Too important to fail-too important to ignore - Treasury Contents

4 Structural reform

Are large banks good for the economy?

89.  As well as proposals for incremental reform, there are proposals for structural reform, ranging from radical restructuring to variants of current practice. The reforms discussed in this section, in one way or another, seek to place restrictions on how banks operate, and targets large, international interconnected banks. In their written evidence to us, Barclays and the BBA mounted a defence of large, integrated banks. The BBA stated that "[ ... ] requiring large banks to radically alter their business structures may limit their ability to service large global clients and would inevitably increase operating inefficiencies resulting in a further source of cost for end-users".[99] Barclays told us:

Frontier Economics, in a recent independent study for Barclays, found that integrated global banks bring a number of benefits to the financial and economic system including:

financial efficiency benefits—reflecting the greater risk diversification, reduced financial intermediation costs and increased financial stability benefits that universal banks offer;

bank customer benefits—reflecting the ability of integrated global banks fully to meet the corporate finance needs of companies (e.g. access to capital markets);

international trade and investment benefits—reflecting the role of integrated global banks in international trade (through trade finance, foreign exchange and other trade services) and in international investment (through direct cross border investment and international capital markets);

competition and innovation benefits—reflecting the propensity of universal banks to expand and enter new product and country markets, so increasing the spread of innovation and best practice; and

UK specific benefits—reflecting the contribution of financial services to the UK economy, even after the costs of the financial crisis and the leading role of UK domiciled universal banks in the global financial system.[100]

90.   Mr Corrigan told us that:

it is a little hard for me to envision a world in which we did not have financial institutions of size and financial institutions that have large amounts of capital to commit to the market place. If you look at one of the examples I use in the statement, it is in the aftermath of the crisis we had a situation in which private partners, thank goodness, had been able to raise something in excess of half a trillion dollars in fresh capital for banking institutions. The amount of risk that a small number of institutions had to be willing to 'fess up to accomplish that is very large. It is a little hard for me to see how that would happen if we had a world of just narrow banks.[101]

Mr Varley was also keen to point out that:

The fundamental point I am making is that investment banking is real economy work. What is it that Barclays Capital does? It offers risk management and financing products to those it serves. Who is on the list of those it serves? The British Government, the French Government, the South African Government, John Lewis, Network Rail and Harvard University. These are real economy players. This is not some activity that takes place in the corner of a room which you might designate as proprietary trading; this is risk management work and it is financing work that lies at the heart of industry and governments to create employment. That is why it is important that these businesses exist within a universal bank.[102]

91.  However, not all the witnesses were as sure of the benefits of large banks. Professor Kay provided the following commentary:

a large part of the synergies which we are talking about in these global banks are to do with tax, regulatory arbitrage and the kind of cross-subsidy we were talking about earlier, so from a public policy point of view we should not have very much sympathy with these synergies—the difference between the structure of HSBC and Barclays that you were describing is a lot more noticeable to Barclays than it is to the customers of either of these two banks. Going on from that, if one talks of other industries, people are endlessly talking in these industries about the desire of large corporations to buy from a single global supplier. I have heard that every year in telecoms, for example, since telecom privatisation began. Most of the evidence is that most of their customers do not: they want to pick and choose who are the best suppliers for particular goods. There are some synergies of that kind, but I do not think we should go overboard about that.[103]

The Governor of the Bank of England stated that: "I do think that I would like to see an outcome in which the size and variety of activities contained within these big institutions, if they are going to be financed in the way they are, is a lot less. To have a small number of big institutions dominating world banking is not a healthy position to be in, and I think the implicit subsidy is in part responsible for that".[104] And Mr Haldane has questioned whether large banks are a necessity:

[ ... ] the economics of banking do not suggest that bigger need be better. Indeed, if large-scale processing of loans risks economising on the collection of information, there might even be diseconomies of scale in banking. The present crisis provides a case study. The desire to make loans a tradable commodity led to a loss of information, as transactions replaced relationships and quantity trumped quality. Within the space of a decade, banks went from monogamy to speed-dating. Evidence from a range of countries paints a revealing picture. There is not a scrap of evidence of economies of scale or scope in banking—of bigger or broader being better— beyond a low size threshold. At least during this crisis, big banks have if anything been found to be less stable than their smaller counterparts, requiring on average larger-scale support. It could be argued that big business needs big banks to supply their needs. But this is not an argument that big businesses themselves endorse, at least according to a recent survey by the Association of Corporate Treasurers.[105]

Or, as Mr Corrigan conceded, although "It is a little hard for me to see how that [recapitalisation] would happen if we had a world of just narrow banks. You can turn around and say maybe we would not have had the problem in the first place."[106]


92.  As well as claiming that that larger financial institutions provide economic benefits to their customers, banks also asserted that larger firms benefited from being more diversified. Mr Flint of HSBC explained that:

What I think works is scale and diversification. The reason we have been able to deal with situations that have arisen is that we have a very diversified business model by geography, a very diversified model by type of business that we do and, therefore, when one piece is doing badly other pieces have been doing well and there has been demonstrably enough value to be able to accommodate stress in one part of our system. Against the popular "too big to fail", we think there is a very strong argument "for being large enough to cope".[107]

In a speech, Mr Haldane made the following observations:

[ ... ] business line diversification can be a double-edged sword. During the upswing, banks enjoyed windfall gains from bets at the race-track. This boosted their buffers. But when those bets turned sour, these same activities put at risk banks' day job—the provision of loan and deposit services to the real economy. 9500 sub-prime mortgage products at the height of the boom might well have been too many. But zero is surely too few.

