Does Vicker's recommendation resolve the "too big to fail" issue?

Sir John Vicker

The UK is getting ready to begin the process of separating the nation's banks' "investment" and "consumer" businesses, implementing the so-called John Vicker Independent Commission Recommendations. British politicians keep talking about solving the "too big to fail" problem with this new legislation, which is to go into effect in its final form by 2015 (4 years earlier than originally proposed).

In addition to the bank "breakup" provisions, the rules would impose a 10% capital ratio for banks with another 7-10% of debt that could be converted into equity if a bank were to run into financial trouble. It all sounds great in theory, but a number of questions remain.

1. Bonds that convert to equity when a bank is in distress are the worst type of instrument for investors.  It has all the downside of an equity security but a limited upside of a bond.  That means the yield on these should be at least as high as equity returns. Therefore banks will not only be issuing large amounts of equity to get to the 10% capital ratio, but will also try to sell these equity-like securities. The UK banks will be raising capital at exactly the same time as the eurozone banks will be flooding the markets.  This is clearly going to present a challenge.

2. Since the new "consumer" portion of the banks will now be viewed as having implicit government support, it has the potential of creating "moral hazard". With competition growing over time, these units will provide consumers with below market funding - and we've seen how that movie ends.

3. The "consumer" unit will be responsible for small to medium size business loans. This would obviously include loans to real estate developers - because those tend to be medium sized businesses. In the US the bulk of FDIC insured bank failures have been due to commercial real estate loans to small and medium sized developers (single and multi-family housing projects, office buildings, shopping centers, etc.). Irish banks failed because of lending to construction firms in saturated markets - particularly in Dublin. Again we are setting up a system that will use its implicit guarantees to potentially create bubble markets.

4. The "investment banking" units will be immediately downgraded because they have no implicit support.

Bloomberg: Standard and Poor’s said Sept. 14 the elements of a bank outside the ring fence face a credit-ratings cut as they won’t be able to count on government support.

That's where all the loans to large corporations are housed. These units will have much more trouble funding themselves particularly in the current environment.  This should make corporate loans relatively expensive - in spite of them usually being better credit than consumer loans. But large UK corporations do not have to borrow from or conduct capital markets business (bond issuance, IPOs, etc.) with UK banks and will simply go abroad to obtain credit.  Swiss, German, US, Canadian, and Australian banks will have no trouble grabbing UK banks' market share for servicing large UK corporations. UK banks will simply end up shrinking or selling these divisions.

The UK's new financial services industry will look quite different - almost like a set of regulated power utilities.  But it's not at all clear this industry will no longer be "too big to fail".

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