The cost of making UK banking safer

The Icesave website seen in October 2008 Image copyright Getty Images
Image caption The new Bank of England rules are designed to prevent losses like those experienced by Icesave customers

To avoid another Icesave and taxpayer bank rescue, the Bank of England (BoE) is proposing new rules that negatively affect competition. The estimated effect is marginal but it's coming at a time when the UK needs more business lending in particular.

Since the financial crash, there have been two main goals in Britain's banking sector - to make banks safer, and to increase lending, partly by increasing the number of banks offering loans. So, is there a trade-off?

This debate is evident in a set of proposals from the Bank of England as to how to regulate foreign banks. It's not the entire answer, but these regulations are geared at avoiding a repeat of the Icelandic disaster in the last banking crisis.

If the branch of a foreign bank goes bust, who pays? Right now, it's basically the UK taxpayer. This is what happened when Icesave collapsed in 2008. British depositors were protected, but because Iceland didn't pay up fully, UK taxpayers were left £100m out of pocket.

Why? Well, the UK's deposit guarantee scheme covers up to £85,000 and applies to UK branches of banks, including banks based outside of Europe. But if that money isn't recouped through the bankruptcy process, then it's a loss to the UK financial system as a whole.

So, to make the banking system safer, the Bank of England wants to change the rules for new entrants, which would also affect 145 non-European banks with branches in the UK, of which 82 offer retail and wholesale banking services. Those branches account for nearly one third, or £2.4tn, of UK banking assets, which is equal to a staggering 160% of GDP (this raises another question about whether that's really the bigger problem - an out-sized banking sector in an economy where there isn't enough lending).

To meet the new safety criteria, the Bank of England's proposed regulations mean banks outside Europe (countries in the European Economic Area) may need to operate as subsidiaries that would be governed by the UK Prudential Regulatory Authority (PRA), and not operate as branches (that are governed by their home country's banking regulations). Subsidiaries, unlike branches, are usually separately capitalised, meaning they hold more capital within the country's borders and are considered safer as a result. Right now, there are far more branches (31% of banking assets) than foreign subsidiaries (14%) in the UK.

It may be a sensible move, but it's not cheap. For a branch with assets of less than £2bn to convert to a subsidiary, the PRA estimates there will be an one-off cost of £525,000 and annual costs of £150,000. There are also other indirect costs the PRA can't quantify, such as having to hold more capital in a UK subsidiary, which is a separate legal entity from the parent bank, unlike a branch.

The PRA estimates there might be a "marginal impact" on competition. In the important retail banking sector, the regulator says the costs of becoming a subsidiary may be too high and lead some firms to leave Britain. It could also increase the cost for any bank thinking about setting up shop to offer retail banking. The PRA doesn't expect much of an impact on wholesale banking, although it can't rule out some "minor" effects on competition. The end result is that it could deter some international banks from setting up in the UK.

In an exclusive interview Andrew Bailey, deputy governor for prudential regulation at the Bank of England and PRA chief executive, agreed the plans could deter some banks, but said he didn't want foreign branches to be how competition returns to retail banking. In other words, subsidiaries are more expensive to operate but would be safer.

It's not only bankruptcy and taxpayers left holding the bill that regulators are worried about. A recent Bank of England research paper points to foreign branches as more volatile in terms of lending than subsidiaries. They end up worsening a downturn because they cut back on lending far more than subsidiaries that behave more like UK banks - though they weren't lending much either.

In the last boom and bust cycle, lending growth by foreign branches to UK households and firms reached a peak of 23% in the third quarter of 2007 and fell by the same amount in the third quarter of 2009. In other words, their lending grew by a quarter and fell by a quarter, which is fairly dramatic. UK banks and subsidiaries of foreign banks were not nearly so volatile. The Bank of England research found it made the credit crunch worse, since foreign branches had accounted for one fifth of all lending before the crisis.

Foreign branches accounted for almost half of all banking assets in 2007, so they are particularly important in Britain. It's down to about 30% as of 2012, but that is still twice as important compared to any other country - the closest are Belgium and Luxembourg, where branch assets account for about 15% of banking assets.

But, for those foreign banks that don't take retail deposits so the taxpayer isn't on the hook, these proposed regulations could make it easier to operate as branches. If they meet the newly specified criteria, including a key one of who pays for resolution in the case of collapse, then becoming branches which are cheaper to operate would bolster London as an international financial centre. Mr Bailey mentioned that Chinese banks in particular could find it clearer as to how they operate as branches. This would support one of the government's aims of making London an offshore hub for the RMB, the Chinese currency.

The PRA comes down on the side of safety and says that even though the costs to set up in Britain will increase and slightly hurt competition, it's a price worth paying to have a sound banking system.

So, there may be several reasons to want to change the banking system and make it safer. Andrew Bailey says the government supports the principle of these proposals. It may, though, go against the government's push to attract more banks to the UK.

After the crisis, the UK retail banking sector shrank considerably and is down to just a handful of large banks. The government has been trying to boost competition in the banking sector, but with limited success. Business Secretary Vince Cable has pointed to the problem being not so much in mortgage, but business lending. In a speech last month, he said: "In mortgage lending we have plenty of competition, the real problem is business lending — they are terribly dependent on a handful of institutions, most of which are contracting their lending."

Even though these proposals may only marginally affect competition in banking, that task may just be that much harder.