There is a second important downside to diversification. While it might be sensible for an individual firm to diversify its business lines to reduce its risk, if this same strategy is followed by all banks the end-result may be greater fragility across the whole system. Why? Because in their desire to look different than in the past, banks' business strategies may end up looking identical in the present. The financial system could then become more prone to herd-like upswings and lemming-like downswings. There is more than a hint of this behaviour during the run-up to crisis. Banking strategies became a whirligig. Building societies transformed themselves into commercial banks. Commercial banks tried their hand at investment banking. Investment banks developed in-house hedge funds through large proprietary trading desks. Hedge funds competed with traditional investment funds. And to complete the circle, these investment funds imported the risk all of the others were shedding. In their desire to diversify, individual banks generated a lack of diversity, and thus resilience, for the financial system as a whole.[108]

Professor Kay was also sceptical of the benefits of diversification that banks were suggesting:

Big banks can reduce risks by diversification They can, but that is not what happened. Diversification can reduce risks, but that does not mean that all diversifications reduce risks. In particular, the diversifications by narrow banks such as RBS and Halifax into proprietary trading and low quality corporate lending greatly increased the risks to which they were exposed. Diversification led to their failure.[109]

We note that Mr Haldane concluded:

[ ... ] recent crisis experience highlights some of the costs of bundling banking services. Given that, there is an intellectually defensible case for some unbundling of these services. This would reduce the risks of spill-over between privately and socially beneficial banking activities. And it would help prevent banks making individually rational but collectively calamitous strategic choices.[110]

93.  We have received evidence asserting the benefits of large banks in two areas: their ability to serve the wider economy, and their ability to diversify risk. Yet there are strong counter arguments to these assertions. We recommend that the Tripartite authorities commission research on the alleged benefits of diversification, and whether the market might be better served by a larger number of providers, with more specialised firms.


94.  Banks may offer a range of products. They may operate in a range of countries. One possible change discussed was a requirement that international firms should operate as constellations of subsidiaries, rather than being allowed to operate via branches. (Subsidiaries are separate legal entities, while branches are legal extensions of the Head Office of a bank.[111])

95.  The banks which gave evidence to us had a variety of views on whether or not operating through subsidiaries was advantageous. Mr Varley, representing Barclays, explained that they operated "both branch and subsidiary structures within Barclays, partly as a result of [their] long history".[112] He was cautious in accepting that a move to a subsidiary structure would be helpful. He explained that:

Sometimes [ ... ] in the creation of a solution to one crisis are the seeds of a problem in the next crisis. I am struck by the fact that three years ago if we had been having this conversation, you and I might well have said to each other, 'We would expect'—if we know roughly what is going to be happening in the world over the course of the coming two or three years—'Central and Eastern Europe to have a major problem at some stage over that period.' I certainly would have expected it. The fact that liquidity was able to flow, not through subsidiary structures but through branch structures, the fact that liquidity was able to flow freely into Central and Eastern Europe, as it did over the course of the last two years, American money, British money, Italian money, French money, Belgian money going in to support those economies prevented those economies collapsing. Had they collapsed in 2008, say, or 2009, that would have been a very damaging development for the global economy.[113]

96.  Mr Flint of HSBC, a bank which uses a subsidiary structure, was more cautious about the benefits of a branch based system. He told us that:

There is no question that there is much more flexibility in a branch structure in terms of moving liquidity and obviously capital is fungible because it is a branch. I am not sure whether that is a good argument for a branch structure. I think there are equally good arguments in terms of risk and control that come with a subsidiaries structure—i.e. there are more reference points in the flow of liquidity and in the flow of capital that comes from a legal framework surrounding that[114]

Mr Flint also noted that subsidiary structures could be weakened, or branch structures improved:

Obviously you could have a subsidiary structure—and indeed there were elements of this in the Lehman situation where you had subsidiaries and then they cross-guaranteed each other— and you could destroy the integrity of the structure. Then you could have a branch structure that also puts checks and balances and brakes in place.[115]

However, he went on to explain that the advantages of a subsidiary system: "There is no question in my mind that a subsidiarised structure, in the event of having to deal with severe stress situations, makes it easier to see how you would deal with them. More importantly from our perspective, it gives us a better management and governance structure internally."[116]

97.  Mr Sáenz of Santander, which also operates a subsidiary system, stated that the advantage was that "the UK unit has capital in the UK, has funding in the UK, has assets in the UK and of course if instances of mismanagement have arisen it is up to the regulators to tell the mother company how it has to deal with that problem".[117] When asked whether branches, as Mr Varley pointed out, allowed liquidity to flow into the crisis situation in Eastern Europe, he replied that perhaps branches were responsible not only for solving, but also for causing that crisis:

The subsidiary model has a very important element which is that the local management is accountable for what is happening in this particular unit. This is very important. When you have a branch the accountability of the management is quite different and the origin of this situation that you mention I think has been the overstretch of the previous cycle that put these branches into problems when the crisis appeared. You cannot judge the situation by the way they have solved the problem when the crisis came but you have to judge the origin of that situation previous to the crisis. My point is that in those branches the over-extension and overstretch of the behaviour in the previous period produced the consequences that had to be solved by the mother company.[118]

98.  The Governor of the Bank of England thought that the move towards subsidiarisation was "inevitable", telling us that "We are likely to see, over the next few years, a movement in the direction of subsidiaries rather than branches because that makes it a whole lot easier for the national regulators to do their job".[119] And Lord Turner appeared to consider such an approach was likely in future:

It could well have an important role to play. It also strongly overlaps with the issue of living wills, resolution and recovery plans. Within that one of the options available to a large global group is to say that you do not necessarily need to think of it as one integrated global group. To a degree it has separate legal subsidiaries, for example Santander Mexico, Santander Brazil and HSBC Hong Kong which have stand alone sustainability where there is at least the option that if in 15 years' time there is any terrible crisis there is burden-sharing between different fiscal authorities as to what to do about different elements. I think it highly likely that the more banks either by geography or function have somewhat separable legal entities where one can see the possibility of resolving this one or that one in a different way, or selling this one and keeping that one, the less we need to go down the route of capital surcharges based solely on size. [ ... ] if we have an institution whose structure is a cat's cradle of complicated legal entities we could end up saying that if it wants to structure itself like that we will hit it with a higher discretionary capital requirement at global level because it has created a system that either will fail in total or not at all.[120]

