To be published as HC 1534-ii




Treasury Committee

Independent Commission on Banking: Final Report

Tuesday 18 October 2011

MR John HitchIns, MR John Grout and MR Matthew Fell

MR John Kay and Dr Peter Hahn

Evidence heard in Public Questions 128 - 224



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Oral Evidence

Taken before the Treasury Committee

on Tuesday 18 October 2011

Members present:

Mr Andrew Tyrie (Chair)

Michael Fallon

Mark Garnier

Stewart Hosie

Andrea Leadsom

Mr Andrew Love

John Mann

Mr George Mudie

Jesse Norman

Mr David Ruffley


Examination of Witnesses

Witnesses: Mr John Hitchins, Senior Banking Partner, PricewaterhouseCoopers LLP, Mr John Grout, Policy and Technical Director, Association of Corporate Treasurers, and Mr Matthew Fell, Director, Competitive Markets, CBI, gave evidence.

Q128 Chair : Thank you very much for coming in this morning. I apologise that we are starting just a little late. We intend to run the session for an hour. I would like to begin by asking each of you where you agree with Martin Taylor’s-and, as far as we can tell, the Vickers committee’s-view that there is no reason why banks should be claiming that there will be a reduction in the supply of credit as a consequence of the Vickers proposals. Perhaps we should start with John Grout and then we will move, as I am looking, from left to right.

John Grout: Good morning. I would have to say that I have no idea which is right. The reason is that this is on top of the working through of the G20 proposals on bank regulation generally, so this is a variation on quite a big theme.

Chair : Sorry, I just want to narrow down the question though. It is clear that there will be aspects of other proposals that will tighten credit, but I am asking only a very narrow question, which is about the Vickers proposals. That is what we are looking at at the moment.

John Grout: Yes. I think that there are clearly risks of there being an effect from inefficiencies introduced, but I would also see the possibility of offsetting factors that would tend to reduce that. If you look at the return on bank capital, which was the target of banks in the run-up to the crisis, this was very high. It was perhaps returned to a more normal return by destruction of value in the crisis. If a more reasonable return is established as more of a norm with less volatility, I would expect to see the requirement for bank return on capital to be so high falling, and that is likely to significantly offset any inefficiencies introduced by ring-fencing, for example, and by the extra capital requirements.

Chair : Am I taking that as a tentative endorsement of Martin Taylor’s view?

John Grout: Absolutely.

Chair : All right. So you agree with him. Good. John Hitchins.

John Hitchins: I think that the proposals will add a layer of additional costs to banks which they will seek to recover from customers, or if they are pushed into meeting the new capital standards too quickly, they will not be able to do it through price increases, which take quite a long time to work through, and will be forced to remove assets. If they are forced to remove assets, the credit supply will be impacted. If you allow the proposals sufficient transition time, the banks may be able to adjust through pricing and cost savings without deleveraging, in which case, although the price will go up, the supply should be unaffected.

Chair : If the price goes up overall, there will be less lending.

John Hitchins: Yes.

Chair : So therefore, you disagree with Martin Taylor and you think that there will be-

John Hitchins: An impact.

Chair : An impact. It is difficult to judge how much. That will be assessed on the basis of the time and the taper, as it is put. Matthew Fell.

Matthew Fell: Good morning. Right at the outset, it is important to say that, when we speak to the entire breadth of CBI’s membership, they say they are absolutely up for reform and they see additional capital as a key layer of defence against future shocks. But precisely for some of the reasons that John has just alluded to, they are just as concerned with the manner and the timing of the way that these proposals are as to the absolute nature of reform, and I think regardless of what you think about the merits of any of the proposals, it seems fairly clear to us that they will challenge lending, and in a number of ways.

Firstly, the Vickers proposals, both through requiring higher minimum levels of capital and by imposing a ring-fence, that puts more capital requirement on to banks, and if you do that, it is pretty inevitable that the cost of lending does increase. Secondly, it seems to us that the ICB’s proposals go beyond the international consensus, looking at G20, Basel and so on, and that we think has a knock-on impact for the cost and availability of credit to UK businesses relative to their international rivals.

Thirdly, I think it is worth while noting that these are very significant structural changes proposed on banks, and when any organisation goes through organisational change, there is an inevitability that there is a period of inward looking-ness about them while those reforms take hold, so it is impossible to quantify the exact impact, but our reading of the situation is that there is quite a lot of downside risk to these proposals in terms of their impact on the supply and particularly the cost of lending. Given where we are in the economic cycle and the subdued nature of lending right now, I think our message is take time to make sure they are carefully and properly implemented, have a relatively lengthy flight path for their introduction, being mindful of the fact there are downside risks to supply and credit.

Q129 Chair : Kind of ascending concerns as I have moved from left to right. You are clearly very concerned that there could be risks to lending, notwithstanding your support for the ring-fence.

Matthew Fell: Correct.

Chair : All right, I have your three positions.

Q130 Mr Mudie: Mr Grout, in your paper though, you said it is important that any structural changes, "be accompanied by significant and practical measures." Firstly, are those absolutely necessary to continue the supply, but secondly, what are they?

John Grout: The reason that we put that comment in is that business uses a lot of services from banks, not just lending and not just as a home for surplus funds. They take a lot of services in terms of risk management products and that sort of thing. The attention therefore to the way in which those services are provided, the systems that support trade finance activities-simple things like issuing letters of credit, guarantees, dealing with bills of exchange and so on and so forth-all need to be thought about. Are they to be duplicated each side of the fence? Are they to be farmed out outside those activities altogether and separately contracted in from another subsidiary of the holding company at the bank? These practical issues need to be thought through, and sufficient time needs to be allowed for implementing the regulatory proposals for all those adjustments to be made and for corresponding adjustments to be made in the clients of the banks. That sort of time allows banks that are not affected by these proposals, such as banks branching in from overseas, for example, and banks who are not undertaking retail business in the UK of the kind that is ring-fenced, to see ways in which they can come into the market to bring in additional alternatives that can reduce the impact of the changes of the ICB. That is one of the reasons I am less concerned about it than my colleagues.

Mr Mudie: Thank you.

Q131 Michael Fallon: Mr Fell, last week we asked Martin Taylor about the increase in the cost of credit, and he said, "There is absolutely no reason why the banks should claim that anything in this report should reduce the supply or increase the price of credit to small companies, nothing at all". That is what he said. Your written submission is pretty clear to us that these proposals will lead to an increase in the cost of banking, so who is right?

Matthew Fell: Our view, particularly at the small business end of the market, is firstly just to note that small and medium-sized firms are much more heavily reliant on bank financing than, say, larger corporates, who can access a more diverse range of financing options, so the pinch point could particularly come at the small company end of the market.

Secondly, when you look at the Vickers proposals, it seems to us that it is a reasonable assumption to make that the majority of SME banking would sit within the ring-fenced part of the bank, which has the higher capital levels imposed upon it, so that would suggest it is more likely to be a cost than supply issue, we think, for credit, but the cost risk is there for small firms.

Thirdly, for small businesses, particularly if they are typically banking inside the ring-fenced part of the new bank set-up, then if they wish to access any of those services that sit outside of the ring-fence from where you do your day-to-day banking activities-I am thinking there particularly of some of the day-to-day risk management services, like wanting to manage exchange rate risk, interest rate, commodity prices and so on, which many small businesses do on a fairly frequent, regular basis to manage risk in their business-I think the cost of those services will again increase if the bank has to go to additional measures to enable you to access those. Again, it is very difficult without seeing the precise detail of the proposals to say who is categorically right and who is categorically wrong, but I think, for those reasons I have just outlined, the risks are that there will be an increase in cost, if not an inhibition in supply of credit to small business.

Q132 Michael Fallon: But your submission is categorical. It says, "It will lead to an increase in cost." When we asked the ICB about this, they said it would be ten basis points or less. Is that really such a big deal?

Matthew Fell: We think that the cost will be higher than that.

Q133 Michael Fallon: Do you disagree with their way of working out how the additional costs are spread across the balance sheet? Is that what you disagree about?

Matthew Fell: Our disagreement is that when you look at the range of risk factors under a ring-fence setup, for small business in particular, the cost of accessing those services could well increase and be higher than that.

Q134 Michael Fallon: All right. What about the cost to households of mortgages, for example?

Matthew Fell: It is not an area that we have looked at in as much detail. Obviously, our constituency is a business one, so the focus of our analysis and consultation has been at the business banking end of the market.

Michael Fallon: Okay, thank you.

Q135 John Mann: Good morning. Mr Fell, "increased costs" -could you quantify how much?

Matthew Fell: As I just outlined, we have not been able to put a precise figure on it. I think there is a lot in the proposals.

Q136 John Mann: A reasonable estimate to give us an indication would be sufficient.

Matthew Fell: It is not a figure that I have to hand, I am afraid.

Q137 John Mann: You must have some basic impression. We cannot consider your evidence credible without some indication of what "increased costs" would mean.

