Britain’s Appetite For Tough New Banking Reforms Wanes

With the U.K.'s economic recovery having stalled at the end of 2010, the government appears more eager to spur growth than to break up big banks.


In the classic 1980s British television comedy series Yes Minister, the show’s manipulative senior civil servant, Sir Humphrey Appleby, recommended to his boss that the best way to sidestep a political scandal was to appoint a committee of investigation. There was just one caveat, he explained: “Never set up an enquiry unless you know in advance what its findings will be.”

The real-life government of Conservative Prime Minister David Cameron is discovering the uncomfortable truth behind that satire. Just weeks after taking power last year, the government in June 2010 appointed the Independent Commission on Banking to consider wide-ranging reforms for strengthening the banking system and reducing the risk of failure by major institutions. Chancellor of the Exchequer George Osborne, who set up the panel, vowed that the commission would examine everything from encouraging more competition to mitigating moral hazard to forcing a separation of retail and investment banking — a modern-day variation of the Glass-Steagall Act, which divided those industries in the U.S. until the late ’90s. The government, having effectively nationalized three major banks during the financial crisis to avert a banking collapse, would do what was necessary to steer the industry back to health and avoid future bailouts, Osborne said in announcing the commission: “The experience of the last three years means that fundamental reform is an absolute requirement. We simply cannot afford to continue as we did before.”

Lately, however, the government’s appetite for reform appears to be waning. With the country’s economic recovery having stalled at the end of 2010 and with a £113 billion ($182 billion) package of spending cuts and tax increases due to begin this month, Cameron and Osborne are more eager to spur growth than to break up big banks. To that end, Osborne in February reached an agreement with the U.K.’s top five banks under which Barclays, HSBC Holdings, Lloyds Banking Group, Royal Bank of Scotland Group and Santander U.K. promised to increase their combined lending by 6.1 percent this year and all but Santander agreed to pay lower bonuses to their staffs for 2010 in return for the government’s commitment to maintaining the financial sector’s competitiveness. As Osborne put it in announcing the deal, “Britain needs to move from retribution to recovery.”

“I can’t tell if the government is placated, but there has certainly been a shift in tone since the agreement,” says Nick Forrest, a director in the economics department at PricewaterhouseCoopers who advised the banks on the lending accord.

The government’s role as a major bank shareholder is also curbing its enthusiasm for tough new regulatory changes. The U.K. spent a total of £115 billion to acquire all of mortgage lender Northern Rock, 83 percent of RBS and 41 percent of Lloyds between February 2008 and January 2009, and officials are eager to begin selling off those holdings later this year or early next year to recoup the Treasury’s money. Robin Budenberg, CEO of UK Financial Investments (UKFI), the Treasury arm that manages the state’s holdings in the banks, whose priority is to maximize profits for the government, said in January that a breakup of RBS and Lloyds would be “negative for value.”

The banks, meanwhile, have stepped up their lobbying against regulatory reform. They believe that enough reforms are already in the pipeline — most notably the Basel III global accord on higher capital requirements — and that any additional measures could put them at a disadvantage relative to competitors in the U.S. and Europe. “Game-changing reforms are already taking place,” says Paul Chisnall, executive director of financial policy at the British Bankers’ Association, “and we seem to be the only country having this sort of discussion about structural reform.”

The pressure appears to be having an impact. The banking commission’s chairman, Sir John Vickers, said in a speech in London in January that the commission was “unlikely to favor radical forms of limited- or narrow-purpose banking,” which would separate the deposit-taking activities of retail banking from riskier investment banking. Even the idea of ring-fencing the retail activities of systemically important financial institutions into separately capitalized subsidiaries, an idea the commission has explored, would run into problems of “practicability,” he said, especially if there was no international agreement on the issue.

Industry observers have scaled back their expectations of the commission, which will issue a preliminary report this month and submit final recommendations to the government in September. “The commission’s bark will be worse than its bite,” says Ian Gordon, banking analyst at Exane BNP Paribas.

Still, the commission’s report may make for uncomfortable reading for the banks, even if it does eschew dramatic structural changes in the industry. Treasury sources and industry analysts say the commission is likely to focus on conventional remedies such as increasing capital requirements and fostering greater competition in the retail banking market. Such reforms, although far from radical, could be significant. Bankers contend that boosting capital standards above Basel III levels would cut their returns on equity and serve to restrict lending.

