UK banks fend off mooted pre-election facelift

Coming into the election, there were clear dividing lines between the parties on bank regulation – Labour thought that the existing mechanism worked well and wanted to keep it; the Conservatives wanted to remake the regulatory system; and the Liberal Democrats wanted to remake the banking system.

The triumph of the Conservatives and Liberal Democrats may result in the Labour proposal being the one that’s actually adopted.

There is no sign of immediate ­government action breaking up banks, although a committee has been convened to consider the matter further. This ­proposal was never entirely defensible – breaking up large banks into smaller banks increases the vulnerability and the risk of failure of those smaller banks – and it is not surprising to see it deemphasised after the election. More significantly, the much-vaunted Conservative proposal to abolish the FSA was always less than it seemed. Moving the supervision of
systemic institutions to the Bank of England and creating a specialist regulator would have left a substantial body of activities to be dealt with. The FSA performs a wide variety of tasks, from regulating insurance companies to acting as a listing authority for securities, and it is hard to imagine the Bank of England being prepared to undertake these. Thus, some sort of successor to the FSA, with supervisory powers over at least smaller banks and markets was always on the cards.

The coalition agreement between the Conservatives and the Liberal Democrats provides a basis for analysing the future of banking regulation. The Bank of ­England will be given control of macro-prudential regulation and oversight of micro-prudential regulation.

Micro-prudential regulation means, in general, the day-to-day business of setting bank capital requirements. The power to set these requirements is in the process
of being vested in the new European Banking Authority. However, the FSA will continue to supervise banks’ implementation of these rules, and the Bank of England is to supervise its supervision.

In principle, macro-prudential policy should involve looking at the banking system in the context of the economy as a whole – for example, by considering whether excessive lending is causing a credit bubble. The difficulty with this is that, having spotted such a trend, the central bank cannot require government to cut expenditure or raise taxes, and is charged with using interest rate policy for an entirely different purpose. The only other possibility is the idea of varying capital requirements upwards or ­downwards to increase or decrease the capacity of the banking system to create credit. This is an attempt to recreate the failed ’corset’ system of the 1970s.

The idea of a modern corset (a boob-tube?) is problematic. There are no rules preventing UK businesses borrowing from non-UK banks, and the larger UK banks lend largely, and in some cases primarily, outside the UK. Thus, raising and lowering group capital requirements for UK banks could result in credit becoming more expensive in Thailand or Botswana but have no appreciable impact in the UK. A modern corset would therefore have to be fairly precisely targeted, with exposures to individual borrowers or asset types subject to differing and variable capital penalties.

It is also suggested that a capital penalty could be imposed on larger banks to reflect their greater systemic importance.

Finally, it is sometimes suggested that such a regime could be ’counter-cyclical’, with capital requirements lowered in times of stress. However, the official
sector is a long way away from any clarity as to what these proposals would entail in ­practice, and it is not at all clear whether they would be compatible with the EU regulatory framework.

Bank regulation – and the banking industry – in the UK will change over the next two years as Basel III, anti-derivative and hedge fund legislation and tax targeting are implemented. But the existing bank regulatory architecture appears to have survived the election broadly intact.

By Simon Gleeson, partner, Clifford Chance