Matthew Fell: I don’t have a percentage to give you today, I am afraid. What I can say is that, again, purely as a statement of fact, if you put higher levels of capital on a bank, that might be for very good reasons and brings increased stability, which is a good thing, but there is a trade-off there because the higher levels of capital you impose on banks, then the cost of lending against that capital, the logic is that that increases.

Q138 John Mann: That is the theory, but we are dealing with what is said to be part of a solution to the biggest financial crisis in 50 years, so we need an impression. If you are saying there is an important flaw in what has been put to us, to the British people, we need to be able to quantify that in some way, rather than vague generalities, or rather, you need to be able to quantify it to convince us.

Matthew Fell: I can only repeat that I don’t have a specific percentage figure to give you today.

Q139 John Mann: I must say that does weaken your argument then. Yesterday, the 300 Club spotlighted what they describe as, "irrational and dangerous market behaviours" and indicated that they regard this as the serious issue that has been unaddressed, and they specifically identify three problems in terms of investment banking: complexity of instruments and models, which creates a feeling that a "free lunch" has been possible; increased focus on products as opposed to investor needs, and relatively benign markets, which have created the view that in the medium and long term, markets will always rise. They have got it right, haven’t they, in their assessments of the problems with investment banking?

Matthew Fell: I think some of those concerns are certainly there, absolutely, yes.

Q140 John Mann: But the problems in the world financial markets did not come from retail, they came from investment, yet we have this report, and all it does is suggest some British tinkering not adopted, as you point out, elsewhere in the world, and totally misses the problem in investment banking that these investment specialists say created the problem. So isn’t this report a huge missed opportunity?

Matthew Fell: It is important to say that the Independent Banking Commission’s report is not the only game in town, so there are, outside of the scope of this, a number of other very significant reforms taking place that will perhaps have even greater ramifications for the investment banking community, including major reforms to require them to hold significantly higher levels of capital, particularly for globally important institutions. Much more robust and intrusive regulation and supervision I think is going to be there as well, and then proposals to operate globally on so-called recovery and resolution models so that in the event of a crisis there is a plan and people know what to do, and that will prevent the spread of problems. That combination of three aspects of very important reforms will do more to address some of the concerns that you have just outlined.

Q141 John Mann: Is what you are saying that the Governor and the Chancellor, in concentrating on this area, are missing that bigger picture? They keep saying, "This is the critical one. This report is the critical change". Are they missing the picture and at the same time disadvantaging British business and British consumers?

Matthew Fell: I am not sure I would agree that they are "missing the bigger picture". That would be a question for them to answer. But I do think that if you think about the major global financial institutions that operate in the UK, of course the Vickers Commission is a very significant regulatory reform facing those institutions, but if you think about the spread of their global operations, I would say those three that are the pillars of reforms that are happening globally will be just as significant.

Q142 John Mann: Mr Hitchins looks like he is bursting to come in. Finally, isn’t this a huge missed opportunity, as the 300 Club is intimating? The big point has been missed and was diverted into an important but small side point at the expense of dealing with the heart of the problem that created this financial crisis.

John Hitchins: I agree with Mr Fell that you need to see the Vickers report as part of the overall jigsaw of financial reform, and it is only one piece of that. To deal with investment banking, which is a global business, you have to have a global reform. You cannot deal with it solely on a UK basis. What the Vickers report proposals do is essentially produce protection for UK retail banking, the banking within the ring-fence, from a disaster in the investment banking market.

John Mann: We hope.

Q143 Jesse Norman: Mr Hitchins, you have obviously spent a lot of time advising banks over the last 20 or 30 years, and it looks from your CV as though you have a very long list of big banking clients. Could you just talk for a second about how the cost-whether it is 10, 20 or 50 basis points, whatever it may be-of the reforms is going to be spread? There seemed to be some suggestion among the Vickers Commission panel members when they came to see us that, as it were, the banks might be able to eat part of the costs themselves rather than pass it on, yet we are hearing worry here that the costs will just be passed straight on. What do you think the likelihood is of that? Certainly when John Vickers was talking about this, he drew attention to the fact that the cost of the reforms would be £7 billion, and also pointed out, rather mischievously, that bonus compensation in the City of London was about £6 billion, and therefore clearly thought that there was scope to eat some of that cost within the banks.

John Hitchins: The problem with that remark, of course, is that a large part of that compensation is paid to banks that are foreign-owned and therefore unaffected by the ring-fence, so to a certain extent the compensation issue is just in the investment banking piece as a principal issue.

Clearly, like any other business faced with the substantial increase in one of its core costs, a business has a choice of trying to pass it on to its customers or absorbing some of it, and the likelihood is that it will do both. Because of everything else that is going on, this is a piece that is overlaid on top of a lot of other costs that banks at the moment are having to absorb, so the scope they have for doing it through cost-cutting is reduced by the fact that they are having to absorb a lot of other costs as well. Their returns on equity are currently depressed, and they face a business need to get those returns back up to a level where they at least cover and give them a margin above the cost of capital, because without that, they are unable to attract future external investment and we go into a potential spiral down once again into another crisis. So they are not in a strong position at the moment in order to absorb much of that cost themselves, which is why we believe they will inevitably seek to pass it on. Where they pass it on will of course be partly driven by the power the customers have. Customers who have the ability to go elsewhere will probably suffer less than customers who are more dependent on bank finance.

Q144 Jesse Norman: There are certainly segments in the banking market that we have examined witnesses on that appear in many ways grossly uncompetitive in relation to equity origination, for example, on the wholesale side, or some of the client services personal banking on the retail side. Presumably, those will be areas where it will be easier to pass on the cost to the customer.

John Hitchins: I cannot predict exactly where it is because I don’t have a detailed study of the market in front of me, but as a general principle, if a customer has an alternative, he has more buying power than someone who doesn’t.

Q145 Jesse Norman: Who would you expect to lose out? Who takes more of the loss and who takes less of the loss?

John Hitchins: The market that is probably the least affected is the large corporates, because they always have the opportunity of raising money directly and they are not as dependent on bank finance. Smaller businesses will probably suffer a bit more than larger businesses.

Q146 Jesse Norman: And presumably individuals.

John Hitchins: And possibly individuals.

Q147 Jesse Norman: So it is not just that the cost of the Vickers report would be higher in the shared view of at least two members of the panel, it is also that they would disproportionately fall-

John Hitchins: It is likely that the proportion will not be even across the portfolio.

Q148 Jesse Norman: All right. That is helpful. We went around this a little bit with the panel from the Vickers Commission when they came in, which had to do with the Government’s arrangements for the ring-fenced bank as opposed to the non-ring-fenced bank. The worry was that the ring-fenced bank would have a chief executive appointed by the shareholder, that is the non-ring-fenced bank, and the question was, would that individual be properly independent and able to take a stand on behalf of the depositor base against the less responsible, potentially, elements? What is your view on that? Do you think there are things they could do to strengthen that? In fact, they promised in their report-they suggested that the compensation for that individual and the compensation within the ring-fenced bank should be set by a board, but they themselves will be appointed by the shareholder, so you have the question of whether they would be really independent.

John Hitchins: The other piece of the jigsaw that helps in this situation is that they would all be subject to the FSA-approved persons regime, so to a certain extent, the regulator has the direct power to monitor how they behave. The other part of the report is that they are tasked with a specific duty to monitor the ring-fence. In other words, as directors of the ring-fenced bank, they have an additional duty on top of their normal fiduciary duty as directors.

There is always a risk that there will be a conflict over strategy, and that is the situation that will have to be managed when it arises, but one would hope that the approved persons regime and the close and continuous supervision regime that the FSA has would enable the regulator to intervene if that became serious.

Jesse Norman: That is helpful. Thank you very much.

Q149 Chair : Just on the fiduciary duty, and to be clear, is it correct that their duty to monitor the ring-fence stands alongside their general fiduciary duties or ahead of it?

John Hitchins: We don’t know that answer yet because the report merely says that they should have that duty.

Q150 Chair : It seems a pretty crucial question, does it not?

John Hitchins: That is the quote. Yes.

Chair : If it sits alongside, their job would be to balance these various duties off against one another, which would lead to radically different outcomes.

John Hitchins: I would agree that is certainly something that needs to be dealt with in implementation.

Chair : All right. Mr Grout, you wanted to come in earlier.

John Grout: Only in respect to the relative impact between large and small companies. Certainly large companies do have the opportunity to use other sources of funding. They also have access to non-UK-based banking. They can shift the relationship between the funds they raise overseas for deployment overseas and funds they raise in the UK for deployment overseas. That is one of the sorts of examples of adjustments that you will see on the customer side, and this is easier for larger companies. Mid-sized companies and SMEs have much smaller freedom. I think the key there is they have not only in practical terms less access, but their negotiating powers with the banks are smaller, and you will see that banks tend to bundle what they sell to them, particularly the mid-sized companies between SMEs and very large companies. John Kay I know is very interested in bundling.

