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Shock treatment

Chancellor George Osborne plans to give the BoE power to split banks if they fail to ringfence their retail arms from their investment businesses and this ‘electrification’ could have serious knock-on effects for the mortgage market

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More than 3,000 years ago in the foothills of modern Turkey there lived an ancient King in a giant castle ruling over his subjects.

One day his servants captured a satyr – a beast of half-man, half-goat – and brought to the king as a gift. But the satyr was no ordinary creature as it belonged to the powerful Greek god, Dionysus.

After a quick sleep the goat was refreshed and returned to Dionysus who was so pleased he granted the young king any wish he so desired.

In a display of shocking greed the young King Midas wished that everything he touched would turn to gold.

Chancellor George Osborne has the reverse condition as everything he touches turns into a disaster.

There was last year’s omni-shambles budget that unravelled so quickly, the loss of Britain’s AAA credit rating or the total lack of economic growth.

It’s been a miserable year for Osborne and his reputation for economic competence and stewardship has been shredded.

But despite Osborne’s reverse-Midas touch, a strange thing has been happening over the last few months.

Osborne has, to a wide consensus, got something very right. And in banking reform it is a good thing to get right after the sector brought the nation to its knees in 2008.

The banking reform bill has been a long time in the making but was finally published in the House of Commons last month.

It is based on the conclusion of Sir John Vickers’ Independent Commission on Banking calling for banks’ retail operations to be ring-fenced from their retail arms.

Osborne already had wide support with similar proposals being made in the EU and the United States.

But since he announced his reforms last June Osborne has toughened them up further with by “electrifying” the ring-fence. This means the Bank of England retains the power to go further and separate banks that it feels are undermining the ring-fence.

“Given the stance of the Financial Conduct Authority and Prudential Regulation Authority, which are going to be deeply, deeply intrusive, the UK will be at the top of the league in terms of the stringency of banking regulation,” says Cicero Group general counsel Iain Anderson.

For brokers this is a strange feeling to behold. An instinctive dislike for more regulation is met with an instinctive dislike for banks and their behaviour in recent years.

But the reforms are ploughing ahead and they will have an enormous impact on the mortgage market over the next few years.

The official backstop deadline to fully introduce new rules is 2019 but some banks such as HSBC and Barclays are calling on the Government to get cracking sooner.

The shape of Britain’s banks will change dramatically over the next few years and brokers need to understand how these reforms will affect mortgage lending, rates and the number of lenders to choose from. It’s crucial.

Ringfence

Firstly, there is the ringfence. It has taken a long time to get to this point – Sir John Vickers’ Independent Commission on Banking took 18 months to conclude a ring-fencing of banks’ retail arms from their investment arms.

When the Libor scandal struck at Barclays last July and the bank was slapped with a £59.5m fine the Government decided to go further.

It set up the Parliamentary Commission on Banking Standards to look into the culture and practices of the banking sector.

After months of painstaking evidence taking from a fascinating catalogue of senior figures such as former Federal Reserve chairman Paul Volcker, it published a report in December.

The report endorsed the Vickers’ proposals but wanted the Government to “electrify” the ring-fence with a reserve power to separate banks if they misbehaved.

“There is absolutely no doubt that myself and colleagues in the commission speak as one for electrification of the ring-fence,” says PCBS member and Conservative MP Mark Garnier.

“It is no secret that one or two members want to go for a far harder version of the ring-fence.

“We know banks can game the system but we want them to know that if they do it to a ridiculous extent they will be split in two. They have an incentive to not go near the ring-fence and if they don’t game the system the banks will be absolutely fine.”

Not everyone believes ring-fencing is a panacea with European commissioner Michel Barnier warning about the impact on growth.

Conservative MP Mark Field warns says Vickers is an “outdated and simplistic” model of reform with a huge cost attached to them.

“Such a burden would be met by the public in higher interest rates and a sharp reduction in the amounts banks are willing to lend,” says Field.

