future of banking commission-uk

8/7/2019 Future of Banking Commission-UK

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The Future of Banking CommissionThe Future of Banking Commission


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ContentsCommissioners 2

Foreword 4

Executive summary 6

List of recommendations 8

Chapter 1 Background 12Chapter 2 Structure 22

Chapter 3 Regulation 38

Chapter 4 Culture and corporate

governance 54

Annex 1 Terms of reference 78

Annex 2 List of witnesses79

Annex 3 The Which?

Big Banking Debate 80

References 82

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Anticlockwise from top right sitting around the table: PHILIP AUGAR, PETER VICARY-SMITH,

RT HON JOHN MCFALL, RT HON DAVID DAVIS MP, DAVID PITT-WATSON, CLARE SPOTTISWOODE


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Welcomefrom the ChairmanDavid Davis MP

The political and economic costs have already been enormous.

We have lost over 16 million jobs around the world. Banks havehad to write down $2.3 trillion o assets.

The problem is even more important or Britain. Banking sector

assets in the UK are ve times the size o our GDP, a ratio greaterthan the USA, Canada, or the Eurozone. When disaster struck in2008, the government stepped in to avert complete economic

collapse. The nancial crisis caused substantial damage to theeconomy and the rescue cost the British taxpayer billions o pounds.

Financial crisies are nothing new in human experience, certainly

not in modern experience. No nancial crisis has been identicalto any o its predecessors, but institutional memory is short andindividual memory is even shorter. Yet another catastrophe o our

own creation has reared its head, and devising a comprehensivesolution has proved itsel a challenge to our best minds.

Each crisis has been bigger than the last, and without intelligent

and decisive action, the next one may be bigger than the Britisheconomy can aord.

We can identiy themes that played a central role in 2008:over-leverage, mis-pricing o risk, misunderstanding o products,and cheap credit, all concealed by concomitant asset price inationand opaque accounting practices. In response to the end o each

asset bubble o the past two decades, central banks introducedexpansionary monetary policy. Instead o allowing several smallmarket corrections, the cycle o monetary expansion uelled one

big collapse in 2008.Banks enjoy an implicit guarantee rom the government because

the core services they provide are considered essential to the

economy and to society, much like a utility. The political cost oanother nancial crisis would be so high that it is impossible entirelyto remove this implicit government guarantee. Britain cannot aord

to leave the taxpayer open to an unlimited assault on the publicpurse. The best option is to make the guarantee explicit and tightly

circumscribed.The Commission has considered some o the most intractablenancial problems acing our society today. Living wills need to be

stronger to limit the taxpayer guarantee and reintroduce marketdiscipline. We need to resolve conicts o interest within universalbanks, and the problem o banks that are too big to ail. The banking

industry has had a high degree o rivalry, but not enough competitioneectively to deliver good products and services to clients. Rather,rms have taken advantage o market ailures such as inormation

asymmetry. We need a regulatory system that will reintroduce therigours o eective competition and market discipline to nancialservices. The possibility o ailure must be real enough that banks

will manage their own businesses prudently. The ormalisation ointernational accounting rules had the perverse and unintendedeect o reducing the requirement on accountants to exercise

judgment in signing o balance sheets. As a result, one o the

historic checks on asset value was undermined.This is a complex, multi-causal problem with multi-part answers.

Nevertheless, in this report the Commission has endeavouredto provide a clearer understanding o the nancial system, andto recommend that the new government implement practicablesolutions to the problems we ace.

We would like to thank all those who contributed to the report.A special thanks goes to those who attended the Which? Big BankingDebate, to the many witnesses at the public events and to those

who provided comments on the report during its development.

The Rt Hon David Davis MP

Chairman

We have established an independent banking commission

In 2010, Britain is emerging rom the worst nancial crisis o our lietimes, a maniestation o

a deep-rooted and persistent set o problems. Banking is a structurally awed industry that

has ailed its customers, its investors, and the taxpayers who stand behind it.

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Not too big to ail: Reorms to thestructure o bankingThe rst area o reorm is the structure o banking. This shouldensure that there is no advantage received by banks or theircreditors who behave imprudently. Where wrong decisions aretaken, they should not threaten peoples savings or the stabilityo the nancial system.

The government currently provides an implicit guarantee tobanks to support the stability o the nancial system and thecontinuity o core services. This subsidy enables banks to reducetheir borrowing costs and run higher levels o risk and leveragethus increasing the likelihood o taxpayers being orced to stepin and support the banking sector.

Banks need to be structured so that they can ail without

catastrophic damage to their customers or the economy.An indispensable rst step is the introduction o a system otransparent and public living wills detailing how the collapse oa bank would be managed. These should ensure that within anybanking group the core deposit and lending unctions and thepayment system are ring-enced. They should also set out howcustomers would be treated in the event o ailure.

Depositors need better protection; it is simply not acceptableor individual depositors in UK banks to discover that they have

unwittingly put their savings at risk through the misguidedactions o some banks in parts o the capital markets. The extento depositor protection must be made clear and transparentto consumers, and individual depositors put rst in the rankingo creditors. A new class o sae haven accounts should beestablished with a 100% guarantee, but which would only beinvested in sae assets.

We received powerul and persuasive evidence rom expertwitnesses in avour o restructuring the banks. The compulsoryseparation o banking activities has the potential to solve manycurrent and persistent problems and the governments newcommission should consider urgently and in great detail astructural solution to the problems caused by large, integratedbanks.

In any case, we also believe the UK government should, withits international partners, create a structure which addresses theconicts o interest inherent in much o investment banking.To this end we would go urther than the so-called Volcker ruleand seek a separation o investment advice rom the executiono trading.

We note the huge growth in securities and derivatives markets,and we also propose reorms to make these more transparent,and less open to creating systemic problems.

Executive summary

We established this Commission because the publics voice has not yet been sufciently heard

in the ongoing debate about the uture o banking. Our cross-party approach and the act that

we have heard rom so many members o the public as well as banks, regulators and experts

gives this Commission its unique perspective. All were united in wanting a banking system that is

secure, protable and that properly ulls its crucial role in society.

To date responses to the crisis have tended to ocus on rebuilding the capital o the banks, to

make them more secure. Yet what struck us is not just the problem o bank solvency. Rather it

was the degree to which the nancial crisis highlighted systemic problems in a sector that had,

or a long time beore the crisis, ailed to deliver or its customers or or society at large.

Putting more capital into the banks, and then returning to business as usual is not enough.

We need to build a sustainable banking sector, ocused on delivering value to the economy

outside its own nancial world. To do this requires signicant reorm to the structure, regulation,

governance and culture o the industry.


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Eective competition: a newapproach to regulationA new ocus o banking regulation should be to ensure thatcompetition delivers benets or those the banks are there toserve and that bankers, not regulators, should take primaryresponsibility or the management and stability o their banks.

We recognise that at present, the nature o the bankingindustry creates temptations to prot in ways which do notdeliver value to consumers. So, or example, our witnesses havenoted that banks are able to deliver short term prot rom taking

on risk, to sell products protably that do not meet customersneeds, and to do all this with other peoples money. Complaintsabout banks are increasing and signicant criticism has beenmade that product choice, suitability and selling practicesoperate against consumers interests.

These characteristics o the nancial services industry makethe introduction o competition difcult. In our view that meansthat all the more eort needs to be put into how eective andbenecial competition can be established in nancial services.In an industry so raught with conicts o interest, consumersneed better protection. Regulation has ailed to make banks,and other nancial institutions, properly subject to the rigourso eective competition.

Consumer protection regulation should have a primary dutyto promote eective competition so that competition providesmarket discipline where possible. Where it is not possible theregulator would intervene so as to mimic the benecial eectso competition.

As the nancial crisis deepened, signicant taxpayer supportwas required to prop up ailing banks. This is unacceptable.However, instead o simply ensuring banks are renanced,regulation should concentrate on ensuring that i in the uturebanks do ail, they pay the price and never again threaten tocreate unacceptable social costs.

To do this, the Commission considers it vital that the prudentialsaety o banks be the responsibility o their boards. It shouldnot be delegated to regulators. The ultimate purpose o

prudential regulation cannot be to bail out the banks, but toensure that banks can ail but without signicant harm to vitalbanking services. Where a bank is too big, or otherwise toosignicant to ail, the prudential regulator would intervene torestructure it.