Any move to weaken the regulatory reform agenda may cause political problems for the government. The Conservatives’ coalition partners, the Liberal Democrats, ran in last year’s election on a platform calling for the separation of retail and investment banking, and the party rarely misses an opportunity to bash bankers. “I am like anyone else: You want to wring the neck of these wretched people who behaved so irresponsibly,” Nick Clegg, the party’s leader and Cameron’s deputy prime minister, said in a radio interview last month. Vince Cable, a senior Liberal Democrat who serves as Business secretary, said recently that he wasn’t softening his views on banking reform: “I think there will have to be change, and it will have to be radical.” What qualifies as radical is being defined downward, however, as the financial crisis recedes and banks gradually return to business as usual.

THE IDEA THAT BRITAIN WOULD EVEN contemplate such ambitious structural reform would have been unthinkable only a few years ago. The country prided itself on the success of its financial services sector, which in 2008 accounted for 8 percent of gross domestic product, a bigger share of the economy than in any other industrial country. (The comparable figure for the U.S. is 6 percent.) The government and industry alike touted the U.K.’s so-called light-touch regulatory regime, which relied on principles rather than the copious rules of the legalistic U.S. framework. The financial narrative for most of the past decade had London and its market-friendly environment steadily winning share from New York and continental European centers.

The financial crisis prompted a dramatic rethinking, however. Although the crisis had its origins in the U.S., the fallout in the U.K. was more severe. Liquidity concerns triggered an old-fashioned run by depositors on highly leveraged Northern Rock, leading the government to nationalize the mortgage lender in February 2008. The collapse of Lehman Brothers Holdings in September 2008 undermined investor confidence in RBS, which had a major presence in the U.S. mortgage-backed-securities market, and in HBOS, then the U.K.’s largest mortgage bank. The Labour government of former prime minister Gordon Brown propped up RBS in November 2008 by buying almost its entire £15 billion share issue, giving taxpayers a 58 percent holding, a stake officials would later increase. The government also encouraged Lloyds TSB to acquire HBOS but had to step in to support the enlarged institution. In addition to those direct stakes, the government also extended hundreds of billions of pounds of asset guarantees and liquidity facilities to prop up the banking sector. The U.K.’s various support measures reached a massive £955 billion, or 69 percent of GDP, by December 2009, according to the National Audit Office. The economic and financial recovery reduced that amount to £512 billion at the end of last year.

Shocked by the scale of the crisis, Britain’s financial watchdogs began calling for emphatic measures to rein in risk-taking. In August 2009, Adair Turner, chairman of the Financial Services Authority, questioned whether many investment banking activities were “socially useful.” Two months later, Mervyn King, governor of the Bank of England, went even further by advocating the separation of what he called the banks’ “utility” operations, such as deposit-taking, from their “speculative” investment banking operations.

Brown’s Labour government had firmly rejected any suggestion of structural reform, but the Conservatives and Liberal Democrats swept to power in May 2010 in good part by riding a wave of public anger at the banks. The two parties’ views were not exactly in harmony. The Conservatives’ campaign platform called merely for an investigation into the impact of RBS and Lloyds on competition in the banking sector, while the Liberal Democrats argued for a breakup of retail and investment banking. As part of their coalition agreement, the parties papered over their differences by setting up the Independent Commission on Banking.

By appointing five heavyweights to the commission, the government signaled that it was serious about reform and not merely looking to duck the issue. Sir John, the chairman, who is head of the University of Oxford’s All Souls College, served as chief economist of the Bank of England in the late ’90s and later as director general and then chairman of the Office of Fair Trading, the U.K.’s chief antitrust regulator. He developed a reputation as an advocate of consumer choice when the OFT in 2001 blocked a takeover bid by Lloyds for the former Abbey National on the grounds that it would reduce competition for current accounts, which are similar to U.S. checking accounts.

The other commission members also enjoy solid reputations and, for the most part, strong reformist credentials. Martin Taylor is a former chief executive of Barclays who dismantled most of that bank’s investment banking operations in the mid-’90s. “After I left Barclays, I said the investment banking activities of a universal bank were at all times parasitic on the retail bank balance sheet,” he remarked last year at the Future of Banking Commission, a private sector effort organized by the consumer magazine Which?. “I used the word carefully, and I would not change it now.” Martin Wolf, chief economics commentator of the Financial Times and a former World Bank economist, has written frequently about the need for structural reform in banking but criticized the so-called Volcker rule, the plank of the Dodd-Frank Wall Street Reform and Consumer Protection Act that bars banks from proprietary trading, saying it fails to address the core problem of banks being too big and interconnected to fail. Clare Spottiswoode, an outspoken former energy regulator, in November publicly bemoaned the fact that the Lloyds-HBOS merger left the U.K. with only five major banks, saying, “we do not have a very healthy competitive market in financial services.” Only the fifth member, William Winters, a former co-head of investment banking at JPMorgan Chase & Co., is clearly identified with the business the commission is seeking to regulate with its proposals.