“One of the causes of the paralysing strategic uncertainty that over the past four years has enveloped the UK’s banking system is the mixed message from the Treasury and central Bank alike over the dual requirements to recapitalise – and thereby reduce risks of future taxpayer bailouts – while being ready to lend to credit-starved UK Plc.”

Others are warning that the true impact of Vickers may be to see higher mortgage rates and lower lending even if it makes banks safer.

The transfer of money from the profitable investment arms to fund cheap credit in the retail arm of banks will no longer be able to take place.

“The ring-fence will inevitably have some impact as banks will be operating less efficiently than in the past,” says John Charcol senior technical manager Ray Boulger.

“There is a question mark over what price is the Treasury department will charge the mortgage division for the money in future.

“This type of transfer pricing is a huge feature of how banks charge for mortgages and if it is higher because of the extra cost involved from ring-fencing then the cost of mortgages will go up.

“It will be hard to tell because there are so many other factors affecting pricing with swap rates going up and down. I doubt it will have an impact of more than 25bps.”

Lansons Communications director Richard Hobbs says an electrified ring-fence will improve banking security for consumers.

“But nothing is for nothing in this world and it must be paid for, which is why concepts such as free banking have always been dodgy,” he says.

“The cost of banking for ordinary folk is likely to go up but the quality of their security is likely to improve too although they won’t feel much better off. It is quite a complicated set of moving paths.”

Former FSA head of training and competency and Ethical Banking founder David Jackson says there is a danger that the ring-fence could push up mortgage rates

“I hope we can construct the ring-fence with enough flexibility as possible and we have to use it intelligently. What really matters is the outcome so we need to be clever in its construction,” he says.

But others such as Your Mortgage Decisions director Dominik Lipnicki do not believe money from banks’ investment arms has funded cheap mortgages.

“Pricing for risk has been the problem in the past,” he says.

“Look at Northern Rock and its products actually made money, the main problem was that the money dried up to lend forward. It wasn’t a loss-making business.

“We need a more sensible market where banks can not borrow their way into disaster. The priority from our perspective is to just help the market to grow.

“They are separate business in their aims and what they do. The retail arm is conservative and focused on risk and the other is, maybe not a casino, but it should be protected from the other. We also need lenders that are not too big to fail.”

Leverage ratio

While the ringfencing is the headline act of banking reform there are other issues which are just as important for the mortgage market, if not more so.

Top of the list is the so-called leverage ratio which is capital measure held against all loans and assets.

Basel III rules are insisting on 3 per cent leverage ratio but Vickers recommends a higher level of 4.06 per cent, which he deems crucial.

Osborne decided to stay with the international Basel requirements of 3 per cent to explicitly protect UK mortgage lending.

Incoming Bank of England governor Mark Carney disagrees with Osborne over the ratio and calls Canada’s low figure the single biggest reason it avoided a banking crisis.

Nationwide have been at the forefront of a lender lobbying campaign to stop the increase as it will have a major impact on their lending.

“We believe that a 3 per cent leverage ratio, which is consistent with Basel III, will avoid significant unintended consequences for low risk firms and the real economy,” a spokesman says. 

“The plans announced by the chancellor to implement this and not introduce a higher rate are therefore welcome. 

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“We fully recognise the desire of many politicians to address concerns with over-leverage in the banking sector.  Should they look to amend the legislation in Parliament, we would strongly urge them to recognise the particular effects a higher leverage ratio would have on low risk firms and ensure that it is not applied in a one-size-fits-all manner.”  

As Nationwide makes clear the debate is not over and the leverage ratio could increase to 4.06 per cent by the end of the passage of the bill with huge consequences for mortgages.

Labour has made it its top priority in banking reform debate to target the Government for “watering-down” Vickers’ proposals.

Speaking to Mortgage Strategy PCBS member and Labour MP Pat McFadden says the banking commission continues to take evidence on the ratio.

“It is important to remember that as well as the structural questions around separation banks have to be made safer and have to be more resilient against shocks in the future. A higher leverage ratio could be an important part of it,” he says.

