Westminster Blog

Stephen Hester has warned that ring-fencing banks could create systemic risk in the system, the opposite of its desired effect. The chief executive of Royal Bank of Scotland is currently being grilled by the Treasury select committee in Portcullis House, Westminster.

The question is pertinent because some form of internal ring-fencing is the recommendation of the Independent Commission on Banking.

It was put to Hester by Andrew Tyrie, chairman of the committee, and the bank chief at first prevaricated. Put on the spot, he said his belief was that, on balance, ring-fencing would cause problems.

“We need to look at the different areas of ring-fencing. It is partly about costs and employment, lending costs to customers and so on. I believe that the creating of ring-fences increases some of the systemic risk and decreases the ability of banks to withstand the risk.”

Hester said he believed that carrying out a ring-fence would increase some of the systemic risk and decrease the ability of banks to spread their risks, creating significant costs.

On the one hand, the retail bit of the bank, which would be seen as the safest part – not necessarily correctly* – would have an obvious state backing and this could create “moral hazard”, he warned. There would be a belief that this big beast would know that “if something goes wrong, don’t worry we’ll help you”.

Conversely the rest of the business would immediately be “more vulnerable” because it wouldn’t have implicit support.

Hester also made the general point that a diversified bank, like a diversified economy, should in theory be safer.

It’s an interesting argument although not everyone will be convinced; the “moral hazard” problem exists already with the assumption that the taxpayer will now step in to rescue all banks – and not only the retail ones.

Douglas Flint, the new chairman of HSBC, gave it short thrift: He said that the priority of policymakers should be to ensure an uninterrupted flow of capital to the real economy. The impact of problems in the structured credit and securitisation markets on retail bank lending had been “tragic”, he admitted.

“I think it (separation) is required,” said Flint. HSBC provided – in a companion document – a suggestion for how the separation could work under a model “closer to a Glass-Stegall type of basis”. It would see a ring-fenced bank (RFB) which contained “vanilla” products by risk (although this would include some derivatives to hedge interest rates and foreign exchange movements) with everything else outside.

“This would have certain inefficiencies but would be much preferable to a structure that risked separating funding from lending.”

Both men were asked whether it would be a good idea to break up their banks to create greater competition in the marketplace; that would not necessarily be the consequence, they both argued.

UPDATE: Incidentally, Vince Cable warned this morning that banks could be taxed more heavily if they don’t step up their lending to SMEs. I don’t get the impression that this idea is entirely endorsed by the Treasury.

* As Hester pointed out: “Some of this is a cost and reward comparison. In the financial crisis the majority of losses have come through regulatory lending. One of the things we need to ensure is how are addressing those systemic risks.”