Banking StandardsWritten evidence from United Food and Commercial Workers Union

Introduction and summary

As part of its endeavours to promote global best practice across the sectors in which it represents its members, the United Food and Commercial Workers Union (UFCW) of the United States has read with interest the Parliamentary Commission on Banking Standards’ call for written evidence to its pre-legislative scrutiny of the Draft Financial Services (Banking Reform) Bill. The UFCW has 1.3 million members in the USA, Canada, and Puerto Rico and represents members in financial institutions, retail stores, manufacturing, drug stores, and car rental firms, alongside its core of food retail, distributions and processing members. It works with fellow trade unions, consumer advocates, and other allies to promote global best practice.

This submission addresses the Commission’s detailed questions pertaining to the ring fence, in particular questions 14, 17, and 18.

The UFCW supports the many positive steps to increase competition contained in the consultation, but would like to share concerns based on experience in the United States and urge the UK Government to learn from mistakes in the US and extend consolidated supervision to non-financial parents of regulated financial firms.

Wholesale re-thinks of the financial sector are infrequent and so any such exercise should be wide in its scope. The Banking Reform White Paper began to address the failures of the existing and historical financial regime but the pre-legislative scrutiny process is equally a chance to learn from inadequacies experienced in other financial markets around the world and to safeguard against other risks.

The UK Government has taken positive steps to increase competition but should act to ensure that supervision is not weakened. The Government has placed utmost importance on introducing new competition into the oligopolistic financial services sector, and has taken several strong steps in that direction. These steps include creating strong challengers via the sale of Northern Rock to Virgin Money and the divestment of Lloyds, lowering barriers to entry, and creating a new current account redirection service to make it easier for customers to switch banks.

However, it is also important for new entrants to be adequately supervised by the regulators. Under the current Financial Services Bill (Clause 25, as in HL Bill 25, 2012–13), new entrants like Virgin Money and Tesco Bank would not face regulation at the holding company level. Rather, holding company supervision only extends to financial parents in the current Bill, which means that such regulation would only cover the traditional banks. It is important that new entrants are as well supervised as the incumbents. There are many ways to promote competition. Offering some firms lighter-touch regulation than others should not, in our view, be one of them, as it carries risks that could impact the consumer and the taxpayer.

As some parliamentarians have argued while debating the Financial Services Bill, it is important to address proactively the potential risks from allowing financial and commercial firms to blend together in conglomerates under giant holding companies.

Historical failures in the UK with the failure of so-called “secondary banks” in the 1970s, in the United States with Wal-Mart’s aborted attempt to acquire a bank in the 2000s, and in Ireland in the 2000s with Anglo-Irish bank, illustrate, in our view, some of the risks of allowing deposit-taking banking to blend with commercial conglomerates without consolidated supervision of the entire group.

Increasing Competition Without Weakening Supervision

1. The Government has placed utmost importance on introducing new competition into the oligopolistic financial services sector, and its several pro-competition initiatives are steps in the right direction. These steps include creating strong challengers via the sale of Northern Rock to Virgin Money and the divestment of Lloyds, lowering barriers to entry, and creating a new current account redirection service to make it easier for customers to switch banks.

2. However, it is also important for new entrants to be adequately supervised by the regulators. In the late 1960s and early 1970s, the UK Government and the Bank of England welcomed new competition from so-called “secondary banks,” seeing them as desirable rivals to the then oligarchy of the large banks. But the Bank of England’s supervisory power did not keep up with the growth of the new banks, contributing to the secondary banking crisis of 1973–75 and subsequent “lifeboat” bailout.1

3. Under the current financial reform plans, new entrants like Virgin Money and Tesco Bank would face different regulation at the holding company level than traditional banks, but it is important that new entrants are as well supervised as the incumbents. There are many ways to promote competition: offering some firms lighter-touch regulation than others should not, in our view, be one of them.

