Evidence to the Vickers Review – 1 Systemic risk

Sir John Vickers is a an accomplished senior academic, with Bank of England and Competition authority experience. He comes to the task of reporting on how the banks should be structured and regulated from a perfect background. I know he will approach it seriously with useful knowledge but no opening prejudices.

One of the first questions he needs to ask is Why did we have banking failures and problems in 2008-9? Some will be urging him to the veiw that it was the combination of “casino banking ” with clearing banking which caused the problems.

The evidence does not bear this out. The worst of the crisis was the collapse of Lehmans, a pure investment bank. In the UK the most distressed banks were three relatively small specialist mortgage banks, without Investment banking arms. Forcing Barclays and HSBC in London to divest their investment banking operations would not prevent a future Lehmans or Northern Rock.

It is difficult to avoid the conclusion when looking at Lehmans, Northern Rock, RBS, the Irish banks or the Icelandic banks that it was misjudgement by the banks of how much cash and cpaital they should keep to cover their risks, and bad judgement by Regulators who did not require them to be more cautious. Bankers and Regulators together presided over a massive expansion of leverage throughout the system. Both shared the view that the advent of new financial isntruments and larger banks alllowed more risk to be run . They threw out of the window the old ideas about prudent levels of capital and cash. The Central banks then withdrew liquidity from markets too rapdily and helped bring about the crisis.

My first conclusion is that splitting Investment and clearing banks is not the answer. Banks of all types and sizes got into difficulties, including small and specialist institutions. It is increasingly difficult to seperate investment bank activities from clearing bank activities. A business customer may need foreign exchange futures and commodity derivatives as well as a bank loan and current account. A retail customer may want investmnt management as well as a means of payment. Seeking to stop banks undertaking certain types fo financial business might just drive them offshore.


  1. Tim Hedges
    September 10, 2010

    I don't think this is too dificult. The imperative for it is that there is an implicit guarantee over the clearing banks. For this they should be made to ringfence their capital (splitting them up is not necessary). Of course clearing bank clients require and must be offered investment banking products but the bank's position must be neutral. Any position in the market must be in the investment banking arm

  2. Glyn H
    September 10, 2010

    So the problem was the removal of banking regulation from the BoE, as devised by Brown/Balls.

  3. English Pensioner
    September 10, 2010

    I agree with most of your points but I still believe that there are strong arguments for splitting retail and investment banking, at least by forcing them to operate at arms length and keeping their finances clearly separate. There is no reason, that the business you postulate, should not be referred from one part of the bank to the other for its financial needs, just as banks you refer to to their favoured insurer if you ask about insurance. I believe that banks should be split, internally at least, into the part that could be allowed to go to the wall, and the part that must be saved in a crisis because of the public interest.

  4. alexmews
    September 10, 2010

    surely the biggest news on this topic is the news from basle yesterday of the proposed 7% tier 1 capital ratio for banks and the idea that this would be agreed by G8 in Norway later in the year. Steph Flanders' blog talked about this yeaterday and the impact it would have on lending & recovery – one of John's recurrent themes. Interestingly also the blog highlighted the impact on many European banks who appearently today have much lower teir 1 capital ratios than UK banks and therefore would need to tighten more and more quickly than here.

  5. alexmews
    September 10, 2010


    John – i notice your campaign to highlight the cash increase in the budget rather than the cuts seems to be getting even less attention today despite your Q in PMQs and your various media interventions on the subject for some time.

    The 'cuts agenda' seems very fully front and centre. I can only think that the cabinet and the Media are in close cahoots on this – Vince, Ken, now George – as well as the BBC of course who have theor own website <a href="http://www.bbc.co.uk/spendingreview” target=”_blank”>www.bbc.co.uk/spendingreview all seem hellk bent on driving the 'cuts agenda' to a fever pitch.

  6. simon_555
    September 10, 2010

    The banks are just slowly getting back to the way they were. A couple of years on and what's happened? Massive bailout, propping up massive house prices , so everyone still needs massive debt to live in the overpriced UK. Gradual easing of lendning criteria, already back to 90-95% mortgages.

    We have no regulations to prevent it all happening except a pathetic 7% cash reserve ratio which is less than what the banks already have and will be introduced over a number of years, PATHETIC. The rest is just talk, wheres the 3x salary lending limit? How long does it take to introduce this simple measure?

    We have massive bank profits and banker bonuses all over again. The inequality that occurred under New Labour has been cemented with the bailout. Only a matter of time before the BoE print more money and devalue peoples savings to keep the whole charade going. The lesson is borrow to the hilt and let the idiots like me who save subsidize you.