99.  The distinct legal structure of a subsidiary may seem to suggest that a subsidiary could be left to fail, without hurting the rest of the group. Many witnesses however warned that in view of the potential damage to the reputation of the overall group, no firm would be keen to let this happen. Professor Goodhart gave the following example:

Bear Stearns had a couple of hedge funds which were effectively separated and the hedge funds had gone quite largely into these sub-prime mortgages and got into difficulties. Bear Stearns felt for reputational risk reasons that it had to support these hedge funds, which both denuded Bear Stearns of quite a lot of capital and, in a sense, just underlined the problem that Bear Stearns was getting into.[ ... ] In an institution with a lot of subsidiaries, people know that they are all of a part, and if one goes down it infects the other.[121]

When asked whether the markets would believe he would let a subsidiary fail, Mr Sáenz stated that:

What the market believes in the practice of our profession is that any kind of problems in a subsidiary are attributable to the management who are managing the unit so you are accountable for that and responsible for that. If the UK subsidiary goes badly it is under our management and the reason for that is mismanagement. We have to face that situation and put in more capital and do what the supervisors require us to do because it is the name of the game.[122]

The Governor agreed that it would be difficult for groups to let subsidiaries fail, noting that:

[ ... ]for some of the big institutions a lot of their value is bound up in the reputation of human capital in the bank, and if one national subsidiary fails, that is going to threaten the credibility of other national subsidiaries.[123]

However, Mr Sáenz hinted there could be cases when a subsidiary might be left to fail:

I would not like to mention any names but to my mind there have been some cases in the last ten years where the reasons for the failure of the bank were not due to the mismanagement but due to the events or acts produced by the governments in a brutal way. In this case there could be a good reason to take a different position.[124]

100.  The use of subsidiaries may also shield the countries in which banks operate from the effects of crisis in another country. Mr Tucker gave a striking example:

The key thing about the legal structure of subsidiarisation around the world is essentially to do with resolution rather than to do with risk in the group per se. There is not such a bank, but let us take a UK bank that has a big operation in India—and we will take India because it is outside the European Union. It is insignificant here but it is very significant in India. It operates as a branch there and gets into difficulty, and so the FSA and we say, "We can just put that into administration and close it." That does not create much economic damage in the UK, but in India it could create a great deal of economic damage. That means that countries which are host to banks which are integral to their financial services industry probably do have an incentive to subsidiarise in order that when the shit hits the fan (to use a rather ugly expression) the local fiscal authority have the tools at their disposal that they need.[125]

101.  The first benefit from subsidiarisation would lie in ensuring that local regulators, if informed and competent, have greater control over subsidiaries, and are able to impose the policy trade-offs that their country requires. If it becomes necessary for a subsidiary to be closed down, it will be helpful to have access to its capital, and as international firms will be less complex, resolution may be easier.

102.  We accept that there are powerful reputational incentives on banks not to let subsidiaries fail. However, regulators might step in to prevent a parent company attempting a rescue which threatened the viability of the overall group to the disbenefit of a group of taxpayers in a particular country.

103.  The use of subsidiaries may also prevent regulatory disputes. If the head office of an international group is closed down by its own country regulator, the knock-on effects in other countries can be severe. While the use of subsidiaries may not entirely prevent this (as can be seen in the case of Lehman's failure), it may give host country regulators more influence. In a world without seemingly effective cross-border financial supervision and cooperation, subsidiarisation may be necessary to protect individual countries' fiscal bases and financial systems.


104.  Reform of the financial services sector will have to take account of the United Kingdom's' position as a constituent of the European Union. We have already reported on some of the proposals to strengthen European Union financial regulation. Among the current proposals at various stages of development are the following:

  • A new systemic risk board, comprising representatives of each central bank and the ECB, with links to EU and national regulators;
  • three European supervisory authorities, with stronger powers to ensure consistency of practice across the union;
  • new regulations relating to the sale of alternative investments, clearing houses for derivatives etc;
  • as we discuss, consideration of harmonisation of European resolution and insolvency proceedings, and possibly the introduction of a European Resolution authority.[126]

105.  The drive in Europe appears to be toward a system which is both more integrated, and more strongly regulated. As the European Financial Integration Report 2009 says:

The realisation of a Single Market in financial services is an important means of increasing the competitiveness of the EU economy as a whole. By reducing financial barriers between Member States, productivity gains are expected, which in turn generate a more efficient and competitive EU financial sector. This is important, not only for the financial sector itself but also for all other sectors that rely on access to competitive sources of funding.[127]

106.  We discussed the impact of the 'passporting system' with Professor Lamfalussy, who might be described as the father of the current system. His views were clear:

We have a major problem with the cross-border banks, and that has to be dealt with specifically. There are about 45 banks, or banking groups, which really count in the European Union, of which 30 or so have their headquarters inside the euro area and the others have them in the rest. That is a question that has to be addressed that has not been addressed so far. There were attempts of various kinds and it has been conveniently swept up under the carpet.[128]

When we later asked whether it was inevitable that we would have to change European law to allow national regulators to impose more subsidiarisation he responded:

I would certainly welcome it. What your Governor said was absolutely right, and maintaining the current ambiguity in this particular case is not healthy. I do believe that playing with the subsidiaries rather than branches is the right direction.[129]

107.  Lord Turner was pessimistic about the likelihood of change:

Essentially, we took the single market concept of freedom of establishment of services across the border and assumed that if that applied to coffee shops, ski instructors and retail stores it ought to apply also to banks. Therefore, it takes us right back to the fundamental assumption. I think it would require treaty-based changes which are immensely difficult to roll back from that situation. The simple fact is that if the FSA today tried to insist rather than encourage a particular bank from an EEA country to set up a subsidiary it would be subject to infraction procedures by the European Commission.[130]

108.  We are not competent to say whether reform would require treaty amendment. However, limitation on the right to establish companies in the EU can be subjected to restrictions in a Member State if justified by pressing reasons. A change of this nature would merely ensure that a bank has to be structured in a way which satisfied the host state's regulators. In other cases where international companies provide potentially hazardous goods in a variety of countries, we do not expect restrictions on the ability of the national regulator to ensure those goods are safe. Moreover, financial services may present systemic risks which other goods do not.

