Ring-fencing and the ICB – elegant, simple, but wrong

The recent – apparently highly-acclaimed – ICB report smacks of an elegantly worked-out solution to problems that other bodies are addressing much more effectively.

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!

Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. He also holds the position of (interim) Director of Catholic Mission at St. Mary’s having previously been Director of Research and Public Engagement and Dean of the Faculty of Education, Humanities and Social Sciences. From 2002-2016, Philip was Academic and Research Director (previously, Editorial and Programme Director) at the IEA. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. He is a Senior Research Fellow in the Centre for Federal Studies at the University of Kent and Adjunct Professor in the School of Law, University of Notre Dame, Australia. Previously, Philip Booth worked for the Bank of England as an adviser on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.

4 thoughts on “Ring-fencing and the ICB – elegant, simple, but wrong”

  1. Posted 13/09/2011 at 14:43 | Permalink

    Agreed on ring-fencing, load of rubbish, as long as there’s no taxpayer guarantee and a clear system of automatic debt-for-equity swaps, or bail-ins as they are now known, problem largely solved.

    Disagree on bank asset tax, this is the best way of taxing banks, certainly far better than transaction tax and probably far better than corporation tax, because the revenue-maximising tax rate is probably also whatever rate we’d need to keep banks to their optimum size – by acting as a wedge between mortgage/lending interest rates and the rate demanded by depositors or bond holders, it would completely deter banks from blowing credit bubbles.

    I’d envisage something like a 2% bank asset tax on the higher of [lending secured on UK land and buildings] and [UK deposits which take priority over bonds in the event of a bail-in], and would be payable by any bank (UK or otherwise) on loans secured on UK land (easily established by looking at HM Land Registry). 2% of £2,000 billion of such lending = £40 bn a year, which is = to the corp tax they already pay plus the amount they fleece off depositors (their net interest margin has gone UP to about £60 billion a year since the ‘financial crisis’).

  2. Posted 14/09/2011 at 08:11 | Permalink

    Mark – you are giving a justification for a completely different way of taxing banks; fair enough. The government’s position is incoherent and smacks of bank bashing for the sake of it

  3. Posted 14/09/2011 at 12:02 | Permalink

    For sure, your basic point that ring fencing is nonsense stands, it’s just a gimmick, I think politicians like “ring fencing” because it sounds cool, even if none of them has any idea what an investment bank actually does.

    I was changing the topic as per usual, apologies.

  4. Posted 16/09/2011 at 13:04 | Permalink

    End it don’t mend it. In an age where consumers can access hundreds of money market funds online, I see no reason why banks should be any more than shop fronts offering these funds (which should not have any guarantee of receiving back initial principal), plus a current account linked to some highly liquid asset (maybe a reserve fund managed by the Bank of England – I hear they have a few gilts). Prospective borrowers would have to borrow money already raised from investors/savers, and not just be extended bank credit. Sure, the transition would not be nice and might require some more bailouts – potentially also of the BoE since presumably they don’t have enough assets to support high powered money outstanding, but I believe we would end up with a much sounder system in the end.

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