A healthy culture: checks andbalances in an ethical rameworkThe third area o reorm is in the governance o the banks.We need to see greater independence and proessionalismamongst those charged with overseeing their operations. Wehave heard how, over the past ew years, those who might haveurged caution ailed to do so: board directors, shareholders,accountants, auditors and credit rating agencies. We need tore-enorce the independence and proessionalism o all theseagents.

Thereore one o the key recommendations o this report isto strengthen all these areas o corporate governance, romthe duty o und managers to the operation o the credit ratingagencies. We have recommendations or reorm o accountingand audit, an area which we believe is in danger o beingoverlooked, designed to enhance the role o the proessionalauditor in maintaining the integrity o our nancial system.

Remuneration practices within banks have been a key sourceo concern. Senior executives should be rewarded or long-termbusiness perormance and shareholder return. To tackle mis-selling and the sales-based culture disliked by customers andbranch sta alike, banks should cease rewarding rontline staor increasing sales. Instead they should receive bonuses linkedto levels o customer satisaction, the air treatment o customers,and resolution o complaints.

These reorms will help usher in a new culture or the bankingsystem. That culture should be underpinned by an explicitacceptance by bankers and others in nancial services o theduties and responsibilities they owe. Bankers, like doctors,teachers and lawyers, should be trustworthy proessionalsmotivated by the service which they and their institutionsprovide. This will require a new approach to dening the culturewithin nancial organisations and ensuring that all levels o theorganisation adhere to it. To bolster this cultural change wewant to see bankers engage in the same sort o proessionalstandards training undertaken in other proessions, with thesame remedies and sanctions applied where individuals ail

in their duty o care.Our recommendations add up to a radical overhaul o the

banking system, a programme that not only seeks to preventthe last crisis rom happening again, but which also addressesthe systemic problems which have destroyed the trust betweenmany banks and their customers and which have at the corethe seeds o another, unoreseen catastrophe. It aims to createa banking industry o which its participants, and the society theyserve, can be justiably proud.

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List of RecommendationsA) Structure

Resolution regimes1. The Commission is supportive o proposals or living willsas a step towards reducing the government guarantee andre-injecting market discipline by allowing banks to ail. The livingwill should ensure that within any banking group the core depositand lending unctions and the payments system are ring-encedwith their own separate balance sheet, liquidity and undingmechanism.

I it is to have a behavioural eect, the living will cannot simply bea private exchange between the bank and its prudential regulator.Rather, it must be a public document.

Depositor protection2. The Commission believes the 50,000 limit should be

applied to each brand rather than to each licensed institution.The Regulator should also prevent the misleading promotion oproducts which claim to provide a guarantee o capital, but whichare not covered by the compensation scheme.

3. There should be clear signs on all bank tills, websites andother promotional material produced by nancial services rmsinorming depositors how much o their deposit is insured by theFSCS.

4. A new class o deposit should be created, which carries a100% guarantee, but which should only be invested in saeassets such as government bonds. This idea was put orwardto the Commission by Mervyn King.

5. Depositor protection should include reorm to the bankruptcyprocedures so that the rank o creditors is changed to putdepositors at the top.

Should there be a ormal separationo banking activities?6. The living will is an absolutely indispensable rst step to reormthe nancial industry, but we need to consider structural reormas well. The commission has received powerul and persuasiveevidence rom expert witnesses in support o restructuring thebanks. There can be no prevarication on this crucial issue sincethe compulsory separation o banking activities has the potential

to solve many current and persistent problems. Thereore thegovernments new commission should consider urgently and ingreat detail a structural solution to the problems caused by large,integrated banks.

Breaking up investment banks7. Extending the Volcker rule to prohibit banks that advise clientsrom trading any orm o securities, and separating corporateadvice rom investor advice, would address many o the problemsthat integrated banks create.

8. Breaking up the banks would be a major recasting o theglobal nancial system. But it would eliminate conicts o interestrom most parts o the banking system and would contribute to asaer system by reducing the scale o individual banks. It wouldrequire global consensus and co-ordination but the UK is one othe worlds leading nancial centres and we encourage the UKgovernment to initiate global debate on this issue.

Derivatives trading9. All securities above a certain size shall only be tradable i theyare registered on a system such as the Stock Exchange DailyOfcial List (SEDOL).

10. Investors, speculators and traders should have to disclosematerial positions in a company, no matter whether thesepositions are held as stock, options or other derivatives, orwhether these positions are short or long.

11.There should be a thorough review o margin requirementsand o all derivatives trades, whether these be undertakenthrough exchange trading or central counterparty clearing. Theprice and volume o all securities and derivatives trades shouldbe known when the trade takes place.

12. The Commission notes the growth o o-market trading inequities and other securities, and the existence o dark pools osupply, and nd it difcult to believe that these add to the stabilityo the market. We would recommend a thorough and ongoingreview o these developing practices.

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B) Regulation

13. There should be a signicantly dierent approach toregulating banks, to ensure there is enhanced competitiveprotection or the consumer, and that the stability o the nancialsystem is maintained, without putting taxpayers at risk. In practicalterms, this entails splitting regulation o the nancial sector intothree distinct unctions, each with a dierent remit:dConsumer protection regulationdPrudential regulationdSystemic risk regulation

Consumer protection regulation14. The regulator responsible or consumer protection regulationshould have both: (a) an explicit mandate to promote eectivecompetition in markets in the nancial sector; and (b) thenecessary powers to regulate the sector to achieve this, including

the ability to apply specic licence conditions to banks andexercise competition and consumer protection legislation. Thesepowers will be concurrent with the competition powers o theOFT, and will enable the regulator to both enorce competitionlaw and make market investigation reerences to the CompetitionCommission.

15. We are in avour o exploring urther a number o specicmeasures that could be taken by a regulator with a dedicatedremit or consumer protection:

1 Ensure customers can easily transer products andaccounts.

2 Ensure customers with overdrats are not overcharged.3 Set deault settings on services, products and accounts in

the customers best interest.4 Allow customers to choose to opt-in to unauthorised

overdrats.5 Ensure banks do not take advantage o existing

customers.6 Act to prevent obscure charges or unair, asymmetrical

contract terms where these are present in nancialproducts and services.

7 Ensure ull and transparent disclosure on all products.8 Consider introducing standard products or some basic

services which all retail providers have to provide, anda common orm in plain English to explain the key termsso that customers can easily compare products provided

by dierent providers on the same basis.9 Empower customers to seek compensation via a collective

redress process.10 Promote bank retail depositors to rank ahead o all other

creditors, including bondholders.11 Ensure consumer deposit accounts clearly highlight

whether or not they are covered by the FinancialServices Compensation Scheme (FSCS).

12 Prohibit those commission structures which incentivisemis-selling.

13 Firewall conicts o interest, and i the conicts areintractable, orce structural change to address the problem.

Prudential regulation16. The Regulator must change its approach rom attempting toprevent ailure to ensuring banks can ail, but without signicantharm to vital banking services. The Commission believes relyingon greater and more intense supervision is the wrong approach.The prudential regulator would take pre-emptive steps to:dProtect ordinary depositors, including by putting basic deposits

above all other creditors in the liquidation preerence,as discussed in chapter two;dEnsure the continuity o all essential services provided byan institution; anddIn the case o any institution that is too big, or otherwise toosignicant to ail, intervene to restructure that institution such thatits ailure would no longer present a systemic risk.

These proposals have two important implications. First, theprudential regulator will be the guardian o living wills. It willsupervise the introduction o, and monitor, living wills with thepowers required to ensure that essential services continue tobe provided even ater a bank has ailed. Second, the prudentialregulator will have specic powers to restructure banks where itis not possible to construct a credible living will.

Systemic risk regulation17. The purpose o systemic risk regulation is to oversee liquidityand capital standards at a macro level, and to translate the macrostandards down to individual rms. It is concerned with the inter-dependence o banks and their exposure to common economy-wide shocks that may aect key sectors, such as commercial anddomestic property. Its role is to act counter cyclically, to take thepunch bowl away when asset price bubbles grow unsustainably.This is not an easy task, and the organisation has to have thecredibility and the backbone to run against the market.

