The future of banking

“My Government will bring forward measures to implement the recommendations of the Independent Commission on Banking”.  By speaking those words to the combined Houses of Parliament on Wednesday, the Queen heralded legislation that will change the face of UK banking as we know it.

The main reform, which has been widely discussed in the media, is the separation of Britain’s universal banks into two distinct legal entities: a ring-fenced retail bank accepting deposits from and making loans to individuals and small businesses, and an investment bank conducting riskier activities like proprietary trading.  It looks like some services, such as accepting wholesale deposits from large companies and local authorities, will be permitted in both types of bank, giving those organisations a wider choice of counterparty to deal with.

So would you prefer to lend your Council’s precious cash to a highly regulated retail bank or to a casino-style investment bank?  Phrased that way, the answer seems obvious.  But that simple analysis ignores the other major change to be included in what will probably be known as the Banking Reform Act 2013.  The Queen’s Speech briefing notes confirm that the Government intends to amend the priority of creditors so that in a liquidation scenario, retail deposits (and hence the Financial Services Compensation Scheme) will be preferred creditors and hence paid out first.

This looks likely to leave local authority wholesale deposits near the bottom of the pile for payout and susceptible to heavy losses in a windup – especially in a retail bank where the majority of the balance sheet could be preferred deposits.  This reform will be particularly notable for building societies where wholesale deposits are currently ranked above retail deposits, and effectively enjoy preferred status at the minute.

It could even be worse than that.  It looks like all long-term investments in banks will be treated as “bail-in debt” or “primary loss absorbing capital”, meaning that the regulator will be able to force losses onto investors even before a bank goes into administration, in order to prevent a failure and contagion in the wider banking system.  In the past this only happened to equity shareholders and subordinated bondholders.  Senior bondholders and long-term wholesale depositors now look likely to be in the firing line too.  If local authorities are considering making long-term investments in banks or building societies, perhaps under the Local Authority Mortgage Scheme, this is something to be borne in mind, especially as it looks unlikely that there will be any transitional protection for existing investments.

It’s not all bad news, though.  Banks will need to offer higher returns to compensate investors for the additional risks, and other reforms in the pipeline should make it less likely that banks will fail in the first place.  There is also plenty of time to consider the implications, for short-term investments at least, as the reforms are unlikely to be fully implemented until shortly before the early 2019 deadline set for Basel III.

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.