When you price the whole relationship, it is very hard for the customer to understand what the expensive service is that he is buying. Is it the borrowing, it is some kind of derivative activity? Is it advice? In the UK, mid-sized companies will often contractually undertake that they will only do those ancillary activities with the lending banks. In the United States of course that would be illegal, but in the UK, it is quite tolerated. That is where the pressure to recover more will be more successful.

Q151 Mr Ruffley: Some questions for Mr Hitchins on the competitiveness of the City of London and how it will be affected by these proposals. The ICB conclude, and I quote, "The historical record does not suggest there is a strong link between the success of UK banks in wholesale investment banking and the success of the City." Do you share that assessment?

John Hitchins: It is certainly true that historically the City has not suffered from having an increasing foreign ownership of its activities. There are certain aspects of this report that will give UK-owned investment banks a potential competitive disadvantage against foreign-owned within the City. That will not necessarily impact the overall City, but it is a separate policy question as to whether we want to have national champions in investment banking.

Matthew Fell: Could I comment on that as well, just very briefly?

Mr Ruffley: Sure.

Matthew Fell: I think it is clearly right to say that the City and the UK more generally have benefited from foreign banking institutions being here, but I think it is equally true to say that it is important that we retain a strong domestic banking market, because the two of them are important for a number of reasons. First, we had a pretty vivid illustration in 2007/2008 that foreign institutions have a tendency to pull back from overseas markets in times of a crisis, which would leave UK businesses and consumers more exposed in the event of any future shocks, if we hadn’t a strong domestic banking market to fall back on.

Secondly, it is very important for competition reasons as well. Business is pretty clear that it wants a diverse and competitive banking market, and if you have that mix of domestic and foreign players, it is important for that.

Finally, as with any other business, headquarter location really does matter for the UK’s general competitiveness and our economic potential. If you think about the impact in terms of employment, investment, tax contributions and so on, we would not want to jeopardise a strong domestic market as well, not least for the cluster impacts it can have with a lot of other professional services, firms and things like that congregating around that activity, so there are good reasons why we would want a strong domestic market as well as making sure the UK stays a good home to foreign institutions.

Q152 Mr Ruffley: Back to Mr Hitchins. Martin Taylor, when I asked him about the possibility of UK banks moving their headquarters abroad, suggested that he received no representations during the course of his time sitting on the Commission from any of the likely candidates: Barclays, HSBC, Standard Chartered. Is that the assessment that your firm has as well of the situation, that it is highly unlikely that there will be any moves? In fact, Martin Taylor went further. He said he had not heard any suggestion that any UK bank would relocate abroad. What is your assessment?

John Hitchins: I think our assessment is that it remains unlikely, but there will be a point at which the cost-benefit equation may change and it might become worth moving overseas. There are-

Q153 Mr Ruffley: Could you say a bit more about that? Absolutely, this ICB set of proposals is but one part of the equation.

John Hitchins: There are a number of factors here. There is always a potentially significant tax cost in moving headquarters overseas. That is one, and that will differ significantly from institution to institution. The second issue is the regulatory cost, and we regard the argument that a bank might move overseas because they would get a softer regulatory touch somewhere else as probably unlikely, because the way regulation is changing and the way regulators are coming together, I am not sure that there is a major financial centre in which you would get "better treatment" from the perspective of the bank.

Within the Commission report, there is the possibility that a bank that has a European subsidiary could try to move its UK banking business into the ownership of that subsidiary and then branch back into the UK and avoid the ring-fence.

Q154 Mr Ruffley: Do you think that is a possibility?

John Hitchins: That is certainly possible. It is a hugely complex thing to do, but the ring-fence itself is quite complex. The unknown is the attitude of the regulator in the territory concerned. It might fail simply because the regulator in the territory concerned does not wish it to happen.

Q155 Mr Ruffley: Without naming any names, is PwC advising on any structure like that?

John Hitchins: Not that I am aware of.

Q156 Mr Ruffley: Final question. Where has that proposition come from? I understand it, and it looks an elegant way of circumventing the ring-fence.

John Hitchins: It comes from reading the rules that the ring-fence cannot override the European law that permits European banks to branch into the UK, so a branch of a European bank in the UK cannot be made subject to the ring-fence, because European law would trump the ring-fence. It is an obvious theoretical possibility. It is an extremely complex thing to do, and therefore the point at which someone does it is when they decide that it is not that much more complex than complying with the ring-fence.

Mr Ruffley: That is fascinating. Thank you.

Q157 Andrea Leadsom: Apparently, Mr Fell, in your submission from the CBI, you said, "The ring-fence will increase the total capital and liquidity requirements on banks, as capital and liquidity will become ‘trapped’. This will both restrict and add to the cost of lending, which at least in part will inevitably be passed on to customers." The ICB denies this. They feel that liquidity will not become trapped, and specifically they have said it is because you will be able to choose which parts of your large wholesale lending can sit inside of the ring-fence so that liquidity does not become trapped. Do you still believe that your concerns are right, and if so, why?

Matthew Fell: The level of flexibility that the ICB has put forward in its final proposals is very helpful and mitigates some of that risk. I don’t think it takes it away entirely, particularly on the liquidity side of things, because you still need to have assets and liabilities on either side of the ring-fence in kilter, and the job of balancing those off is trickier if you are doing it in the two separate bits of a ring-fence set-up than it is under the entirety of a bank, so I would say those concerns are mitigated by what the ICB has put forward in terms of flexibility, but it doesn’t take away that risk entirely.

Q158 Andrea Leadsom: Do you think that that has an inevitable impact on the cost of activities inside the retail ring-fence? Will that be passed on from the bank to the customer?

Matthew Fell: If the situation arises where there is an element of capital liquidity that becomes trapped, clearly if it is on the liability side, you would need to take on additional assets to get them back in kilter, and those assets at that point are not being put to productive use, so that would result in an increase in cost. Under that set of circumstances, yes, I think it would add something to the cost, and I think it is naive to think that at least part of those costs would not be passed on to the end customer.

Q159 Andrea Leadsom: You might feel this is slightly outside the remit of the CBI, but do you think there is a risk that if there were excess assets in the retail ring-fence, it could lead to again foolish or uneconomic loans being made that kind of fuel the fire of the next bubble? Is that a potential unintended consequence of trapped liquidity?

Matthew Fell: As you say, our focus has been very much more on the business impacts of this, but it would seem on the face of it that that danger of increasing a moral hazard style set of circumstances could be there if the assumption is that that is the much more protected bit of the bank.

Q160 Andrea Leadsom: Mr Hitchins and Mr Grout, do you have any thoughts on that trapped liquidity, trapped capital?

John Hitchins: I think that the two are different, because it is clear that the ring-fence was designed with the flexibility to allow surplus capital to be moved between the two parts. Liquidity is more difficult, because surplus liquidity in the ring-fence would be subject to the economic independence constraints-large exposures and so on, restrictions on transactions between the two sides-so you could get surplus liquidity in the ring-fence that the group would like to use outside the ring-fence but is restricted from doing so in that situation.

Q161 Andrea Leadsom: Yes. Specifically with regards to the difference in equity requirements between ring-fenced and non-ring-fenced parts of a group, could you see that there might be an incentive to transfer activities from the ring-fenced part of the group to the non-ring-fenced and vice versa for reasons of simply the lower equity requirements? Do you think that there is a risk of that?

John Hitchins: Clearly the banks need to do some long-term capital planning in deciding, for those activities that are optional, which side of the ring-fence they would fit them. Moving whole businesses, once they are in the ring-fence, back out again will be quite difficult, but it is possible that they might try to book certain transactions outside or inside the ring-fence, depending on where the surplus capital is. I don’t personally see that as a problem, because that is subject to the normal capital management of any bank.

Q162 Andrea Leadsom: In answer to Mr Ruffley’s question on passporting, I think you are saying that all of these things-artificial moving around of businesses between ring-fenced and non-ring-fenced, between European branches and UK branches-would be theoretically possible, but potentially too difficult and not really worth the effort unless the ring-fencing becomes truly onerous. Is that a fair assessment?

John Hitchins: Yes. That is a fair assessment.

Q163 Andrea Leadsom: Mr Grout, do you have anything that you wanted to add to that?

John Grout: On the trapped liquidity and capital, I think the trapped capital point has been dealt with. On the trapped liquidity point, remember that UK banks tend to have a shortage of deposits against loans, and the ability of banks to bid for deposits or to reduce the competitiveness of their bidding for deposits means that liquidity, I would have thought, is manageable over a sufficiently long period and that you are unlikely to get long-term effects like this. It is perhaps something that I am less concerned about.

Andrea Leadsom: Okay, thank you.

Q164 Chair : Could I just clarify one point? Do all of you think that over time the regulators are going to be capable of keeping up with a flexible ring-fence for the purposes of wholesale lending and the innovation that is likely to take place in the market?

John Hitchins: They will need to be adequately resourced to do it. Part of the flexibility-providing the way it is implemented is done through something like an FSA permission, so something that can be changed fairly quickly-is a strength, because it does give the regulator the power to act fast if somebody designed an arbitrage opportunity. The danger with a rigid ring-fence is that people do find ways of arbitraging it and then it is very difficult to stop it. There is an advantage in the regulators having the flexibility and power, but they do need to be properly resourced in order to monitor it.

