"Ringfencing" Banks Won't Work

The new report on UK banking reform fails to understand the real problem...

THE NEW 363 page report from the International Banking Commission implies more rules, more regulation, substantial taxpayer costs in drafting, implementing and overseeing. Will this approach work to protect the taxpayer from future bailouts? asks Gordon Kerr for the Cobden Centre.

I would make three comments:

1. The establishment of this Commission has received insufficient recognition for what it is – a formal acknowledgment that our present bank regulatory triumvirate of the FSA, Bank of England and HM Treasury has failed dismally to date and cannot be relied upon to protect us in the future.
2. The substantial increase and regulatory cost implied by the Report (it must be noted that this is only a report; draft legislation is not yet available) will have the unintended effect of erecting even greater barriers to entry for competitor banks. This will in turn provide no incentive to our banks to address their culture of entitlement, of high and unwarranted compensation, of disdain bordering on aggression towards customers.
3. Having skimmed through its 363 pages, I sense the ICB is unaware of the kernel of the problem: deeply flawed accounting standards and treatments of transactions leading to falsification of profits and capital. RBS for certain, and perhaps other major UK banks, are insolvent. Their liabilities exceed their assets and capital, properly measured and reported. RBS cannot continue as a going concern, and it at least should simply be put through an orderly liquidation process rather than conferred the respect that the ICB proposals imply.

In the context of 'respect', I would say that I have considerable respect for the ICB. Martin Taylor, in particular, strikes me from his media appearances as understanding the severity of the crisis and the task he shares with the four others. It is not my place to make apologies on his behalf, but others have commented on the framing of the terms of reference limiting the scope of their responses.

Sadly, however, the measures will fail to achieve their objectives, primarily because the doctors do not appear to understand the cause of the illness.

Early in the Executive Summary (page 10) the ICB refers to one advantage of ringfencing as being to protect retail banks from "external financial shocks". This implies that the 2008 crisis was caused by such external factors. But the crisis that began in 2007 and continues to this day was not a function of "external financial shocks"; it was a crisis stemming from the insolvency of the banks, as even the Bank of England now accepts.

IFRS accounting rules, despite the 2009 mark-to-market reforms still allow or encourage banks:

• to "mark up" to market assets whose prices they can claim have risen, thus reporting a profit despite no actual transaction;
• to transfer assets whose market values have fallen (such as Greek sovereign debt) between "accounting classifications" (e.g. onto the "Held to Maturity" book) to avoid recognizing losses;
• to pay bonuses despite such banks being loss-making under UK Company Law accounting standards – in other words to operate as Ponzi schemes – and furthermore not to deduct promised bonuses from reported profits.

Retail banks "should have different cultures" the ICB Report pleads (page 11). Dream on. Regulators cannot influence cultures. Only markets, shareholders and the threat of job losses, as feared by workers in insolvent companies outside of the banking sector, will.

I mention shareholders, but when the shareholders are the public sector they seem to impose no such corrective influence. There has been not a whimper of concern from these shareholders in response to Royal Bank of Scotland's overstatement of its 2010 profit and capital by about £25bn.

Further, the concept of the ring fence implies that, in a crisis, the investment banking bit can be cut off and allowed to fail, yet exceptions to the ring fence are permitted for banking services that involve an exposure to the sister investment bank. This is not a ring fence, and if this rule survives, expect substantial gaming.

The ICB will counter that they are providing the regulators with sharper teeth. But the regulators will not use them. Why should they? 

As Professor Kevin Dowd points out in his book Alchemists of Loss, FSA staffers, after presiding over the worst financial crisis in living memory, were paid record bonuses in 2009 after submitting to their pay committees testimonials from the banks they were supposed to have been scrutinizing.

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