The Risks of Unregulated Commercial-Financial Conglomerates

Exposing the deposit protection system to commercial risks

4. To ensure confidence in the financial system and prevent bank runs, most national financial regulators guarantee bank deposits through deposit protection systems. Under deposit protection systems, corporate conglomerates with bank subsidiaries may have incentives to shift risks from other parts of the conglomerate to the banking subsidiary, and the Government’s deposit protection scheme. If risks in a commercial parent company should spread to the financial subsidiary, this threatens a costly and improper expansion of the public safety net, intended to protect depositors and maintain confidence in the financial system, to commercial firms, which should be subject to market discipline.

It’s happened before: US savings & loan crisis bankrupted the deposit protection fund

5. The risk is not theoretical: applying free market principles without adequate safeguards to a system distorted by deposit protection contributed to the savings & loan crisis in the US. Between 1986 and 1995, more than 1,000 banks with total assets of over $500 billion failed, bankrupting the deposit protection fund created to insure customer deposits. The crisis ultimately cost taxpayers $124 billion.2

6. Savings and loans companies (S&Ls), which had been strictly confined to making mortgage loans, were allowed to expand into other activities in the 1980s. Trying desperately to attract customer deposits with high interest rates, S&Ls invested those deposits in risky commercial enterprises like shopping malls, housing developments, fast food franchises, wind farms and even Nevada brothels. As one commercial banker facing competition from S&Ls complained, “Evidently you don’t have to run an S&L well as long as you have it insured [with government deposit protection].”3

Potential for unfair competition and conflicts of interest

7. Deposit protection is also important because, along with access to the central bank’s lender of last resort functions, it renders banks’ liabilities less risky, allowing banks to raise funds at reduced, subsidised rates. When the bank is located in a commercial holding company or group and is allowed to lend or transfer dividend payments to the parent company, that subsidy spreads to other subsidiaries in the holding company. The conglomerate earning subsidies in one market can then exploit this advantage in the other, leading to unfair competition.

8. We believe that there are other potential opportunities for anti-competitive abuses of market power by commercial/bank affiliations, such as:

a bank subsidiary refusing to extend credit on favourable terms to customers of a competitor;

a commercial firm coercing its suppliers to finance supply contracts with credit from its bank subsidiary.

9. Furthermore, commercial-financial conglomerates could potentially undermine the arms-length relationship appropriate to most financial transactions, such as a bank subsidiary lending to its parent or other members of its group on dangerously easy terms.

It’s happened before: Bank of England rescue of Slater Walker

10. Slater Walker Securities, which featured prominently in the British secondary banking crisis, was an investment firm with wide ownership interests in various non-financial corporations. It also owned Slater Walker Bank, 75% of whose advances were to companies in which Slater Walker Securities had, or previously had, an interest, or to individuals to finance shareholdings in those companies. This led to poor lending decisions, insolvency, and eventually to the Bank of England’s takeover of Slater Walker Bank.4

It’s happened before: Anglo Irish Bank’s entanglement with part-owner Sean Quinn contributed to bank’s collapse

11. During Ireland’s property-fuelled credit boom, banks loaned freely to builders like industrialist Sean Quinn, who built an empire from his base manufacturing the materials used in the construction boom to create a massive, far-flung conglomerate. In the late 1990s, Quinn expanded his empire to financial services, and in 2006 he began building an ownership stake in Anglo Irish Bank through derivative instruments, eventually controlling 29% of the shares.5 Anglo-Irish then reportedly loaned billions of Euros back to Quinn,6 much of it allegedly intended to cover the margin calls on Quinn’s investment in Anglo itself.7 When the property market collapsed and took Quinn’s empire down with it, the Irish state guaranteed the deposits and creditors of all its banks, leading to the need for an EU and IMF bailout. Anglo’s ultimate cost to the state was estimated to be between 29.3 billion to 34.3 billion Euros.8

It’s happened before: Japanese banking-commerce groups contributed to bubble, and collapse

12. Japan, for example, has allowed commerce and finance to blend, both through the keiretsu system of cross-shareholding between banks and commercial firms, and in allowing banking and commerce to blend within single firms. This allowed troubling relationships between firms to flourish and contributed to that country’s economic crisis in the early 1990s. To cite one example of abuse of these relationships, finance subsidiaries of commercial firms in banks’ keiretsu groups bought the banks’ debt in the late 1980s to help those banks meet capital requirements. That is, the banks lent money to their traditional customers at cheap rates, and the companies, via their finance subsidiaries, then lent the banks their own money back at a slightly higher interest rate.9 Needless to say, this is not how regulators prefer capital requirements to be met.