Confict in regulatory objectives18. The duty to have regard to the international character onancial services and markets, and the desirability o maintainingthe competitive position o the United Kingdom should beabolished as a specic objective when regulating banks.This objective creates a conict o duty and tends to supportthe status quo and discourage new entrants. Internationalcompetitiveness is best served by ensuring that domestic banksare able to compete eectively, without subsidy or specialtreatment. Promoting the success o British industry is a jobor the government and the industry trade bodies, not or theregulator.

Independence o the managementboards o the regulators19. In uture, the board o any nancial services sector regulatorshould be balanced to comprise members who are independento the industry, while also having members with the backgroundand skills necessary to understand the workings o the nancialservices sector.

PETER VICARY-SMITH, CHIEF ExECUTIVE OF WHICH?

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C) Culture and corporategovernance

Bank directors and boards: right people,right duties, right resources20. The Commission recommends that the Companies Act beclaried and, i necessary, reinorced by a change that requiresdirectors to give consideration to the eect o a companysactivities on the stability o the nancial system as a whole, evenwhere this conicts with a narrow denition o shareholdersinterests. There should be a statement in the accounts to theeect that directors believe they have ullled this duty.

21. The Commission recommends that non-executive directorsshould make greater use o their powers to appoint independentadvisers to assess risk and to measure customer experiencethrough commissioning their own research. These reportsshould be disclosed to shareholders.

22. Non-Executives should be charged with particular tasksand particular areas where their challenge is expected.This would help ocus the minds o both non-execs, andthe rest o the board, on creating a comprehensive skill set.Stakeholders could compile a list o people who would be wellqualied as bank directors, and encourage the chairmen othe nominations committee to consult this list beore makingappointments. I bank behaviour does not change, we believegiving stakeholders nomination rights to the board should beconsidered, similar to the systems in Sweden and Italy whereminority shareholders have nomination rights.

Remuneration: right incentives23. The Commission recommends that remuneration structuresor senior executives need to be ar longer-term in nature, withreward or nancial measures aligned to return on assets, andthe creation o sustainable long-term absolute shareholder valueover a 5 and 10 year period. There should be no reward orincreasing return on equity or earnings per share, which can beaccomplished by increased leverage and taking extra short-termrisk.

24. Rewards or senior executives in retail banking should belinked to customer measures including overall satisaction,complaint levels and their air resolution and regulatorycompliance. The details o these measures should be available

on the banks website, or senior executives as well as ordirectors.

25. The Commission recommends that remuneration orrontline and branch sta should not be linked to sales, andshould reward customer satisaction the air treatment ocustomers, and the air resolution o complaints. There shouldbe no commission or bonuses received or selling products.

26. In the interim, the FSA should make it clear that institutionswhich do not adopt this rule will be subject to close scrutiny, andthat senior management will be subject to enorcement actionor any remuneration structures or sales targets which contributeto mis-selling by putting excessive pressure on rontline sta.

Corporate governance: shareholderoversight and trustee duties27. The Commission believes trustee bodies holding shares andother securities have responsibilities o ownership, and shouldnot only be allowed, but should indeed be expected, to exercisethem. The law could useully be claried on this point.As a matter o course, contracts between trustees and agentsmanaging shares on their behal should ideally incorporate thesame duciary duties which a trustee owes to their beneciary.

28. The Commission recommends that implementation o theStewardship Code or Institutional Investors be mandatory orthose und managers which own bank shares. Shareholdersshould also be able to state that they ask the boards o banksto generate value in the long-term, and to avoid undue risk or,

i they have dierent goals, should be explicit about what thosegoals are. Fund managers should report by what process theyseek to inuence banks, and should report actual engagementactivity, and its relative success or ailure in inuencingmanagement practice.

UK Financial Investments (UKFI)29. The Commission recommends that UKFI works as anactive shareholder, not only to encourage the restructuring othe two UK banks o which it is the majority owner, but alsoto work with other shareholders to ensure that, at the point odisposal, the structure o the UK banking industry is sustainableor the long-term. This should be done in coordination withother shareholders, and its aim should be to help ensure theimplementation o the recommendations o this report. Inparticular, UKFI should work to ensure the needs o long-termshareholders, individual customers, households and rms areplaced at the heart o a transormed banking system.

30. The government should be held to account to ensurethat UKFI applies a public-interest test to its restructuring andnal disposal o public shareholdings or ownership o banks,to ensure the architecture o the industry is sae, and thatcompetition is stronger post-divestment.

Corporate governance:accounting and auditing

31. There need to be undamental questions asked about thepurpose o the audit. The Commission is concerned that auditorsailed to report on the higher levels o risk and leverage beingrun by the major banks.

32.There should be a reinstatement in law o the principle thatnancial accounts represent a true and air statement o theposition o the company, and that they are presented in a waywhich places substance over orm.

33. Auditors should be asked to attest that bank accountsrepresent a true, air and comprehensive statement o theaairs o the company, and that they are prepared in keepingwith the spirit as well as the letter o solvency and otherregulatory requirements.

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34.The accounting principle o prudence or conservatismis relevant when determining whether an asset is recoverable,and thereore has its place in determining loan loss provisions.The quest or objectivity also has its place, through mark tomarket and other devices, where doing so provides meaningulinormation (either in the balance sheet or in the notes). Havinga robust classication criterion or assets and liabilities, so theyare classied appropriately, either at cost or at air value, is criticalto ensuring the numbers reported are meaningul and relevant.Regardless o the measurement basis, there is no substitute orthe proessional judgement o the auditor.

35. The auditor should be required to report all signicant riskactors which come to their attention as part o the audit. TheFSA should extend its current trend o encouraging much more

dialogue with auditors and the FSA should require urther workrom the auditor o any areas o a banks activities where theyhave concern. It is important that early work is done to nip thingsin the bud, and auditors are well placed to help in this activity.This does, however, depend on improving the level o dialoguebetween the auditor and the regulator. In the unlikely event thatauditors nd that this creates a conict o interest, their dutiesshould be claried to deal with this point.

Corporate governance:credit ratingagencies36. The key problem is that rating agencies compete to oera better service to those who issue bonds, rather than to thosewho buy them. For practical reasons, it is difcult to receiveincome rom the many thousands o institutions and individualswho may buy a bond. However, it would be possible to removeconict o interest i, or example, a bond issuer was assigneda rating agency, rather as a judge might be assigned to try acase. Rating agencies which could show they delivered accurateratings could be assigned more work, to give an incentive orthem to improve their perormance, and indeed to encouragenew entrants to the market. Alternatively, buyers o bonds couldbe asked to set up a not-or-prot organisation to review theCRAs ratings. The unding or these proposals could be raisedby a levy on bond issuance.

A code o conduct or

the banking industry37. The Commission recommends the development o a GoodFinancial Practice Code. This code should have a similar statusamongst the banking proession as similar codes o conducthave in the medical and other proessions.

38. In addition to the development o a Good Financial PracticeCode, the Commission recommends that bankers receivecompulsory ormal training beore they are able to ully practicein their proession. This should include training in the ethicalbehaviour expected o the members o their proession,including how to resolve conicts o interest.

39. The Commission recommends that this Code should bedevised and enorced by a new proessional standards bodyalong the lines o the General Medical Council, or the LegalServices Board.

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Chapter one

Why we have written this reportFour core beliefs underlie this report

Banking mattersThe banking industry has undamental problemsCurrent banking reorm wont solve themWe need a new approach which recognises why banking is dierent


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John Wright, chairman, Federation of Small Business

I think the banks have got a big job to actually

try and restore the confdence o smallbusinesses in their service, without any shadowo a doubt, and they have to work much harderthan they are at the present time

Bkg mttesAn eective banking system is essential to the working o amodern economy. Although much heat has been generatedabout whether parts o our nancial markets are 'socially useless',a key lesson rom the crisis is that banking is so undamental tosociety that governments had no choice but to support it. Thealternative would have been economic collapse. It is thereore oproound importance that we have a sustainable banking systemwhich serves the needs o society eciently and eectively.This is particularly true o the UK where the nancial servicesindustry employs over a million people and, led by banking, hascontributed between 5% and 8% o nationaloutput over the past decade.1

Evidence rom Robert Peston'One o the things that seems to be slightly odd abot banks is

i yo look at social [and] economic instittions, its ery hard to

think o any that does [anything] that is more sel. They take

srpls saings rom people who dont really know what they

particlarly want to do with them at any particlar moment, and

conert that into loans to hoseholds who may wish to by a

property; or to bsinesses that need nance or inestment.

