UK report proposes ring-fencing of retail banking

The final report from the Independent Banking Commission (IBC), otherwise known as “the Vickers report,” was published yesterday. There are no big surprises here, and the share prices of UK banks actually increased somewhat. The report supports and strengthens the Basel proposals already underway, and maintains its previous proposal to “ring-fence” the retail part of the larger UK banks. This will “narrow” the banks, although it remains to be seen how much narrower they will be (e.g. the banks can decide whether to keep banking services for large corporations inside or outside the ring-fence).

According to the proposal, UK banks will have to put their retail operations in legally separate entities that are well capitalized and can run independently of the rest of the financial group. Investment banking will be conducted outside the fence and should—in principle—be allowed to fail without government intervention (not so likely, according to the Economist).

As usual, however, “the devil is in the details,” as the US Treasury has discovered as it tries to implement its own ring-fence proposal—the “Volcker rule.” The WSJ reported yesterday that efforts to flesh out the Volcker rule, to define what is proprietary trading, have been delayed beyond the October deadline. Interestingly, the US approach is to give a positive definition to non-permissible trading activities, whereas the UK is trying to achieve the same objectives by defining the permissible retail part of the bank. Neither is easy.

A more radical proposal would be to narrow the retail bank 100%, e.g. to limit the investments of the retail bank to only government securities. This is the well-known Chicago plan from the ‘30s proposed by Henry Simons and Irving Fisher, among others (for an excellent overview of the proposal and its history, see the Levy Public Policy Brief no. 17, 1995 “Narrow Banking Reconsidered” by Ronnie Phillips). This would insulate vital banking services (an important objective for the IBC) but perhaps compromise the underwriting function of the banking system. As Hy Minsky wrote in 1992: “The 100% money proposal is losing sight of the main object: The capital development of the economy” (Levy WP no. 69, p. 36).

Recognizing that the role of banks is not primarily the intermediation of funds between savers and investors, but providing essential working capital for production stretched out in time, Minsky would rather see the widespread use of small “universal banks”—Community Development Banks—that could combine retail payment services with extending loans to small and medium-sized businesses.

Whether the UK proposal can pave the way for more community banking remains to be seen. There is a definite risk that the proposals will have been forgotten by the time of implementation—i.e. 2019.

Editor’s Note:  Thorvald Grung Moe has just joined the Levy Institute as a Visiting Scholar for one year. He is also a Senior Adviser in Norges Bank (Central Bank of Norway), where he has been working since 1985. He has held a wide range of positions there, covering topics such as exchange control, financial stability, monetary policy, payment systems policy, and strategic planning. He has been department director for the financial stability report and an observer from the central bank on the board of the FSA Norway. He has also been a regular observer at CEBS (Committee of European Banking Supervisors). Before joining the central bank, he worked at the World Bank in the US and at the Ministry of Finance in Norway. He has consulted widely with the IMF in the Middle East, Latin America, and Eastern Europe. His has published books and articles on banking regulation, the financial crisis, and how to resolve cross-border banking crisis. He will be using his time at the Levy Institute to study the works of Hyman Minsky and explore how his insights can be applied to the challenges facing the financial sector today.