COMPARING FINANCIAL SYSTEMS

Lesson 3 The UK financial system 1 What you will learn in this lesson

 Overview of banking system in the United Kingdom.  The features and changes of banking sysyem.  The features and changes of building societies. The banking system in the UK

 The financial system in the United Kingdom is a typical market-oriented system, in the sense that markets play an important role.  However, the UK system is characterized by much less regulation than that in the US.  The City of has traditionally been a major center for international banking and finance.  The foreign and domestic sectors of the banking industry are roughly equal in size.  This large foreign presence may partly explain the large ratio of banking assets to GDP.  Although there was no equivalent to the Glass-Steagall Act, until the late 1990s the domestic sector was divided into commercial banking and (merchant banking, in UK terminology).  Currently, however, most in the UK offer very similar services, distinguished only by differing interest rates. The banking system in the UK

 In the 20th century, with the outbreak of World War I, UK banking flourished and the so-called ‘’’’ (the five largest UK-based banking groups) commenced a series of takeovers and mergers.

 These banks (Westminster, National Provincial, , Lloyds and Midland) were eventually reined in by government control.

 Between the wars, however, there was a decline to match the general depression of the time.

 But the banks fought back by taking action to recruit less wealthy customers and by introducing small saving schemes.

 Only in the 1950s there was a real recovery, with a huge increase in provincial branch offices and the emergence of the high street (large retail banks with many branch locations).

 Relaxation of some controls over mergers and acquisitions led to consolidation in the 1960s. The banking system in the UK

 The Big Five became the Big Four, along with the takeover of several regional banks (Martins, , , Glyn Mills and William Deacons).

 At the same time the government launched a new banking service, the National Girobank.

 In 1976 the Banking Act increased the supervisory role of the Bank of .

 Introduction of computing, credit cards and many new services continued to drive the expansion of banks and as deregulation was introduced competitiveness increased.

 Banks improved services, refurbished antiquated premises and brought in further technology such as ATM. The banking system in the UK

 In 2010, more than 300 banks and building societies are licensed to accept deposits in the United Kingdom.

 However, the provision of services is highly concentrated.

 Of the 16 clearing banks present in 1960, fifteen are now owned by the four big UK banking groups: RBS, Barclays, HSBC and (LBG)

 These banks, along with Nationwide and Santander, together account for almost 80% of the stock of UK customer lending and deposits.

 Collectively, however, the four largest groups account for a smaller share of the market for these services than the banks from which they originated. The banking system in the UK

 In last years the UK banking has been impacted by major shocks.

 These include the turmoil of the 2007–8 global financial crises, the 2011 euro sovereign debt crisis, the mis-selling of payment protection insurance (PPI), LIBOR, FX and other rate fixing scandals.

 As a consequence of these ‘shocks’, the UK banking has suffered big losses, forced significant government intervention and led to major regulatory reform.

 The scale of government intervention has been unprecedented and has included three main types of intervention:

1. guarantees for bank liabilities;

2. recapitalisations;

3. various asset support measures. The banking system in the UK

 Total state support to the UK banks between 2008 and 2013 amounted to 19% of the country’s gross domestic product (GDP).

 Around €191 billion was for guarantees and other liquidity measures and the remainder went to recapitalizations and asset relief (€140 billion).

 The significant injection of state funds, coupled with subsequent regulatory reforms (including moves to adhere to Basel III capital and liquidity requirements) have aimed to boost banking system soundness, limit excessive risk-taking, and improve banking sector conduct.

 A new bank resolution regime has also been put in place.  The authorities have also been active in promoting new bank entrants, known as “challenger” banks to compete with the Big Four.  There has also been ongoing investigation into the competitive nature of the UK banking, most recently highlighted by the findings of the Competition and Markets Authority (CMA) report on retail banking (2016). The banking system in the UK

 This highlights the authorities desire to increase competition in the system, especially in the light of the high degree of market concentration in certain sectors of the banking business (especially personal and small and medium-size enterprise (SME) areas.

 It also illustrates concerns over “too-big-to-fail” or “too systemically-important- to-fail” issues that surround the largest banks.

 In fact, the big four banks all had consolidated assets greater than national GDP. The banking system in the UK

UK-based banks  This sector has traditionally been dominated by the big four clearing banks: Barclays, HSBC, Lloyds Banking Group, The Royal Group.

