Fundamental changes needed to corporate governance of British banks

Published on Thursday, 03 November 2011 11:27
Posted by Scott Buckler

In its latest Review, the National Institute of Economic and Social Research publishes a paper by Dr. Angus Armstrong, Director of Macroeconomic Research at NIESR, that assesses the recommendations of the Independent Commission on Banking (ICB - the "Vickers Commission")


Dr. Armstrong concludes that while the recommendations of the ICB are a serious attempt to address what the Chancellor has called the "British dilemma" - the problem that the UK has one of the biggest financial sectors in the world but cannot afford to bear the associated risks - they do not go far enough, and in some areas miss the point.

Deeper and more fundamental reforms of the governance of banking and funding markets are required.
In particular:

- there is a strong case for full separation between retail and wholesale banking. Full separation, rather than just ring-fencing as proposed by the ICB, would have a better chance of addressing the severe corporate governance issues in banks
- moral hazard was at the core of the crisis. But there is a distinction between whether this is caused by executives and shareholders knowing that they are personally immune from heavy losses and whether, in particular, they expect governments to support failing institutions. If the former is the case, which we suspect, then changing he ownership structure of banks and legal responsibilities of executives is necessary.
- the ICB report largely ignores the role of shadow banking, which was to a large extent the proximate cause the crisis . Indeed there is a risk that tighter regulations on capital and liquidity will have perverse effects, and lead to the further migration of lending beyond the regulatory perimeter, to the shadow banking system.
- the ICB's reliance on competition to improve bank behaviour in both retail and wholesale markets is excessive. Given the informational asymmetries in key funding markets, and way in which the failure of those markets propagated contagion, it is essential that regulators do not simply apply a naive view that competition alone will lead to optimal outcomes but rather consider the public good aspect of well functioning funding markets.

Most important, however, Dr Armstrong argues that the ICB's recommendations place too much faith on regulators and regulations - some of which may not be operational in the "fog of war". There will only be a real reduction in excessive risk-taking when the personal incentives of those in the industry to take excessive risk are reduced. This requires a fundamental reassessment of the formal and informal institutional environment - corporate ownership and governance, the structure of markets, and even ethical standards.


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