Q165 Chair : Okay, but I asked you whether you thought they would be up to it, not whether we would be capable of writing a-

John Hitchins: I would say they need more resources than they currently have.

Q166 Chair : So you disagree with the Governor, who says he thinks we need less resources to do this job properly, not more?

John Hitchins: In a steady state, he may be able to reduce the resources, but the complexities of implementing this mean the FSA-or the PRA, as it will become-does need significant resources now, in my opinion.

Q167 Chair : But do you think they are up to it, on the basis of evidence we have had so far of regulatory performance?

John Hitchins: If you set aside the regulatory performance leading up to the original 2007/2008 crisis, the lessons learned have significantly changed the way the regulator operates.

Q168 Chair : These replies are not filling me with confidence and enthusiasm for the-

John Hitchins: Well, I cannot sit here with my hand on my heart and say, "Yes, they are up for it. They are fine," because we have a relatively short period of the new style of regulation working.

Q169 Chair : Your answer really is you do not know, but you hope so, and it is going to cost a lot more.

John Hitchins: Yes, correct.

Q170 Chair : Does anybody else want to add anything to that reply? It seems to be quite a crucial issue.

Matthew Fell: I would just add that having high-quality regulation in terms of overseeing the flexibility that would exist in the ring-fence is clearly an important part of making it a success, but high quality, I think, is not unique to this. It is something that has, as Mr Hitchins has suggested, been on an upward trajectory since 2007, much more robust, and that trajectory needs to continue.

Q171 Chair : So we need regulators to up their game pretty dramatically if we are going to make a success of the Vickers proposals, is what you have just told us. Yes or no? Am I putting words in your mouth?

John Hitchins: I think the point is they have upped their game significantly, and they will need to continue to do that.

Q172 Stewart Hosie: Matthew, you seem to be the most anxious about the future loss of credit availability or the potential increase in cost, but you could not put a figure on it. Could we assume Vickers’ £47 billion cost is correct, that the largest single element of that is the withdrawal of the implicit taxpayer subsidy through the special liquidity scheme, and that does amount, as Michael Fallon said, to somewhere around 0.1% of a £6 trillion asset base? If the private sector were asked to absorb costs of 0.1% of a £6 trillion asset base, you wouldn’t bat an eyelid. If the Chancellor demanded that the public sector make their efficiency savings of 0.1% of a £6 trillion cost, you would say they are not going far enough. Why are you so anxious that this fractional, additional potential cost by 2019 is going to be the problem you think it is?

Matthew Fell: I hope we conveyed in our response that our primary concern is with the timing of the introduction of these proposals rather than the proposals themselves per se. If those costs come to bear through to 2019, when with a fair wind the economy will be much more resilient and able to absorb that cost increase, I think our concern is less than it would be, which is good in terms of the Vickers proposals, than if the proposal on the table were a rush to implement all of this over the next 18 months to two years. That is why we have emphasised concerns about the timing of implementation as much as the nature of reforms. I think it is that timing aspect that is the real concern.

Q173 Stewart Hosie: That is of course why the Vickers Commission gave the 2019 timeline, because it was in tandem with the Basel timeline.

Matthew Fell: Correct. Why we have emphasised that that is a sensible timetable is because we know that we still operate in a climate where, for very good reasons, people are keen to see bank reform and greater stability measures introduced as soon as possible, and the trade-off there is the timing of when the economy can withstand the reforms. I am just keen to put on the table that we shouldn’t lose sight of the fact that we think the Banking Commission has come up with a sensible timetable.

Q174 Stewart Hosie: That is helpful. John Hitchins, the ICB’s recommendations do go beyond the current global consensus. Do you or PwC have any concerns that all of this might be in vain if we find out that the UK ends up being unable to deviate from common European rules?

John Hitchins: There is that possibility that if the CRD IV gets enacted on a maximum convergence basis, the UK cannot impose any super-equivalent capital rules.

Q175 Stewart Hosie: How real do you think that fear is?

John Hitchins: It is a real one, but I don’t know enough about where the negotiations have got to as to where we are on that.

Q176 Stewart Hosie: Just on a more general point, whether we are able to do this or not, notwithstanding potential risks and whether they are real or not, why has no other major economy as badly affected by the financial crisis gone down this domestic restructuring route?

John Hitchins: I can’t answer that, except that clearly the two major economies most affected directly by it were the US and the UK, and the US has gone off in a different direction with the Dodd-Frank legislation. I don’t think the others have had quite as big a bail-out as some of the others. Their own economies were not as dependent on financial services, so although they have bailed banks out, they didn’t have as big a section of their economy affected.

Q177 Stewart Hosie: Nonetheless, this is a question to all three. You would presumably still fundamentally agree that what we have with Vickers, in addition to Basel, makes sense in terms of long-term macroprudential stability and the removal of systemic risk, or would you not?

John Hitchins: I agree with the principles of the ring-fence. I think there is a question about where you calibrate the capital. You could do the ring-fence and still just have the Basel III capital arrangements.

Chair : John Grout, I know you wanted to come in.

John Grout: Just on the timing of the implementation of Vickers and its relationship to the timing of the Basel III implementation through CRD IV and the other changes that are being put through, the one thing we do need as early as possible in that process is clarity of what the rules will be by the end of it, because these adjustments, both on the part of the financial institutions and on the part of their customs, take a long time. If you are an ordinary company now thinking of undertaking anything significant that is going to require banks providing you services-even lending you money down the track, you will need more money once the factory is built and you are funding working capital and you hope your business is growing-there is a need that investors now can see clarity that the banks they are currently dealing with will be there and able and willing to do things for them down the track. They will not have that clarity until we know precisely how Vickers may be implemented and precisely how CRD IV will come out and all the other changes are clear. As soon as possible, we need clarity. Implementation can come later.

Matthew Fell: I would like to put on record that I agree with that, the clarity.

Q178 Chair : Just while we are on this timing issue, do you think that there is a risk, as we are already seeing with some of the capital and liquidity requirements, that the markets are forcing the banks into early action, which is therefore leading to unnecessarily tight conditions at a time of stress? This is what the banks are arguing. If so, how are we going to protect ourselves from the risk that this happens with Vickers?

Matthew Fell: I would agree that that threat is there, and we are seeing patterns of that emerging, particularly in terms of capital ratios specifically.

Q179 Chair : Do you have specific proposals on how we can protect from this, how Vickers can be designed, how the proposals can be implemented in a way that protects us?

Matthew Fell: The next steps, if you like, in terms of Vickers, will presumably be a further set of detailed proposals from HM Treasury. I think the political response and mood music around that will be very important in terms of confirming the table that Sir John Vickers has outlined in his report. The political reaction to that could be a strong signal to send to the markets.

Q180 Chair : In any case, Vickers is saying no later than the beginning of 2019 and you are saying no earlier.

Matthew Fell: I am not saying no earlier than 2019; I am saying, "Don’t rush to do it all in the next two or three years."

Q181 Mr Love: I really wanted to just get a comment on the idea that the UK is in a unique position. It is a major international financial centre, but in terms of comparison with bank balance sheets and GDP, it is really closer to the range of Switzerland or Ireland than it is to the United States or indeed some of our European competitors, and therefore there was much greater onus on Vickers to come up with the long-term solution that would address the need to ensure that we didn’t get ourselves into the position we were in in 2007/2008, even more than the United States. Don’t you think that Vickers had the responsibility to ensure that the package he was delivering would ensure that we did not find ourselves in that position once again?

John Hitchins: I would take exception to the word "ensure", because I don’t think anyone can ever do that.

Mr Love: Absolutely.

John Hitchins: Vickers is a mechanism for making sure that the cost of resolving another crisis is a lot less, because it would be a lot easier to do, and it also gives a degree of protection to the retail bank for a sister investment bank getting into a disaster, as I have said earlier. It is clearly a fact that the UK was more dependent upon financial services as a proportion of the economy than many others, as you say, Switzerland probably and Ireland. That in itself means that this is a more serious topic for us, yes.

Q182 Chair : Thank you very much for coming today. Before I close the session, is there any major area that any of you felt you wanted to get on the record that you have not had the opportunity to talk about?

John Grout: There is one I would just like to mention, which is the reaction you were alluding to in terms of people beginning to early-implement what is proposed. The reaction is already underway in the real economy as well as in the banking sector. Companies are reacting, for example, to the downgrading of the British banks, particularly to single A recently. They are responding to that. They began to respond earlier this year. We have seen a lot of companies seeking to reduce their dependency on borrowing from the two now single A banks, and we have also seen companies beginning to experience difficulty in having enough credit limit marked by the company for the bank for both depositing and doing derivative and other risk management product business with them. Those adjustments are already taking place. You see companies inviting in, for example, Japanese banks they did not used to deal with in order to bring in more possibilities. That adjustment is underway. That, I think, is benign.

There is also a possibility that there is a negative early adjustment, which is investors in banks demanding that their balance sheet look as soon as possible as it is supposed to look in 2019.

