Oct 2011 – Mutuals are part of the banking solution
The ICB’s report into banking provides a powerful endorsement of the building society approach. Adrian Coles, director-general of the Building Societies Association, explains
The final report of the Independent Commission on Banking, published on 12 September 2011, has been subject to extensive, albeit, on occasion, over-rapid, analysis.
Some have suggested that the proposals it contains are too tame and will not curb the alleged risk taking tendencies of banking institutions that result periodically in their mistakes having to be underwritten by taxpayers.
Others have suggested that the report represents an unwarranted intrusion into the business models of mostly successful institutions, operating in markets in which the UK has a comparative advantage, paying substantial amounts of tax in the run up to 2007 and enabling considerable investment to be made in public services such as health and education. The wide ranging debate will no doubt continue long into the future.
For building societies, and other financial mutuals, the impact of the report is somewhat muted in that the major proposals will have an effect on the business of their competitors (if implemented), but not directly on themselves.
One of the most important suggestions of the report is the erection of a retail ring-fence within banking institutions to separate the so-called utility banking (savings, mortgages, lending to small businesses and money transmission) that the general population rely on, from the more esoteric City of London based investment banking activities deemed less worthy by many commentators of possible taxpayer support, and which might contaminate the utility business.
For deposit taking financial mutuals the expectation would be that virtually all, or indeed all, of their activities, would be within the retail ring-fence.
Building society model
Indeed, the report seemed to see building society regulation as something of a model for future banking regulation. Paragraph 3.53 of the report is reproduced in its entirety below:
“The precedent in building society legislation appears to provide a particularly good basis for the risk management functions of ring-fenced banks. Building society regulations have operated effectively for a long time. A number of former building societies failed in the crisis or were taken over as a result of poor business models, sometimes associated with their treasury-related activities.
However, evidence to the Commission suggested that problems that occurred in the treasury function only did so following the lifting of the relevant restrictions after demutualisation. In principle a ring-fenced bank should be able to undertake its necessary risk management within the building society regulatory framework, although the types of permitted instruments might need some extending given the wider range of services which may be provided by ring-fenced banks.”
Banks
Clearly there are limits on the extent to which the precise restrictions in the building society legislation could be imposed on retail ring-fenced banks. The prohibition against taking proprietary positions in the foreign exchange, commodities or derivatives markets could be usefully retained in any extension of building society regulation to other institutions – currently building societies can hedge positions only to reduce risk.
It makes sense, for example, for a building society funded by variable rate retail deposits to be able hedge the risk of offering a fixed rate mortgage by using the derivative markets.
On the other hand, building societies are required to hold at least 75 per cent of their lending in the form of residential mortgages. It would not seem appropriate to apply this rule to retail ring-fenced banks given current concerns about the flow of bank lending to small and medium-sized enterprises. A requirement on retail ring-fenced banks to concentrate on residential mortgages would be far too restrictive.
Some critics of the report have suggested that a retail ring-fence would not have done anything to prevent the crisis at Northern Rock, say, or Bradford & Bingley which were essentially retail banks. What few such critics have acknowledged is that Sir John Vickers answers this point in paragraph 3.56 of his report where he indicates that part of the definition of the ring-fence would be a limit on wholesale funding:
“Properly controlled wholesale funding could improve the diversity of a ring-fenced bank’s funding base and finance its growth. On balance, a ring-fenced bank should be allowed to raise wholesale funding, but in addition to existing regulations backstop limits should be placed on the absolute level of wholesale funding permitted.”
The paragraph goes on to note that building society legislation contains a 50 per cent maximum of wholesale funding but suggests that this figure would need looking at in the context of its wider application.
Building societies and other financial mutuals did not cause the crisis in the financial markets, but it is clear that they are part of the solution both in terms of the regulatory approach that the authorities have taken and in respect of the general, more prudent, approach that the institutions themselves have adopted before and during the crisis. Bankers and their regulators could learn a lot from mutuals and their regulators over the next few years!