The Financial Services (Banking Reform) Bill should give Regulators Consolidated Supervision Powers over Commercial-Financial Conglomerates

13. The mixing of commerce and banking within a single conglomerate poses unique challenges to regulators. The first of these is the lack of consolidated supervision. Without consolidated supervision of both the parent company and the bank subsidiary, the financial regulators will not be able to oversee risks in the unregulated commercial business that could spread to the deposit-taking subsidiary.

Consolidated supervision of financial conglomerates

14. Policymakers regularly invoke the importance of consolidated supervision with regard to financial conglomerates. According to a Financial Services Authority policy paper from 1999, “There is a clear need for regulatory oversight of a financial conglomerate as a whole,” since there may be “risks arising within the group […] that are not adequately addressed by any of the specialist prudential supervisory agencies that undertake their work on a solo basis.”10

This is because, according to the paper:

“Many of the threats to the solvency of the institution can be assessed adequately only on a group-wide basis. This includes the assessment not only of whether the group as a whole has adequate capital, but also of the quality of its systems and controls for managing risks, and the calibre of its senior management. […] Moreover, there needs to be an effective exchange of information and a co-ordination of regulatory requirements across the regulators responsible for different parts of a conglomerate’s business, as well as mechanisms for co-ordinated action when problems arise in a conglomerate.”11

15. Furthermore, regulators may learn about transactions between the parts of a corporation only after the fact, as the recent saga of MF Global’s alleged “missing money” has made all too clear,12 making pro-active supervision of the entire conglomerate essential. Related-party transaction rules or other regulations may not be sufficient to monitor transactions between the regulated entity and other entities owned by the same holding company.

Consolidated supervision of commercial-financial conglomerates

16. Not only do these very same problems arise in the case of commercial firms holding financial subsidiaries; we believe in many cases that they may be exacerbated. Holding companies, for example, may be allowed to own entities that the financial institution itself might not be allowed to hold, such as other unregulated financial institutions or commercial enterprises.

UFCW part of coalition raising concerns about Wal-Mart opening bank

17. The lack of consolidated supervision was a key issue raised in objection to Wal-Mart acquiring a bank in the US. In 2005, Wal-Mart applied to federal and state regulators for a licence to own an industrial bank, a type of banking licence allowed in certain states in the United States. The UFCW joined in a coalition with bankers, real-estate agents, and legislators of both parties in opposition. While Wal-Mart’s application was pending, the then Federal Reserve Chairman, Alan Greenspan, without naming Wal-Mart, called on Congress to examine the loophole in the existing law that allowed some commercial firms to own industrial banks, on the grounds that the loophole prevented the Federal Reserve from having the power to oversee the parent company and the bank subsidiary on a consolidated basis.13 The Federal Deposit Insurance Corporation (FDIC)—the US supervisory body that guarantees the safety of deposits in banks—imposed an unprecedented moratorium, also without naming Wal-Mart, on applications for the type of licence that Wal-Mart sought. Legislators in Congress introduced bills to prohibit commercial firms from owning banks. Wal-Mart subsequently withdrew its application, claiming the timing of its withdrawal was a “coincidence”.14 This is a clear example of risks foreseen by regulators, lawmakers and stakeholders worthy of UK legislators’ close attention in the context of the Financial Services (Banking Reform) Bill.

