Ring-fencing and the ICB – elegant, simple, but wrong
The ICB is right to seek ways to ensure that taxpayers do not bear the cost of banks’ failures. However, recent parliamentary legislation, together with developments at EU level and arising from the FSA, will deal with these problems in a way that will be much more effective than that proposed by the ICB. The key to banking reform must be the development of resolution procedures to ensure that failed banks can be wound up. The ICB proposals for the general ring-fencing of retail and investment banking operations are not the best way to achieve this objective.
It is interesting to see that the second ICB report has a different emphasis from the interim report. The popular reason suggested for separation – often repeated by Vince Cable – is that the risky investment banks might bring down the safe retail banks. However, both investment and retail banks take risks and the diversification of a bank can help reduce the risks it faces. The main events that precipitated the crisis did not arise from the infection of a retail bank by an investment subsidiary but by risks accumulating in different types of institutions – some pure retail banks, some pure investment banks.
Instead, the ICB report has used different justifications. Firstly, it is suggested that by ring fencing retail banks we can make them so well capitalised that they will never fail – working for retail banks will become a bit like working for the civil service (except with much higher pay and bonuses). Secondly, it is argued that the separation will make the banks simple enough to facilitate a resolution if either the investment or the retail part goes bust.
However, as we saw in the crisis, if we do not have credible resolution procedures then investment banks will not be allowed to go bust in any case. On the other hand, if we do have credible resolution procedures, then why not apply them to retail banks too (therefore removing the need for huge capital buffers)? What would happen if we had an extremely complex investment bank or an extremely complex retail bank? The ICB approach smacks of the approach of a mathematician to an economic problem. An approach that might have been appropriate would be to give the Bank of England powers to require ring-fencing – or some other organisational change – in a particular bank that did not have a credible resolution plan. In other words, the main job of the Bank of England would be to ensure that primary law applying to the insolvency and administration of failed banks could be applied to all banks in practice. This would come close to the ideas set out by Geoffrey Wood of Cass Business School in the IEA publication Verdict on the Crash.
During the US Glass-Steagall regime, there were huge failures in the separated investment and retail banking sectors that led to government rescues and the development of the ‘too-big-to-fail’ mentality. Separation is an elegant solution looking for a problem.
The ICB report was disappointing in other respects. It discusses at length the adverse affects of tax discrimination against equity finance but makes no recommendations other than for more regulation of banks’ equity capital.
The government has welcomed the report. This is unfortunate but, given that it has, it should also respond by immediately abolishing the bank levy. The explicit justification for the levy is that the costs of bank failure fall on taxpayers. If the government really has confidence that the ICB’s proposals will work – as it has stated – then the bank levy should have no future!