Breaking the banks - Neil Baker

As the world looks to international decision-makers to protect against another financial crisis, IBA Global Insight assesses whether the UK’s Vickers report has the answers.

Banking is as old as civilisation itself. In 14 BC the Chinese were using paper money written on stag skin; well before them, Babylonian monks were making recorded loans. But modern banking as we know it today was, arguably, first established in 17th-century London, when Italian merchants moved to the city to finance a boom in trade. To this day, London remains a global banking centre, which is why it – and Britain more widely – has been particularly hard hit by the financial crisis.

The country’s national economic output last year was 4.5 per cent below its pre-crisis level and 10 per cent beneath where it would have been if its 2007 growth trend had continued. Unemployment has risen by more than 800,000 since 2007. And among its leading banks, more than 80 per cent of RBS and 40 per cent of Lloyds are in state ownership.

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No wonder then that Britain has been so actively trying to learn the lessons from the crisis and to reduce the likelihood of something similar happening again. The last two years have seen an unprecedented level of activity by regulators and policy makers, culminating with the Independent Commission on Banking – known as the Vickers report, after its chairman, Sir John Vickers, a former Chief Economist at the Bank of England.

The Commission’s interim report – published in April – underlines how hard it will be to provide any simple solutions to the problems that caused the crisis. Getting more control over banks is difficult, and doing so without undermining the global competitiveness of the UK financial sector is harder still. And, in any case, effective supervision of banking is, increasingly, a global problem that requires global solutions.

Banking review

When the government created the Commission last year it gave Vickers a clear brief: to find ways to reduce systemic risk in the banking sector; to mitigate moral hazard – where some banks are too big to fail; to reduce the likelihood and impact of a bank going bust; and to promote competition, especially where large banks are gaining competitive advantage from the expectation that government will bail them out if they run into problems. One issue underpinned all of those questions: should banks be forced to separate their retail and investment businesses?

The Vickers report begins with a cogent analysis of what went wrong in the global financial sector. Both lenders and borrowers took excessive and ill-understood risks, and banks operated with excessive leverage and inadequate liquidity, it says. Regulators allowed banks to crank up the ratio of their assets to their capital base far too high – to twice normal levels – and when they needed market funding they could not find it. When the crisis hit, many bank balance sheets could not absorb their losses, and as institutions began to fail, the complexity of their market operations made it impossible to sort the good parts from the bad in an orderly way. To avert panic and ensure basic banking services continued, government had to step in.

One means of avoiding the need for such intervention in future is to force banks to separate their retail and investment operations. The Vickers report – in a very British compromise – argues that some form of separation is needed, but adds that ‘a balance must be struck between the benefits to society of making banks safer and the costs that this necessarily entails’.

Full separation – where banks are carved up and cross-ownership of retail and investment banks is restricted or banned – might give retail customers the greatest protection, and therefore minimise the need for government intervention, Vickers argues, but it would also remove many of the benefits of universal banking, whereby banks use their investment activities to provide cheaper services to retail customers. But on the other end of the scale, simply separating the operating systems inside a bank, so that a failing one can be broken up or fixed more quickly, would probably not be a big enough reform, the report says.

As a mid-way, the report suggests what it calls ‘retail ring-fencing’, whereby retail banking operations would be carried out by a separate subsidiary within a wider group. The idea at this stage – and full conclusions will be out in September – is that universal banks should maintain minimum capital ratios and loss-absorbing debt to cover their UK retail banking operations, as well as for their businesses as a whole. But as long as they don’t dip below those minimum levels, they will still be able to transfer capital between their UK retail and other banking activities. The proposal is that ‘systemically important’ banks and all retail banks in the UK should have a baseline ratio of equity:risk weighted assets of at least 10 per cent.

‘It is open to debate whether a retail ringfence would give more or less banking stability than full separation between retail banking and wholesale and investment banking,’ the report says. ‘It would be less costly to banks because they would retain significant freedom to transfer capital. The required UK retail capital level would constrain banks only when they wanted to go below it to shift capital elsewhere, say to their wholesale and investment banking operations. But at times of overall stress it would not be desirable for the leverage of UK retail banking operations to increase in this way.’

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A threat to competition?