Treasury select committee member Stewart Hosie has also said that the leverage ratio could be “revisited” if it is not working.

“The leverage ratio is only one of a number of factors that analysts and shareholders will look at to reflect the soundness of the banking sector,” Banking consultant Mehrdad Yousefi says.

“If the chancellor says it has to be 4.06 per cent then it will take that much longer for banks to shrink their lending assets and incur a longer economic recovery, probably by a few years.

“I wonder if Labour was in Government would they genuinely insist it is 4.06 per cent or is it political goalscoring because they are in opposition.

“Someone needs to get the balance right between regulating the banks so they don’t fail and give them some help so that we have a meaningful economic recovery in the next couple of years.

Hobbs argues that a liquidity ratio at 3 per cent, which is what Osborne has been arguing, will tend to be more favourable to retail mortgage books.

“At the Vickers proposal at 4.06 per cent you begin to have significant effects in retail markets and that is code for mortgages which no one wants,” he says.

“I find 3 per cent quite a racy ratio but it just shows how difficult the room for manoeuvre there is. In a stronger economic situation he may have gone for 4.06 per cent. Looking at banking alone it would seem right to go higher but when you start factoring the feeble in economy it becomes 3 per cent. It will enable more mortgages to be sold more cheaply.”

If it looks like the leverage ratio will be increased to 4.06 per cent in the banking reform bill then banks will prepare for it.

It could cause huge reductions in mortgage lending and higher rates so it could become a major regulation for the mortgage market to combat.

Brokers would be well advised to follow this debate closely because while it seems technical and distant it is crucial.

Derivative dilemma

Another area of dispute has been around the sales of simple derivative products in the wake of the interest rate swap misselling scandal.

In July Barclays, HSBC, Royal Bank of Scotland and Lloyds Banking Group were ordered to pay redress to around 40,000 customers for misspelling products.

It sparked a debate over whether they should be sold within retail banks to unsophisticated customers and was considered by the Parliamentary Commission on Banking Standards.

In last month’s bill derivatives could still be sold within retail banks but the question is still up for debate in parliament and could change.

The most obvious question for mortgages is whether a fixed rate mortgage falls into the category of simple derivative product.

“For a fixed rate mortgage an institution must be going into the market and hedge the interest rate risk out in the market, which is a derivative,” says Hobbs. “But it is a derivative on the institutional side of the book so it is done at the level of great tranches. A retail swap sold ethically is not a bad thing, it is the way it has been sold.”

Challenger banks

MPs have been banging the drum for more competition for years as the five biggest lenders have consistently taken more than 90 per cent of the UK mortgage market.

In the Financial Services Act 2012, which introduced the new regulatory regime, the FCA was given an explicit objective to foster competition.

FCA chief executive-designate Martin Wheatley is also in the process of relaxing rules for new entrants to encourage more banks as only Metro Bank has managed to obtain a UK banking licence in more than 100 years of UK financial services.

But the biggest reform could come from the overhaul of the payments system included in the current bill. This will make it far easier for customers to switch banks accounts and should, in theory, help new banks to grow and attract customers.

Osborne says he wants to make it easier for challenger banks to enter the market and favourably highlights the growth of Virgin Money and expansion of the Co-operative Group after it bought more than 600 Lloyds branches.

“The idea of making it easier for challenger banks to come in is a good one. It has been too difficult for challengers to enter the UK market,” says McFadden.

“Osborne didn’t have much new to say on seven day switching, which is happening in autumn anyway. It’s a good idea to open up the payments system.”

For mortgages increased competition would take the form of smaller banks such as Aldermore and Precise.

There is concern among building societies about an exemption to the ring-fence for banks with assets under £25m. It would mean that small banks could operate under the ring-fence and still have investment arms alongside retail.

The Building Society Association argues that such a move would create unfair competition with some of its small societies. Indeed a successful small investment arm could create cheap rates for a small bank that a small building society, which draws its funding solely from savings, would struggle to compete with.