Chair : That is the point to which I was alluding.

John Grout: I think that second point is to be urged against.

Chair : Urging against it is one thing. Stopping it is another. Do you have any ideas?

John Grout: It is very difficult.

John Hitchins: The only other point I would raise is that I think it may be very difficult for the UK to go it alone on bail-in-able debt, given that the investor market in bank debt tends to be an international market.

Chair : That is very helpful. You are all chipping in now.

Matthew Fell: We have not spent much time on competition today, but I just emphasise that it is important that competition, particularly in the small and medium-sized business banking market, receives as much attention as it does in the consumer space, and quite detailed but small pieces of proposals in Vickers in terms of switching processes and the ability to transfer security from one bank to another is pretty critical if you are going to-

Q183 Chair: You have seen this Committee’s report and those proposals. Does the CBI agree with those proposals? In particular, does it agree about the need to make competition a primary objective of the regulators?

Matthew Fell: We certainly agree that competition should be an important objective for the regulators, and my point on-

Chair: Cautious man.

Matthew Fell: Cautious, yes. I don’t have the full report in front of me, but there was a lot in there that we recognised and echoed.

Chair: This is prompting more comment.

Q184 Mr Love: I just wanted to get your comment on whether switching should be, as has been suggested by the Commission, a procedure, or whether we should take on board the hardware necessary in order to allow account number switching, which would be much more efficient but at considerably greater cost.

Matthew Fell: From the business banking market, I think that number portability is of lesser importance than this ability to transfer security. That is what we see as the major driver for the small business banking market in particular.

Chair: Thank you very much for coming before us today. If you have further thoughts as a result of this, which experts often do, please put them on paper and we will consider them in written form. Thank you for coming in today.

Examination of Witnesses

Witnesses: Mr John Kay, Cass Business School, and Dr Peter Hahn, Cass Business School, gave evidence.

Q185 Chair: Let us get underway, because we are overrunning slightly already, but we will allow you to sit down. Thank you very much for coming before us this morning. First, I would like to ask a few questions of both of you about what you think the behavioural response will be from banks to the ring-fence proposals. Why don’t I start with John Kay? I will divide it into two questions. Do you think any UK banks are going to relocate as a consequence of the Vickers proposals?

John Kay: A possible consequence is that Barclays will split itself up and Barclays Capital would relocate its headquarters.

Chair: So the answer is yes?

John Kay: I think that is certainly a possibility.

Q186 Chair: Okay, and do you think that investment banking net will be attracted to the UK or will move out of the UK as a consequence of the ring-fence?

John Kay: Overall, it will not make much difference. The majority of the investment banking activity that takes place in London is undertaken by foreign companies, the subsidiaries of foreign companies, and will continue regardless. I think what we are talking about is, as a whole, relatively modest compared to the total investment banking operations of the UK-located banks. Of course, in relation to HSBC, which is one of the big ones, that is a global bank whose UK retail activities are relatively small in relation to the total.

Chair: Dr Hahn, have you any preliminary thoughts on those two questions?

Dr Peter Hahn: I would disagree a little bit. There are banks, some like Standard Chartered, which have limited activity within the UK, where it would make a decision easier on this if it starts to affect them in certain ways. It is not clear necessarily how it would affect them. Other banks, would they leave? As I think you heard before, the costs of leaving are so high that we have to see what the eventual costs would be.

Q187 Chair: Yes, but that is not a very happy situation, is it, trapped banks who decide not to push off? What we really want is a globally competitive industry.

Dr Peter Hahn: No, and I think there were a number of allusions before about looking at doing business in the UK through foreign entities that raised a number of long-term questions, but I would go back to the foreign investment banks that are in the City. Firstly, a number of them do business here through branches and those branches have activities that tend to fall under ring-fence restrictions. We might find that some of the investment banks that are here will curtail certain of their business activities in the UK. Many of them have retail accounts to a limited extent. They do lending, certain lending activities out of the UK. Will that force them to do headcount and some of their business activity here? Potentially, yes.

Q188 Chair: In the scale of things, where would you place Vickers against other alleged causes of decline in attractiveness of the UK with respect to location; for example, the bank levy, the 50% tax rate, the adverse alleged political culture?

Dr Peter Hahn: Vickers right now is about the banks’ reaction to it. If I were running a bank, I would be quite passive in my response right now and I would like to see how it plays out, how some of these details are fleshed out going forward over a number of years. I do not think I would stand up and protest quickly. I would wait and see, so I had more-

Q189 Chair: In the scale of things, do you think Vickers is likely to be a major driver of location or do you think it’s more likely to be a 50% tax rate or a bank levy or none of them?

Dr Peter Hahn: They all add up, certainly, but I do not see the Vickers report as really being a major issue with that, with perhaps the exception of Barclays.

Chair: Okay, that is the same point that John made earlier.

Dr Peter Hahn: Ultimately, when one thinks about where one wants to locate, part of that equation is where your major business is. Many corporations are located in the UK because it is easy to raise capital here, but capital is now easier. For Barclays’ investment banking activities, will they be more in New York in a few years than in the UK?

Q190 Jesse Norman: Professor Kay, can I just talk to you about the ring-fence? Would it have been better, in your view, to have gone for full separation? You have certainly argued in the past that there have been concerns that might motivate that kind of fuller, more direct approach.

John Kay: On balance, I would have preferred full separation, but I think 98% of a loaf is pretty good and I am fairly happy with that. If one went for full separation, there would be a set of additional complications, just as there are a set of additional complications with this solution. This solution, I think if it is properly implemented, achieves most of what I was hoping to achieve through a separation.

Q191 Jesse Norman: What are the parts that are missing? What is the bit you would really like to have seen that is not in here, because it did not go down the route of full separation?

John Kay: One large issue which has just been raised is that we now have years for the banks to fight against this, so I have a serious worry as to whether the ring-fencing that is ultimately implemented will be what most of us want and need. That is one worry. This may come up in some of the other questions that you raise, but I would have preferred to have had a cleaner solution that had more separation between the different banking activities of a universal bank that would have enabled us, for example, to direct Government funds to the support of business lending and mortgages, if that is what we want to do, or not, if it is not what we want to do, instead of remaining in the business as we are at the moment of feeling we have to support a very large operation or not do so. I would like, for example, to see small business lending as a separately conducted activity. That is one group of issues.

I am also concerned as to how we regulate the treasury activities of the retail banks we are creating, because one of the things that happened in the past was that the treasury operations of retail banks grew until in effect these businesses were running investment banks through their treasury, or certainly activities with many of the characteristics of investment banking.

Finally, I am concerned to re-establish the culture of retail banking. I think the majority of people in these retail banks would like to do the kind of business they did traditionally and we all want them to do, but I think they have been infected over the last decade by the transaction-oriented culture of investment banking. That is behind a lot of the complaints that your constituents would now have about the nature and kind of services they have from their retail bank.

Q192 Jesse Norman: That is an incredibly helpful answer. We have four issues you have identified. One is, as it were, the "lobbyability" and the "implementability" of these proposals. The second has to do with the indirectness of the policy levers that remain to Government, given the universal banking model. The third would be potential abuses of the treasury function even within the ring-fenced businesses. The fourth would be the culture of retail banking. Could you talk a little bit about the treasury issue for a moment? As you said, treasury functions have become enormously expanded under universal banks into significant profit centres in their own rights. Do you think they have been materially affected by the Vickers proposals?

John Kay: It depends on more detail of the implementation of the Vickers proposals than we yet have. The objective of clamping down on the treasury operations can be done. As I see it, what we want is treasury operations that do what banks traditionally use the treasury for, which is essentially to manage their day-to-day imbalances between deposits and loans and should not regard them as activities from which they seek to make a profit in their own right. That is the key distinction. That can be implemented partly by sets of rules about what these banks can do, but probably better and more effectively by a supervisor, whoever he might be, saying, "Come off it. This is not a treasury operation. This is an attempted profit-making activity". Now, that is a hard line to draw, but there is a difference in scale which you can see. If we have the right kind of supervision, that might be possible.

The other thing I think we need to do, which is in Vickers, is restrict the derivatives transactions that the retail bank can conduct. Basically, a properly conducted retail bank would want to be trading in interest rate swaps just to manage its book, but I cannot see that it needs to engage in other derivative transactions.

Q193 Jesse Norman: As a final question, I note in what you have just said that you would be supportive not only of potentially regulation and legislation, but also of a specific duty on the regulator to manage the relationship with the management of the ring-fenced bank to ensure that the treasury function was properly carried out along the lines you describe.

John Kay: Yes, and I have also wondered about putting that kind of duty on the board of the retail bank.

Q194 Jesse Norman: That is the question I wanted to come to, which goes into really the issue of culture. If that board is being appointed, with the exception of non-executives, by the shareholders, that is by the larger entity, and if that board is setting the compensation arrangements for the chief executive, as we now learn-it may be in response to questions that we had at the last meeting with panel members-do you think that culture can ever really be retained, or do we need stronger promise of corporate governance and stronger cultural signals to the ring-fenced entities to return them to the kind of banking that we all want?

