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Inside Track Insight Banking

Not going for broke

William Peakin Business Correspondent

Can the industry be made safer and more competitive?

Tree years ago, it was all so different. In

the Sidlaw auditorium of the Edinburgh International Conference Centre, 250 people had gathered for Scotland’s first Global Financial Services Conference, the culmination of a week of events celebrating the country’s pre-eminence in banking and investment. Te Royal Bank of Scotland’s then chief executive Sir Fred Goodwin was not there, but then he considered his company above such collective back-slapping. Andy Hornby, his counterpart at HBOS, did speak, though, describing a business that delivered value to its customers and avoided risk. “Tat went ok, didn’t it?” he murmured

to colleagues afterwards. But he probably already knew that he and his peers were in trouble. HBOS’s exposure to America’s toxic sub-prime mortgage market was, at £430m, relatively small. Te problem was the ratio - 177 per cent - of its loans to deposits. Te bank had fuelled its growth in the mortgage market by borrowing from other banks instead of using deposited reserves. It faced a “funding gap”, a mismatch of obligations and available funds, which stood at £198bn. But the other banks, because of the sub-prime market, were no longer willing to lend. With some insight, Hornby described the

problem this way: “If you have ten bottles of water in front of you and you know one of them contains poison, you are unlikely to drink any of them.” Six months later, both he and Sir Fred had been sacked and their companies bailed out by the taxpayer. “When the Titanic hit that iceberg, at

first the crew didn’t think it was so bad. Te ship’s hull was divided into watertight

Bank of Scotland HQ

compartments, and not enough of them had been ripped open to sink the ship,” the New York Times’ columnist Paul Krugman observed in the autumn of that year. “But the flooding from the initial hole tipped the ship, and the compartments were open at the top, so that compartments that hadn’t been ripped open by the impact of the iceberg started filling up, tipping the ship even more, flooding more compartments … remind you of anything in the news lately?”

“If we don’t cure this, the

taxpayer is going to remain very much on the hook”

When the Scottish Government convenes

its planned summit of banks and businesses sometime in the next few months, it will do so in a markedly different context. It will be held against the background of a savage realignment of the UK economy. Tere is the ongoing tension between the Coalition Government and Britain’s four biggest banks over executive bonuses and the amount they are lending to small and medium- sized businesses under their ‘Project Merlin’ agreement. And the forthcoming report of the Independent Commission on Banking (ICB) could recommend that some of the banks be broken-up. Sir John Vickers, the ICB’s chairman, was

in Edinburgh recently and picked up on the Krugman analogy: “When some of these enormous banks got into trouble, governments like ours had to save the whole lot. Tey were not in the form where you could separate out the retail bit and let market forces take care of, say, the international investment bit.

If you think of a big bank like RBS, it didn’t have internal separations; it wasn’t like the Chinese junk with the compartments in the hold to stop the penetration of water sinking the whole thing. So governments had to intervene on an absolutely massive scale. And we are left with a situation where if we don’t cure this the taxpayer is going to remain very much on the hook.” Te option of a complete break-up of

the banks was “not off the table”, said Sir John. But he and his four colleagues on the commission – “We are not just an independent commission; we are five very independent people” – have, in their interim report, so far stopped short of such a radical recommendation and are instead considering forms of “retail ring-fencing” under which retail banking operations would be carried out by a separate subsidiary within a wider group. Tis would require another of the commission’s main initial recommendations; a so-called equity ratio of at least 10 per cent (and preferably several per cent more), designed to absorb any unforeseen losses. “Te sub-prime crisis was a big economic

shock in itself but look at the havoc it caused. Remember those early days of October 2008 when there were very real concerns that ordinary high-street bank services, like getting cash out of an ATM, were in jeopardy. How was it that those banks put the things that were absolutely imperative for economic and social life at risk? Part of it was that banks in the last decade had leveraged their balance sheet relative to shareholder equity. You had a very thin layer of equity and when those losses were experienced or even in prospect, not only did that thin layer vanish but the banks were structured in such a way that made it impossible for them to absorb the shocks.” Sir John said that the commission was against single solutions: “Some would say you just have to pile up capital requirements. Others would say you have got to split up the banks. We think there is merit in both lines of argument, but we think it’s got to be a package, for all sorts of reasons. We also think a package is the best way to combine safety and the international competitiveness of UK-based banking. So we have proposals on loss absorbing capacity; we believe that UK retail banks need at least a 10 per cent equity cushion. “Secondly, we’ve considered structure

very carefully. Not off the table is the idea of a total split between retail and wholesale

13 June 2011 Holyrood 29

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