Are British Banks Safe From SVB/Credit Suisse -Style Scenarios? - Anonymous Banker

I have a friend whose economic and financial analysis is always interesting because it is apolitical. He is a former City economist with decades of experience. Unfortunately, like many people who have something genuinely valuable to add to the conversation, he prefers to protect his privacy in our turbulent political and cultural landscape. But I’ve always found his explanations and insights useful and I think you will as well. That’s why he’ll be contributing to my Substack from time to time as the Anonymous Banker.

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The beleaguered Conservative government recently announced a so-called Big Bang 2.0 for the City, a shakeup of regulation post Brexit. Chancellor Jeremy Hunt stated his reforms aim to “secure the UK’s status as one of the most open, dynamic and competitive financial services hubs in the world. The Edinburgh Reforms seize on our Brexit freedoms to deliver an agile and home-grown regulatory regime that works in the interest of British people and our businesses”.

In my view, it would be something of an exaggeration to compare the reforms to the original Thatcher/Lawson Big Bang but there are some interesting elements. At the very least, the reforms do represent one area where the government has finally got around to doing something with the freedoms Brexit was supposed to provide.

The press has emphasised some of the more political choices such as the relaxation on bankers’ bonuses. Notwithstanding the awful, tone-deaf timing of this move given the pressure on the average worker in the UK at the moment, there are good arguments as to why these rules needed to be looked at, especially in the context of a post-Brexit world. Arguably, the cap on bankers’ bonuses made banks more risky rather than less as it raised fixed costs and lowered variable costs (those that vary with how the business is doing). It also provides London with an advantage vis-a-vis Europe as it is no longer constrained by EU rules on compensation and removes a potential barrier to bankers choosing to base themselves in New York, Hong Kong or Singapore.

An area of the reforms that attracted less attention (understandably as it relates to the world of insurance) but is perhaps more significant was changes to Solvency II. This area of EU legislation regulated how much capital insurers had to hold relative to their liabilities and also constrained the areas in which they could invest. The intention was to make them more able to weather financial storms of the type experienced in 2008.

Jeremy Hunt’s recent reforms roll back some of this EU legislation, allowing insurers to invest capital that was previously constrained purely for regulatory reasons. A practical example of the constraints of the Solvency II regime meant that insurers could not make investments in long term infrastructure projects as it was deemed too risky to have capital tied up in long term assets – i.e. we need to protect the economy from the risk that the insurance sector can’t pay out against the insurance policies it has sold if it has invested its money in assets that it can’t access swiftly when needed. It partially also explains why recent UK nuclear projects sought Chinese funding rather than raising finance from the City. The proposed changes to free up regulatory capital should be good news for investment in the big infrastructure projects that the UK is crying out for such as in energy security.

On a related note, Hunt also announced his intention to scale back the ‘ring-fencing’ regime UK banks were subjected to under EU rules post the 2008 financial crash. This is an area that should be closely scrutinized. Prior to 2008 banks had successfully lobbied politicians into believing that their sophisticated risk management techniques (no laughing at the back, please!) could allow them to house investment banking businesses and retail banking under one roof.

What does this mean in layman’s terms? Think of retail banking as your High Street bank (or better still watch Bank of Dave on Netflix), which provides savings accounts and lends money in the form of mortgages or loans to small companies. Investment banking is the more glamourous cousin – advising companies on Mergers and Acquisitions but also playing the casino of the world’s stock and bond markets. Following the Wall St Crash of 1929, it became clear that allowing these two types of banking businesses to co-exist in one bank increases the risk of the institution – to itself and its shareholders, but more importantly to society at large (which has to step in and bail them out when it inevitably goes wrong). It was sensibly decided that those that wanted to “gamble” on the markets should be incorporated in businesses where they would lose their shirts if they played the markets badly – they must bear their own risk.