109.  As we have seen, decisions about what financial system might be desirable depend on precisely what assessment is made of the necessary trade-offs between different objectives, each of which may have some desirable outcomes. For example, there is a trade-off between the benefits of integration and the increased risk of contagion it may bring. European discussion appears to be based on an assumption that financial stability will be safeguarded by better, stronger, regulation; there is little sign that current thinking is prepared to consider structural reform.

110.  The financial crisis was not wholly the product of European banks, or European regulatory systems. However, it was exacerbated within the EEA by a system which placed undue faith on the harmonisation of regulatory structures, and discouraged national regulators from inquiring into banks headquartered in other Member States. While also considering wider international reform, there are powerful arguments for strengthening the role of national regulators within the single market.

111.  We stress that, if achievable, better coordination between regulators of international institutions is desirable, and consistent thoughtful frameworks for regulation are likely to be helpful. However, as we have said earlier, we do not believe that regulation will prevent financial crises. We believe that the financial system should contain what the Governor of the Bank of England described as "firebreaks and firewalls", to lessen the impact of crisis when it inevitably occurs. We agree with the Commission that the "overriding policy objective is to ensure that it should always be possible— politically and economicallyto allow banks to fail, whatever their size" We believe that it would be desirable to revisit the principles of European regulation to assess the extent to which they achieve this.

112.  One possible reform would be to allow national regulators to require that foreign owned banks operated as subsidiaries rather than branches. As we have pointed out, requiring international banks to operate through subsidiaries would not solve all problems. However, it deserves serious consideration. It would be perverse if the European Union ruled it out on the questionable basis that the right of banks to operate through branches rather than subsidiaries was essential to financial integration. As Professor Lamfalussy said, the problems posed by cross-border banks were conveniently swept under the carpet. The scale of the crisis means that Europe now has no choice but to confront those problems, and, if necessary, revise the Treaty. It cannot help European financial integration if the Governments and populations of Member States associate cross-border banking with financial instability.

Narrow banking

113.  Subsidiarisation is an attempt to segment global banks in legal entities by geographical area. Narrow banking attempts to segment such groups by type of business, rather than geography. The proposals for narrow banking have come in different forms, some of which we examine below.


114.  Professor Kay's proposals are set out in his paper Narrow Banking: The Reform of Banking Regulation, in which Professor Kay envisages a split between deposit taking institutions, and the rest of the financial system. Professor Kay outlined the following characteristics of his narrow banks:

Narrow banking implies the creation of banking institutions focussed on the traditional functions that the financial system offers to the non-financial economy:

- payments systems (national and international), for institutions of all sizes;

- deposit taking, from individuals and small and medium-sized enterprises.

Only narrow banks specialising in these activities could describe themselves as banks. Only narrow banks could take deposits from the general public (deposits of less than a minimum amount, say £50,000). Only narrow banks could access the principal payments systems (CHAPS or BACS), or qualify for deposit protection.[131]

Professor Kay's proposals also suggested that the liabilities of the narrow banks should be matched by safe assets:

The most effective way to ensure that public subsidy to failed financial institutions is not required is to insist that retail deposits qualifying for deposit protection should be 100% supported by genuinely safe liquid assets. Ideally, this means government securities, since nothing else has assured safety and liquidity. The model presented here does not require this restrictive view of asset quality. But this restriction is both feasible and desirable.[132]

115.  Professor Kay explained why he considered there was a need for deposit liabilities to be matched with safe assets:

It seems to me that if we are going to have deposit protection we need to minimise the taxpayer risk from deposit protection. That means ensuring that deposits are backed by safe assets—and not just partly backed by safe assets but wholly backed by safe assets. The blunt fact is that in the world we have got into over the last 20 years, where the rating agencies would attach triple-A ratings to anything, the only thing we can be sure are safe assets are government securities of various kinds. I see narrow banking and deposits that go with narrow banking being backed by genuinely safe assets of that kind. That is also the only protection I can see against the kind of thing that happened.[133]

Professor Kay then told us why he preferred this 'structural' type of regulation, over a 'behavioural' one:

for the last 20 years I have looked quite a lot at the whole process of regulation, deregulation, privatisation in British utilities and transport—is that one very clear conclusion from regulatory history is that if you can regulate structure it is almost always better to try to regulate structure than behaviour; that is, to put in place structures that give firms roughly the incentives to do the kinds of things you want, rather than engage in detailed monitoring of the activities they engage in. That has been true across the utility sector. Almost all the industries where we think regulation is going wrong are those where we have ended up trying to regulate behaviour, and there we end up, as we do in financial services, with a regulation that is at once extensive and intrusive and yet not very effective, and subject to what people call regulatory capture.[134]

116.  One of the other areas explored was whether the narrow banking model as envisaged by Professor Kay would be able to support lending. In his paper, he provided the following explanation:

Narrow banks might, but need not, engage in lending activities appropriate to retail financial institutions, particularly consumer lending and mortgage finance. They might, but need not, lend to small and medium size enterprises. Funding for these lending activities would have to come entirely from wholesale markets, and the banks' own capital. There are already specialist institutions which offer credit cards and mortgages based on wholesale funding. An expansion of such finance could take the form of securitisation, or be achieved through more traditional forms of money market funding. Since there would be no regulatory advantages to one form of finance over another, market forces would determine the outcome.[135]