This is an absoltely extraordinarily alablesocial andeconomic nction.

'And looked at another way they also proide a bit o social

mobility. I we didnt hae banks prepared to engage in that kind

o matrity transormation, the only people who wold be able

to inest in bsinesses or by hoses wold be people whoe

inherited ast amonts o wealth.

'So all o this is antastically sel, and the only reason I was

thinking abot it in those terms is it is absoltely extraordinary,

gien all this sel st they do, that their reptation is so

nbelieably poor.'

Lord Turner has pointed out that all parts o the industry maynot have an equally valid social purpose. Some parts o thebanking industry matter more than others; but all those who gaveevidence to the Commission, including regulators, academics,banks customers and bankers themselves, broadly agreed thatthe essential unctions o the banking system are:

1The acilitation o payment: the agreement and mechanismsto distribute cash and credit payments between individualsand businesses, including access to direct bank transers (BACSand CHAPS), card payment systems and ATMs;

2Co-ordination: bringing savers (deposit holders) andborrowers (investors) together, despite the dierent sizeso unds or dierent timings in the demand or money, by oeringa return on savings and lending at interest; and

3Risk management: pooling the deposits and diversiying theirrisk by lending to a diverse range o borrowers.Box 1 contains some o the views on the unction o the bankingindustry, expressed during the Commissions evidence sessions.The Commission believes John Kays observation, that the valueo banking lies in the services it provides to the world outside, notto activity within the nancial system, is o particular note.

The bkg dusty hsfudmetl poblems

Banking changed dramatically in the 1990s and early 21st century.Historically, it had been a straightorward business, in whichbanks collected deposits rom savers, and then lent these out toborrowers. Over time, banks themselves became part o widernancial conglomerates, which led to new risks and confictso interest. But this basic model was recognisable as late asthe year 2000, when the British banks, between them, loanedout no more than they held in customer deposits.

Between 2000 and 2007, powerul orces, which had beenbuilding or more than a decade, transormed the industry. Thetrigger was the deregulation o the US banking industry in the1990s, which enabled the previously heavily restricted US banksto undertake a wide range o activities. These new practicesormed the template or banking in other countries. Oneimportant development was the increasing use o securitisation,a new nancial technique that enabled banks to slice and dicethe loans they had made, and sell them on to others. (See Box 2,p16, or more detail on securitisation.)


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Participant Big Banking Debate

Banks dont value

customers they view

us as cash cows

the world changed, the models did not work. Risk had beentranserred and concealed, not reduced. And it had been

amplied by modern nancial instruments, such as derivatives,and the consequences compounded by unoreseen linkagesin the newly connected global economy.

The faws in the model are evident at many levels. Within theintegrated banks, losses rom the riskier investment bankingactivities can put the deposits o their individual current accountand savings customers at risk. Potential conficts o interestare rie. Pricing is opaque. Competition appears not to work.Customers are dissatised. Shareholder value has been eroded.Damage has been caused to the real economy. These issues aresystemic, not just conned to a ew badly run banks. The marketor banking services, both at a wholesale and at retail level, doesnot consistently generate the incentives or companies to work inthe interests o their customers. In a well-unctioning market, theorces o competition would encourage banks to deliver essentialservices ever more eectively and at ever lower costs. In banking,they have not done so. This leads the Commission to theinescapable conclusion that this is an industry with undamentalproblems, which is in need o radical reorm.

Evidence rom Antony Jenkins, chie executive,global retail banking, Barclays

COMMISSIONER Still on the same point, did yo

say that two-thirds o yor cstomers are either

satised or ery satised?

ANTONY JENKINS Yes.

COMMISSIONER And then 1% complain?ANTONY JENKINS Yes.

COMMISSIONER That means then that one third

o yor cstomers are less than satised?

ANTONY JENKINS Thats correct.

Cuet bkg efom wot solvethe dustys poblemsIn contemporary economics, there are ew more importantproblems than xing the broken banking model. The cost opublic support to the banking system is both unacceptableand unsustainable. The immediate and direct public cost to thetaxpayer o bailing out the banks has been huge, estimated at

131bn4 in cash injections, and publicly unded guarantees o850bn made available in the midst o the crisis.5The cost tothe economy in lost output due to the volatility brought on bythe instability in the nancial sector is much greater.

The knowledge that there is an implicit government subsidy, asProessor Julian Franks told the Commission, gives banks a low

ANTONY JENKINS

LORD TuRNER


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16

Beore the adent o

secritisation, uK banks

typically made loans sing the

deposits placed with them by

consmers and bsinesses.It was a simple model: raise

money throgh deposits, and

then lend some o that money

ot. The bank took the risk

that the borrower wold not

be able to repay, and hence

was carel abot who shold

receie a loan.

In the late 1990s, uK banks

began to make increasing

se o secritisation. First,they borrowed in the

secrities markets, in essence

replacing the need to nd

new depositors. By 2008,

uK banks had expanded their

loans to oer 800 billion

more than their deposits.

Northern Rock was

particlarly actie in

borrowing rom the secritiesmarkets. It wold make loans

to its cstomers, sing the

secrities markets to nd

them. This allowed Northern

Rock to expand its loan book

aster than it wold hae been

able to i it had remained

dependent on attracting

saers to nd lending.

At their peak, its loans

were more than three timesthe leel o its cstomers

deposits. This made it

lnerable to any disrption

to liqidity in the wholesale

banking market.

Second, particlarly in

the uSA, secrities markets

were also sed to sell the

loans which the bank had

made. Take, or example the

secritisation o mortgages.

Mortgage secritisation

is a transaction whereby

indiidal mortgages are

pooled together and trned

into bonds (called mortgage-

backed secrities), which can

then be boght and sold.

Sometimes these mortgageswere made or 'originated'

by banks, sometimes by

others. The key thing was

that those who originated the

mortgages were no longer

responsible or them, they

wold sell them on, either to

banks or to other inestors.

The attraction or inestors is

that these prodcts oered

a steady income proidedby the repayments being

made by cstomers towards

the indiidal mortgages

each month. Frthermore, by

bying a package o these

mortgages, the risk o dealt

on any indiidal mortgage

is spread, and hence, all else

eqal, risk wold be redced.

Wht wet wog?In the rn p to the

credit crisis, mortgage

originators increasingly sed

secritisation to expand

lending into higher risk areas

sch as sbprime. The theory

was that by diiding p the

parcels o loans into dierent

tranches, dierent risk proles

cold be accommodated andrisk cold be increasingly

spread throgh the nancial

system. What was orgotten

was that those who originated

mortgages now had little

interest in ensring that the

borrower wold be able to

repay. Inestors depended

on the assessment o CreditRating Agencies as to

whether the secrities they

were bying were 'inestment

grade'. Bt these agencies,

(who were paid by the

originators o the mortgage

secrities), got things badly

wrong. The nderlying sb-

prime mortgages started to

dealt. Once this started

to happen, inestors lostcondence in the whole

system and liqidity dried

p. Banks, like Northern

Rock, who depended on the

secrities markets to nance

their operations discoered

that their sorces o nds

had disappeared. And when

depositors became aware o

this they withdrew their nds.

Borrowing and lending

thogh the secrities markets

had proed to hae some

ery dierent characteristics

rom traditional banking

operations. It allowed

dramatic expansion in

banking operations. Bt it

meant that those issing loans

were no longer responsible

or the credit worthiness othe borrower. That loss o

responsibility proed to hae

toxic conseqences.

BOx 2: SECUriTiSaTiOn


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17

cost o borrowing, (because those who lend to the banks knowthe government will bail them out i things go wrong), and soencourages banks to lend more and more.6

'I yo look at some o the costs o capital reported by banks,

it was lower than water companies. How can the cost o capital

and risk o a bank be below that o a water company? The

answer is it wasnt, bt they were gien these explicit and implicit

garantees, which redced their cost o capital. This made hge

incenties to increase leerage.'

The subsidy also means that creditors do not exercise sucientexternal infuence. The consequence o this has been that themarket ailed to constrain the risky behaviour o large, complexbanking institutions. Mervyn King told the Commission:

'The real problem we hae now [is] not so mch that the

managers o banks go in saying, how can I be reckless today?