Foreign banks  London's role as an international financial center means that the foreign sector is roughly the same size as the domestic sector.  With a few exceptions, such as , foreign banks are not involved with the domestic market.

Building societies  The primary role of these institutions historically was to provide mortgages.  Deregulation allowed them to expand their activities into other banking activities.  This has prompted many to change from a mutual form into banks in recent years. Other major financial sectors

Pensions funds

Public  This covers all residents, with a lump sum for everybody. There also exists a component linked to average earnings during working life, but this can be opted out of. However, it has low replacement ratio. Private  Largely defined benefit based on final salary. Provisions for total or partial indexation are common (75% of participants).

Insurance companies  Provided by bank subsidiaries as well as insurance companies.  The industry is highly fragmented and lightly regulated.  Lloyds exchange is important for domestic and international syndicates. UK-based banking

 Today the big four clearing banks are essentially universal banks and provide a wide range of banking services to consumers and firms.

 Some have moved into life insurance, travel services, real estate, and trust management.

 They also offer underwriting and other services through wholly owned subsidiaries.

 The regulations on the activities they can undertake are limited. Some restrictions

 The only restriction with regard to securities activities is that gilt-edged market making must be conducted through a subsidiary (gilt-edged securities are bonds issued by the UK Government).

 There is not even a restriction requiring firewalls between different parts of the bank.

 For insurance subsidiaries, they cannot count their investment as part of their capital, but apart from that, insurance activities are unrestricted.

 Real estate investments are unregulated.

 Banks can invest in the equity of nonfinancial firms and vice versa. Building societies

 These financial institutions were originally formed to help people buy homes by supplying mortgages.

 Therefore, many were mutual organizations.

 In the past, their activities were fairly closely regulated by the Building Societies Commission.

 These regulations have gradually been relaxed, and building societies have essentially become competitors to the big four.

 Many have changed from being mutual organizations to shareholder- owned banks. Banking sector

 The UK banking sector has traditionally been highly segmented.

 The usually allocates institutions to whom had granted a banking licence to one of seven sections, reflecting their function (‘retail banks’, ‘accepting houses’, ‘discount houses’ and so on).

 However, what we think of as ‘a bank’ is often just one division (usually the retail division) of a much larger banking group.

 The group as a whole offers a full range of banking functions and even a variety of financial services, like asset management, which we would not usually think of as part of banking at all.

 Barclays Group, for example, is a large conglomerate which operates a retail banking division alongside corporate and investment banking and asset management functions. Deposit-taking and lending services by the clearing banks in their 1960 and 2010 forms Banking sector

 In these circumstances, we can still distinguish between different types of banking function or activity, but we should not think about these activities being the sole activity of a particular firm. 

 There are some investment banks in the UK which specialize only in that activity but most banks are parts of a much larger group which offers everything.

 The Bank of England publishes the list of banking licence holders in its Annual Abstract of Statistics.  In this list, banks are classified by their ‘nationality’ (the location of their headquarters).

Liquid reserves

 Considering liquidity risk, the first thing to notice in the UK banking system is the very small ratio of instantly available ‘liquid reserves’ to the rest of the balance sheet.

 But this figure does not strictly correspond to ‘reserves’ since the figure for ‘Balances at the Bank of England’ includes ‘cash ratio’ deposits.

 These are deposits which banks must maintain at the Bank of England, to 0.15% of their assets, in order to generate income for the Bank.

 By adding ‘Operational deposits’ to notes and coin to calculate a ‘reserve ratio’ (reserves/deposits), it amounts in average to just 1% of sterling deposits and to about 0.5%, if we include foreign currency deposits (including euro).

 In the UK this ratio is only a ‘prudential ratio’.  It is chosen by banks themselves in the light of what experience tells them is a safe minimum. Banking regulation

 In UK there is a requirement, however, that any bank that intends to change this ratio should give prior notice to the Bank of England so that the Bank is always in a position to form a view about the likely availability of liquid assets relative to banks’ requirements.

 This ratio is usually higher for retail banking divisions (around 2%) and lower for non-retail banking.

 Such a very low reserve ratio makes the availability of ‘second tier’ liquidity very important.

 In the UK this is provided by ‘market loans’, ‘repurchase agreements’ and ‘bills’. ‘second tier’ liquidity

 Market loans are loans to the interbank and other money markets, many of them for very short periods or even overnight.