The commission is based in an ornate beaux arts–style building in central London that gives a false impression of extravagance. Its offices are suitably sober and austerely furnished, and the five commissioners are conducting their inquiry with the help of a team of 14 civil servants. The commission has so far held about 400 meetings, mostly on a small scale, with a variety of industry executives and regulators from around the world. Although it has not held high-profile televised hearings like the Financial Crisis Inquiry Commission in the U.S., the U.K. commission represents the country’s most serious effort to investigate the root causes of the financial crisis and propose regulatory remedies.

In its initial issues paper, published in September 2010, the commission discussed the possibility of adopting a U.K. version of Glass-Steagall, as well as an alternative proposal for so-called narrow banking. Under the first option, a financial institution would not be able to combine commercial banking, including deposit-taking, with investment banking activities such as the underwriting and trading of securities. With even the U.S. having rejected a return to Glass-Steagall and Sir John appearing to have ruled it out in January, few observers expect the commission to propose such a move. The narrow-banking option would require institutions to put their retail banking operations in separately capitalized subsidiaries and back consumer deposits with safe, liquid assets such as government bonds, effectively insulating them from investment banking activities. Banks contend that such a change, known as subsidiarization, would saddle them with prohibitively high funding and administrative costs. RBS recently estimated that the funding and other benefits of its universal banking structure, which the proposal would eliminate, amount to as much as £4.8 billion a year. “A ring-fenced retail banking unit would face higher funding costs, and that in turn would raise the cost of borrowing for corporates,” says Giles Williams, a financial services regulatory partner at accounting firm KPMG. Sir John’s recent comments questioning the practicality of this option suggest that the banks are winning the argument.

Even if the commission does propose structural changes to the industry, most analysts see little chance that the government would endorse such measures because the Treasury’s interests as a shareholder are gaining sway. In March, UKFI appointed Deutsche Bank as an adviser on strategic options for Northern Rock; bankers say the agency will probably want to conduct a sale as soon as possible after the banking commission publishes its final recommendations in September. RBS and Lloyds may pose tougher challenges. Both banks are eager to exit from government ownership; RBS CEO Stephen Hester said last year that he would be disappointed if the divestiture process didn’t start in 2011, while António Horta-Osório, who took over as CEO at Lloyds at the start of March, has already revamped top management and announced job cuts to ready the bank for a share sale. The stock prices of both banks have been trading below what the government paid, however. Lloyds was trading late last month at 60 pence a share, below the government’s purchase price of 63p, while RBS was trading at 42p, compared with the government’s price of 50p.

Still, banking industry executives expect the commission to propose some new regulatory restraints, most likely in the form of higher capital charges or divestitures of retail branches. “There won’t be a do-nothing option,” says the BBA’s Chisnall.

Sir John has frequently cited capital as a chief area of concern, saying in January that banks needed to increase their “loss-absorptive capacity.” Those comments suggest that the commission could recommend raising capital requirements above the 7 percent minimum level stipulated by the new Basel III accord. Commission members have held talks with regulators in Switzerland, where authorities have decided to set a higher core tier-1 ratio of 19 percent — known as the “Swiss finish” — by 2019.

The major U.K. banks already exceed Basel III requirements. At the end of 2010, Barclays reported a core tier-1 capital ratio of 10.8 percent of risk-weighted assets, followed by RBS at 10.7 percent, Lloyds at 10.2 percent and HSBC at 10 percent. Those levels were well in excess of the 5 percent minimum that the European Banking Authority will require under a new round of stress tests it is conducting on banks this spring. In coming years the Basel accord will progressively tighten the definition of capital to equity or equitylike instruments, but even so, all of the big U.K. banks insist they will be comfortably above the 7 percent minimum that takes effect in 2019.

Banks have already begun lobbying against any additional capital requirements, arguing that any such move would defeat efforts to boost bank lending. New capital charges could also rattle investors and undermine bank share prices. HSBC’s shares tumbled 4.7 percent in February after CEO Stuart Gulliver announced that the bank was lowering its return-on-equity target to a range of 12 to 15 percent from 15 to 19 percent because of the new Basel capital standards. Douglas Flint, the bank’s chairman, said Basel III made it a “near impossibility for the industry to expand business lending at the same time.”

Many investors and analysts agree. “The U.K. banks would have to shrink their balance sheets if they were asked to raise their capital ratios any further,” says Exane BNP Paribas analyst Gordon. Paul Vrouwes, who manages the €350 million ($495 million) ING (L) Invest Banking and Insurance fund at ING Investment Management in Amsterdam, says higher capital charges would hurt U.K. bank stocks. “Swiss banks are less attractive now than banks in Germany, where extra capital buffers are not expected, and I expect that U.K. banks would also be at a disadvantage if the commission raised capital requirements,” Vrouwes says.

