Implications of Vickers report for LA treasurers

It’s common knowledge that the Government intends to divide the UK’s big universal banks like Barclays, HSBC and RBS into investment bank and retail bank companies.  This was one of the central recommendations of the recent Vickers report, and is intended to simplify and speed up the resolution of a failing institution to stop a drama at one bank becoming a crisis affecting them all.  It is less well known that the Government also intends to amend the Insolvency Act to adjust the hierarchy of creditors in financial institutions; it is hoped that this will reduce the cost to the taxpayer of future bank failures.

While the Treasury is now fully committed to most of the Vickers recommendations, it is still consulting on the new creditor hierarchy.  Deposits insured by the Financial Services Compensation Scheme seem certain to become “preferred”, i.e. to rank above other senior unsecured liabilities in insolvency.  In addition to maximising the FSCS’s recovery from liquidation, this measure should also incentivise the remaining creditors, who will be on the hook for greater losses than before, to exert market discipline on banks’ behaviour.

The Banking Reform White Paper asks whether there is a case for preferring any other deposits, such as those belonging to foreign people, pension funds, local authorities or charities performing socially valuable activities.  I suspect most local authority treasurers will be saying “yes please”  rather loudly, referring to the reform’s objective of protecting public funds.  Depositor preference in Iceland has vastly increased the payouts for local authorities from Glitnir and Landsbanki above the 30% levels that were being whispered about in the early days, and at first glance, it seems an obvious thing to be in favour of in the UK.

But there are some downsides to consider.  First of all, banks will certainly pay less interest on preferred deposits and more interest on the remaining newly subordinated liabilities, with a view to keeping their overall funding costs broadly unchanged.  We know that there is a spectrum of risk and return, and creditor hierarchies are a good example of this.  Receiving next to no interest in return for a greater recovery in the unlikely event of default may not fit with your Council’s attitude to risk and return.

Asking for special treatment could also raise the issue of competence.  The European Commission recently questioned whether local and regional authorities should retain their professional client status under the Markets in Financial Instruments Directive.  The representatives of UK local authorities lobbied to keep the status quo, citing Councils’ knowledge, expertise and ability to assess risk.  The Government correctly believes that individuals with a few thousand pounds of savings are not best placed to evaluate the relative safety of different banks, and therefore need protection.  Multi-million pound investors, including local authorities, can reasonably be expected to exert some market discipline on banks or to move their money out if they are uncomfortable with the risks being run.  How many treasurers really want to claim that they are only as competent as my grandmother at managing money?

In coming to a final decision, the Government will also consider the wider market issues.  The benefits to the FSCS of being a preferred creditor when it stands in for retail depositors will be diluted if more people get the same status.  Just like priority boarding at the airport, if everyone gets special treatment, it’s the same as no-one getting it.  I can also see other wholesale depositors requesting preference for their cash investments too.  Universities, housing associations, NHS trusts, outsourcing firms, care home providers and utility companies all perform socially valuable activities too, often with public funds.  They would have a good case for equal treatment with local authorities and charities.

The Government is seeking your views, and I encourage anyone with an opinion to respond to the consultation, which can be found here.

David Green is Head of Sterling Consultancy Services, a provider of treasury management advice to local authorities and other not for profit organisations.  This is the writer’s personal opinion and does not constitute investment advice.  It should not be relied upon when making investment decisions.