  7. Mark
    September 10, 2010

    Perhaps a key element here is the extent of cross guarantees among subsidiaries. If a "casino bank" has no parent company guarantee or cross guarantee from fellow retail subsidiaries, it can be left to go bust should its bets go wrong without damaging the rest of the bank. Shareholders can still benefit if the "casino bank" is successful. Limitations can be placed on the loans made by other subsidiaries to the "casino bank", so that it funds itself in transparent ways. The bank can still nudge its customers towards the services of its "casino" arm should they wish them – though as a potential customer for services, I think I might prefer to choose among competing offers. Of course, not being able to raid the retail balance sheet for funds will increase the cost of capital for the "casino" operation – but then the retail account holders don't benefit from the profits it makes.

    A real key is transparency. Before Enron went bust, there were very few who had much inkling that the company was in deep trouble, believing the published accounts. Suspicions began to be aroused among trading partners who saw Enron making consistent bilateral trading losses. Only when the forensic accountants went in afterwards was the real extent of the problems revealed, involving off balance sheet vehicles and mark-to-fiction valuations of illiquid positions. These are exactly paralleled by the problems that emerged in banking.

    There may be questions about whether some of the financial instruments that have been developed should be permitted. There is a big difference between a deliverable futures contract and a cash settled one: in the latter case, the price is determined by the deepest pocket – not the need to match commitments to supply with sources of supply. Apparently losing plays on physical markets can be geared up into massive wins on cash settled terms. Similarly, CDS can be issued in a highly geared manner, encouraging distorting trade in equities and corporate bonds.

    The shedding of risk within the banking system using derivatives turned out to be more apparent than real. The concentration of CDS risk in AIG is a case in point – theoretically, banks had shed their risks, but they had done so overwhelmingly with one counterparty, which in fact concentrated their risk. Banks were taking very similar risks on sovereign debt and property, and gearing them up. There was no oversight of where risk truly lay: only internal risk accounting that professed that individual institutions had shed risk. Again transparency might have prevented many problems.

    Banks naturally fight transparency because they can make added profit from lack of transparency. However, if I invest in a bond or a share, I like to understand the business I am investing in – to know what its real assets and markets are, to understand its risks and basis of profitability. We really should have advanced from the lessons taught by the South Sea Bubble which exploded in 1720: we should not be faced with investing in businesses that profess "… carrying on an undertaking of great advantage; but nobody to know what it is."

  8. ferdinand
    September 10, 2010

    You are right of course about the UK banks who failed. The problem is that it is only customers who can improve the banks' capital base by forgoing interest on savings or by paying high mortgage rates viv a vis base rate. We are caught and the banks need just sit back and wait whilst we suffer.

  9. Lola
    September 10, 2010

    Fundamentally it is not within the capacity of any State to 'design' a bank or banking sector. At least short of totalitarianism. If the bureaucrats are so sure that they know how a bank should be built and run, let them set one up and run it (in the private sector obviously).

  10. Lola
    September 10, 2010

    Part two

    Combine that with a disfunctional and incompetent central bank, a wildly useless and unaccountable 'reg-yew-lay-tor' and useless and spendthrift goverments with an entirely cavalier attitude to (other peoples) money plus deliberately debasing that same money, and you will always have bad banks.

    We've sort of dealt with the useless government bit, but to deal with the rest the only answer is to shut it down. Tinkering with more rules will not ever solve the problem because the problem is the rule makers.

    So, shut down the FSA, reduce the B of E to lender of last resort and general umpire, and if you absolutely insist on keeping a state monopoly of money require sensible capital requirments of banks. Better would be to return to us , i.e. the banks, the freedom to make our own money and let Gresham's law sort it out. Of course there must not be a fixed exchange rate between crappy state money and good private money.

    Roll on the revolution.

  11. Alan Wheatley
    September 10, 2010

    I do not see the sense in government/regulators telling bankers what sorts of banks they should run. On the basis of your analysis all three have made mistakes.

    On the other hand, government should be quite clear of the consequences for the nation that would result from the actions of all banks, beneficial and detrimental. Clearly government can not let the nation be in the position, as you have oft described it, of there being a large bank with a small country attached!

    Where depositors have the assurance of a government guarantee that their money is safe the risk to the guarantor should not be unlimited and the bank should not be able to luxuriate in the knowledge that the guarantee holds not matter what they do and how they structure their business. So, with good regulation, depositors should know clearly the extent of the guarantee, and if they do not like the terms applicable to one bank they have the option of moving their money elsewhere. This does, of course, rely on there being plenty of competition, and at the moment the banks are too much alike. A wider choice is required.

  12. GJWyatt
    September 10, 2010

    I understand “systemic risk” to be the chance of a run on the banks arising from customers’ loss of confidence in fractional banking – what we glimpsed in 2007 with Northern Rock – and the likelihood of contagion throughout the banking system. In the UK we don’t have a statutory cash reserve ratio, so our banks are free to choose (prudentially) how much cash to keep to meet requests for withdrawals. Do you think a statutory minimum cash reserve ratio should be brought back in?