Its that the mechanism that we rely on or discipline to be

imposed on those instittionsis largely coming rom creditors,

the proiders o nance to those instittions. The blk o the

nance and the banking system is in debt orm, it comes

rom wholesale or other sppliers o debt nance and retaildepositors. Bt i all o these people eel that they eectiely hae

a garantee rom the state, they hae absoltely no incentie

to monitor the behaior o those instittions to which they are

lending, becase in essence, they probably think theyre really

not [exposed to] the instittion bt to s The taxpayer will bail

them ot, and that remoes one o the big disciplining elements

in the way the system is spposed to operate... ultimately,

the heart o the problem does come down, in my iew, to the

inherent riskiness o the strctre o banking that wee got,

and the difclty o making credible the threat not to bail ot the

system, which is what is nderpinning the implicit sbsidy and

creating cheap nding or large banks taking risky decisions.'

The implicit government subsidy has two particularly damagingeects. It is greater or larger banks and so distorts competitionby weakening the ability o small or new entrants to becomeserious challengers.

It also encourages banks to intertwine risky investmentbanking activities with essential banking services, such as thepayment system and retail deposits. This means that when abank is in danger o ailing, the government has little choice butto extend support to the ull spectrum o activities. The result hasbeen that the taxpayer has provided guarantees against losseson loans, not only to small businesses and consumers, but tohedge unds based in the Cayman Islands, and portolios ocomplex securities which the bank thought it would be ableto trade or a prot.

For the UK, the problems are particularly serious given therelative size o the countrys economy relative to the guaranteesit has made. I all bank assets are guaranteed, this is ve timeslarger than GDP.7 Hence, the regulatory approach to managingthe UK banking sector is not sustainable. As Mervyn King toldthe Commission:

'Or ability to sstain a large international nancial centre, in

my iew, depends on demonstrating not only to the rest o theworld, bt to orseles, that that centre doesnt depend on

taxpayer garantees, becase i it does, we will hae to redce

the size o it to a leel proportionate to or ability to proide tax

nance to nderpin it.'8

Since the crisis o 2007, the banking industry has beensubjected to extensive review. There have been a largenumber o ocial reports. National banking regulators haveupped their game and the G20 countries have set their nanceministers, central bankers and nancial regulators to work toachieve a co-ordinated response, the outcome o which will beknown later in 2010.

Lord Myners, former Financial Services Secretary

The banking industry, because

its been underwritten implicitly

against ailure, without payinga premium, has enjoyed

a huge subsidy


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Some important steps have been taken to shore up theindustry. New rules on leverage ratios and capital adequacywill increase the industrys saety margin in the short-term. Butthese alone will not create a healthy industry. The structure obanking remains unchanged. The regulatory ramework allowscompetition, but not the sort o competition that will necessarilylead to benets or customers. And the culture and ethics obanking have not been undamentally challenged.

The Commissions ear is that the present response to thebanking crisis is, by the admission o those charged with itsimplementation, inadequate. It has ocused almost exclusivelyon reviewing international agreements governing the level ocapital banks must hold, and giving greater prudential powers tothe regulators, in particular to the FSA and the Bank o England.The Commission thereore questioned the chairman o the FSAand the Governor o the Bank as to whether, had regulators hadmore powers, they would have stopped the nancial crisis takingplace. Mervyn King used the example o Citibank. Refecting onits management he told the Commission:

'[They] were highly intelligent. We wold hae chosen them to

be the best team that yo cold hae to rn a bank, thats on

the exectie side. Then the bilding itsel was ll o reglators,there were people liing there, dozens o them reglating

Citibank... None o these people managed to stop the risks

materialising or things going wrong. Now I cannot beliee that

any reglator arond the world cold honestly pretend that they

wold do better than what happened there.'

Both Mr King and Lord Turner were adamant that such powerswould not have been used by the regulator, since they, likethe rest o the nancial system were in the grip o a 'fawedintellectual model'.

As the great British economist Alred Marshall9 noted, there isalways a need or honesty and uprightness amongst those who

manage our money, i the nancial system is to work well. Thismeans we need to think broadly about the best structure o thebanking industry. It suggests that simply strengthening the role othe regulator is unlikely to create a stable nancial system; onewhich is t or purpose, where competition is eective, whereagents act airly on behal o their principals, and which is lessopen to capture by 'fawed intellectual models'.

The prudential regulations that are being imposed on ourbanking system may well prevent an identical meltdown takingplace. But they do not address these undamental issues. AsProessor Hu o the University o Texas, who recently joinedthe US Securities and Exchange Commission, has noted, theprocess o innovation in nancial markets aims to get around theclassications which regulators establish. So regulation imposedtoday may simply set in train a process whereby our banks andnancial institutions simply try to nd ways to maximise theirown advantage within the letter, rather than the spirit, o the law.

Once the structural issues have been addressed, it will bepossible to achieve a deep seated change in the industrysculture, an issue that troubled many witnesses. Chris Rhodeso Nationwide told the Commission:

'I think cltre is incredibly important becase it sets the toneltimately or the ales o the organisation... I strongly beliee

yo cannot encapslate eerything yo need to do in rles and

reglations, thereore a ocs on the ale sets and behaior

in an organisation is key.'

Stephen Green, chairman o HSBC, took a similar view:

'I think the most important lesson rom this crisis is actally an

old lesson and not a new one, namely that rles may well be...

necessary [bt] are eqally clearly not sfcient. No bsiness,

certainly no banking bsiness, can aord to do withot a

board-led, senior management-spported, ethical approach

MERvYN KING STEPHEN GREEN

HECTOR SANTS AND LORD TuRNER


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19

Will Hutton, executive vice-chair, The Work Foundation

The notion that banking is

a completely private sector

activity upon which we have no

view as a national community,

is an impossible one

to behaior; to nderstand that there is a prpose to the

bsiness that yo do, which is not simply measred by

short-term protability, is proondly important, and nless

that cltre is there in an organisation, no amont o rle-

setting and no amont o carel compliance is going to

be an adeqate sbstitte.'

The Commission would wholeheartedly agree with thesesentiments. However, as the exchange between the Commissionand the chie executive and chairman o the FSA, below,indicates, regulators clearly have some diculty in addressingthe issue despite a recognition o the need or cultural change.

COMMISSIONER Becase i yo dont get the cltre right its

ery difclt or the reglator to sole the problem?HECTOR SANTS Yes, so we need cltre, and we need early

interention. Bt early interention withot cltral change wont

sole it, and cltre alone wont sole it....

LORD TuRNER And I think the other thing to say is... we simply

dont know whether we really hae tools which can help

change cltre.

This suggests we need a very proound change to the bankingsystem. We need not just to place a sticking plaster on those partso the system which are seen to have ailed, but to usethis opportunity to re-engineer the system.

Witnesses rom the banks seemed to believe that such achange was taking place. For example, in his evidence, Stephen

Green, chairman o HSBC, told us,

'I dont think that theres a mood in the indstry that says, jst

let the storm blow and we can get back to bsiness as sal.

That wold not be a characterisation o the mood amongst the

leadership o the indstry so ar as I perceie it.'

Others thought the reverse. Robert Pestons evidence illustratesthe point.

'I dont think the bankers themseles beliee the world has

changed in a ndamental way. When I talk abot how it wold

be a good thing i, or example, there was a bit more simplicity in

their strctres and a bit less complexity in the kind o prodcts

and serices they proide in wholesale markets, they look at me

as thogh Im completely mad.'

We need a new approach that recognises why banking is dierent.Solving all this is dicult because there are several reasons

why banking markets behave dierently to others. We wouldpoint out three distinct characteristics. The rst has to do with

prot and risk. It was summed up eloquently in the evidencegiven to us by the late Sir Brian Pitman:

'One o the great dierences I think between banking and other

actiities, is that [in banking] yo can increase the prots o the

ott simply by changing the risk prole. I was chairman o Next

[a retailer] at one time, and we coldnt wake p in the morning

at Next and say, what were going to do is greatly expand or

bsiness, what were going to do is increase the risk prole. Bt

in banking, its perectly possible, in the short term, to decide to

be more risky than yor competitors. That will get eerybody to

beat a path to yor door, and will wind p [in the] short term with

ery big prots. And i yo gear p the remneration system

appropriately, yo can become rich qite qickly.'