John Kay: I think it is a real difficulty. As we all know, and you have heard these people in front of you, investment bankers who now run large conglomerate banks are rather strong personalities and so are the group of people they lead. Whether you can create entities within holding companies that are effectively insulated from that kind of approach I think is a real difficulty.

Jesse Norman: Thank you very much indeed.

Q195 Andrea Leadsom: Very interesting, thank you. I would like to just talk to you a bit about the impact of the ring-fence on the cost of lending into the wider economy. In particular, last week Martin Taylor told us there is absolutely no reason why banks should claim that anything in this report should reduce the supply or increase the cost of credit to small businesses. Now, to the contrary, we have heard a lot of reports from industry that that is not the case, that in fact there will be restrictions on both credit and increases in the cost of credit. I would be grateful if we could get your views on that.

John Kay: One very clear starting point, which I think came out a bit in the evidence you had last week, is many people do not realise just how small, in the context of overall bank balance sheets, lending to businesses and SMEs is. Lending to non-financial, non-property businesses by UK banks is about £200 billion. It is between 3% and 4% of their total balance sheets.

Q196 Andrea Leadsom: Yet that is what drives the real economy, employment and all the rest of it.

John Kay: Yes, and that is why I was talking in my answer to Mr Norman really about separating out that element of the overall bank, because it is so vitally important from a public policy point of view and yet subsumed at the moment in this great universal banking activity. The fact there is a rise in the cost of capital or may be a rise in the cost of capital to the universal bank as a whole, the part of that that relates to this crucial activity is really quite small, but the key point I would want to make is that margins in that are going to be dependent primarily on the competitive structure of that particular part of the industry. We know it is not very competitive. There are not many players in it.

I would hope that you might think about a different concern on the cost of capital, which is not the cost of capital calculations that are being made by the banks on the one hand and the critics of the banks on the other, but the fact they cannot raise these huge increases in capital requirements that we are imposing on the banks in capital markets, which are not willing to provide to the current banking structure the scale of capital that would be required either under Basel or Vickers. The money is very largely going to come from their own retained profits. One of the problems we have is that the small business part of the banking system is seen as a source of these earnings, which can go and build up their capital base. That is what concerns me a lot. The other restrictions that we have imposed have rather made it easier for them to cartelise that activity.

Q197 Andrea Leadsom: Are you saying that the costs will rise to SMEs? You are not commenting on the availability of lending, but you are saying that banks will need to make more out of their SME business to keep in retained profits to meet their capital requirements?

John Kay: I think we have to worry about the impact of capital requirements, which is a different worry from the worry that the withdrawal or the partial withdrawal of the Government guarantee on the whole of the activities of the universal bank will raise the cost of capital. Ideally, looking ahead, one would see there being a different cost of debt to the ring-fenced entity, if it was properly ring-fenced, than to the universal bank. If a retail bank was being well managed, it ought to have a lower cost of debt than the investment bank. It is only in the interim that we have a single cost of capital against the whole.

Q198 Andrea Leadsom: I know Mr Garnier is going to come on to talk about competition, but specifically in answer to my question, all things being equal, is the ring-fenced arrangement going to lead to an increase in the cost of lending to small and medium-sized enterprises and is it going to make it harder to get loans for them?

John Kay: I take the view that the Commissioners took last week that this is not a significant element, either positive or negative, on the cost of loans.

Andrea Leadsom: Right.

John Kay: I would hope in the long run if there is a proper, effective ring-fence, it should reduce it and make obtaining loans easier for the reasons I have described.

Dr Peter Hahn: And segment the market quite a bit. Overall, costs of borrowing are going to go up for funding, capital, everything. There are a number of requests that are going to be pushed through. When we look at small and medium-sized businesses, the term is a little bit too generic. If we have really small businesses, my little business, I have to put up a guarantee to borrow money. That is easy for banks to do. Essentially, those are wealthier people putting up their personal assets behind their businesses. That business is a good business. In fact, it tends to almost fund itself, the amount of assets they have in the bank, compared to what banks lend, it sort of self-funds itself.

It is above that level-the sort of mid-sized business, which I think is much more the core of employment to the country-that is the real problem, because it is that group that borders on the area of buying multiple services. You have heard a little before about packaging of services and all these things. Cutting up the provision of those services between the non-ring-fenced, the ring-fenced creates inefficiencies. It may make it undesirable to provide credit to some of those companies and to monitor what the profitability of doing business with one of those companies might be. I think there is a potential risk for the mid-size. The large companies have choice.

It further boils down to the concept of even though it is a small business and we have five players there, by region, we often find-and have discussed this-that there is often one or two players in a region. While it may look like there are even five or six players in the country who play it, you may find that your choice is one bank. I do not see new entrants coming into that business.

Q199 Andrea Leadsom: Just turning back to what Mr Kay said earlier about the cultural change, just to pursue that slightly, within this ring-fence, because of the fact that by definition it will be a tiny proportion of the overall activity of the group and it will tend to be focused on the SME and personal current account-although there might be one or two other things in there-does that mean that there could be a cultural return to that sort of old style of banking that we loved, where your bank manager played golf with you and understood your business and so on? Is that a possible silver lining to this?

Dr Peter Hahn: I would be very, very careful with that. The ring-fenced side will not be that tiny, because it has the retail aspect to it, which is bigger than the SME side in many ways. We forget about technology of banks. Today, when you apply for a mortgage, if you do it online, by the time you get the money it is totally automated. We do not want somebody to go back into that. It will make it more expensive for everybody. The work that is done at the coalface is a lot more customer service, but it is not in the provision of credit and the efficiency.

That is one of the critical things that we forget in this kind of report about SME-type lending. We automated a lot of what amounts to retail credit, but business cannot really be automated. Every business is unique. So it is against this tension of how we think about providing credit to the industry. Should Vickers have addressed more about ways potentially to standardise provision of credit to smaller businesses? I think it would have been very helpful, because it is just going to grow as a problem.

Andrea Leadsom: Thank you.

Q200 Mark Garnier: The CBI, when it put in a written submission, talked about the fact that there would be pools of liquidity gathering in the ring-fenced bank, and yet when I was talking to Martin Taylor and Martin Wolf last week at the ICB, they were saying, "No, no, no, you have nothing to worry about. They will manage to find a release valve into large lending." Who is right?

Dr Peter Hahn: Did you see the news yesterday from Wells Fargo Bank in the United States?

Mark Garnier: I have to say no.

Dr Peter Hahn: It announced that its earnings were down because it is attracting deposits as one of the stronger banks and they cannot lend it, so they now got this problem. I think there is the whole liquidity question of what is inside the ring-fence bank. I heard also a bit of amusing news yesterday. I am sure you saw the Deutsche Bank casino exposure. It was a fund. Deutsche Bank apparently has US$4 billion to $5 billion exposure to Las Vegas casinos that are in difficulty, all of those made as loans conceivably could have been in a ring-fenced bank. They are not derivative securities and so this concept that it is purely safe is one that we need to probably focus on a lot more.

With liquidity, traditionally the more you restrict the activity, you find narrow banks. Eventually, the management is going to try to find a way to use that. Can regulators stay up with that game?

Q201 Mark Garnier: Let me create a scenario for you. You have a situation where you have a ring-fenced bank, which is essentially a kind of retail bank, which does have potentially this ability to lend to the huge corporates, but possibly may not, as we have found in the case of Wells Fargo. We have huge corporates who we know have quite a lot of cash anyway, plus they have access to capital markets and all the rest of it. You end up with a retail ring-fenced bank with a pool of liquidity that then has to go and lend this money, because of course they have to have two sides of the balance sheet. They go and lend this money and we get back to a situation where we are lending irresponsibly, creating a bubble in terms of credit and creating a bubble in terms of property market. Why is that scenario not going to happen? Reassure me that it is not going to happen again.

Dr Peter Hahn: No one knows. This is obviously the challenge. Do you know when you are there? The banks that will make those decisions at first will probably look like they are doing the smart thing or it is an interesting opportunity or maybe they have seen a few other banks do it, but it is as you go further along the line. In a way, this potential liquidity trap-and I think it is a potential one-does create those problems, very clearly.

John Kay: I am puzzled by this whole line of argument, because until very recently we were told that the problem in the UK was that UK deposits were not enough to support UK lending. If you go through the numbers, the huge element that we have not really discussed at all this morning is mortgages and mortgages are by far the largest part of a bank lending to the non-financial economy. In terms of the potential lending by banks, if we just look at the numbers as they are at the moment, there is £1.3 billion to £1.4 billion of residential mortgages.

Mark Garnier: Trillion, not billion.

John Kay: Sorry, trillion, yes, of residential mortgages. There is £200 million, I was describing, of lending to non-financial, non-property businesses, another £200 billion to £300 billion of lending to property businesses. In addition, the Government, as we know, has a total funding requirement which is now in excess of £1 trillion. The idea that there are not enough safe assets around to absorb considerably more than all of UK deposits is just not supported by the numbers. I do not see it.