The Retail Bank Ring-Fence should apply to Commercial-Financial Conglomerates

18. Different regulatory regimes may be appropriate for different divisions of a single conglomerate containing financial services subsidiaries:

most commercial regulation, including securities trading, investment banking, and commerce, is based on market discipline: including, in extremis, that firms must be allowed to fail;

retail banking regulation, however, is much more robust, being based on a regulatory compliance system. This is necessary because of the overriding need to maintain confidence in the financial system. It is preferable to have banks satisfy regulators rather than face bank runs from jittery depositors.

19. The differences in appropriate regulatory regimes have informed the Draft Financial Services (Banking Reform) Bill’s provision that financial conglomerates be forced to “ring-fence” their securities trading and investment banking arms from their traditional deposit-taking retail banking arms: the former must be allowed to fail, without taking the retail bank with it. The same reasoning applies to commerce and banking: commercial firms must be subject to market discipline and be allowed to fail without jeopardising the deposit-taking and lending activities of retail banks. If retail banks should be ring-fenced from broker-dealers within a financial conglomerate, so too should they be ring-fenced from department stores and supermarkets.

The Financial Services Bill and the Ring-Fence: an Incomplete Solution

The Financial Services Bill (currently before the House of Lords, at time of writing) fails to extend consolidated supervision to commercial-financial conglomerates

20. The coalition Government has a plan to reform the UK’s financial regulatory system. The first component is the current Financial Services Bill, which includes a provision giving the new financial regulators powers to supervise the parent companies of regulated financial firms. Surprisingly, this power only applies to financial parent companies: retail and other corporations with bank subsidiaries would be untouched. Part 2, Clause 25 of the legislation (“Powers of regulators in relation to parent undertakings”) gives the Treasury the option to extend the jurisdiction of the regulators to non-financial firms by Order, but refrains from giving these powers to the regulators directly.15

21. However, in its policy overview explaining the principles behind the Draft Financial Services Bill prior to pre-legislative scrutiny in June 2011, the Treasury gave the following as an example of when the regulators might find it necessary to use this power:

“During severe stress, the different priorities and responsibilities of the board of a parent undertaking relative to the regulated company boards can be exposed. […] The FSA does not have legal powers to require action at the level of the parent undertaking. This could mean a number of potential recovery options are unduly dismissed. For example, it may be appropriate for the parent undertaking to provide additional capital or liquidity to improve the position of the regulated entity.”16

22. In our view, it is not difficult to imagine precisely the above conflict of interest arising between a retailer and its bank subsidiary. The draft version of the Bill from June 2011 was unclear about whether this power would apply to non-financial “parent undertakings”. Unfortunately, the Financial Services Bill that ultimately emerged in early 2012 following pre-legislative scrutiny, does not directly give the power to regulate non-financial parent companies to the regulators.

23. By only giving the Treasury the option to extend the regulators’ jurisdiction, a signal is sent to new entrants that their regulation would be “light touch”. Moreover, by not making the oversight of non-financial holding companies an issue upfront, this opens the possibility that this power will not be enacted until there is already a problem—when it is too late to prevent it. In short, if a company wants to become a bank holding company and own a bank, we believe that it should be regulated as a bank holding company.

Parliamentarians raise questions

24. During debate on the Financial Services Bill in both Houses, MPs and Peers raised questions addressing just these types of issues. For example, in the Commons committee stage Shadow Economic Secretary to the Treasury, Cathy Jamieson MP, expressed concern about the “loophole” in the Financial Services Bill:

The Bill enables the new regulators to oversee parent companies that own financial subsidiaries. […]That is a welcome move; we do not have a principled objection to it. However, I am keen to hear the Minister’s views on the Bill’s seeming inconsistency, because some parent companies will be exempted. We were somewhat surprised that the Bill grants the power of consolidated supervision only to parent companies that are classified as financial institutions by the Treasury. [...] Given the emergence of new-entrant, non-traditional banking firms, which are often the subsidiaries of non-financial parent companies, that loophole risks creating an inequitable situation, and it could be dangerous.17

25. Ms Jamieson pointed out that closing the loophole would be quite easy, and would not extend the reach of the regulators into the non-financial aspects of these commercial conglomerates. For example, in the case of a bank owned by a supermarket or an airline, it would not give the financial regulators the power to tell these businesses how to stock their shelves or plan their routes.18

The ring-fence leaves retail banks exposed to potential risks from commercial activities

26. The second component in the Government’s financial reform plan is the ring-fencing of investment banking and securities trading from retail banking, as proposed in the Vickers Report and the Treasury’s Banking Reform White Paper. The ring-fence should be extended to protect deposit-taking retail banks from commercial risks as well.