 The latter can be liquidated on demand or ‘at call’.

 Repurchase agreements (when listed under ‘assets’) are loans that have been made, again usually to other banks or other financial institutions, by ‘buying’ assets (usually government bonds) from the borrowing firm on the strict condition that the borrower will repurchase them within 14 days at a higher price.

 Bills are short-term money market securities with an original maturity, usually of three months.

 By holding a range of ‘repos’ and bills, banks can ensure that they have a continually maturing stock of interest-earning assets which provide them with a constant flow of funds.

 In a real emergency, a fraction of these assets can be easily liquidated at a moment’s notice. Banks’ assets

 The bulk of banks’ earning assets are held in the form of loans or ‘advances’ to the ‘non-bank, non-building society private sector’ (‘M4PS’).  ‘Investments’ refers primarily to securities and most of these are short-dated government bonds.  Sterling business and foreign currency business account for about 45% and 55% of the total, respectively, of the banking system as a whole.  In retail banking, however, foreign currency deposits make up less than 25% of the total, while wholesale banking foreign currency business accounts for about 70%.  Obviously, retail banks are central to the payments mechanism.  For this reason virtually everyone needs a bank sight deposit account and sight deposits make up about 50% of retail bank deposits.  But for wholesale banks, deposits are much more likely to be time deposits.  Consequently the degree of ‘maturity transformation’ undertaken by wholesale banks is less than it is for retail banks and this partly explains why wholesale banks can operate with smaller reserve ratios than retail banks. Banking supervision

 Until 1998, supervision of the UK banking system rested with the Bank of England, under the terms of the Banking Act (1987), which required the Bank of England to exercise the following powers:

 licensing of all deposit-taking institutions (except building societies);

 ensuring that institutions have adequate capital, liquidity and controls;

 ensuring that they make adequate provision for bad debts;

 checking that directors of banking institutions are ‘fit and proper persons’.

 In 1997, however, the Bank of England was given ‘instrument independence’ for the conduct of monetary policy.

 To avoid conflicts of interest, the supervisory powers were transferred from the Bank of England by the Bank of England Act (June 1998) to a newly established Financial Services Authority (FSA) which will eventually be responsible for the supervision of all financial intermediaries.

Banking reforms

 The UK authorities have introduced extensive reforms aimed at making the banking sector more resilient to shocks, easier to fix when faced with problems and also reducing the likelihood and severity of future financial crises.  As in the case of the US and the EU reforms, the aim is to make sure that taxpayers do not have to bail out troubled banks and that retail customers are least affected by banking crises.  Minimizing the likelihood of bank runs

 The main structural reform has been the Financial Services (Banking Reform) Act of December 2013, where the legislation aims to improve bank loss-absorbing capacity and also to ring-fence retail and wholesale banking activities.  Increased loss absorbency relates to the UK banks having to comply with regulatory capital requirements that are higher than the measures proposed by Basel III. Banking reforms

 Ring-fenced banks will be required to have a ratio of equity to risk-weighted assets of at least 10 %, compared with an EU-wide requirement of 7 %.

 In addition, the legislation seeks to impose higher standards of conduct on the UK banks.

 The legislation enacts the recommendations of the Independent Commission on Banking (the Vickers Commission) set up by the government in 2010 to consider structural reform of the banking sector.

 It also introduces key recommendations of the Parliamentary Commission on Banking Standards, which was asked by the government to review banking conduct (professional standards and culture) in the banking industry.

 The Act impacts on all the UK banks that have more than £25 billion of deposits (just the largest five banks (Barclays, Lloyds, HSBC, RBS and Santander UK). Banking reforms

 By mid-2016 all these major banks were in the process of finalizing how their activities should be separated, with much legal discussion as to what parts of the bank should be inside or outside the fence.  Ultimately, they have to shift their retail operations into separate subsidiaries legally apart from investment banking activity, with 2019 as the deadline date.  The main objective of the ring-fencing is that in the event of extreme stress an institution can be recovered or, in the event of failure, rapidly resolved and so reduce the likelihood of contagion through parts of the same banking group.  The new legislation imposes higher standards of conduct on the UK banks by introducing criminal sanctions on bank employees if their actions lead to bank failure.  The legislation also gives depositors, protected under the Financial Services Compensation Scheme, preference if a bank enters insolvency.  Depositor protection stands at £75K (£150k for joint accounts) in line with the €100k in the EUs Deposit Guarantee Schemes Directive. Banking internationalisation

