Four crucial calls for the shape of UK banks

September 9, 2011

By George Hay and Peter Thal Larsen The authors are Reuters Breakingviews columnists. The opinions expressed are their own.

Sir John Vickers is about to drop his bombshell. On Sept. 12, the chairman of Britain’s Independent Commission on Banking will unveil the results of a 14-month probe into stability and competition in the UK sector. The ICB’s mission is to solve what finance minister George Osborne has dubbed the “British dilemma”: how to maintain a large financial industry while protecting taxpayers from future bailouts.

The ICB is expected to recommend that lenders “ring-fence” those operations deemed vital to support the economy in separate subsidiaries. The government looks set to follow that advice. However, the future shape of UK banking will depend on how the ICB answers four key questions.

1. How wide?

The first conundrum is which assets should be allowed inside the ring-fenced subsidiary. A “narrow” fence would be limited to retail deposits and mortgages. A “wide” option would include small business lending, and possibly large corporate deposits and loans. Only investment banking activities are certain to be left out.

Splitting out safe deposits will raise the risk profile of the businesses on the other side of the ring-fence. This, in turn, will increase banks’ funding costs and squeeze earnings. But where the line is drawn affects banks in different ways.

Barclays <BARC.L> and Royal Bank of Scotland <RBS.L>, which have large investment banking operations, would probably fare better with a narrow ring-fence: it is the option that will do least to disrupt the funding of their remaining businesses. The narrow scenario would knock 13 percent off RBS’s 2013 pretax profit, according to Credit Suisse. But if the ring-fence was wider, the lender’s pretax profit would drop 27 percent.

By contrast, UK-focused Lloyds Banking Group <LLOY.L> would be better off with the wider option. That would enable it to put up to three-quarters of its assets in the safer ring-fenced subsidiary. A wide ring-fence would reduce Lloyds’ 2013 pretax profit by just 4 percent, Credit Suisse calculates. But if the ICB chooses the narrow option, the bank’s earnings would fall by quarter.

2. How high?

Another question is how strictly ring-fenced assets are separated from the rest of the business. Should a ring-fenced bank be allowed to pass surplus capital to the rest of the organisation? Should it be able to provide funding to non-ringfenced assets? Banks would prefer the fence to be low, allowing capital and liquidity to flow to the rest of the bank. But the point of the exercise is to protect the flow of credit to the economy even if non ring-fenced businesses get into trouble. This suggests the IBC will limit the ring-fenced subsidiary’s ability to interact with the rest of the bank — adding to the cost of reform.

3. How flexible?

Then there is the issue of the small print. For example: where is the dividing line between a small business customer, whose assets may be inside the ring-fence, and a large corporation, which may be excluded? And how should banks distinguish between retail customers, and ultra-wealthy clients which resemble institutional investors? The ICB is likely to leave it to the authorities to sort out these details, creating another opportunity for bank lobbying to chisel away at its prescriptions.

4. When?

Regardless of how the ICB answers the first three questions, ring-fencing will be complex and costly. Vickers could sugar the pill by recommending that implementation could be delayed, to say, 2015. With a reasonable phase-in period (perhaps aligned with the timetable for Basel III bank capital rules) that could push full compliance to 2018-19.

It’s easy to see why banks and the government might favour a long implementation. Markets are volatile and the economy is weak. According to Ernst & Young’s ITEM club, the impact of ring-fencing could knock 0.3 percent off UK GDP. That is significant when UK GDP may only grow by 1.1 percent in 2011.

However, delay may not help that much. After all, most lenders are striving to hit Basel III standards well ahead of the official schedule. If ring-fencing renders some aspects of their business models obsolete, it’s hard to see investors giving them much credit for negotiating a few years’ stay of execution. Banks would be better off accepting the new reality, and start working out how best to adapt to it.

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