One of the report’s aims is to increase competition in the UK banking sector. A reduction in the implicit government guarantee enjoyed by systemically important banks will help, but will not be enough on its own, the report says. The big incumbent banks have few challengers and one of them – Lloyds – now holds around 30 per cent of current accounts. Vickers suggests a mix of measures to fix this. They include forcing Lloyds to sell a package of assets and liabilities (The European Commission has already called for this, but Vickers says Lloyds needs to do more) and reforms to make it easier for retail customers to move their accounts.

‘A balance must be struck between the benefits to society of making banks safer and the costs that this necessarily entails’
The Vickers report


Along with the proposed new capital rules, these reforms are what Vickers calls ‘a combination of more moderate measures’. They may not be as radical as a forced split between retail and investment banking, but they will entail costs to banks nonetheless. However, these costs ‘appear to… be outweighed by the benefits of materially reducing the probability and impact of financial crises,’ the report says.

One reason for the ‘moderate’ approach is that Vickers needs to shore up the UK banking system in a way that doesn’t harm its international competitiveness. Hence the report does not suggest that UK banks should have to meet higher capital standards than those agreed internationally, ‘provided that they can fail without risk to the taxpayer’. Indeed, it argues that its reforms ‘would support the competitiveness of the economy and would be likely to have a broadly neutral effect on financial services’.

That’s because they would affect only a small proportion of the international financial services industry based in the UK, says Vickers, and, in any case, ‘improved financial stability should be good, not bad, for the competitiveness both of the financial and non-financial sectors’. Countries that suffer from financial crises are less attractive places for international businesses to locate, it says, so ‘More resilient banks are therefore central to maintaining London’s position as a leading global financial centre, not a threat to it.’ A domestic taxpayer guarantee might help some banks to compete internationally, but ‘it would be a fiscally risky subsidy without justification,’ the report concludes.


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Mixed reaction

The Vickers report – or at least its interim findings – garnered a mixed reaction, with many in the media opining that banks had been let off lightly. Bank share prices certainly strengthened on news that Vickers was not calling for a forced break-up of banks that were deemed too big to fail. But Vickers himself believes that the reforms outlined in his committee’s report are ‘far-reaching’ and ‘could be transformative’. At the press launch of his findings, Vickers dismissed suggestions that banks were getting an easy ride. ‘I absolutely reject any notion that we bottled it,’ he said.

But Ashurst regulatory partner Rob Moulton says the ‘balanced route’ taken by Vickers raises a lot of unanswered questions. ‘The Commission has tried to chart a course between splitting up the banks and not disrupting their role. This is a difficult course to plot. Banks are either separate or they are integrated in some way. Like pregnancy and death, you either are or you aren’t,’ he says.

‘How will the failure of the investment banking arm of a retail bank not impact upon the credibility of its retail operations, which depend upon continued public confidence? Will the proposal encourage banks to operate their main businesses from abroad, where no such restrictions apply, and conduct their UK operations from a branch in London?’

‘Banks are either separate or they are integrated in some way. Like pregnancy and death, you either are or you aren't’
Rob Moulton


Nabarro corporate partner Alasdair Steele says Vickers acknowledges a lack of empirical data on whether the proposed reforms will drive major banks away from the UK, but then seems to dismiss the future risk of any such relocation. ‘While the immediate impact of the loss of a major bank’s headquarters may be relatively small, the long-term risk is considerably greater,’ says Steele. ’New products and business lines are more likely to be developed from headquarters outside the UK, which over time will lessen the importance and influence of London as a financial centre.’

Norton Rose financial services partner Jonathan Herbst also questions the impact on competition. ‘The decision not to go the whole way to require the splitting up of the banks is welcome but this half way house will only succeed if it is workable and does not leave the UK at a competitive disadvantage globally,’ he says. ‘The jury is still out on this’.

Law firm Olswang, in a client briefing note, said it doubted whether Vickers’ proposals would have a neutral affect on the competitiveness of UK banks. ‘Retail banks based in the European Economic Area [the European Union plus Iceland, Liechtenstein and Norway], which want to accept UK-based customers or establish branches here, do not need to operate through a UK subsidiary and a change in European law would be required to force them to do so,’ it said. ‘In consequence, the proposals are anti-competitive as regards the UK’s position in the European retail banking market.’


