By Izabella Kaminska

The UK’s Independent Commission on Banking has published its Interim Report on Monday.

We’re going through it at the moment, but for now, we’ve put up in the Long Room and provided you with its conclusions.

As the press release states, the Commission was asked “to consider structural and related non-structural reforms to the UK banking sector to promote financial stability and competition, and to make recommendations to the Government by September 2011.”

Here are its main findings:

4.170 In view of the evidence gathered and its analysis so far, the Commission proposes to focus its work on financial stability reforms on further consideration of:

••introducing over time greater loss-absorbing capacity for systemically important banks comprising: an equity surcharge of at least 3% above Basel III requirements for systemically important banks; additional loss-absorbency provided by debt through bail-in mechanisms and possibly contingent capital; and some form of depositor preference; and

••a UK retail ring-fence, in which UK retail banking activities can continue to be provided by universal banks but must be contained within separately capitalised subsidiaries.

The Commission is also strongly supportive of ongoing initiatives to improve the resolvability of banks more generally, including through the development of recovery and resolution plans, increasing the clearing of derivatives through central counterparties and limiting exposures between banks.

4.171 In combination, these measures appear to have potential to make the banking system better able to absorb losses, to make it easier and less costly to sort out banks that get into trouble, and to curb incentives for excessive risk taking.

They should therefore reduce the probability and/or impact on the UK (including on the fiscal position) of financial crises in the future. At the same time they appear likely to maintain the efficient flow of credit to the economy, protect basic banking services and support the ongoing competitiveness of the UK economy including the City.

4.172 These measures are designed to strike an appropriate balance between the costs and benefits of reform. The current judgement of the Commission is that milder measures may not deliver adequate benefits in terms of financial stability, and that more radical options might impose costs, including to UK competitiveness, disproportionate to their benefits.

4.173 The Commission favours a combination of measures for several reasons. First, because there is inherent uncertainty about the nature of the next financial crisis, and therefore about exactly how individual measures will operate. Second, because measures may be mutually reinforcing.

For example, one of the ways in which increased loss-absorbing capacity limits the impact of crises is to make resolution less costly, and a ring-fence also helps secure this objective. Third, this complementarity may provide a way to economise on some costs. For example, without a ring-fence there may well be a case for capital requirements higher than those set out above.

4.174 Further analysis is needed of the relationship between different measures and their relative cost and benefits. In addition, the timing for the possible implementation of any of these measures will be needed to be carefully considered.

5.44 The Commission’s current view is that structural and behavioural changes are both necessary to improve conditions for competition in UK retail banking, not least to redress the increased concentration and loss of challengers as a result of the crisis.

The planned LBG divestiture represents an opportunity for entry of a strong, effective challenger in the retail banking market. However, as currently structured, it is unlikely to give rise to a credible challenger.

Substantially enhancing the LBG divestiture would make it more likely that the new institution would exert a competitive constraint on the large incumbent banks in the short term, and would reduce LBG’s market share. If a substantially enhanced divestiture does not result, there could be a strong case for the competition authorities to conduct a market investigation of the personal and SME banking markets in the UK.

5.45 Enhancing the divestiture would be more economically efficient than reversing the Lloyds TSB/HBOS merger. The costs of reversing a merger once it has taken place are high – hence the ex antes nature of normal merger policy – and the benefits of recreating the ailing HBOS are questionable. Creating a new, effective and stable challenger would give similar or improved benefits, without undoing the merger synergies for LBG.

5.46 Besides increased concentration, conditions are generally poor for consumer choice in the banking sector, due to (real and perceived) difficulties in switching accounts, difficulties in understanding and comparing products, and barriers to entry facing new players who might have a better customer offering. There is reason to believe that a radically improved system for switching accounts could and should be introduced at a reasonable cost within a short timescale.

This would help to reduce obstacles to switching, which constitute one of the main barriers to entry as well as blunting competition between established banks. This could be less costly and simpler to introduce than full account number portability, while delivering many of the benefits.

5.47 Finally, it is important that competition in the sector is the subject of more active regulatory monitoring and improvement. The FCA has the opportunity to be a strong force for competition in a way that has not previously been possible in this sector. Giving the FCA a primary duty to promote competition could be a vital spur to competition in UK retail banking.

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Source: Financial Times