Can banks dodge the break-up?

BBC business editor Robert Peston on the Independent Commission on Banking

There is a slightly odd lead story in the FT this morning, which says that "senior Whitehall officials are pushing for a three-way peace deal between government, big banks and the Independent Commission on Banking".

That may be so. However, if it is, the commissioners don't know about it - and nor does the Treasury. And the commissioners are certainly in no mood to alter their interim report, due in 10 days, for anyone.

It is also mildly amusing that one of the commissioners is the FT's Martin Wolf. I am confident he had no role in the creation of that splash story.

What is happening is that the UK's big banks are thrashing around in a state of mild panic, because of their concerns about what the commissioners will recommend.

The penny has dropped for them that this is the big event, more important than the final report due in the autumn - because it will condition the public and political debate about how to fix the banks, which will in turn determine what the government eventually feels confident it can deliver.

So what do I expect from the commissioners?

Well, as I have said for some time, I would be staggered if they don't recommend some form of break up of the universal banks - Barclays, HSBC and Royal Bank of Scotland - which combine investment banking and retail banking.

A formal, physical separation isn't likely however. What I would expect is a proposal for investment banking and retail banking to be put into separate subsidiaries, each of which would be obliged to have their own respective pots of capital to protect against losses.

The idea would be to insulate the retail banks - the bits of banks that look after our savings, move money around and lend to individuals and to smaller businesses - from the risks taken by investment banks.

Think of the separation as the equivalent of building a super-strong steel and concrete firewall in the middle of a building - which would protect one half of the building if the other half were to catch fire.

You probably think that all sounds sensible. But the banks don't like it, for two reasons.

First, capital is expensive for banks, because of the rewards expected by the investors who provide capital. So if the bits of RBS, Barclays and HSBC that do investment banking are separately capitalised - to use the jargon - they would probably have to become much smaller organisations, focusing only on business that is particularly profitable.

But perhaps an even great worry for these mega banks is what would happen to the cost of the money they borrow. They fear it would become much more expensive for their investment banks to raise the finance which they then use for lending and investing.

How so?

Well if creditors of Barclays or RBS, for example, came to believe that the relevant investment bank was now so separate from the retail bank that the government would no longer feel under any pressure to rescue the investment bank to protect ordinary savers and the money transmission mechanism, that investment bank would be perceived to be riskier.

It would no longer be seen to be "too big to fail".

And once any institution is seen to thrive or sink according to its own management of its affairs - and is no longer benefiting from any kind of protection or insurance from taxpayers - well, at a stroke it has to pay more to borrow.

Now you might think that is the whole point of what the banking commission is trying to achieve. And you would be right.

But the banks don't like it, because if they have to pay more to borrow, then either their profits are squeezed or they have to pass those increased costs on to customers.

And, they say, they would not be able pass those costs on to customers - because they face competition from overseas banks which don't face the same strictures.

Now, for what it's worth, the banks believe that the benefits to their funding costs of being too big to fail, of being implicitly protected by taxpayers, have been overstated.

As readers of this column will know, the Bank of England estimated this implicit subsidy as being worth around £100bn per annum at the peak of anxiety about the fragility of banks in 2008-9, and perhaps half that figure subsequently.

What the banks would say is that at least some of the lower funding cost for universal banks derives from the perceived benefits of business diversity - that investors prefer lending to organisations whose eggs aren't all concentrated in one basket.

Hmmm. Some will see that as an admission that investors don't really like lending to investment banks, precisely because they are perceived to be riskier. Which brings us back to the question of why on earth taxpayers should underwrite investment banking?

Anyway, if you are with me so far, you will understand why the likes of Barclays, HSBC and Standard Chartered are all muttering about moving abroad to avoid this kind of enforced break-up.

Which brings me, in my meandering way, to my destination: are these threats to move abroad credible, and if they are, how much should we care?

One of the most startling omissions from the debate about how to make our banks safe is any serious analysis of the costs to the UK of the relocation of the head offices of one or a number of banks to another country.

Let's be clear what we are talking about. Barclays and HSBC could not move their branches. Nor could they quickly or easily move those bits of their investment banking operations that serve UK or continental clients. We are talking about the economic impact of relocating head office functions.

How much would this damage the prosperity of the City of London and the UK? Would it damage the UK more than the benefits of reducing the UK's vulnerability to the kind of cataclysmic banking shock we experienced in 2008?

The truth is that we don't really have the numbers to make a quasi-scientific analysis of the benefits and costs. So, paradoxically for an industry that prides itself on its facility with numbers, this is a debate conducted largely in fatuous emotion and generalisations.

Which is why I am sure the Independent Commission on Banking has done some work to estimate the financial benefits to the City and the British economy of having so many mega bank HQs here - and the potential costs of their possible emigration.

It will be fascinating to see how it evaluates the scariness of the banks' threat to leave.

I suspect the commission will also shed light on the credibility of that threat to depart - especially the question of whether the single European market would make it easy for our big banks to dodge the proposed reforms merely by relocating to Luxembourg, Frankfurt or Paris.

It is possible, I think, that the commission has found that EU law makes this kind of regulatory arbitrage impossible - even if it were possible that Barclays, for example, would enjoy the idea of embracing the German or French way of doing capitalism (which seems highly implausible).

As for Luxembourg as a possible HQ, that is absurd. The idea that Luxembourg has the regulatory resources or sovereign balance sheet to play host to banks whose balance sheets are bigger than the UK economy is not credible.

What about taking flight to some other part of the world? Well I think it would be surprising if Standard Chartered didn't move its head office to Asia or thereabouts some time in the next five years whatever the commission recommends - simply because it looks more and more odd that a bank with no serious operational presence in the UK is run from here.

But what about Barclays going to New York or HSBC going to Hong Kong?

In an earlier post, I explored why HSBC will find it hard to move. As for Barclays, how easy would it be for that bank to retain its complicated and beneficial tax arrangements if it relocated?

Not very easy, according to my tax specialist chums. So would Barclays owners be pleased to see the bank move, if that generated a big tax bill? They would probably not be ecstatic.

You can keep up with the latest from business editor Robert Peston by visiting his blog on the BBC News website.

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