 Banking, like most forms of financial intermediation, is increasingly an international activity in the UK, too.  Banks with headquarters in foreign countries may obviously operate subsidiaries in the UK.  Thus, much effort in recent years has gone into the international coordination of banking supervision.  The capital tests imposed by the FSA are enshrined in the EC Capital Adequacy Directive (1996).  These are based upon recommendations of the ‘Basel Committee’ in 1998.  In accordance with the EC Second Banking Coordination Directive (1993) branches of banks with headquarters in other EU states are permitted to operate in the UK on the strength of the licence issued in the home country.  Vice versa, FSA is responsible for the supervision of branches of the UK banks operating in other EU countries on the strength of the licence issued in the UK by the FSA. Recent banking changes in UK

 Banks in the UK have been subject to pressures for change which affect banks throughout the western economies, although the results have not always been the same as in other countries.

 The most noticeable trends in recent years have been:

1. the increasing automation of banking services;

2. the concentration of the industry through merger and acquisition (a European and North American trend);

3. the closure of branches (a rather more peculiarly British development involving mainly retail banks).

4. the increasing use of securitization. The concentration process

 Though strictly dependent upon cost structures, merger and consolidation is a feature of most maturing industries and it has been a characteristic of banking since the earliest days.

 This partly reflects the economies of scale that are present in most financial activity.

 But it is also partly a product of the benefits of diversification and, until the early twentieth century, it also reflected the increasing integration of the national economy in the UK.

 When trade was local and then regional, a regional banking system was perfectly adequate.

 But when markets became national and trade and payments went from one end of the country to the other, a national network of banks had obvious attractions.

 Hence the history of the current big four is a continuous history of absorption of the smaller by the larger. Consolidation of the UK banking sector 1960 to 2010 The concentration process

 However, the economic need for a national banking system in the UK was met some years ago.  With the top four banking groups holding 60% of the UK sight deposits, the question confronting further mergers is whether the process has gone too far when it comes to competition and consumer choice.  So, in 2000, the merger between the and NatWest was accepted by the competition authorities.  But of the two further mergers proposed in 2001 ( with Bank of Scotland and Lloyds-TSB with ) only the former was allowed.  In UK, the integration of the national economy can hardly be called on to justify the continuing trend to consolidation and we maybe have to look to economies of scale and diversification as the driving forces.  But before doing so, it is worth considering whether the demands that originally flowed from national integration might be replaced by those that flow from international integration. The closure of branches

 The reasons for the closure of branches in UK are twofold, though both are closely connected with the increasing automation of basic banking services.  Firstly, it is now possible for clients to carry out many of their banking operations by telephone and by internet.  There is therefore some truth in banks’ assertion that the decline of branch banking is demand-led, by customer preference.  However, it is interesting to note what is happening in branches that have remained open and in particular in those into which banks have put most investment.  This suggests that there may be other advantages (to banks and their shareholders) and that banks may not be simply following customer preferences.  The branches into which banks have put most development effort are in major centres of population.  No doubt this reflects the familiar banking economies of scale again.  But it also means that these branches are open to a large potential market for a whole range of financial products and services. The closure of branches

 The downside of all this is the restricted access to banking services for those who live away from major centres and do not have access to internet.  This, together with banks’ understandable desire to target their products and services at their most affluent customers, has led to public concern in UK that sections of the community (typically the poor and the elderly) are in danger of suffering ‘financial exclusion’.  A more immediately pressing issue has been the plan by the UK government to pay social security benefits directly to bank accounts (rather than in cash over a Post Office counter).  This clearly raises the question of how the ‘non-banked’ public is to receive these payments.  The closure of bank branches has been a trend largely confined to retail banks, which traditionally relied upon branches as the ‘gateway’ through which customers accessed banking services.  It is of little relevance to wholesale banks. Building societies

 The history, function and regulation of building societies distinguishes them quite clearly from banks.

 Building societies began in the eighteenth century as friendly or mutual societies, often with a local focus, into which members made periodic payments in order to finance the building of houses.

 Unlike banks, a society has no shareholders.

 Its members are the ‘owners’ and they lend to the society by buying shares, though these shares are, in effect, deposits.

 In the early days, it was quite common for building societies to be dissolved once their specific house building programme was completed.