  13. kraut
    September 10, 2010

    It's refreshing to read an analysis of the banking crisis that actually considers the causes before coming up with "solutions". I agree completely – splitting retail and investment banks is pointless and counterproductive. More stringent regulation, stricter capital requirements, and a clampdown on dubious accounting practices is a better way forward.

  14. Rob
    September 10, 2010

    Sir John Vickers may well be very accomplished and have lots of experience but then so where lots of the people who failed to see the crash coming. These people suffer from having too much education and being too focused on financial matters which leaves them little time for people that have more generalized experience and can see the greater picture. Old fashioned prudence and wide experience would surely be better qualities.

  15. Tony
    September 10, 2010

    At least some one in the UK has remembered the UK banks requiring capital where those with small or no investment banking arms. Interesting your post mentioned Lehman’s as an investment bank, which of cause it was but can I suggest a look at “To big to fail”.
    The problem at Lehman’s which lead to its failure and the issue at the other US investment banks, Morgan Stanley, Goldman etc was not the trading activities normally associated with investment banks.
    They had started off underwriting and managing issues of CDO, typically on mortgages, which is there normal business. However, they liked the return so much rather than sell them they held on to them. At the time of the crisis in the US these investment banks where effectively massive mortgage lenders. The issue was not with investment banks acting as investment banks, unlike say in the LTCM crisis, but because they became conventional mortgage lenders to an over inflated property market.

    September 10, 2010

    We definitely have no expertise in this field and are more likely to ask common sense questions from a voter’s perspective than to suggest clever answers.
    Is the key likely to be a method of ensuring that ordinary depositors cash and savings – that the Government guarantees in effect – are never invested in anything that is not rock-solidly safe such as government securities and mortgages, albeit at low interest rates as a trade-off for security?
    The capital for more speculative investments and ‘instruments’ should come from those who seek a higher rate or from elsewhere in the money market. Those funds would not carry government guarantees.
    Surely that would be easy to understand and to enact?

    Given these rules it would be up to the Banks and money-men themselves to get on with things without too much further government time and interference.

    As we say we’re just asking not telling!

  17. bathugeo
    September 10, 2010

    John, the worst failure of this crisis may have been Lehmans but only because it was the one that the US Govt chose not to bail out. RBS was by far the worst failure here, although with tough competition from BoS and NR. The difference was that the govt at the time felt compelled to bail them out because they were also retail banks.

    No regulation in the world is going to work if the banks assume that they will be bailed out for mistakes. Retail banking gives them this implied guarantee. Removing this is an essential, but not sufficient, measure to a more stable banking world.

    The common factor throughout the banking crisis (and indeed previous market failures, such as Arthur Andersen) has been a failure of accounting not of regulation. That is, banks and other companies have misled shareholders over the true value of their assets and not stuck to the conservative accounting principle, i.e. the worst case.

    The solution to this is not just to break the 'too big to fail banks up' but also to stop conflicts of interest in the accounting and credit rating industries.

  18. Corin Vestey
    September 10, 2010

    I agree with you Mr. Redwood, but we no longer regulate our own financial institutions or markets, do we? Mr. Barnier has his own ideas, sadly.

  19. Sally C.
    September 10, 2010

    … and lo, a voice called from the wilderness… 'I don't suppose there's any chance of an Austrian economist being appointed to the MPC ?'

  20. doppelganger
    September 10, 2010

    I disagree. The financial crisis was systemic and would not have been if operators in the financial sector had their activities clearly segregated and properly regulated.

  21. Richard
    September 11, 2010

    We need to make it much easier for new Banks, Building Societies and Insurance companies to start up.

    Over the last decade there has been a trend towards monopoly power in these sectors with mergers and take overs being common.

    Now we have just a few, huge, multi national banks, building societies and insurance companies.
    There is not enough competition in the market and a failure of just one develops into a crisis.

    Encourage citizens to have insurance cover on their deposits and warn banks that the Goverment will not bail them out in the future.

    Legislate to make top directors and partners personally responsible if their bank goes under.

    The problem is these institutions are multi national and there is no world body capable of effectively legislating against them.

  22. StevenL
    September 11, 2010

    What about over-reliance on raising money through bond issuance, now that we have the moral hazard of taxpayers/sterlingholders bailing out the owners of corporate bonds.

    Maybe banks that have a poor deposit base should be punished with higher capital requirements, or some other kind of risk premium.

  23. Mark
    September 12, 2010

    I think there are lessons to be learned from examining what happened with AIG and Enron. Not sure why my post remains in moderation – is "casino bank" an unacceptable phrase?

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