Separating the retail bank from investment banking meant that customers could have faith that when putting their savings into a retail bank, it would be there when they came back to use it. It wouldn’t have been gambled away by a City spiv on the financial equivalent of the 4.40 at Doncaster. This is what is meant by “ring-fencing”, keeping deposits safe from the riskier aspects of a bank’s business.

Contrast the treatment of the Barings collapse in 1995, with the response to the 2008 financial crash. The Bank of England/Treasury took the view, rightly in my view, that the people who should bear the costs of the epic mismanagement of the bank should be its shareholders and bondholders – if you have invested in an investment bank, you must be comfortable bearing the risk. In order to prevent moral hazard[1], they allowed the firm to fail rather than socialise its losses at the taxpayer’s expense. The losers in the Barings collapse were big global investment firms and wealthy individuals who should have known and understood the risks they were exposed to and were therefore deemed not entitled to protection from their folly by the state. In fact, we have a live example of this dilemma with the recent collapse of Credit Suisse. Rather than the Swiss government nationalising the huge global bank, it forced it to merge with its major rival UBS, on punitive terms for shareholders and bondholders in Credit Suisse[2].

In 2008, however, the government was forced to step in because of the nature of what our banks had become, housing both retail customers’ savings and mortgages, alongside investment banking activity whose risks they had grossly misunderstood and mismanaged. They really had no choice and I believe Gordon Brown and Alastair Darling deserve more credit than they get for the way they dealt with the situation. Notice that in the US, Lehman Brothers, a major investment bank with no retail exposure, was allowed to fail, purely because of the moral hazard signal rescuing it would have given to other firms. It’s likely that the recession the US and the world faced subsequently was much worse than if the US Treasury had taken the expedient decision to step in and save Lehman. In contrast, those US firms that combined retail and investment banking were offered state aid to protect consumers. Notice the recent actions of the Federal Reserve in response to the collapse Silicon Valley Bank (along with other small banks) – equity and bondholders in the banks were wiped out, but deposits were guaranteed by the state to prevent financial contagion. Those who should know better were punished, whilst those who deserved protection (in my view) were kept whole, which then also protects the rest of society.

The reason for this digression to 2008 and discussion of these recent events in global banking is that these themes and dilemmas inform Hunt’s policy decisions today. The government is consulting on changes to the ring-fencing regime that will review which activities banks are restricted from undertaking (such as proprietary trading[3]) and taking those firms who do not have significant investment banking activities out of the regime to reduce their red tape.

Hunt has sought to present these reforms as a measured and pragmatic post-Brexit response rather than a bonfire of regulation. It’s an area we should scrutinise going forward – banks will always chafe against regulation but we need to remember why it was there in the first place. This will represent a delicate balance for the UK going forward – the temptation to deregulate relative to the EU must be tempered against the risks involved. After all, the deregulation that culminated in the disaster was also conceived with good intentions.

Overall, the changes are an interesting first deviation away from the EU regulatory regime. They aren’t as dramatic as billed by press briefings but on balance look a pragmatic step in a new direction for UK financial services. However, the recent collapse of Credit Suisse and Silicon Valley Bank shows us deregulation is no free lunch (despite what many free market Brexiteers may believe) – the cost of getting the balance wrong can be very high indeed. And not just to the bankers.

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[1] Moral hazard is a term in economics whereby incentives are such that individuals don’t bear the consequences of the risks they take on. In this context, the fact that the government will have to bail banks out because of their importance to the economy perversely incentivises them to gamble – if I win, I keep the profits; if I lose, you pick up the pieces.

[2] Controversially, the Swiss chose not to value Credit Suisse shares at zero in the deal, and imposed losses on a special bond the bank had previously issued that should have been paid before shareholders. To my knowledge this is unprecedented and likely to result in a legal challenge. In addition, the Swiss central bank has also had to pledge loan facilities to get UBS comfortable with taking on what it might find at Credit Suisse, which means the state does have some financial involvement here and it is not an entirely market based solution. Nevertheless, it’s a different league to the bank bailouts of 2008.

[3] Proprietary trading involves trading the banks’ own money in the markets for their own gain.