 Some, however, became ‘permanent’ societies, adopting a continuous programme of housing construction and finance.  It is these that have survived to today. The history of building societies

 The history of the societies is important because it explains why, although in many respects it seems natural to treat them as a form of bank, they have been able to behave rather differently from banks and have been subject to different regulatory regimes.  Because they were mutual societies, their regulation was for many years the responsibility of the Registrar of Friendly Societies.  Because they were not companies, their trade association, the Building Societies Association, was able for many years to operate a system of ‘recommended’ deposit and mortgage (interest) rates without contravening restrictive practices legislation.  These were usually below market-clearing rates and thus provided comparatively cheap funds for house purchase but also created queues for mortgages and led to non-price rationing.  The interest rate cartel broke up in 1983 following the entry of retail banks into the mortgage market. Building societies today

 Today they are deposit-taking institutions.  Since 1989, when M4 replaced M3 as the official measure of broad money in the UK, their deposits have been unambiguously ‘money’.  Together with UK banks they form what the ECB refers to as the UK’s ‘Monetary Financial Institutions’ (MFIs).  However, for most of the 1980s, the treatment of building society deposits was something of a problem.  Undoubtedly depositors themselves saw the deposits as money.  They could go into a building society branch and draw cash on demand.  For larger purchases they could obtain, also on demand, a signed by the manager payable to whomsoever they nominated.  In the first case, though, it was the cash that was money while in the second case careful examination of the cheque would show that it was drawn on the building society’s bank.  It was the building society’s bank deposit that was functioning as money, not a deposit with the society itself. Building societies and banks

 Competition between banks and building societies drove their products closer and closer together during the 1980s.

 Eventually, the Building Societies’ Act, in 1986, removed some of the formal distinctions.

 Most importantly it allowed building societies to issue cheque guarantee cards (so their own deposits became instantly acceptable as means of payment).

 It also provided for societies to ‘incorporate’ themselves as banks.

 At the time, building society deposits were included in a measure of ‘liquidity’, ‘PSL2’, but not in M3. Building societies and banks

 After the 1986 Act this differential treatment of building society deposits became very difficult to sustain.

 A change was finally forced by the decision of the Abbey National Building Society, at the time the second largest society, to convert to banking status in 1989.

 This would have meant an overnight increase in M3 of about 11%.

 This large break in the series persuaded the Bank of England to discontinue publication of the M3 measure and to treat M4, first published in 1987, as a replacement for PSL2, as the official measure of broad money.

 Thus, from a monetary point of view, the societies have become indistinguishable from banks. Building societies’ assets

 The building society movement is only a fraction of the size of the banking system.

 Just like bank deposits, building society deposits are used as means of payment.

 So, building societies must be ready to meet demand for convertibility to cash and for transfer.

 Banks, as we saw, do this by holding cash and very small balances at the Bank of England.

 By contrast, building societies rely much more on deposits.

 But these deposits are held with the banking system rather than with the Bank of England and are generally interest-bearing.

 In spite of the freedoms conferred under the Building Societies’ Act (1986), the bulk of assets remain mortgages secured on residential property.

 Much of the rest is secured on land or other property and only a little part is unsecured lending to members. Building societies’ liabilities

 Deregulation has had slightly more impact on societies’ sources of funds.

 Liabilities remain overwhelmingly members’ deposits but some a little part consist of wholesale funds, if we assume that building society bonds are largely held by other financial institutions.

 During the 1980s, building societies found themselves under increasing competitive pressure.

 There was competition within the industry following the ending of the interest rate cartel in 1983.

 But there was growing competition too from retail banks. Building societies’ liabilities

 Societies responded with a number of innovations.

 They introduced new types of deposits which paid premium rates of interest for regular contributions and for minimum balances.

 They introduced cheque book facilities and automated cash dispensers.

 Nonetheless, it was felt, firstly by the societies, but eventually by government, that the existing rules, dating from the eighteenth century, put societies at a disadvantage when compared with banks, and created an artificial segmentation of the loan/deposit market which inhibited competition.

 The existing rules restricted societies to lending only on houses or similar property.

 They could not make unsecured loans and thus could not permit overdrafts. References

 Bain K., Howells P., The Economics of Money, Banking and Finance. A European Text, Pearson Education, 2008, ch. 3  Allen F., Gale D., Comparing Financial Systems, MIT Press, 2001, ch. 3