Professor Kay also envisaged that the rest of the system, outside of narrow banking would be essentially unregulated. He explained that:

The long term objective would be to dismantle all other financial services regulation. Capital requirements would be abandoned, and the licensing of wholesale market activities by public agencies would relate only to the approval of individuals and institutions as fit and proper persons. Issues such as market abuse that did not fall within the scope of the criminal law would be a matter for private activity by self-regulatory institutions.[136]

117.  Lord Turner was concerned about the impact Professor Kay's proposals would have on credit extension. He told us that he believed that "if you did what John Kay suggests and deregulated the rest of the system the rest of the system would include the whole of credit creation and extension and we would find that was just as risky and volatile as it is today."[137] As such, Professor Kay's proposals would appear to carry a trade-off with our objective to provide sustainable lending to the real economy. This view was also expressed by Professor Goodhart, who noted that:

I do not think [Professor Kay] appreciates sufficiently that it is not just about deposits, it is not just the liability side, it is the asset side. It is the provision of credit for our companies and mortgages for our people that are so important. You can have a development whereby the system is unable to provide sufficient credit and the economy will go down, whatever happens to the deposits and whatever happens to the payment system.[138]

118.  Professor Kay also stated in Narrow Banking that "In a free market, narrow banking would have emerged spontaneously and immediately". Professor Goodhart however told us that:

We have had narrow banks many times. Indeed, Parliament arranged for two narrow banks going back to the 19th century—the Post Office Savings Bank was one, the Trustee Savings Bank was another—which operated exactly along the lines that John wanted. Neither of them was very successful. In competition with other banks which could take more risk and therefore offer a higher rate of deposit, the Post Office Savings Bank and the Trustees Savings Bank had a losing role.[139]

He went on to add that:

[John Kay] says that the market is being constrained by deposit insurance. But deposit insurance only came in in the 1990s, after BCCI. There was none before then. The narrow banks were able to compete and effectively lost out. The problem is that if you required narrow banks to hold entirely riskless assets, those assets would have very low rates of return. Also, the services that narrow banks like the Post Office Savings Bank could offer were relatively limited. In competition with the other commercial banks, effectively they lost.[140]

Professor Kay however rejected Professor Goodhart's conclusions:

[ ... ] we had narrow banks, which were called building societies. Not only did they compete, they were steadily winning market share at the expense of other banks. We mistakenly, in retrospect [ ... ] allowed them to diversify their activities, which they did—unsuccessfully in every single case—and failed. That is a large part of the problem which we have in the UK financial services sector today. This kind of solution is perfectly feasible. [ ... ]We have had narrow banks, they have worked in this sense, and this kind of proposal can work in the future. It is going back to a world which worked perfectly well in the past..[141]

119.  Another problem identified by those critical of Professor Kay's proposals was that of the 'boundary problem', which Professor Goodhart explained as follows:

The boundary problem is very simple. If you impose constraints and/or various kinds of burdensome regulations and taxes on one sector, it means there is a tremendous incentive for people to do the same kind of business over the boundary in the unregulated sector [ ... ]. When it is unregulated the results may be considerably worse [ ... ] if you are going to regulate, control, or constrain the banking system so much, you will shift the business elsewhere, possibly into the market; possibly into various other kinds of hedge funds. The end result may be that you will have a nice little protected sector at one point, but you will have a potentially dangerous unregulated area at another. I think my concern is that we will never actually avoid crises in the financial system, but if we make the banking system a great deal safer, what we will do is we will have the next crisis occurring in a shadow banking system or in a part of the unregulated market. You have to look at the financial system as a whole rather than concentrating just on one small part of it because of the boundary problem.[142]

Professor Kay was, unsurprisingly, keen to defend his proposals against this criticism:

[ ... ] it is true of any form of regulation, whatever form of regulation we have, that we will get regulatory arbitrage in which people seek to do the same kind of thing in a rather different and differently regulated way. In whatever kind of regulatory structure we set up we are going to get problems of that kind. We have had them in spades over the last two decades. Indeed, a very large part of what has set up the problems which we have encountered in the last two years has been regulatory arbitrage in which people reconfigured and restructured transactions in order to reduce what they perceived as the regulatory burdens. [ ... ] What I think we have to do is to try and find a relatively narrow area that is guaranteed, be very clear about what that is and be clear also that everyone understands what is guaranteed and what is not. At the moment I think we are in a terrible position where we really think everything is guaranteed but we are not quite sure [ ... ].[143]

120.  Professor Kay's reforms are ambitious, and would further alter the architecture of the financial system. We recognise that while his proposals demand a radical restructuring of banking, that may be needed in respect of the radical changes which have already developed in an ad hoc way, with ill consequences, over the last two decades. We also recognise that, if they worked as intended, his proposals would protect consumers who used narrow banks, and reduce the role of the Government in a financial crisis, insofar as it proved possible for the Government to let firms in the wider banking system fail. There would be a likelihood of a significant transfer of risk into the unregulated sector. We would need to address whether the resulting financial system could provide sustainable lending.


121.  On 21 January 2010, the President of the United States of America announced a set of possible changes to the US financial system. They were as follows:

1. Limit the Scope—The President and his economic team will work with Congress to ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.

