Sir John Vickers on Building a Safer British Banking System

Britain’s economy took a hard hit in the financial crisis and is still struggling five years later, in part because its banking industry was especially fragile.

Banking represented a large share of gross domestic product in the United Kingdom, yet Britain lacked some of the fundamental regulatory safeguards to contain risks and ensure stability.

Sir John Vickers, Warden of All Souls College at Oxford University, led the charge of shaping fundamental reforms to improve banks’ stability and competition when he chaired the United Kingdom’s Independent Commission on Banking in 2010-11. He shared insights on its recommendations, progress toward reform, and “unfinished business” at the Myron Scholes Global Markets Forum cosponsored by the Becker Friedman Institute and the Initiative on Global Markets on Oct. 2.

Vickers, a former chief economist at the Bank of England and 2013 Visiting Scholar at the institute, outlined the unique vulnerabilities of British banks. “Why did we have such a horrible crisis? Because we had this very thin equity layer and, because London is a global financial center, we also had remarkable international exposures. These shocks happen and in no time, there’s tremendous losses in plain vanilla UK banks,” he said.

“There are no structural breaks within the banks, so when fire broke out, there was nothing to stop it,” he continued. “I’m not just saying we lacked Glass-Steagall,” said Vickers, referencing elements of the US Banking Act of 1933 that formerly separated retail and investment banking. “We didn’t even have that.”

He focused on two aspects of the many strands in the huge proposal for reform. The first was loss-absorbing capacity. Under capital requirement standards put forth by the Basel III agreements, by the end of 2013, banks must retain equity capital of seven percent in terms of risk-weighted assets (and up to nine and a half percent for those deemed “globally systemically important banks”).  “I think that’s disappointing and unambitious,” he said. “The international community needs to go further but it hasn’t.” In the US, current proposals on equity requirements remain under consideration in Congress.

His commission did go further: “Where we ended up is that large retail banks should hold 10 percent with a 25x backstop of 25 times leverage.” While these requirements are costly for banks, they are necessary because standard bankruptcy won’t preserve crucial banking services and taxpayers end up on the hook for enormous losses.

Vickers said personally he would prefer to double the commission’s recommended standards if economic “skies were blue, but skies are cloudy,” and the commission kept a close on the economic impact of requirements.  Those requirements are costly for banks, but markets work best when those who reap the rewards also bear the costs of possible losses.

Vickers applied the famous Modigliani-Miller theorem–essentially, that in an efficient market, the value of a firm is unaffected by how that firm is financed–to assess whether such requirements were costly to the economy. The answer is no: “For given risks in the economy, why would the aggregate value of claims depend on debt/equity mix?” said Vickers. “The social costs of bankruptcy argue for more equity. So do the social benefits of getting the taxpayer off the hook [for losses].”

The second strand of recommendations dealt with structural reform, to create appropriate barriers to contagion within banks and banking activities. “What we recommended was ring fencing,” Vickers said. This calls for separating core retail banking activities (deposits, lending, and overdrafts to individuals) from activities like trading and underwriting of derivatives and debt, asset-backed or equity securities, and lending to financial companies. The latter fall outside the fence and would be prohibited for banks. In between the two zones lie a set of activities like financial advising and non-financial lending that could be permitted.

Vickers said he remains optimistic about the political chances for adopting the commission’s recommendations in Britain, but said more work remains to be done to implement sufficient safeguards globally.

Touching on similar recommendations from the Liikanen Report on reforming EU banking structure and proposals in the US, he saw a “transatlantic convergence” toward healthy reform.

Responding to a question from the audience, he added, “There are huge issues remaining, such as the point of origin and the debt structure between parent and affiliate financial institutions. There is work going on in the Federal Deposit Insurance Corporation, the Federal Reserve, and the Bank of England, but there is a huge amount of work still to go.”

The Becker Friedman Institute cosponsored Vickers’ talk with the Initiative on Global Markets at Chicago Booth. The lecture serious is generously sponsored by Myron Scholes, MBA’64, PhD’70.  The IGM also receives support from Kenneth and Anne Griffin.

­–Toni Shears