Q202 Mark Garnier: The point I am trying to make is that still we have a pretty inflated property market. We have a huge amount of debt against that. Part of the reason the property market got to where it is is that we had a credit bubble. What is to stop that happening again in the future under the ring-fenced bank? I suppose my question could be asked in a slightly different way. Will the ring-fencing of banks potentially increase the risk of another property and credit bubble in the future because there is a lack of ability or reduced ability to move the money around within the universal bank?

John Kay: My answer to that is I do not think we have done very much to stop there being another property bubble, particularly in the commercial property market. Insofar as we have done anything, we have to hope that the FPC will do something in relation to that. I rather share your reaction to that observation.

That takes me back to the point I made earlier that I would like to see a lot more siloing of banking activities so that we can direct policy to particular areas of banking instead of doing what we have been rather unsuccessfully doing in the last three years, which is attempting to pull these very long and bendy strings on universal banks in order to have some specific part of the universal bank to do what it is we want.

Q203 Mark Garnier: Is it not the case that the real answer to the problems that we have here is that we should have a lot more banks? It should be much easier for new banks to set up ab initio in Kidderminster or in Leeds or wherever it happens to be where there is a demand. Part of the problem is that we have a very poor clearing system that does not allow for ease of access and we have a regulatory regime that seems to be causing slightly more problems for new entrants to the market than it does in terms of helping.

Dr Peter Hahn: The regulatory regime is always going to be penalised for failures in banks and it will not receive an award for the economy doing well. The Government in a sense gets the upside and the downside. The regulator only has the downside. The regulator trying to be more conservative is going to be part of the process.

Another omission that the Vickers report made, which answers some of your question, is that the retail side of banking, even paying out the SME side of it is largely a utility. The average person chooses their bank because it is close to where they work or where their house is or some other convenient factor that is there. They look at it similar to the water company, in my view. If you think about the way we regulate utilities, in large part it is about cost control and making sure that costs are not pushed through. A utility part of the banking structure might have a common infrastructure company. When we look at eight or nine years of implementation to have a common company that services bank accounts behind banks, it creates an amazing advantage to potential resolution of bank failure, maybe allows other front-end providers to participate in it. That just seems to have been totally not addressed.

Q204 Mark Garnier: That is a US model, is it not?

Dr Peter Hahn: No, I do not think it is anywhere, but I think we have to face the fact that retail banking-I speak to a lot of banks and hope they are not offended-is a commodity business. It is a mature commodity business and it is a utility. We need to think more about it as being a utility. Now, that means basically different people, but a common infrastructure company that provided the same service would cut massive costs out of the retail delivery systems.

Mark Garnier: It would allow more competition-

Dr Peter Hahn: And risk resolution. You just switch the accounts. The failed, you just switch them to another bank.

John Kay: I have pushed these utility analogies very hard, because I think even if people have been fussing in the last few days about not enough competition in energy, taken as a whole, utility regulation has been a lot more successful than financial services regulation over the last 20 years. What we do in an area like this is exactly what Peter has described. We set up a separate company for the monopoly infrastructure, which is not allowed to be vertically integrated, and we regulate its costs and we impose requirements of access. That is the way we regulate the gas and electricity grids. We have moved not quite far enough, but a long way towards that in telecoms. We should do something similar here.

Q205 Mark Garnier: Why do you think the ICB has not addressed this?

John Kay: The ICB was asking what is the minimal change to the structure of the industry they could propose that would achieve the objective of eliminating or reducing the tax-based subsidy to investment banking. That is the framework in which I see it.

Q206 Mark Garnier: This is a patch rather than a new boat, as it were. Here is a million dollar question-or a trillion dollar question, sorry-do you think we should start again and have a think about this type of model that you are discussing and really have a serious conversation about this to resolve the problems once and for all?

Chair: That is not a leading question.

Dr Peter Hahn: No, no. The driver for all of us as taxpayers is eliminating what a cost is in a failure. We have to allow failure. That is the point of capitalism. Coming up with structures like a common infrastructure, for example, allows easy failure without disruption to the system. Here, I think this is tinkering rather than stepping back and saying, "How do we get there?" Now, the Basel regulation on resolution, the resolution side really focuses on isolating key services and how to do that, but it does not really give us a guideline. Somehow moving towards common infrastructure companies does provide that, so the resolution effort of regulation is heading in that direction.

John Kay: If I could come back to an issue, there is less of a need for more banks than there is for more diversity of banks. Our problem is not simply that there are not very many banks, but that to most people they all look the same. That is something that historically regulation has encouraged and still does encourage. If you want to have a licence for a new bank, not only is it hard work, but in order to do it, you have to promise to behave like an existing bank and recruit the people around existing banks in order to operate it for you.

Mark Garnier: That is a very interesting point. Thank you very much indeed.

Q207 Chair: So the regulation is a barrier to increasing competition.

John Kay: In that sense, it is a barrier to entry and competition.

Chair: Before bringing in Andy Love and George Mudie, Andrea Leadsom wanted a quick rejoinder on one of the points.

Q208 Andrea Leadsom: Yes, it is just this idea of common infrastructure. I spoke to members of the ICB before they did their paper and put it to them, "Surely this has to be worth considering". The response was that it was out of scope. It seems to me-and I would be interested to probe you slightly more on it-that if you had a common system that was perhaps owned by the Bank of England, any financial institution that wanted to plug and play could do so. It would even be set up by PFI. It does not even have to burden the banks or taxpayer with the cost of setting it up. The receipts obviously would be the licence fee. You would have a common system where every bank was in effect white-labelling its products on the top of a common system. You have then immediately full account portability, but also in addition you have the ability for the Bank of England to withdraw access from its own customer accounts to a particular bank if it thought it was in difficulty. I have, as yet, to find someone who can really say why that is not going to work, so the Chair is kindly allowing me to challenge you to prove that it would work.

Dr Peter Hahn: Why should it not be owned by the banks? As much as their accounts go into it, they can be mutually owned.

John Kay: I am sure you will hear from people as to why it would not work. I can remember having it explained to me in enormous detail why separating the electricity grid from the supply of electricity would not work and so on, but of course it did.

Chair: The banks will be listening to this hearing. Even if there are not many people in the room, I am sure someone down there is listening. If they have good reasons for objecting to the proposal that our witnesses seem to think it is a good idea, they had better put it on paper and send it to us.

Q209 Mr Love: Mr Kay, I was intrigued by your comments about diversity. We are just about to start an investigation into a new financial conduct authority. I have been one that has been quite engaged with the idea that there should either be an objective of a financial conduct authority or they should have regard to diversity. What is your view on that?

John Kay: I think they should have a primary obligation to promote competition. Implied in the promotion of competition is the promotion of diversity, because for me the essence of competition is not just that several people do things. It is that people try to do things differently. If they do them well, these things get imitated. If they do things badly, then they bear the consequences. That is how competition creates progress.

Dr Peter Hahn: On the competition aspect for the FCA, there is an inherent conflict in that a bank has a product that needs to be approved. It is looking at a certain profitability of that. Encouraging competition in certain product streams, does it create a lower profitability for the institutions that want to be the innovators? Do we stifle innovation by having a regulator look at safety and look at competition at the same time-the same regulator? It is a point that confuses me, because they are normally looking at safety. To give them the burden of competition may create quite a conflict for them.

Q210 Mr Love: I am interested in what you have to say. I was not primarily interested in the issue of competition. We have a view as a Committee in relation to a primary objective of competition. Coming back to the diversity point, as we spoke about earlier on, there is likely to be-because of the ICB recommendations-greater competition for retail deposits. That may well squeeze out certain sectors of the marketplace, particularly in the provision of mortgages. I wondered whether you think that your limited support for diversity would be enough to ensure the continuation of a diverse market or will we see further concentration as a result of the recommendations of the ICB report?

John Kay: I do not see myself why it should promote concentration. I think you are thinking about your small specialist mortgage lenders. I do not see why they should be disadvantaged. I guess they might be disadvantaged if big retail banks become better at serving their customers than they have been in the last ten years. They do that. I think that is the way the market works.

Q211 Mr Love: You reassure me. You also mentioned this issue of implicit subsidy being at the core of the ICB reports. When they came before the Committee, they were confident that they had either eliminated or certainly were very close to eliminating it. Do you both have a view? Are you as confident as they are that this will be eliminated as a consequence of the changes that they are recommending?

John Kay: If the ring-fence is tight and effective, then I think it very largely will be.

Mr Love: How about you, Dr Hahn?

Dr Peter Hahn: The practicality of it is quite different. If you have a very large investment bank and non-ring-fenced operation in the same company, it has long-term swaps with major pension funds, insurance companies, it is spread out all over the system and it has a crisis, is their confidence shaken in their ring-fenced bank at the same time? Possibly it is. As I pointed out, I am not sure the ring-fenced bank is as safe as it might be built to be. The question is if there is a problem in a ring-fenced bank, does it poison the non-ring-fenced at the same time? These things are maybe years and years away where the market can look at them quite differently. Maybe they need to have different names on the front door as well to establish that they are totally separate, even though they may have the same ownership. For the time being, I think they will feed off of each other and will be that way.

