On Wednesday, 19 June, the Report of the UK Parliamentary Commission on Banking Standards was published with an intriguing title: Changing Banking for Good. The title has a double meaning ~ one is that its recommendations, if implemented right, will change banking for the good of everyone; the other is that it will change banking forever.
This report is important for many reasons. First, it was commissioned by both houses of the UK Parliament, with membership from different political parties, and included the Archbishop of Canterbury, the head of the Church of England. Second, it addressed the UK banking professional standards and culture, ostensibly after the LIBOR rate-setting scandal, and their implications for corporate governance, regulations and government policy. Third, it complemented the Independent Commission on Banking (Vickers Report) published in September 2011 to address structural reforms in the UK banking industry.
The Vickers Report basically looked at ways of protecting retail depositors from bank failure and imposing too much burden on the tax payer. It recommended that the retail business of banking be ring-fenced through structural reform, rather than a total separation of the retail/investment banking business of large banks. Retail banking would be put under a separate legal subsidiary, and these would be required to maintain capital requirements higher than Basel III, the global standards.
In addition, all UK-headquartered banks and all ring-fenced banks should maintain a leverage ratio of Tier 1 capital to consolidated total assets of at least 3 per cent (a 33 times overall leverage ratio).
The UK Government accepted most of the recommendations of the Vickers Commission, especially the principles of ring fencing and depositor preference. Large retail banks will have to hold equity capital of 10 per cent and a loss absorbing capacity of 17 per cent for large banks. It also accepted the principle of improved competition through easier switching of bank accounts.
This new Report is about 600 pages in length, with 73 pages devoted to summary conclusions and recommendations. The key recommendations are around five themes ~ making individual responsibility in banking a reality, especially at senior levels; reforming bank governance; empowering consumers; reinforcing the responsibilities of regulators and specifying the responsibilities of the government and parliament.
The Report felt that the current system of sanctions against individuals is failing, since “there was little realistic prospect of effective enforcement action, even in many of the most flagrant cases of failure.” A new Senior Persons Regime will assign clear and unambiguous responsibilities to specific individuals, together with a new licensing regime. These persons would be judged against a single set of Banking Standards Rules, the breach of which would be subject to enforcement. In order to align incentives better for long-term strategic value creation, the Report suggested that a higher proportion of bank remuneration be deferred to as long as 10 years, with such deferred pay being subject to cancellation in the event of individual misconduct or business downturn.
The Report was frank in arguing that serious regulatory failure contributed to the failings in banking standards. “The misjudgement of the risks in the pre-crisis period was reinforced by a regulatory approach focused on detailed rules and process which all but guaranteed that the big risks would be missed.”
“Regulators need to resist the temptation to retreat into a comfort zone of setting complex rules and measuring compliance. They need to avoid placing too much reliance on complex models rather than examining actual risk exposures.”
Specifically, the most senior regulatory staff should be expected to use judgment, rather than relying on procedures, and to take direct personal responsibility for ensuring that they engage with the banks and the board to secure the information required to assess risks. The regulators would be accountable to Parliament on their responsibilities.
It is interesting that the Report cast doubt on whether the creation of a professional institute of bankers for self-regulation would be sufficient. Furthermore, the Report rejected the idea that setting higher banking standards would be against the UK&’s competitiveness. Bluntly, the Report argued that the commonly-heard argument that forcing banks to raise capital will hurt lending is false.
In a swipe against the EU regulations, the Report suggested that “the prescriptive and box-ticking tendency of EU rules designed for 27 members will impede the move towards the judgment-approach being introduced in the UK.”
The significance of this Report, made by law-makers even as the new banking legislation is being passed, is critical to the future development of banking not just in the UK, but also world wide. As the leading international financial centre, London has to set the benchmark for global banking standards. This report has helped clarify many issues of not just principles, but also the difficult trade-offs between more rules or more judgment.
The real problem is that banking is, as outgoing Bank of England Governor Mervyn King said so eloquently, global in life, but national in death. That means that the interactive, interconnected forces of competition, technology, innovation and consumer ignorance of new financial complexity make unacceptable behaviour systemic in nature. The traditional lines of defence against “reckless behaviour” failed at almost all levels ~ at the management, board, audit and regulatory levels, as well as supposedly independent credit rating agencies and informed analysts.
Where do you put final responsibility for this recurring crisis? There was flawed bank behaviour, flawed supervision and also flawed monetary policies based on flawed economic theories. There are no simple answers.
This Report is a landmark study and compulsory reading for bankers, regulators and law-makers globally because it accepted a fundamental view that the existing common law approach of sanctions was found wanting in addressing system failure. But is more legislation the solution to system failure?
So far, the rush for more rules and more legislation is definitely good for lawyers. Whether it is good for all remains to be seen.
The writer is President of the Fung Global Institute.