Either way the bill is explicitly designed to encourage more competition in banking which could see the break up of big banks such as RBS or Lloyds group.

Wheatley believes such reforms can help competition but the real change will come from technology and “mobile banking” rather than “bricks and mortar”.

For brokers this is excellent news as they are a ready-made trained, flexible sales force for the mobile banks of the future to sell mortgages.

The more banking reform allows new entrants online or without branches the more crucial brokers will become.

Does it matter now?

The banking reform bill is not due to come into force until 2019 so may seem like a distant project that does not affect your clients today.

Clients today may not be affected but future clients most certainly will and brokers should get to grips with the issues now so they can explain the ongoing trends in mortgages.

When clients ask whether rates will be higher in a few years you can warn them of any impact from the ring-fence or leverage ratio.

It is the biggest shake-up of British banking in a generation and the UK mortgage market will be profoundly altered as a result.

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Banking reform timeline

September 2007

The first run on a bank in 100 years hits Northern Rock as it asks for emergency liquidity support from the Bank of England. It is nationalised within six months.

October 2008

The Royal Bank of Scotland is bailed out by the Government to the tune of £45bn with billions more in implicit guarantees.

Lloyds bank buys HBOS to become Lloyds Banking Group. The Government then takes a minority stake in the combined group to inject desperately needed capital into the firms.

May 2010

The Conservatives fulfill an election pledge to abolish the Financial Services Authority and bring financial regulation back under the auspices of the Bank of England.

It launches the Financial Services bill which would become law in December 2012 and with the new regulatory regime in place by April 2013.

June 2010

Chancellor George Osborne sets up the Independent Commission on Banking, led by Sir John Vickers, to solve the “too big to fail” dilemma that led to bank bailouts in 2008.

Senior figures such as business secretary Vince Cable and Bank of England governor Mervyn King push for full separation of banks.

November 2011

After 18 months of taking evidence Vickers recommends ring-fencing banks’ retail arms from their investment divisions in his final report.

Vickers suggests a backstop deadline of 2019 to implement reforms but wants to see different institutions.

June 2012

Osborne uses his annual Mansion House speech to unveil the Government’s banking reform plans where he adopts the vast majority of Vickers’ recommendations.

He disagrees on introducing a maximum leverage of 4.06 per cent, opting for 3 per cent in line with Basel III rules.

Labour accuses the Government of “watering-down” reforms focusing on the key leverage ratio recommendation.

July 2012

The aftermath of Barclays’ record £59.5m fine for Libor rigging creates public anger and a political storm. In response Osborne sets up the Parliamentary Commission on Banking Standards to looking into the culture and practices of the sector and feed into the banking reform bill.

Labour calls for a full judge-led “Leveson for the banks” inquiry but eventually lends cross-party support to chair Andrew Tyrie’s PCBS.

October 2012

Osborne appears before the PCBS to give evidence in a testy exchange where he warns the panellists not to “unpick” the Vickers consensus.

He signals he would not accept full separation of the banks if it was recommended by the commission.

December 2012

After months of taking evidence the PCBS publishes its interim report, calling on the Government to “electrify” the ring-fence.

After consultation the PCBS decides that simple derivatives can be sold from within a ring-fenced bank despite the interest rate swap misselling scandal.

February 2013

Banking reform bill is published and the Government partly adopts the PCBS recommendation to “electrify” the ring-fence.

It gives the Bank of England a reserve power to separate individual banks that are viewed as trying to undermine the ring-fence rules.

Labour brands the move “half-hearted” for not keeping the power to separate all banks if the sector is seen to be ignoring the ring-fence rules.

March 2013

The bill is currently being debated by MPs on the floor of the House of Commons and is expected to pass through parliament later this year.

The final PCBS report in culture and standards in banking is set to be published with Osborne promising the recommendations will feed into the bill.

The PCBS will focus on the culture of major banks rather than the previous concentration on structural issues.

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