The final report of the UK Independent Commission on Banking (Vickers Report, 2011) was released on September 12, 2011, and recommends a number of significant changes in the structure and regulation of banking in Britain. While some are driven by issues specific to Britain, the question arises of how other countries, such as Australia, should react to the Report's more general proposals.
At the risk of oversimplifying (and more detail is given in the Appendix), the proposals can be grouped into three main types.
Banking sector structure – involving operational and legal separation via "retail ring-fencing" of what are sometimes referred to as "utility" and "casino" banking activities.
Increased capital requirements for larger more systemically important banks
Greater failure management powers for regulators and protection of depositors.
The structural separation proposal reflects a long-standing idea that "narrow banking" has merit – by virtue of limiting risk-spillovers from other activities typically undertaken within a bank with a broader range of activities. The Vickers report argues that benefits of retail ring-fencing include: insulating vital retail banking services from global shocks; making resolution of troubled banks easier; and facilitating banking competition by allowing different regulatory approaches to domestic retail banking and global wholesale/investment banking approaches. Within the "broad bank", only the ring-fenced bank would be able to provide basic retail banking services, it would be separately capitalized, and have independent directors. While it would be able to share operational services with, and access financial services from, other parts of the broad bank it would be precluded from a range of "non-basic" financial activities.
Can such a separation be done without imposing excessive social costs? Would it have the benefits claimed? Australian experience is potentially relevant here.
Not too many years ago (until changes to the Banking Act in 1989), the major Australian banks operated as structurally separate – but operationally integrated – Savings and Trading Banks with the former historically having been effectively limited to taking deposits from individuals and making housing loans. The State Government owned (and Trustee) Savings Banks were the only Savings Banks allowed to provide payments (checking) services until legislative changes in 1984. While a return to the (very) heavy regulation of those days (which prompted growth of alternative non-bank institutions) needs to be avoided, the historical record does suggest that structural separation is feasible, and not necessarily excessively costly. The continued profitable operation of specialist retail ADIs (credit unions and building societies) also suggests that retail ring-fencing is a viable option.
The history also suggests that limiting the activities of ring-fenced institutions has merit – if it prevents them moving into areas outside their particular expertise and without adequate governance and risk management capabilities. The demise of the State Banks of Victoria and of South Australia at the start of the 1990s, arising from expansion into investment banking type activities are good examples.
But retail ring-fencing in the modern financial sector can create complications. A major growth area for banks is wealth management, involving provision of financial advice to individuals and creation of financial products such as managed funds, margin loans etc for use by those individuals. Where these activities would fit is unclear.
More relevant is the issue of dealing with imbalances in the demand for and supply of funds from the "ring-fenced" retail clientele. While the nationwide branch networks of banks create a form of internal capital market able to smooth out geographical liquidity imbalances, it is far from clear that in aggregate there is a "natural" balance between household loan demand and deposit supply. Indeed, retail loan demand generally far outstrips deposit supply, such that ring-fenced banks would need to obtain funds from other sources, such as via securitizations or loans from their parents or affiliates – thereby indirectly creating counterparty exposures to their "casino" banking activities.
These issues do not seem insoluble, but would require careful regulatory consideration. Such a separation would, most likely, involve limitation of the Financial Claims Scheme deposit insurance to the retail-ring-fenced bank.
It is also worth noting that, some fifteen years ago, the Australian Financial System Inquiry (Wallis, 1997) considered the issue of financial conglomerates. While their focus was more upon entities combining banking, insurance, funds management and securities activities, rather than different types of banking activities, their preference (p346) was for use of a Non-Operating Holding Company structure as the best method for effecting prudentially desired separation. Their Recommendation 49 to permit such a structure was subsequently facilitated by legislation in 2007 and Macquarie Bank converted to such a structure in that year.
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