John Kay: If I go back to my analogies with utility regulation, we have experiences there of these kind of mechanisms that they worked. When Enron went bust, Wessex Water was essentially unaffected, both operationally and financially. In a slightly different form of ring-fencing, we were able to liquidate Railtrack and Metronet without that affecting the operation of the trains or the tubes. We have experience in getting the kind of resolution and ring-fencing separation, not only of having proposals of that kind, but of making them work in practice. They could be improved, but I do not think we should throw up our hands and say, "When the crisis comes, we will just have to sign very large cheques anyway, as we did in 2008."

Q212 Mr Love: You may well have started a completely new line of inquiry in terms of utilities, but we are here to deal with the ICB report, unfortunately. I just wondered, the credit reference agencies, at least certainly in the shape of Moody’s, seem to have taken a view. It downgraded 12 banks, but it said about the five larger, more systemically important financial institutions that it was a reduction of systemic support by one to three notches. How do you read that? Do you read that as they are confident that the ICB recommendations will eliminate it or do you think they are hedging their bets?

John Kay: I think they are not sure yet. It is clear that the British Government is moving towards the door, but it is not clear it has got there yet. For the moment, it plainly has not got there.

Q213 Mr Love: Do either of you have any sympathy for the view put to us by a leading universal bank chief executive that contrary to the ring-fence improving the situation, over time the ring-fence will be seen to "have a protected status"? Do you think there is any danger that the market will come to look on the ring-fence as where the Government could not possibly allow it to go bust, even in desperate circumstances?

Dr Peter Hahn: Yes, I think that is very much an appearance of, "How do you stop that from happening?" I think that is a real danger. Again, there is that example of good old Wells Fargo Bank across the sea. There is a perception it is a big retail bank and it cannot be allowed to get in trouble. Ring-fenced banks will start to look like-those are the ones that the Government will choose.

It goes into a much greater stream. What ICB did not grasp is that the forces in regulation and economics right now are creating an atmosphere where no country wants to be seen going forward bailing out a banking business in another country. No government wants to take it to its taxpayers and do that. That creates a burden both ways for us in the UK, because we have foreign banks that are here and our banks are going there, of course. In this, there is an acceptance of the EEA rules that are there. I wondered whether the Commission should have flagged the point that the problem going forward is those rules and that we as a nation need to make it clear that our resources can only provide support for what is done in this country. Other countries are moving that way. How do we get together and fix that problem in Europe, as opposed to just saying we cannot do anything about it?

John Kay: There are several important issues there. One is I think it is the case that if we set up the regime that is being described, we will not allow retail banks to fail. What I hope will happen will be that if they come close to failing, we will put them into resolution, take over and sell the operations, and perhaps some creditors will take a haircut in that event, certainly the people who are in the bail-out capital that Vickers has proposed and conceivably other creditors. We will go through the kind of resolution that we should have been able to do, but were not able to do for the banks that failed in 2008. Yes, the reality is that the retail banks will be protected.

What I think we will, however, be able to say with reasonable confidence, is that protecting the retail bank does not oblige us to bail out any failed investment banking activities. We are not in that position at the moment. We are very far from that position at the moment. We have created a global expectation that essentially any large, failed financial institution should be bailed out.

Could I also just pick up the very important points Dr Hahn has made on the international side of things? One is to say that there are issues here we have not dealt with yet. If you remember, in 2008 Kaupthing operated a subsidiary in the UK; Landsbanki operated a branch in the UK, which meant it was regulated and ostensibly protected in Iceland. That was a mechanism that did not work. It is the mechanism that is still there. The corollary of that, as he says, is it is not at all clear why the British taxpayer should want to bail out depositors in other countries of UK financial institutions. The population of Iceland who did not think that Landsbanki was their problem had a point. As it happens, I have a Barclays France account, which I recently learned is now the responsibility of the UK taxpayer, rather than the French taxpayer. I am not clear why, as a UK taxpayer, I should be pleased to know this.

Q214 Mr Mudie: John, you put great attractiveness into diversity. As that was the sort of thing that got us into the mess we are in in the first place-the movement of banks into casino banking-what is your limit on diversity?

John Kay: Diversity rather than diversification. What I meant by diversity was really different business models, the kind we were closer to having when we had at least building societies as well as banks, which operated in a different style with somewhat different products.

Q215 Mr Mudie: Were they really that different?

John Kay: No, they were not that different. By the end, they had become much the same. That was the process we saw really from the 1980s, in which almost all financial institutions turned themselves into these large, multi-purpose universal bank-based financial conglomerates.

Q216 Mr Mudie: They did that themselves. The government helped them and encouraged them, but they did that themselves, because of the rewards the boards and chief executives saw that were available. They did not do that because the original model failed. Maybe the board or shareholders thought in terms of returns, but it was a good going model. The whole purpose, as I think you are saying, is it comes back.

John Kay: Yes, and what happened, as you are describing, is the people around these institutions thought it would be a lot more fun and certainly a lot better paid-

Mr Mudie: Yes, absolutely.

John Kay: -to be chief executives of whizzy, global, financial conglomerates, which they were not very good at running.

Q217 Mr Mudie: In your answer to Jesse Norman, the top point you raised was the timetable and your fear of what I call political arbitrage, that if you leave it on the table for so long, the bankers will move all the politicians and the politicians, the further away the crisis grows, will get weaker. Now, in the ICB’s report, it specifically says that it would like this ring-fence introduced as soon as possible. It gives the Basel III date as the maximum time, but not the minimum time. Have you any idea how reasonable it would be to see this ring-fencing introduced well before Basel, and if so, when roughly, if you can?

John Kay: I would have to listen to the banks’ arguments and explanations on that, but I would start with scepticism.

Q218 Mr Mudie: Why go to them, because they will want Basel III, will they not, in the hope of that arbitrage. You should not listen to them, really. You should be saying it should be done as quickly as possible, as the ICB has said.

John Kay: You are right. It should be done as quickly as possible. The question is how quickly possible it is. I cannot believe "possible" demands eight years.

Dr Peter Hahn: I do not think it would take eight years to do it. There is no question about that. How long it would take, yes, it is separating businesses, putting in employees, having different action plans. It is going to be at least a few-year process to do that. Maybe it is two years, maybe it is three years. It could be done.

Part of the argument the banks are making is that there are other forces of regulation and control that are coming at them at the same time. Which ones go first? Which ones do they do? Then dealing with capital shortfalls and sovereign problems, it is almost too much change happening at one time.

Q219 Mr Mudie: My wife says men cannot multi-task and it sounds as though this is the same as that.

Dr Peter Hahn: My wife says the same thing. I have made three dinners at the same time for my children.

Q220 Mr Mudie: Are we not all falling into the same conventional thinking that the banks would love it? The Government does not want to rush them so they conveniently forget those phrases in the report that say "as soon as possible".

Dr Peter Hahn: Yes.

John Kay: Yes, eight years seems to me ridiculous. In the life of an investment banker, eight years is infinity.

Q221 Chair: Before I ask one more question, do either of you have anything that you feel is crucial to have on the record that we have not given you an opportunity to say so far?

Dr Peter Hahn: The one issue I would like to leave you with is a focus on the coming legislation on enabling bail-in to work in the UK. It needs international agreement. There is a long way to go, but the choice seems to be right now that we could wait until European legislation comes along in a couple of years, then has a two-year implementation period. It could be four years or more until that happens. For the UK to start enabling that-because right now we have a situation where bail-in works when a bank gets to resolution, but we do not have a situation when it is before resolution-

Chair: Vickers points that out.

Dr Peter Hahn: Yes, that aspect is to me the most critical part of that report. We have to get that done because we want to be able to be in a situation where, if a bank gets in trouble, we can fix it and it stays out of resolution. Once it goes into resolution, we have powers, but the cost of resolving a bank is so enormous that we want to do everything to make sure they do not get there. To me, that is the critical factor.

Q222 Chair: I wanted to ask John Kay one final question. You said a moment ago that you thought investment banks were a long way from being allowed to pay at the moment. Once all the global regulation, as far as we understand it, is in place and Vickers is also implemented, do you think it would be safe to allow BarCap to fail?

John Kay: Yes, I think the sooner the British Government feels able to say that if BarCap failed we would not stand by it, the better, but I think that can be-

Q223 Chair: Yes, that is true, but I am asking if they have the right recipe. It is a considerable endorsement if you think that they have.

John Kay: I do, although we would obviously be under immense international pressure to do so.

Q224 Chair: "To do so" meaning to bail them out.

John Kay: To bail them out. This is why, if BarCap were to go to New York I would be very happy, and I think a good deal happier than SEC and the Federal Reserve would be.

Chair: That is a very interesting remark, which I will not develop, but thank you both very much for coming today and giving us such interesting evidence. It will be extremely useful to us in the preparation of our report. I am very grateful.

Prepared 21st October 2011