Although one bank executive disagreed with Sir Brians view, arguingthat risk could equally be taken by an auto manuacturer whoskimped on saety to increase short-term prots, the Commissionsupported Sir Brians view that the ability to generate short-term protrom lending is qualitatively dierent rom that in most other industries.


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Participant, Which? Big Banking Debate

Id like them to understand I have

peaks and troughsWhen youredoing well theyre happy but they

dont help when times are hard

This is because revenue and prot can be received by banksbeore the costs are realised. A borrower may pay interest or awhile, but it is not until they repay in ull, or deault, that the cost othe lending is known. It is or this reason that so much regulationcentres on the prudence with which bank lending is made. It isalso the reason that governance systems, such as a statutoryaudit, have been established to ensure bank boards are notprone to making injudicious loans, or to recognising prot beoreit has been earned10.

A second eature is one which economists reer to as'asymmetric inormation'. These are situations where the sellerknows more about the product than the purchaser, and where thepurchaser is unable to judge which seller will give them the bestdeal, and hence can be taken advantage o11. These situationsoccur throughout the nancial services industry, and were clearlyarticulated in the Commissions exchanges with Gill Kirk, a ormerbranch employee o one o our large banks, who was concernedthat the incentive structures at banks encouraged the mis-sellingo nancial products.

COMMISSIONER Wold the cstomer know that [they had

prchased a poor prodct?]GILL KIRK I wold say that the cstomer woldnt know that

theyd been sold the wrong prodct. And when yore jst in

ront o the cstomer and selling them, yo woldnt... know that

the prodct that yoe sold them wasnt the right one, becase

yo werent then inoled in the tre o that cstomer, yo

were jst inoled in selling the prodct.

Lord Turner reinorced this point:

'The point abot the nancial serices [indstry] is that when yo

by a pension or a long-term insrance prodct, yo are bying

something which, i yo dont like it, yo cant simply saya week

later, I didnt really like that experience, Ill go next door. Yore

bying something which lies with yo a long time, and yore

also bying something where yo will not know whether that is

a good prodct or not or 10 or 15 years aterwards.'

The consequence, as Je Prestridge, personal nance editor othe Mail on Sunday, explained, is that:

'We are now in a sitation where a lot o the banks are trying to

sell prodcts that are ar too complicated, essentially to meet

great prot targets... The act is that [cstomers] are repeatedly

being mis-sold or they are mis-bying prodcts.'

The third eature is the act that, throughout the banking andnancial services industry, those who deposit money trust thatthe bank will manage it on their behal. As the owners o themoney deposited, consumers are what economists would call the'principals'we trust that the banks, 'our agents' will work on ourbehal, and not on their own. Adam Smith noted o this relationship:12

'It cannot be expected that they will watch oer it with the same

anxios igilance with which [owners] watch oer their own.

Negligence and prosion mst always preail...'

Relations between principal and agent can be managed by lawand regulation, and the nancial services industry includes manyagencies whose activities are governed by trustee law, ratherthan by contract law, with independent expert monitoring. Butprincipal and agent relations work best when there is a culture

o trust between them.Bankings unique characteristics make it susceptible to

distortions, and witnesses told the Commission that these pervadethe banking system, rom the way in which contracts or creditcards are written, through to the construction o complex securities.They inhabit equally the incentives given to boards o directorsand to branch sta. And unless these undamental eatures arerecognised and addressed, we will not have constructed aneective, sae, and secure structure or the banks o the uture.

The aim o the Commissions report is not just to oer asolution to the recent banking collapse. Rather, it is to map outthe path towards a sustainable culture, structure and regulatorylandscape or the banking industry, which will, o course,minimise the risk o uture banking ailures, and will extricate

the government rom its current implicit role as guarantor o theindustry. But the larger aim is to create a stable yet competitivebanking industry, where the interests o consumers andbusinesses are aligned with those o banking executives andshareholders, and where banks can be allowed to ail withoutrisking the stability o the wider economy.


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The remit o the Ftre o

Banking Commission was to

seek to join-p the missing link

in the debate oer the banking

crisis: the iews o ordinary

people and wider society.

In order to do this, Which?

set p the Big Banking Debate.

This was a chance or ordinary

people to get inoled

and hae a real and lasting

inence on the tre o the

banking system. An eent

attended by oer 300 people

was held on 4 Febrary 2010 in

London, while interiews with

consmers were ndertaken

p and down the contry.

Consmers were also gien the

chance to sbmit their iews

and stories ia the Banking

Commissions website.

What was clear both rom

the eidence o indiidal

experts, rom the iews o

the 300 people who came to

or big banking debate, rom

interiews with consmers

arond the contry, and

rom the wealth o written

eidence we hae receied,

is that the banking sector

was not working in the best

interests o consmers or

smaller bsinesses beore

the onset o the crisis. The

crisis itsel highlighted new

potential concerns sch as

the saety o their deposits,

which may hae beore been

taken or granted. Bt many

problems, sch as poor leels

o cstomer serice, a sales-

drien cltre, nair charges

and lack o transparency were

raised as endemic isses which

preailed beore the onset

o the banking crisis.

Mppg out the solutoIn this short paper, we cannot claim to have addressed in detail allthe reorm needed, or the issues raised by reorm o the bankingindustry. However, we hope to stimulate a wider, ongoing debateabout the role and nature o this most critical o industries. There is

a concern, as the media spotlight moves on, that bankers and theirregulators will tend to return to 'business as usual'. This would bea mistake, both or the industry and or the wider community it isthere to serve. We note the comments o Mervyn King that:

'I the time horizons o the people inoled in those discssions,

whether they be politicians and ministers, or whether they

be ofcials, i their time horizons are short they will nd deep

relctance in pshing ahead with a debate abot ndamental

reorm, which ineitably will take time to conclde and then to

implement... My ear wold be that well hae this debate that

we will set ot possible alternatie models or the strctre o

banking, bt not ery mch will happen, therell be a bit done

here and there, bt it wont actally preent the next crisis, the

next crisis will be een bigger, and at that point people will look

back and say, well they had the right idea ater the preios

crisis, they jst didnt implement it bt now we will.'

In this report we will not have been comprehensive or denitivein all our recommendations. But we hope we will have stimulated

an ongoing debate about the uture o our nancial servicesindustry, and contributed to a civil economy which aims toimprove its perormance.

In this report we make 39 recommendations. Some suggestimmediate action. Others, such as the drive towards cultural

change, will require a longer process o change. We are notsuggesting that there is a nal 'perect' model o how banksshould operate. Rather we should be trying constantly to improvethe perormance o the industry. The mathematical modelswhich were used to calculate risk beore the crisis turned out tobe precise, but wrong. Our view o the world will be much lessprecise but will, we hope, have the merit o being correct, albeitapproximately so.

When we embarked on this work, some believed thatwe would have to address many questions, each needingdierent answers, rom the mis-selling o products in bankbranches, to the instability o bank leverage. In the processo taking evidence, we have been struck by the act that ourwitnesses have all described similar problems: lack o eective

competition, inappropriate structures, a ailure o trust ando checks and balances. Thereore, rather than trying to ndindividual solutions or each banking market, we are purposelysuggesting a broader perspective needs to be taken, where thebanking industry is designed to deliver the services or which itwas established.

BOx 3: THE WHiCH? BiG BanKinG DEBaTE


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22

Chapter twoStructure


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23

Experience shows it is inevitable that some banks will continue

to ail and that periodic systemic crises will recur. The authorities

task is to allow or these corrections but to ensure they do not put

the entire economy at risk.

This is currently achieved by the unsatisactory method

o the government standing behind the banks. This implicit

subsidy erodes market discipline and gives the banks a higher

credit rating than they would achieve as genuine standalone

businesses. It enables them to reduce their borrowing costs and

run higher levels o risk and leverage in both retail and investment

banking. Indeed, it encourages banks to maximise the benet

to themselves rom the implicit subsidy, by intertwining highly

leveraged and risky investment banking activities, with banking

services such as retail deposits and the payments system, which

are vital to the unctioning o the economy.

By standing behind the banks, the government creates what

economists describe as moral hazard. Because creditors know

that the money they lend to the banks is guaranteed by the

government, they take less care to ensure that the bank they

lend to is behaving prudently. By encouraging high and excessive

leverage, the implicit subsidy actually increases the likelihood o

taxpayers being orced to step in and support the banking sector.