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International agenda

One thread running through the Vickers report is a recognition that the question of how better to regulate international banks is one that will require – largely – an international answer. This effort is being led by, among others, the Basel Committee on Banking Supervision, the European Commission and the G20’s Financial Stability Board.

The European Commission has created three new supervisory bodies to oversee Europe’s financial services industry and capital markets, including the European Banking Authority, which opened for business on January 1. Hector Sants, chair of the UK Financial Services Authority, said recently that Europe’s national financial regulators will see their powers curtailed as these new supervisory bodies get up and running.

Commenting in the FSA’s latest annual report, Sants said it was ‘important to recognise the implications of the change’, which will see the issues of most importance decided in Brussels. The new bodies will soon become ‘the key policy-making forums’ in Europe, said Sants.

But will this move to a new, more international regulatory framework have the desired effect? The IBA created a Task Force on the Financial Crisis to review global regulatory shifts and report on their impact. Some individual countries may have worked hard to fix their own national banking sectors, but ‘on an international level there are serious doubts as to whether what has emerged so far represents a big step forward,’ writes Task Force Chair Hendrik Haag, a partner at Hengeler Mueller, in the task force’s report. The regulatory organisations involved are ‘too large and clumsy and not remote enough from the political process,’ he says.

When the crisis broke, the expectation was that there would be a fast and radical change of bank regulation around the globe, according to Haag. ‘One of the themes was that there must be a single regulator for global financial institutions to prevent a similar crisis from happing again. About three years later we are now looking at the first results of the reform process. There are very few elements that one could honestly call a radical change.’

‘On an international level there are serious doubts as to whether what has emerged so far represents a big step forward’

Hendrik Haag, Heneler Mueller
Chair, IBA's Task Force on the Financial Crisis

One problem, says Haag, is finding ways to get national regulators thinking beyond their domestic interests. ‘The Lehman Brothers case has shown that national regulators quickly become very self-centred in their thinking when it gets to repatriating or locking in funds necessary to preserve the liquidity of the parent bank or a subsidiary in their own country,’ he says. ‘This may be understandable, but it is certainly not always helpful. Better cooperation of national regulators based on clear cut rules negotiated beforehand would certainly be a great step forward.’

The world has become a better place in terms of less fragmented and better coordinated supervision of the financial industry, the IBA report says, but it is still far from being in a position to deal with the next crisis in a fundamentally more efficient manner, let alone to prevent one. ‘The necessity of rescuing a too-big-to-fail institution with government help will not become a matter of the past soon,’ writes Haag.

And that creates an interesting question: if there was – however briefly – enthusiasm among regulators and politicians for deeper reform, did the crisis create an opportunity that was quickly wasted? Haag says that isn’t the case. ‘While some of the proposals were squelched by lobbying from the banking industry and political debate between opposing parties, much of the compromise that has been found is based on the perception that an efficient and innovative financial industry is necessary for the wellbeing of the world economy as a whole. Too much regulation is likely to have a negative impact on the ability of the financial industry to perform that role.’ And that is the difficult balance that Vickers’ final recommendations will need to achieve.


Legal and regulatory responses to the crisis in the UK

The Banking Acts
The Banking (Special Provisions) Act 2008 was introduced as an emergency measure when the Northern Rock bank ran into difficulty. It gave regulators the power to take action with regard to troubled institutions before they had become formally insolvent and created a new insolvency procedure for banks. The Banking Act 2009 updated and extended the 2008 version.

Turner review
The Turner review, published in 2009, was a government-commissioned report from the head of the FSA on the causes of the financial crisis and how the UK regulatory system needed to change. It led to the FSA promising a ‘fundamental shift’ in its approach to regulation, so that it focused less on internal processes and more on business strategies and system-wide risks.

Walker Review
The Walker Review, also published in 2009, was a government-commissioned report on the quality of corporate governance in the UK financial sector. It made a series of recommendations on issues such as the role of the board chairman, the disclosure of executive remuneration and high-level processes for reviewing strategic risks. It also created a new stewardship code setting out the governance role of institutional investors.


To view IBA filmed content on the financial crisis go to:


Neil Baker is a freelance journalist. He can be contacted by e-mail at

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