Question

A crisis needs a firewall not a ringfence

By Alistair Darling

Fortunately I’ve only ever had to take one telephone call that made my blood run cold. On the morning of October 7, 2008, Sir Tom McKillop, the then chairman of Royal Bank of Scotland, called me to say that his bank was fast running out of money. He asked me what I was going to do about it.

This was three weeks after the collapse of Lehman Brothers. The markets were in a panic. RBS shares were in free fall that morning. We were on the brink of an international banking collapse.

I had no doubt what had to be done. If RBS closed its doors people would panic. The cash machines would close down. There would be no way for customers to get their money out. That panic would have spread to other British banks and then to the US and beyond.

The UK government had seen what happened 12 months earlier with the run on Northern Rock. Yet it was a comparatively small bank where, in reality, depositors’ money was guaranteed by the government.

So that October morning I had no choice but to bail out RBS, to do whatever it took to stop a catastrophic banking collapse across the globe. It was not an easy decision. RBS, one of the largest banks in the world, had a balance sheet about the same size as Britain’s gross domestic product. Added to that, we knew we would have to bail out HBOS. It was in the same precarious position.

We did what was needed. But it was at a substantial cost. I hope that none of my successors are ever faced with the same scale of horrors.

It is against this background that I looked at Monday’s announcement by Chancellor George Osborne on ringfencing, made as part of a speech on banking reform. Would a ringfence, or even the “electrified” version he now proposes, have made any difference? I don’t think it would. A partial bailout would not have worked in those febrile times.

The theory is that if a bank is divided so that its retail and investment activities are separated then it would be possible to save one part but let the other go to the wall. The argument runs that I could have saved RBS’s high street activities and abandoned the investment arm to its fate.

I am not so sure that would have worked. In the face of blind panic and a total collapse in confidence, the government needed to erect a firewall to show that it was not prepared to let the banking system collapse.

After all, Lehman Brothers was just such an investment bank. The Americans let it go. Its collapse was not the cause of the ensuing crisis but it was certainly a major catalyst.

Ringfencing will not avert the possibility of bank bailouts in a time of acute crisis. No government can say that it will never again have to bail out a bank or intervene in the face of such crisis. It should be different in more tranquil times, when there is no reason that a failed bank cannot be treated like any other failed company and face the consequences.

Ringfencing is a perfectly sensible measure. It would help in identifying good and bad assets. It took months to discover the sheer horror of the scale of RBS’s problems, particularly outside of the UK. But ringfencing – even with electrification, whereby regulators will have the power to break up a bank – has its limits.

The proposals by the Independent Commission on Banking – headed by Sir John Vickers – were entirely sensible. The banks should adopt them and they are entitled to ask that there are very clear rules in place if in future the regulators are to take enforcement action.

But there are two other elements of the Vickers proposals, and surely the most important is the capital that banks are required to hold and the lending ratio they are allowed to support. Vickers recommended capital of 4 per cent, a lending ratio of 25 to 1. The chancellor, in an apparent sweetener to the banks, has said the ratio should be 3 per cent, allowing a 33 to 1 ratio.

A requirement to hold more capital and to be more prudent about the amount of money that can be lent will, I suspect, be a far greater buffer against calamities than a ringfence.

Nor have we heard how, in future, bond holders will be made to take some losses in the event of such failure. We have to end a situation where in the good times they profit, but in the bad it is the taxpayer who loses out.

A lot of work has been done on “bail in” for bond holders. That needs to be developed into a set of firm proposals. Sadly, when normal companies go bust there is some pain, but not in banks.

Finally, we can never sort out our banking problems in the UK until the eurozone does the same. The putative banking union will not work in its present form. The recommendations of Erkki Liikanen, governor of Finland’s central bank, which were meant to mirror those of the Vickers commission, appear doomed. The French and German governments – and more particularly their banks – have made it clear they will not accept ringfencing.

This presents further risk to add to that of failing to recognise that some of Europe’s banks still badly need more capital and further write-offs.

Ringfencing is a useful tool to help manage banks but it is certainly not a complete answer. Too many risks still remain.

*The writer is a former UK chancellor of the exchequer

Class work Questions

“Ringfencing is a useful tool to help manage banks but it is certainly not the complete answer” (Alastair Darling, Financial Times, 4 Feb 2013).

1) Briefly describe what Alistair Darling means by “ringfencing”, and how it might help prevent a banking collapse such as RBS:

2) Briefly describe the further measures apart from Ringfencing, that Vickers proposes? Look for information about those policies. (internet search)

3) How the implementation of those proposals affected many European banks? (some internet search)

4) Did the UK government do well to save the UK banks while the US government did not save Lehman Brothers? What kind of problems this decision may create in the future for the banking system?

Answer 1

1) By ringfencing, Mr Darling means separating commercial and investiment banking activities of financial institutions. This way, in case of a crisis like that of RBS,commercial banking canbe bailed out, but investment baking can be let gone.

2) Vickers proposestighter capital requirements, BASEL 3 norms are making capital requirements more stringent. He also proposes quicker recognition of bad loans, which the IFRS9 implementation is working on.

3) Some European banks like UBS, Credit Suisses and Deutsche Bank boosted their capital to meet these regulations. They also tightened up the lending practices.

4) The UK government did well to save their banks even as US did not save lehman brothers. But the US government did set an example whereas the UK government has created more moral hazard by giving blanket bailouts to the banks.