The Commission believes that these issues require a change to thenancial architecture, to limit the guarantee and create an absolutely

credible and real threat o ailure. Changes to the regulatory

approach to banks, necessary to underpin and support these

proposals, are outlined in Chapter 3. It may mean some nancial

services are, on the ace o it, more expensive, that borrowers

nd it harder to get credit and that the level o trading activity

in some markets may reduce. However, this must be balanced

against distortions caused by unlimited taxpayer guarantees.

Rs rsResolution arrangements can make banks saer to ail. The recent

Financial Services Act 2010 places a new duty on the FSA to

require rms to produce Recovery and Resolution Plans (RRPs) or

living wills. These are intended to orm a plan on how to manage

a collapse without jeopardising nancial stability or requiring

support rom taxpayers.

The Commission is supportive o proposals or living wills as

a step towards reducing the government guarantee and re-

injecting market discipline by allowing banks to ail. The living

will should ensure that within any banking group the core

deposit and lending unctions and the payments system are

ring-enced with their own separate balance sheet, liquidity and

unding mechanism.

An important aspect o the living will is that it should change

the behaviour o the bank and its trading partners in terms o

how they price risk and how they extend credit. In order to

guide their behaviour eectively, there should be a ring-encing

o the core banking activities rom the non-core activities. The

principle should be that the core deposit and lending unctions,

and the payments system, should be ring-enced with theirown separate balance sheet, liquidity and unding mechanism.

These ring-enced deposits should not be used to und

investment banking activities.

I it is to have a behavioural eect, the living will cannot

simply be a private exchange between the bank and its

prudential regulator. Rather, it must be a public document.

Mervyn King, Governor, Bank of England

I think that clearly one o the consequences nowis that with the implicit subsidy rom [being] tooimportant to ailthere is an advantage to beingnot so much large in terms o size, but large in termso scope. So you really want to have a big link to thepayment system and retail deposits, and do a lot oother things, because then you know the governmentcant aord to let you go under, and that implicitsubsidy clearly has value. We need to get rid o that


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In an emergency resolution situation, the living will must explicitly

delineate which part o the bank is to be supported and kept

solvent, eectively drawing a dotted line down the balance

sheet. The resolution authority should be able to metaphorically

tear along the dotted line, and separate the protected rom the

unprotected portion o the balance sheet. Precedents or this

exist in the US, where the Federal Deposit Insurance Corporation

has successully wound down a large number o ailed banks.

The living will must also cover how customers are going to be

treated in the event o ailure. Ensuring that any living will oers

sucient protection or customers interests and the provision o

essential services will be a key task or the prudential regulator

which we describe in Chapter 3. It will also be the responsibility

o the bank to convince the prudential regulator that their

management inormation, inormation technology and internal

controls are capable o executing the procedures envisaged

in the living will. A ormal and transparent living will should also

encourage the banks creditors to demand a simplication

o both the banks legal structure and accounts. As noted in

Chapter 4, the accounts o individual banks can be opaqueand dicult to understand.

Pr pssAs a complement to living wills, banking reorm should also ocus

on protecting deposits. The UK has already begun to address this

on a unilateral basis. Retail deposits up to 50,000 are already

guaranteed under the Financial Services Compensation Scheme

(FSCS). There is still more that could be done to ensure the

scheme is ully transparent and understandable by consumers.

The Commission believes the 50,000 limit should be applied

to each brand rather than to each licensed institution. The

Regulator should also prevent the misleading promotion o

products which claim to provide a guarantee o capital, but which

are not covered by the compensation scheme.

There should be clear signs on all bank tills, websites and

other promotional material produced by nancial services rms,

inorming depositors how much o their deposit is insured by

the FSCS.

This will prevent market entrants like Icesave marketing less

securely protected accounts to customers who are not ully

aware o the extent o their rights. It is intended, however, that the

reorm o the liquidation procedure, proposed later in this section,

will reduce the likelihood that the insurance provided by the FSCS

is called upon.

A new class o deposit should be created, which carries a 100%

guarantee, but which should only be invested in sae assets

such as government bonds. This idea was put orward to the

Commission by Mervyn King.

This new deposit class would allow retail investors with

savings in excess o the government guarantee, risk averse high

net worth individuals, homeowners temporarily placing large

sums on deposit during housing transactions and SMEs to have

the option o placing their deposits into sae haven accounts.

Sae havens would be the only accounts to have an unlimited

government guarantee.

It would be or the government to decide how the taxpayer

would be protected rom the risk o having its guarantee called in.

This could be achieved by requiring sae haven operators to keepa large proportion o the deposits in UK government securities,

by requiring them not to lend the ull 100% o their deposit base,

by a nancial levy, or by a mixture o the three. To cope with high

demand in times o crisis, an appropriate notice to deposit period

might be required or sae haven depositors to allow the sae

haven account operators to build up the required liquidity buers.

Banks might wish to oer other accounts, perhaps paying

higher interest which would have the 50,000 protection limit, but

no other government guarantee. Depositors in these accounts

would need to accept that their money could be invested in risky

assets with a risk o the bank going down.

Depositor protection should include reorm to the bankruptcy

procedures so that the rank o creditors is changed to put

depositors at the top. This would have the added advantage o

removing the additional protection which is currently aorded to

bondholders by the belie that, since they rank in the same order

as depositors, their investment will be protected. It must be clear

that bondholders can lose money and will not be supported by

the government.

Participant, Which? Big Banking Debate

Privatising proft and

socialising the lossesis the summary o the

fnancial crisis


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Stephen Hester, chief executive, Royal Bank of ScotlandWhat we need to do is to fnd a way or that(bankruptcy) to happen with banks, so that a bankcan continue to provide its essential unctions whileyou attribute the losses, and its easy to attributethem to shareholders we all know how to do it andthats happened. What has been difcult is then totake those losses beyond shareholders to creditorso one sort or another while having the bank unction

because o the vulnerability o money

When a banks creditors are covered by an implicit government

guarantee, they do not have the incentive to keep the bank rom

getting close to administration. In eect, exposing creditors to

the true credit risk o banks limits the exposure o the taxpayer

to nancial crisis.1 Furthermore, ormal reorganisation is more

costly than inormal reorganisation, and both equity holders

and creditors retain more o their investment under inormal

reorganisation. By removing the government guarantee o a

banks creditors, we can encourage inormal reorganisation and

limit the taxpayers exposure to nancial crisis.2

S r r spr s?The living will should go a long way towards improving stability

and reintroducing market discipline to the nancial system,

protecting depositors, and limiting the taxpayer guarantee.

However, structural reorm can strengthen the measures o the

living will.

Universal banks contain three core businesses. These are:

Retail banks looking ater deposits and making loans to private

individuals and SMEs and operating the payments system.

Commercial banks providing balance sheet and other nancial

services to corporates o mid-size and above.

Investment banks advising and acting in the capital markets or

corporates, governments and nancial institutions. Stephen heSter


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ci, csqucssw. tis quis isi ws dbs i ssm.Discmis scxis i bi. t is idc bi bs m ci. Bdsc isiuis cmx m s.t sui is i sm,sim isiuis.

box 4: PRinciPal aRgumentS uSed foR StRuctuRal RefoRm

Stephen green, paUl thUrSton


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wd w i wdlm Bs i.ni B Ss lm Bs wdsii bs.Bs sciisi i w ciiis is . Bs sciisii i d/ cmmcibi suc s nrc, Wsi Muud Id Mc id. tsbs sm id iss s c , us

ui ssmic is.gssS did w.t US xicd mbi ius dcd cmicudi ubw cisisi sis d s sci 1980s.t ci cisis wscusd b xcssi d idqu ci sc d c b ddssdb ss dic suis bi u bs.

box 5: PRinciPal aRgumentS uSed againSt StRuctuRal RefoRm

Whether or not these integrated activities should be split up

is widely debated and there is a striking dierence in views

between the top o the UKs nancial services regulator and the

countrys central bank. Lord Turners report described breaking

up the banks as not easible. In contrast, the Governor o the

Bank o England, Mervyn King told the Commission that the idea

has merit, and in a powerul, recent speech Andrew Haldane, the

Banks director responsible or nancial stability, said that banking

reorm may need to look beyond regulation to the underlying

structure o nance.3

The academic world is also divided. The Commission heard

rom Proessor John Kay that core narrow banking unctions

such as payment services, lending and deposit taking should

be isolated rom riskier activities. Proessor Jon Danielsson, on

the other hand, said universal banking is no riskier than narrowbanking and that narrow banking is a bad idea.