Conclusion: Complete Financial Reform by Regulating Commercial/Financial Conglomerates and Ring-Fence Deposit-Taking Banks from the rest of their Groups

27. The Government’s proposals to reform the financial system are designed to address the causes of the devastating 2008 financial crisis, in which universal banks torpedoed the financial system. Thus, the Financial Services Bill aims to bring a form of consolidated supervision to financial conglomerates, and the Banking Reform White Paper recommends ring-fencing retail banks from riskier activities. These measures are wise, but in our view they are not enough to safeguard against probable commercial developments in the UK’s financial sector originating with non-banking entrants to the sector.

28. As the commercial/bank conglomerates grow larger, under the proposed legislation there is a risk that they will not face the same level of regulation as financial conglomerates. We believe this is a mistake with potentially damaging consequences for consumers, the financial sector and the taxpayer alike. Consolidated supervision and ring-fencing should in our opinion apply to commercial/financial conglomerates as well.

29. While it is vitally important to increase competition in financial services, it is also essential that all companies in the market face the same levels of regulation. In her history of the secondary banking crisis, Margaret Reid said “the benign attitude of the Bank of England towards the extension of London’s banking fraternity at a time when its own surveillance capacity was not growing in step with that community’s rapidly expanding size” was an “encouraging factor” to the crisis.19

30. That mistake must not be repeated. We believe Parliament should have amended the Financial Services Bill to increase the powers of consolidated supervision and make sure they apply to commercial conglomerates as well as strictly financial ones, and retail banks should be ring-fenced from the rest of their groups, regardless of whether these conglomerates contain investment banks or supermarkets. Should that opportunity be missed, this matter should be addressed by the Draft Financial Services (Banking Reform) Bill.

31 October 2012

1 Reid, Margaret. The Secondary Banking Crisis 1973-1975. 1982, p. 4.

2 Amadeo, Kimberly. “Savings & Loan crisis.”

3 Phil Rigney, CEO, First National Bank. Qtd. In Kathleen Day, S&L Hell: The people and politics behind the $1 trillion savings and loan scandal. May, 1993. P. 229.

4 Reid, Margaret. The Secondary Banking Crisis 1973-1975. 1982, p. 184.

5 Carswell, Simon. Anglo Republic: Inside the bank that broke Ireland. 1993. P.114

6 Ibid, p. 191

7 Ibid, p. 128.

8 Ibid, p. 314.

9 Wood, Christopher. The Bubble Economy: Japan’s extraordinary speculative boom of the ‘80s and the dramatic bus of the ‘90s. 1993. p. 28.

10 Briault, Olive. “The rationale for a single national financial services regulator.” FSA Occasional Papers in Financial Regulation. May 1999.

11 Ibid.

12 Stump, Dan. “MF Global trustee: customer funds missing days before bankruptcy.” Dow Jones Newswires, 6 February 2012.

13 Alan Greenspan letter to Rep. James A. Leach. 20, January, 2006.

14 Wysocki, Bernard. “How broad coalition stymied Wal-Mart’s bid to own bank.” Wall Street Journal, October 23, 2006.

15 Financial Services Bill (HL 25, 2012-2013).

16 HM Treasury. “A new approach to financial regulation: a blueprint for reform.” June, 2011.

17 Transcript of Public Bill Committee Debate re: Financial Services Bill, Clause 25. Thursday 8 March 2012 (Afternoon).

18 Ibid.

19 Reid, Margaret. The Secondary Banking Crisis 1973-1975. 1982. p. 4.

Prepared 2nd January 2013