Rod MacLeod: Seeking stability through bank reforms will come at a price

TODAY, Edinburgh plays host to the latest in a series of public meetings being held across the country by the Independent Commission on Banking (ICB). The commission is seeking the views of consumers, businesses and industry professionals on a number of proposals to reform the UK financial sector, which it outlined in its interim report last month.

Foremost among the reforms are two proposals designed to make the UK financial services industry a safer place for all concerned. First, the main UK banks (HSBC, Barclays, Royal Bank of Scotland and Lloyds Banking Group) should be required to hold more core tier one capital equivalent to about 10 per cent of their risk-weighted assets.

In other words, the banks will have to ensure that they have enough capital squirrelled away to allow them to absorb any losses and stand on their own feet without government intervention in any future financial crisis. Second, the retail banking and investment banking activities of these "universal banks" should be ring-fenced by forcing the banks to split their retail and investment operations into separate subsidiaries, with each subsidiary required to raise their own capital independently of each other.

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In theory, this should make it easier to cut-off the bad arm of a bank if it's in trouble, rather than having to support it just to keep the patient alive.

However, the demand from the Business Secretary, Vince Cable, earlier this week for a "significant improvement" in lending to small and medium-sized companies (SMEs) highlights an inherent conflict between the commission's proposals to improve the stability of the financial services industry and the urgent need to get the banks lending again.

Under the commission's current proposals, bank lending is likely to decrease rather than increase. The cost to the banks of implementing the additional capital raising and operational restructuring requirements is likely to run into billions of pounds and no doubt some of that cost will be passed on to customers in the form of higher loan repayments for borrowers and lower interest rate deals for savers.

However, in basic terms, the more a bank lends, the more risk-weighted assets it has on its books (i.e. the loans) which means having to raise or keep more capital in reserve. Therefore, the simplest strategy for dealing with the increased cost of additional capital raising is to stop lending or start off-loading borrowers.

Admittedly, the government has a difficult role to play in encouraging the banks to start lending again through initiatives such as Project Merlin while at the same time ensuring safeguards are in place to reduce the risk of another collapse of the banking system.

Nevertheless, publicly flogging the banks for not lending enough while at the same time proposing measures which provide an incentive to do the exact opposite is a bit like pulling the rug out from beneath the banks' feet. The government needs to come-up with a better strategy for harmonising its objectives rather than the default-setting of using the banks as a political punch-bag.If banker-bashing was an Olympic sport then Team GB would be a sure-fire bet to bring home the gold medal in 2012 (the hardest job would be whittling down the volunteers from a cast of thousands), but the government isn't doing anyone any favours by openly turning the screws on the banks in the media. There's no argument that the rate of lending needs to rise for UK PLC to get back on its feet or that the UK banks have an express or at least a moral obligation to play their part in the economic recovery, if only as a "thank you" for keeping the banking system afloat.

It's also understandable that politicians have to be seen to be cracking the whip over the banks in addition to actually sorting out the financial mess. Nonetheless, by calling for increased lending while at the same time proposing conditions which will make it even more difficult for banks to lend, the government is setting unrealistic expectations and undermining all-too-fragile confidence in the banking industry.

A safe and stable banking system will undoubtedly reduce the risk of another bank bailout and lessen the strain on the public coffers, but we're kidding ourselves if we think that it won't come at a price.

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• Rod MacLeod is a senior associate in Tods Murray's banking and finance team