2. Limit the Size—The President also announced a new proposal to limit the consolidation of our financial sector. The President's proposal will place broader limits on the excessive growth of the market share of liabilities at the largest financial firms, to supplement existing caps on the market share of deposits.[144]

122.  The proposals were heavily influence by Paul Volcker, the Chairman of the President's Economic Recovery Advisory Board, and the President referred to them as the Volcker rule.[145] The Economist referred to the proposals as "Glass-Steagall lite",[146] after the Glass-Steagall Act (the US Banking Act 1933), which was introduced after the 1929 US stock market crash. The Act created the Federal Deposit Insurance Corporation (FDIC) and prohibited commercial banks from engaging in investment banking; the latter was intended as a means of protecting bank depositors from the additional risks associated with security transactions.[147]


123.  We discussed the proposal to ban proprietary trading extensively with our witnesses, and with those we met on our visit to the United States. Proprietary trading is trading on behalf of the firm, rather than on behalf of a client. Mr Sáenz told us that "whatever you call it, proprietary trading or market-making, in fact it is a high risk activity. It is some kind of speculative activity, that is quite clear".[148] But one of the concerns about the US reforms was whether or not it would be possible to identify what proprietary trading actually was, in a legal or regulatory sense. Mr Tucker highlighted this point:

no-one has the faintest idea how to define proprietary trading. The positions that blew up half a dozen of the biggest banks in the world were not especially proprietary positions in the way that would normally be understood in the bars; they were large parts of securitisations that the banks had chosen not to distribute. This is going to put on hold for a second the very narrow banking approach. Let us say that I run a bank which is funded by retail deposits. I originate a load of loans for my customers and I securitise nearly all of them but I still have deposits to invest and so I have to buy assets from the market. I have become an asset manager. Is that proprietary trading or not? I do not know. I agree with the spirit behind the President's proposals. Coming from the level that it does, from the President, it is the spirit in it that is important. I take him and Paul Volcker to be saying that banks should be less risky businesses if they are going to be funded by insured deposits and if they are going to be highly leveraged, and I agree entirely with that. We will learn a lot from how they go about legislating this and defining proprietary trading.[149]

However Mr Tucker appeared to be mildly supportive of the efforts to combat proprietary trading in deposit holding institutions. He told us that:

I think the spirit of the thing about proprietary trading and principal investment is the most important thing; it is to do with reducing the riskiness of banks and leveraged institutions that borrow short. Proprietary trading, principal investing may be one way into that, but it would not be the only way into that; banks do plenty of other things that are very risky. If we look back through the past and, I am sure, if we look into the future, there will be banking crises driven not by proprietary trading, but driven by bog-standard over-extension of loans to the commercial real estate sector, and that has happened again and again. So some of the relatively easy wins are technocratic—to shift the risk weights on lending of various kinds so that banks are taxed more, in effect, for holding them.[150]

124.  The banks acknowledged that a ban on proprietary trading might make the system safer, but were less keen to acknowledge that the effect would be large. Mr Varley outlined the following position for Barclay's:

I understand why it is that [Mr Volcker] alights on proprietary trading as a source of risk if combined with other activities. I do understand why he does that. I do not know whether he regards this as a silver bullet. I sort of doubt he does. I certainly would not regard it as a silver bullet. Could you trace the origin of this crisis to that combination? You could not. Proprietary trading for most banks in the world is a marginal activity. If I look at Barclays, you can imagine there is a lot of contention for capital within Barclays. I want all of our capital, every penny of our capital in Barclays, to be serving client and customer business. I do not want capital directed into proprietary risk-taking. [ ... ] Is he right to say that the isolation of proprietary risk-taking from retail deposits would lead generally to a safer society? That is true, but I do not think that it would have saved the system.[151]

He downplayed the amount of proprietary trading occurring at Barclays:

If I look at Barclays, it is completely inconsequential. Indeed, in my definition, in any event, I would not point to any activity in Barclays and describe it as proprietary risk-taking, although Mr Volcker may take a somewhat different view. But he and I would agree, if he were privy to the detail of Barclays' activities, that it is completely irrelevant.[152]

125.  Mr Sáenz also downplayed the amount of proprietary trading occurring at his company, Santander, telling us that "We have negligible proprietary trading, almost nothing, we do not deal with those kinds of activities and our business model is traditional commercial banking—when I say commercial I mean individuals and small to medium-sized companies and some large corporations in our footprint where we have commercial activities, and this is our business model". [153] In spite of this he did not favour a structural break between commercial banking and proprietary trading, but rather told us "I would be in favour of any kind of extra requirements of capital for the more risky activities like proprietary trading, so rather than say there should be a clear separation I would advocate additional capital requirements".[154]

126.  Mr Sáenz also shared Mr Tucker's concerns about the regulators' ability to define proprietary trading. He gave us the following example:

I do not think there is such a clear-cut differentiation between proprietary trading and dealings on behalf of your customers. If you like I can give you some examples. It is what our people in the treasury department call "market-making" so proprietary trading is on one side, the customer is in the middle and in between is something that is called, in our profession, market-making. What market-making is, is if I take a position with you as a customer and I want to hedge, to cover, that position that I have opened in a deal with you, I can do it in two ways. I can either cover it immediately back to back with another counterparty with you as a customer and another customer or another bank, that is one way, or another way is to do market-making, so-called. There I leave it open for a few days in order to see if I have a vision, a view, about the future course of the market in order to make this hedging in a more profitable way. There are two days that the positions I opened with you are open. The question is, is that proprietary trading?[155]

Mr Flint argued that some definitions of proprietary trading would have real world effects:

If you were to have a system where banks were not allowed at the end of the day to end up with a net position, ie no proprietary or principal position, the inevitable consequence is that the bid offer spread, ie the price, of intermediation would go up because people would only deal on the basis of a price that they knew they could get out on the other side, which would mean that ultimately clients would find that too expensive and would either not hedge their risk or would do it outside the banking system. You could end up with a multiplicity of unregulated entries providing the platforms through which risk is managed. At the moment what the banking system does is provide a platform for risk management for non-banking institutions and it does so as principal.[156]