The Commission takes the view that although the banking

crisis was not solely caused by the combination o retail,

commercial and investment banking, the progressive integration

o the industry over the past two decades played a major part.

We believe it to be signicant that having avoided a global

banking crisis during the 65-year lie span o Glass-Steagall,

the world stumbled into one within a decade o the Act being

repealed in 1999.4

The reintegration o retail, commercial and investment banking

symbolised a state o mind that said anything goes in nance.

That mindset encouraged investment bankers to gear up their

own balance sheets and chase down the retail banks with

new derivative products. It persuaded previously staid nancial

institutions such as Northern Rock, Bradord & Bingley and

HBOS that it was sae, perhaps even expected, or them to

leverage up to levels previously seen only at the most racy o

investment banks. Changing that mindset means changing the

structure o banking.

phIlIp aUgar

DavID pItt-WatSon


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R bCi id SMe bi50,000 u bd ccusFu m u s ccuso msssmlii wi

cr bWs biSdicd stsu icudi cuc

d is swsScuiisi bmid wi xd i si i mab d db u di b

is b Is ss c bsisIs scC dicScuiis udwiirsicis us wss d sc disibu

ius scuiis issus

tr btdi db, quiis,cuc, cmmdiistdi diisassmbi d icisucud diis dis d ism bsawd cduccusm d idiWud b wd i dicCud b wd b dis b

box 6: how a diSaggRegated bank would look

Participant, Which?Big Banking Debate

Consumer

banking must

be split rom

investment

casino banking

The living will is an absolutely indespensable rst step to reorm

the nancial industry, but we need to consider structural reorm

as well. The commission has received powerul and persuasive

evidence rom expert witnesses in support o restructuring the

banks. There can be no prevarication on this crucial issue since

the compulsory separation o banking activities has the potential

to solve many current and persistant problems. Thereore the

governments new commission should consider urgently and in

great detail a structural solution to the problems caused by large,

integrated banks.

Structural reorm should:

Protect depositors

Limit the taxpayer guarantee and thereby

reduce moral hazard

Impede cultural contamination o retail

banking by investment banking

Eliminate confict o interest within banks

Curb the too big to ail problem

Any structural reorm needs to be carried out careully and in anordered sequence with potential break points to refect evolving

circumstances. There are several natural break points upon which

to disaggregate a bank, articulated in Box 6.

There are strong arguments or making a unique separation

o retail banking, and or dividing the investment banking

division between its advisory and trading unctions. Separating

retail banking would protect depositors, limit the taxpayer

guarantee, and impede contamination rom the investment

banking culture. Splitting the trading arm o an investment

bank rom its client advising and securities underwriting

would reduce internal conficts o interest and curb the

too big to ail problem.

Spr r r r ssssA stage beyond living wills would be to require all banks

operating a retail business in the UK to do so in standalone retail

banks that would conduct conventional retail banking and lending


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29

and operate the payments system. This would protect depositors,

and reduce the moral hazard by limiting the taxpayer guarantee.

Moreover, it would halt the contamination o retail banking by the

investment banking culture.

With the exception o 50,000 per brand and any money

invested in these banks sae haven accounts, depositors

with these retail banks would not be guaranteed by the

government but regulators would require the banks to

adhere to prudent levels o capital, leverage and lending and

would require them to hold a certain proportion o deposits

in gilts. I the UK was to implement this without international

agreement, the separation would need to be in respect o

banks UK business only.

The Commission heard opinions rom Mervyn King, John Kay,Julian Franks and others in avour o the ormal separation o

retail rom other banking businesses. Others argued that this

would be unnecessary i living wills were eective since the retail

bank could be detached rom the universal bank in the event o

the parent bank getting into diculty.

Formal separation has advantages over living wills. Retail

deposits would not risk being contaminated by high-risk

investment banking. A separate retail entity with its own board

o directors and shareholders and a straightorward business

model should be easier to manage and to supervise. With

confict o interest much reduced, it should be possible to

establish the cultural and ethical standards we advocate in

our nal chapter. Full separation would also reduce the not

inconsiderable risk o banks being able to nd ways round the

rules o resolution regimes.

Standalone retail banks are not a guarantee against ailure

as the ate o Northern Rock showed. But with better regulation

including capital and leverage rules, they would be a robust

component o a new nancial architecture.

br p s sI it were deemed necessary, isolating retail banking rom other

banking activities could provide a measure o protection to

consumers but it does not address the wider issues o scope

and scale in global banking. Solving these problems requires

global agreement and discussion over the medium term but it is

important to commence that discussion beore the waters close

over the recent crisis. We must also address conficts o interest

within investment banks.

The Commission believes that Senator Carter Glass and

Representative Henry Steagall were correct to identiy the co-

mingling o securities trading and banking as the ault line in the

20th century banking system. That ault line has been widened

by nancial innovation and deregulation (including the repeal otheir 1933 Act in 1999).

The dangers o this structure were orcibly articulated by Sir

Martin Taylor, the ormer CEO o Barclays:

t ism bi ciiis uis b w ims siic i b bc s. I usd wdcu d I wud c iw w. I i sius ds, d i u i uis bs,ud b b su u u m cu d d Ism bi ciiis, ub u sm m sm m . ad ub w iis w ub ciiis b cmbid wi xcss wic s u w isi is.

Banks are now allowed to take deposits, provide other vanilla

banking services and also to engage in investment banking.

Within their investment banks, they are allowed to advise

corporate and institutional clients, to trade or themselves and

others, and to cross-sell a myriad o balance sheet and other

SIr MartIn taylor


30/84

30

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c , c iuss d cmbiidic d di i sm isiui.

box 7: the SecuRitieS and exchange commiSSionv goldman, SachS & co and fabRice touRRe


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www.which.co.uk/banking

The retail banks on which individuals

and small businesses rely, must be keptquite separate rom the speculators,

merchant banks and hedge unds

which themselves ought to be properly

regulated and controlled

nancial products. In eect there are two related issues: the

integration o traditional banks and investment banks, and the

breadth o the permitted investment-banking model. Together,

they produce our problems.

Banks scale and scope creates huge prots and very biginstitutions, and with this comes unquantiable risk. I you

allow banks and investment banks to engage in every kind o

nancial activity, dont be surprised i they grow into behemoths.

Allowing the integrated model to persist guarantees the

existence o system-threatening nancial institutions.

The model is so complex that eective risk measurement is

not sustainable. Rising markets always create the illusion that

risk has been mastered, and it takes an event such as Long

Term Capital Management, a hedge und that ailed in 1998, or

the banking crisis o 2007, to serve as a reality check. Among

the worlds leading investment banks, theres scarcely one that

hasnt aced its moment o crisis, and as the nancial services

industry grows, the stakes and price o ailure get bigger.

Their breadth o activity gives the banks so much knowledgethat it is dicult or the market to operate airly. Every line o

market-related business fows through their dealing rooms.

They are giant inormation exchanges with global reach and

multi-product inventories. They have their ngers on the

pulse o market movements as they happen, tracking price

ormation and customer fows. Universal banks and integrated

investment banks use this to their unair advantage. Their

superior market knowledge stacks the odds in their avour,

giving them an edge over other market users. 5

There is an irreconcilable confict o interest in advising clientson both sides o a deal. Trading in the market adds to the

confict. This means that the industry cannot achieve a solid

ethical platorm under the existing structure. Recent allegations

against Goldman Sachs illustrate the issue. The clients interests

might be said to come rst, but which client takes priority?

Confict o interest also jeopardises a air market and is at the

heart o many o the industrys problems. It suraced in 2000-

2001 in the dotcom crisis when the leading investment banks

were exposed as having shamelessly promoted worthless

internet stocks to investment clients in order to benet

corporate clients. The Enron scandal is another example oinvestment banks and auditors being incentivised to turn a

blind eye to corporate malpractice. It distorts the takeover

market because Chinese walls do not work and inorm

future of banking commission-uk

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