A tricky balancing act or an impossible one?

stephen clarke, 12 September 2011

Today the Independent Commission on Banking (ICB) released its final report. Little has changed in terms of the recommendations of the Commission since the interim report, and as expected the result is a balancing act between a number of different goals. While bankers and their bashers may both criticize the result, it is clear that the Commission has done a good job considering its tricky task. The bigger question is whether the balancing act the ICB has attempted, works in practice.

The ICB aims to create a more stable and competitive basis for UK banking in the longer term. The ICB clearly appreciates that there is often a trade-off between stability and competition however it is keen to suggest that competition can buttress stability. This is not implausible, competition between businesses can ensure that customers benefit from the best service at a competitive price, however this requires discerning, knowledgeable customers. However this is where the ICB fails to identify a contradiction in its thinking. On the one hand the Commission envisages vigorous competition among banks created by well-informed customers yet on the other it also recognises that ordinary depositors [do not] have the incentive (given deposit insurance to guard against runs) or the practical ability to monitor or bear those risks [that banks will fail].

It is not difficult to appreciate how the ICB’s welcome proposal to improve competition by making it easier to switch banks could lead to instability. I was recently incredibly annoyed with my bank when it blocked my debit and credit cards when I was abroad, this was despite the fact that I had told the bank that I would be abroad and where I was going. I was also annoyed when I was forced to remain on hold for over half an hour to sort the problem out. Under the switching regime envisaged by the ICB it would be incredibly easy for me to switch banks, perhaps to one that spent more money on customer service, or one more willing to absorb losses from fraud. However a bank offering a better service would have to pay for it, and may try to do so by taking on more risk. This could happen if banks compete more vigorously for depositors.

This is not to argue that competition would increase risk, but that it could be a double-edged sword and with more competition there will be winners and losers and as in all industries losers may lose money. However in banking, depositors cannot be losers, something banks realised a long-time ago.

This takes us on to stability and reducing the exposure of the tax payer to bank failure. The ICB recognises that although consumers welcome competition they do not welcome suffering as a result of it. Thus consumer deposits will continue to be protected, but banks should no longer benefit from the Government’s willingness to insure deposits. To achieve this, the ICB proposes ring-fencing deposits and other retail services and increasing the loss-absorbing ability of the retail part of banks. Partial separation of retail banking and wholesale and investment banking is intended to increase stability, while allowing banks to continue to benefit from a diversified business model.

Banks, in particular Barclays and RBS, which pursue this diversified model will undoubtedly complain that separation reduces their profitability and competitiveness. The ICB recognises that this could happen, but argues that this is a fair price to pay to ensure that risk is priced correctly and that the public cost of possible bank failure is included. The ICB states: ‘The fact that some other countries may implicitly subsidise their wholesale/investment banks does not make it sensible for the UK to do so.’ In effect the ICB does not wish to undermine the competitiveness of Britain’s financial sector but it does not wish to subsidise it either.

Although I have pointed out a number of inconsistencies in the ICB’s thinking; in particular between informed yet protected customers and diversified yet separated banks, this is not a criticism. The ICB clearly recognises that banking is a complex and at time almost paradoxical industry. This is especially true in the UK and the ICB recognises this:  indeed part of the challenge for reform is to reconcile the UK’s position as an international financial centre with stable banking in the UK.

Whether these two goals can be simultaneously recognised remains to be seen, but the ICB has done a good job of attempting to reconcile them. Sadly, if reconciliation is impossible there could be far harder choices ahead for Britain and its financial services.