern. This beggars belief. Invoking caveat emptor without considering the enormous detrimental consequences for rest of the economy should earn the Commission a failing grade. The sudden closure of key wholesale funding markets amplified the losses throughout the banking system. For example, trading suddenly ceased in the UK mortgage backed securities market which had funded around half of all new mortgages. Regulators must ensure the infrastructure of systemically important wholesale markets minimises their vulnerability. These markets as well as banks provide funds to the real economy and so are a matter for public policy.

In conclusion, the PCBS is another incremental step towards banking reform. But given the seriousness of the crisis, one is struck by the timidity of each step.[6] On all the big issues of bank separation, capital and leverage, competition, wholesale market reform and individual responsibility the reform process leaves the system almost unchanged.[7] Some members of the commissions have regretted not taking bolder steps, suggesting they did not consider them to be politically feasible. But this defeats the point of having independent or at least non-partisan commissions. If this is for fear of tampering with the UK’s position as world financial centre, this may backfire. The strength of the City is its ability to innovate and operate in incomplete markets and not guardian to the biggest financial conglomerates. That dubious honour will go to the states which can afford the backstop.