127.  Lord Turner, like Mr Sáenz, felt that a reduction in proprietary trading could be achieved by raising capital requirements on such activities and considered that to be "the general direction of change".[157] In our conversation with Mr Volcker on our visit to the United States, he did indeed appear to combine a legal and capital surcharge approach, telling us that:

Now, once you say that, how do you prevent the trader from engaging in essentially speculative activity under the cover of saying this is customer related? Now I don't think there is any very bright line you could draw, but I think you can have the law strongly state that we don't want proprietary trading in the bank and the supervisor should be directed towards guarding against the rise of proprietary trading in whatever guise it may arise. And I think any sophisticated supervisor sitting at a trading desk examining trading results over a period of time could reach some reasonable judgement as to whether this is an unduly expansive interpretation of customer trading. And you don't have to make the decision in black and white. You could say 'look, you look a bit out of bounds and we have the authority, and will apply the authority, to demand a much higher capital allocation against this activity'. And if it gets big enough, the capital allocation will get very large and make that business unprofitable, so the bank would naturally have to pull back, I don't think that's simple, but it's not impossible.[158]

128.  There is a consensus that proprietary trading is a riskier activity than others banks undertake, and therefore may require closer control in deposit-taking institutions. There is a strong case in principal for such control. However, the definition of proprietary trading appears to be a 'grey area'. This may well mean that bold structural reform is difficult to implement, although Mr Volcker was confident that these definitional objections could be overcome. In practice, Mr Volcker's proposals may be implemented by higher capital charges on activities regulators deem risky.

The structure of bank ownership liability

129.  Since the crisis began, there has been a great deal of work on effective corporate governance within financial institutions. Our own inquiries into the topic suggested that companies' ownership had not provided effective control. In this inquiry we questioned whether a change in the actual ownership structure was required. In a speech in Leeds in September 2009, Mr Haldane noted that limited liability had changed the risk/reward payoff for owners of a firm:

Limited liability means that returns to shareholders are capped below at zero, but not above. That provides a natural incentive for owners to gamble, pursuing high risk/high return strategies from which they import the return upside but export the risk downside to depositors or the public sector. During this crisis, the pursuit of those strategies has resulted in the public sector picking up the cheque for the downside in an effort to reduce risks to depositors.[159]

Mr Haldane told us that "the value of limited liability to the equity holder is particularly great when a bank is taking on risky activities—essentially because, when those risks are realised, the losses are not borne by the equity holder, but the higher returns for taking that risk are borne by the equity holder".[160]

130.  Professor Goodhart outlined the reasons there had been a move towards limited liability:

Back in the 19th century we had a mechanism of controlling risk which actually worked quite well. That was unlimited liability for the shareholders and of course the managers were shareholders. We got rid of it. Why did we get rid of it? We got rid of it because what resulted were relatively small institutions which were not able or prepared to take on very large risk in supporting industry. The UK looked at France and Germany and the countries in the Continent which were developing universal banks which were much bigger, and they saw themselves and their banking system falling behind. They said to themselves, effectively, 'What we have to do is to provide a condition in which our banking system provides the support for growing industry and is prepared to take up much larger positions much riskier positions, much longer term positions.' In order to get sufficient capitalisation to do that, you needed to move from unlimited liability to limited liability, which everybody recognised was going to make the financial system much, much riskier, and there were attempts to offset that by increasing accountancy and transparency and all that sort of thing. And of course it did make the world a bit riskier.[161]

131.  Professor Goodhart noted that "there are many who feel that the shift in the major American investment house from partnerships to limited liability companies was not a step in the right direction with regard to risk-taking".[162] When we questioned Mr Corrigan on this, he explained why the banks, such as Goldman Sachs, had moved away from the partnership model:

there is more than a grain of truth in your hypothesis that, other things being equal, the private partnership model had an awful lot to commend it. That I think is the reason why the decision by Goldman Sachs and others, including some private banks here in the UK, to give up their private status and become publicly held companies went on for years and years and years at times before the decision was made to take that step. I think that it is probably true that the core reason why most of what had been private, financial groups in the UK and in the US tradition made the shift from private to public was access to capital. They concluded, as the world was changing, as the scale of transactions was changing, as the risk factors were changing, that they needed more capital than they could accumulate as a private company.[163]

Mr Haldane however warned against an immediate return to unlimited liability. He remarked that "I do not think now is the time for us to return to a system of unlimited liability. Given the lending that is needed to support the real economy, the risks of pursuing that track just now are frankly too great."[164]

132.  Banking has progressively been shedding unlimited liability as part of its ownership structure. This may well have increased the riskiness of the financial system, and led to a greater level of financial activity. It is interesting to note that limited liability is particularly beneficial to those undertaking riskier transactions.

The Government's position

133.  In July 2009, the Government published its White Paper on Reforming financial markets. In that document, it rejected limits on banks' size or complexity (the latter being an approach similar to Glass-Steagall). It provided the following explanation for its decision:

Proponents of formal limits on the size or activities of banks focus on the need to protect the core banking system from risks to depositors, the taxpayer and wider financial stability arising from risky investment activities. They also believe that, as firms grow to a certain size, they become beneficiaries of implicit or explicit guarantees by governments, which they use to justify or subsidise certain forms of speculative activity. The approach assumes that smaller, less complicated institutions should be easier and less costly to wind down.

