Today's Interim Report from the Independent Commission on Banking contains some useful thinking, but on its central task – consideration of the structure of the industry – it fails properly to diagnose the problem, fails even to consider the most useful potential reforms, and produces a proposal that will make things worse, not better.
Let's start with the good ideas.
As I have explained before, in January the European Commission proposed the introduction of Special Administration regimes for banks, in which bondholders were subject to semi-automatic conversion of their bonds into equity in the event that banks become distressed. The Vickers Report (section 4.43ff) is supportive of this idea. It also (section 4.47-48) is sympathetic to the concept of making depositors into preferred creditors.
This approach (now described as "bail-ins") is, as regular readers will know, what I urged should happen in 2008 and 2009 instead of the taxpayer "recapitalisation" bailouts. So obviously I'm gratified that Vickers and the European Commission have caught up on this point.
Here's a nasty question, though, which few in the press seem inclined to ask. In 2008-9, when I proposed this, I was told the idea was unworkable, that no government could contemplate allowing bondholders in a bank to lose out, and that all serious opinion favoured the bailouts. Indeed even now, after the UK has had the worst recession since the 1920s and the bailouts have totally bankrupted Ireland, and with us even yet – four years into the banking crisis – still chucking a few more tens of billions at the banks every few months (now relabelled "sovereign debt bailouts"), almost all UK commentators still hail Gordon Brown's late 2008 policy as masterful and claim that there was no credible alternative. But if bail-ins are to be one of the centrepieces of how authorities deal with future banking crises, why was it so impractical for them to be used in 2008-9? Why, when we could have used bail-ins, did we prefer to nationalise banks, destroy the functioning of private capitalism, induce the worst recession of modern times, and bankrupt several states?
The Vickers Report also has some sensible things to say about competition. The European Commission, of course, already requires certain of the UK nationalised banks to sell off some of their assets. And the European Commission has indicated that it intends to instruct far more such sales. The Vickers Report backs up what the European Commission has said. Final proposals will need to be more detailed and specific, but the thrust is clear and welcome.
Now let's turn to the less welcome elements. These are the proposed subsidiarisation into retail and investment banking units; the increased capital requirements on systemically significant retail units; and the failure to engage with the reforms that would potentially be most useful.
The Vickers Commission was set up to resolve a debate between elements of the Coalition. Vince Cable had gone out on a limb insisting that banks had to be divided – full separation – between retail ("utility") components and investment ("casino") components (along the lines required by the 1932 Glass-Steagall Act in the US). Osborne, by contrast, had urged that the key structural reform should be the break-up of banks into smaller units when the government privatised the nationalised (or quasi-nationalised) banks – perhaps creating six banks out of the three nationally-owned (or part-owned). Rather than having a row about this immediately, the Coalition set up the Vickers Commission to look into the issue of retail/investment banking separation and competition issues.
Cable's central point was that government guarantees of depositors were used by the banks to engage in high-risk activities. He was right about that, but his conception of how far-reaching this problem was didn't go far enough. For it is not correct to suggest that "retail" activities of banks – deposit-taking, lending to businesses, lending for mortgages, lending for personal loans – is risk-free. Indeed, the Vickers Report correctly and repeatedly argues (e.g. paragraph 4.63 footnote 37, paragraph 4.75-4.76) that retail lending is an intrinsically risky activity. To remove the incentive for firms to take risks off the back of government guarantees, we would need to restrict what banks do with government-guaranteed funds much, much more than simply to retail activities. What would, in fact, be required is to mandate that, with deposits guaranteed by the government, all that banks can do is to buy government debt – so the government guarantee is only in respect of its own debts (plus of course the regulation that requires the bank to do what it says rather than act fraudulently). That would be the storage deposits that I proposed in Incentivising Boring Banking and of course earlier in What Killed Capitalism? and here.
Thus, one way to think about what Cable gets wrong here is that he sees the problem, but is too timid in his solution. It is tempting to spin the Vickers Commission proposals as involving a variant of the storage deposits concept – a set of insured deposits ring-fenced from the other activities of the bank. Vickers does indeed have one variant of its scheme as including only deposits within the ringfence, and activities such as mortgage or commercial lending outside the ringfence. But the Vickers Commission does not even offer explicit consideration of my storage deposits concept – despite storage deposits being endorsed by Mervyn King and by the Davis (Which?) Commission on the future of banking. The closest Vickers gets to considering the idea is in a discussion of the concept of abolishing fractional reserve banking and requiring, instead, 100%-backed banks (a concept I don't support – remember, 100%-backed storage deposits are to coexist with ordinary fractional reserve "investment deposits"). I have every confidence that Osborne and Cable's teams won't make the same mistake of failing even to consider storage deposits - by doing so, the Vickers Report has diminished its relevance.
The Vickers Report recognises that retail banking is intrinsically risky, but does not properly follow through the implications. The subsidiarisation into retail and investment banking units is intended to make it easier to allow the investment bank to fail without the government being tempted to bail it out. But such subsidarisation will make it more likely that the government will feel it has to bail out the retail bank! So implicit guarantees will be strengthened, not weakened. But the key task should have been to identify structural solutions that made it more plausible that the government would not bail out anyone!
If government guarantees to retail units are strengthened, such units will have greater incentives to engage in risky practices. They will lend to more risky businesses, lend on riskier mortgages, make risker personal loans. So more people that should not receive loans will be dragged into debt and default. That will increase macroeconomic volatility, because the businesses concerned will close down and the individuals concerned will fall into bankruptcy. The Vickers Commission seems to neglect this point, being focused upon how to shield the retail banking unit from collapse – as if banking sector collapse were the only source of macroeconomic volatility. But even here its solution is unconvincing. It recommends increasing capital requirements for systemically significant retail banks by an additional 3% to 10% of risk-weighted assets. But that isn't remotely enough to prevent there being circumstances in which a retail bank will go bust (the Vickers Report itself points out that falls of only 3.5% in the value of assets would wipe out capital – with 10% ratios that only rises to 5%).
And the solution isn't to require even higher capital ratios! Even were it possible, it would be totally counterproductive to force banks to hold so much capital that they could never go bust. Quite apart from the fact that we want businesses taking risks and innovating, company failure is an essential and ineliminable part of the competition process. One of the most important obstacles to new entry in the banking sector, impeding competition, is that failing banks are saved by the government. In other sectors, a successful new entrant will tend to undermine incumbent competitors, so if it is successful one or more of its rivals will go bust, creating a space for it in the market. In the banking sector, a successful new entrant making one of its rivals go bust will see that rival subsidized by the state and then biting back on the new entrant, undermining its competitive position such that it, in turn, goes bust. If you can't kill off your rivals to make room for yourself in the nest, you aren't going to be a very successful cuckoo.
Thus, although its proposals on bail-ins and competition are okay as far as they go, in its most widely-advertised elements – subsidiarisation and increased capital requirements – the Vickers Report is going down the wrong path. Implementing these proposals would miss the opportunity to address the real issue – government guarantees of deposits that are then used in intrinsically risky activities – and, by making it even more certain that governments bail out retail units and by increasing real economy volatility through riskier retail lending, would make the banking sector's structural problems worse, not better.