Swiss banks have so far embraced their tougher capital regime, if only out of necessity, undermining the U.K. banks’ complaints. In February, Credit Suisse CEO Brady Dougan boasted about his bank’s groundbreaking $6.2 billion issue of contingent convertible securities, which change into equity under stress situations and count as core tier-1 capital under Basel III. “We are at the forefront of industry developments, and it underscores our commitment to a sustainable business model for the new environment,” he said.

In a January research paper, economist David Miles, a member of the Bank of England’s Monetary Policy Committee, estimated that raising core tier-1 ratios to a range of 16 to 20 percent would increase funding costs for U.K. banks by only 0.1 to 0.4 percentage point. He also asserted that forcing banks to replace 5 percent of debt securities with equity every year would triple their equity capital in 15 years and enable them to increase lending by 7.5 percent a year.

“Raising capital ratios to Swiss levels would not be seriously damaging to the banks,” says Simon Johnson, a research fellow at the Peter G. Peterson Institute for International Economics in Washington and former chief economist at the International Monetary Fund. “The effect would be to lower returns on equity, but investors should accept this in return for lower risk.”

The commission is also focusing its efforts on competition in retail banking — not surprising given Sir John’s antitrust background and the concentrated nature of the British market. The Big Five banks alone have combined assets of 450 percent of GDP, a dramatic concentration of financial power compared with the 1960s, when the U.K. had 16 clearing banks with assets totaling 32 percent of GDP, according to research by Credit Suisse banking analyst Jonathan Pierce.

Competition is in the eye of the beholder, of course, and industry executives insist that the U.K. market has far more of it than most of Europe. The Herfindahl index, a statistical measure of industry concentration commonly used by regulators, indicates that the U.K. ranks a lowly 23rd in Europe, says the BBA’s Chisnall, citing European Central Bank figures. By that measure, U.K. banking concentration exceeds that of Germany and Italy but is lower than France’s and Spain’s.

The commission has been holding its cards much closer to its chest on this issue. In its September 2010 issues paper, the panel said it was considering “the option of requiring the U.K.’s largest banks to divest assets with a view to creating a more competitive market structure.” It also pointed out that the government’s holdings in RBS and Lloyds provided an opportunity for a “pro-competitive restructuring” of the banking sector.

Increasing competition would probably appeal to Chancellor of the Exchequer Osborne, who expressed concern about the level of competition in the retail market before last year’s election. Some economists say competition can help address the systemic problem of banks being too big to fail. “A larger number of smaller and simpler banks is desirable,” says the Peterson Institute’s Johnson. “At the moment, we have too many banks that are too important to fail, and the result is lemon socialism, in which the state ends up holding the lemons.”

As it is, some British banks are already facing pressure from European regulators to reduce their footprints. In 2009 the European Commission, which reviewed all of the state aid granted to banks, examining its anticompetitive effects, ordered Lloyds to shed 600 of its 3,000 retail branches and RBS to unload 318 of its 2,200 branches. Analysts say those banks would be the most likely targets of any similar recommendations by the U.K. banking commission. Lloyds alone will have a 25 percent share of the U.K. market for current accounts and 23 percent of the market for credit cards and mortgages even after it complies with the European divestiture order.

“The commission would like to create a sixth big retail bank in the U.K., but it’s not clear how this could be achieved,” says PwC’s Forrest. In recent years only a few new entrants, such as U.S. entrepreneur Vernon Hill’s Metro Bank, have come into the U.K., and analysts see few potential acquirers lurking on the horizon. “The barriers to entry are very high as the FSA has strict rules on certainty and security for depositors,” says KPMG’s Williams.

One way to jump-start competition would be to require Lloyds to spin off HBOS, undoing its crisis acquisition. The idea has some notable supporters. In a submission to the banking commission, Sir George Mathewson, former CEO and chairman of RBS, contended that the HBOS acquisition was “fundamentally wrong for several reasons — competitive, cultural and commercial.” Reversing that government-sanctioned deal would be a bold step, however, and so far the commission has offered no hints that it is prepared to go that far with its recommendations.

Meanwhile, doubts about what the commission will ultimately propose in its September report are weighing on bank share prices. “It’s a factor holding back the rerating of bank shares to precrisis levels,” says Exane BNP Paribas analyst Gordon.

Cameron and Osborne may not know the commission’s endgame, but they have plenty of reasons to want to end the regulatory uncertainty surrounding British banks.