There are strong counter-arguments to all these points. First and most significantly, there is little evidence to suggest that artificial restrictions on a financial institutions' size or complexity, including introducing a distinction between commercial and investment banking activity, would automatically reduce the likelihood of firm failure:

  • a fundamental assumption of the Glass-Steagall approach is that there is in fact an absolute size below which a firm can be safely left to fail. Events of the last 18 months have demonstrated that this is clearly not the case. Banks of all sizes—not just institutions above a certain size—have encountered difficulties, challenging the assertion that only larger banks are likely to fail or have systemic consequences. Caps on size, therefore, may not be an effective way of managing risk;
  • moreover, some institutions that failed engaged solely in commercial lending or investment banking activity, while one of the most significant failures of all—AIG in the US —was not even a bank. The existence of Glass-Steagall provisions would have failed to address these two points;
  • crucially, the Glass-Steagall approach does not guard against systemic risk contagion between firms, which as recent events show can easily travel between pure deposit-taking institutions (large or small) and large investment banking institutions;
  • while many large, universal, banks lost money on trading activities, they also suffered losses as a result of bad lending, poor corporate governance and risk management procedures. The latter are examples of basic problems that can exist across both "narrow" and "broad" banks, again transcending the Glass-Steagall divide.

Second, the aggregate economic costs in the event of failure would not necessarily be reduced. Separating commercial banks from investment banks would not address counterparty risk exposures between banks, nor tackle liquidity problems arising from the cessation of interbank lending in the event of a single firm failing. Lehman Brothers was an investment bank, but its failure led to wide and varied knock-on effects to the rest of the financial system.

Third, there are benefits to the economy in having access to the services of large, broad institutions, which can use scale and scope to provide for risk diversification, as long as there are sufficient regulation and other safeguards as discussed earlier. Additionally, some large or complex banks are by nature likely to be international in business coverage, facilitating more cross-border investment and trade, and broader and larger banks provide a vital form of intermediation between the capital markets and the real economy; as a result some efficiency of allocation would be lost.

Fourth, there are practical challenges to implementing this approach. It would be extremely difficult to identify any optimum threshold for the size or scope of financial institutions, let alone to mitigate the moral hazard problems that come with specifying this threshold to the market.

Finally, a Glass-Steagall-style separation would need to be applied across all countries to be effective. In the absence of any global consensus on this approach, and on what the appropriate threshold for bank size or breadth might be, the introduction of these restrictions could inhibit the growth and continued competitiveness of the UK financial market, and might encourage even sound UK financial institutions to move to other countries.

For the reasons set out above, the Government does not believe that Glass-Steagall style provisions, with artificial limits to firm size or breadth, would constitute a suitable response to the question of how to effectively manage the risks of systemically significant institutions [ ... ][165]


134.  The Government has ruled out structural reforms such as narrow banking in its changes to the regulatory structure of the financial system. President Obama's proposals do include structural reforms, which suggests that the Government's conclusions are not universally accepted. The debate on banking reform should remain as wide as possible. Structural reforms should not be ruled out.

135.  As a counter to structural reform, it has been argued that narrow banks also failed during the current crisis. This, in part, may be due to how those 'narrow banks' were allowed to interact with the wholesale markets. Moreover, this argument focuses on the system which existed before the crisis. Global responses to that crisis have created a new set of problems, in that markets now expect Governments to support the banking system. Structural reforms may be one way significantly to alter those expectations.

99   Ev 131 Back

100   Ev 103 Back

101   Q 308 Back

102   Q 268 Back

103   Q 45 Back

104   Q 165 Back

105   Speech given by Andrew Haldane at the Association of Corporate Treasurers, Leeds, Credit is Trust, 14 September 2009, pp 10-11 Back

106   Q 308 Back

107   Q 386 Back

108   Speech given by Andrew Haldane at the Association of Corporate Treasurers, Leeds, Credit is Trust, 14 September 2009, pp 12-13 Back

109   John Kay, Narrow Banking FAQs, pp 4-5 Back

110   Speech given by Andrew Haldane at the Association of Corporate Treasurers, Leeds, Credit is Trust, 14 September 2009, pp 12-13 Back

111   Ev 114 Back

112   Q 188 Back

113   Q 196 Back

114   Q 362 Back

115   Q 365 Back

116   Q 365 Back

117   Q 434 Back

118   Q 435 Back

119   Q 133 Back

120   Q 507 Back

121   Q 43 Back

122   Q 432 Back

123   Q 133 Back

124   Q 432 Back

125   Q 117 Back

126   See paras 151-153. For details of reforms see the European Financial Integration Report, Annex 1: Policy Achievements in 2009 Back

127   Brussels, 11.12.2009, SEC(2009) 1702 final, Commission staff working document, European Financial Integration Report 2009 Back

128   Q 530 Back

129   Q 540 Back

130   Q 525 Back

131   John Kay, Narrow Banking, p 52,, September 2009 Back

132   John Kay, Narrow Banking, p 58 Back

133   Q 23 Back

134   Q 16 Back

135   John Kay, Narrow Banking, p 62 Back

136   John Kay, Narrow Banking, p 65 Back

137   Q 503 Back

138   Q 30 Back

139   Q 26 Back

140   Q 8 Back

141   Q 27 Back

142   Q 48 Back

143   Q 49 Back

144   The White House, Office of the Press Secretary, 21 January 2010, President Obama Calls for New Restrictions on Size and Scope of Financial Institutions to Rein in Excesses and Protect Taxpayers Back

145   The White House, Office of the Press Secretary, Remarks by the President on Financial Reform, 21January 2010  Back

146   The Economist online, Obama and the banks, Glass-Steagall lite , Barack Obama proposes limiting the activities of big banks , 22 January 2010 Back

147   HM Treasury, Reforming financial markets, Box 5.A Back

148   Q 448 Back

149   Q 116 Back

150   Q 81 Back

151   Q 224 Back

152   Q 227 Back

153   Q 410 Back

154   Q 410 Back

155   Q 447 Back

156   Q 376 Back

157   Q 494 Back

158   Ev 149-150 Back

159   Speech given by Andrew Haldane at the Association of Corporate Treasurers, Leeds, Credit is Trust, 14 September 2009, pp 14-15 Back

160   Q 148 Back

161   Q 17 Back

162   Q 32 Back

163   Q 307 Back

164   Q 149 Back

165   HM Treasury, Reforming financial markets, paras 5.30-5.36 Back

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