When the banking sector imploded in 2008, recession struck and the mortgage market nosedived, making banking reform inevitable. Three years later, as the British Bankers’ Association likes to point out, many of these regulatory reforms have already taken place.
They have been implemented globally through the Basel III requirements for banks to hold more capital to guard against failures.
At the European level, capital adequacy requirements and the European mortgage directive are having a big impact.
Nationally, the Financial Services Authority is being abolished to be replaced with a new structure separating prudential and conduct regulation under the Bank of England.
A bank levy to raise £2.5bn was introduced earlier this year, although Labour’s 2010 bonus tax has been abolished.
Despite this, the coalition government wanted to go even further and ordered Sir John Vickers to head the Independent Commission on Banking to suggest ways to make the banking system safer.
Banking reform was the first line of the coalition agreement and is the glue holding the Liberal Democrats and Conservatives together.
The commission was set up to tackle the issue of banks considered too big to fail and protect depositors in failed banks all without affecting the UK’s competitiveness.
Earlier this month Sir John published the long-awaited final report and there was little surprise in its conclusions.
Most significantly the report advocated separating banks’ retail operations from their investment ones. This means savings, credit cards, personal loans and mortgages will fall under a section of the bank ring-fenced from the rest.
The idea is to protect retail customers from the riskier effects of investment banking and the potential for collapse.
The report also came out against ordering Lloyds Banking Group to sell off more branches than the 632 it is divesting under European competition laws.
Furthermore, it echoes the capital requirements of the international regulators but asks for all retail operations to go further and set aside 10% of risk-weighted assets.
The report was welcomed by the main political parties with the changes set to be implemented by 2019 and costs estimated at between £4bn an £7bn a year.
The impact could be huge on mortgages, with lenders subject to restrictions on access to wholesale funding, passing on extra costs in rates to consumers and needing to hold more capital.
The BBA says banks are well on the way to implementing the sweeping reforms to ensure that if they fail in the future savers and taxpayers will be protected and the supply of finance to the economy maintained.
“Any further reforms adopted by the authorities need to be carefully analysed and compared with those agreed internationally,” says a spokesman.
“It is vital that the full impact any further reforms will have on the economy, the recovery and banks’ ability to support their customers in the UK is understood.”
Bernard Clarke, communications manager at the Council of Mortgage Lenders, says it is too early to speculate on how the reforms may affect mortgages when implementation is such a long way into the future
“It is not going to happen in isolation and other events will have an impact on their implementation,” he says. “Our key concerns are to ensure that the way the reforms are brought in doesn’t adversely affect the market.”
Ray Boulger, senior technical director at John Charcol, says there are much more pressing issues for the mortgage market.
“In the short term the eurozone sovereign debt crisis is more relevant to the banking sector, and so mortgages,” he says. “A Greek default is now a foregone conclusion. It is a question of when will it happen and how big the haircuts will be.”
Clarity is needed
The CML says another key issue for the ICB is the uncertainty surrounding how all the changes will be implemented, such as whether retail banks can still access wholesale funding markets.
The trade body also warns that any regulation introduced must guard against unintended consequences.
Lawyers have pored over the final report and initial findings reveal huge uncertainty about the impact on banking.
Simon Gleeson, partner at Clifford Chance, says many of the details of the ring-fence are undefined.
“The most important issue is the fact that the activities of the ring-fenced bank are likely to be riskier than the activities of the wholesale bank,” he adds.
“In general, bank crises are caused by the popping of asset bubbles, and this impacts hardest on asset-backed lending notably mortgages and commercial real estate.
“This activity will almost certainly be within the ring-fence. What the proposal does is to deprive the ring-fenced entity of access to the assets and profits of the wholesale bank in order to meet such losses.”
Gleeson believes no financier or company would rationally advance funding to such an entity in circumstances where depositor preference made him a subordinated creditor.
“It is therefore arguable that the proposal increases rather than decreases the prospects of actual bank failure of a domestically systemic bank, and therefore increases the risk of the necessity of government intervention,” he says.
Gleeson says the proposals will make private banking in London almost impossible, because it appears to specify that individuals and small and medium enterprises will be prohibited from banking with any entity other than a ring-fenced bank.
Michael McKee, head of financial services regulation at DLA Piper, also believes private banking will suffer.
“Most interesting is the detail of how the ring-fence will operate,” he says. “It will focus on individual and small business deposits but this is likely to catch a lot of private banking business too.
“It looks like it will be a hard ring fence a retail bank will have to deal with other parts of the group at arms length and apply large exposure rules.”
He believes the ICB has withstood political pressure from the Lib Dems but has taken a tough line on the content of its ring-fence.
One of the biggest beneficiaries of the proposed reforms could be building societies as they have no investment side.
With extra costs being forced on banks, societies could thrive and the Building Societies Association welcomes the report.
Adrian Coles, director-general of the BSA, says that if the reforms are implemented they will make the banking system in the UK more stable and competitive.
“The ring-fence proposals appear both sensible and proportionate,” he says. “This report is a vote of confidence in the UK building society model which has provided security and good returns to UK consumers over many years in good economic times and in bad.
“Building societies have not been part of the problem but are seen as a model for the solution with the ICB advocating this as a particularly good basis for the risk management of ring-fenced banks.
“Our hope now is that the government will move ahead with these recommendations and at the same time use it to do what it promised in the Coalition Partnership Agreement and bring forward detailed proposals to foster diversity in financial services and promote mutuals,” he adds.
Coles’ sentiments are echoed by Nationwide, by far the biggest member of the BSA.
“We have been operating under ring-fencing for many years,” says Graeme Hughes, group director of Nationwide. “Our customers have been getting great deals and excellent service in the knowledge that we are safe and secure and do not take unnecessary risks with their money. There is no reason for this to change in the future.”
Safe and secure
Hughes says the ICB is right to see the building society model as a framework for designing the ring fence.
“The ICB’s proposal to ring-fence customer deposits is a sensible one. As a building society, Nationwide has always operated a ring fence model and this has stood us in good stead to weather the financial crisis.
“The banks could learn a lot from taking a look at how building societies have protected their members’ money. In our view, it is the most sensible and sustainable way forward.”
“Now that the report has published the government should press ahead with these reforms.”
With political parties calling for the proposals to be implemented in unity there should be little to prevent the report becoming law. It also received the broad backing of Barclays, the Royal Bank of Scotland and HSBC while bank shares rose on the back of its publication.
UK economic growth, any shocks from the eurozone and potential further regulation will dictate the pace of reforms.
The details of the ring fence in particular will take a long time to finalise such as deciding what crossovers there can be and how strict the separation is.
The cost of reforms and higher capital requirements will inevitably put pressure on mortgage rates as the price is passed on to consumers.
There is also concern over access to the securitisation markets for a retail bank but these are expected to be made clearer soon.
Overall, the report has been welcomed and is set to be the biggest shake-up of UK banking in a generation.