Containing the virus

Oscar Wilde observed that “Life imitates art far more often than art imitates life”. Those watching Contagion, a new thriller that details the rapid spread of a virus globally, might agree as events in the financial world seem to be following the same script recently.

In the real world the “virus” seems to be emanating from Europe. European central bankers continue to debate bailing out one of their own and are trying to reassure the public that things are under control and will not spread. The UK seems to be focused on prevention as the Vickers report made recommendations to restructure the banks to ringfence the good bits of the institution in the event of future bad behaviour from the investment bankers.

The old adage “Beware of Greeks bearing gifts” has been turned on its head as European policymakers worry instead about “Greeks accepting gifts and not being able to pay for them”. While the latest plan to enhance the European Financial Stability Facility has passed through the European parliaments, each week brings politicians announcing new deadlines of just weeks to save the euro. Market concern may finally be translating into political will, as the G20 expect a solution at the European summit.

Whatever the outcome of this deliberation, there is a continuing challenge for investment strategists whose clients are looking for clear guidance and options. One UK fund manager expressed clients’ frustrations – “In the past if clients didn’t like the look of the markets they would simply park their money in cash, but at current rates that is unattractive. Or they would put their money into bricks and mortar, but the UK housing market is flat and finance is difficult to come by. So we are seeing people just staying put.”

For the banks this may not be a bad thing, as clients will tend to stick with the devil they know, especially if there are not compelling reasons to switch.

While managing quasi-global and regional responses to the crisis has taken up a lot of air time recently, many countries are looking to fix things closer to home. The Vickers Report from the UK’s Independent Banking Commission was released last month. It had been widely anticipated as the final judgement on whether the UK’s banks should be broken up in a wholesale re-enactment of Glass Steagall.

In the end, that did not happen. Instead, Vickers has opted for ringfencing: an approach which has higher capital requirements and more governance in place than separation of banking activities by Chinese Walls, but does not require banks to break up. Banks operating in the UK will have to put a robust ringfence around their retail and small business deposit and overdraft business. This ringfenced activity will have its own board and a higher capital requirement of 10 per cent of risk-weighted equity and loss-absorbing capital of 17-20 per cent.

Outside the ringfence will be securities trading, debt and equity underwriting and derivatives activity. Banks can then opt whether to put their other activities, such as consumer lending, trade finance, and so on, inside or outside the ringfence.

So, where does this leave the wealth management businesses of banks? The answer is in a rather uncomfortable position. According to Vickers, high net wealth (HNW) customers will likely have multiple banking relationships and so are better placed to withstand the shock of a single bank failure. Therefore, Vickers concludes, some HNWs will want to put assets outside the ringfence to access the markets and should be permitted to do so. In other words, it looks likely that HNW business will, quite literally, straddle the fence.

Vickers calls for regulators now to step in to place stringent limits on the type of customer and customer business that can be conducted outside the ringfence to avoid abuse of the ruling, but ultimately, it is likely the wealth management business in the UK will be divided into ringfenced and non-ringfenced activity.

Broadly, the reaction of the industry has simply been to look at the start date for the new regime – which is currently set for 2019 – then file it in the “not urgent” compliance category. However, there is a distinct danger that the detailed regulation on how to deal with different kinds of HNW business will run away if the industry does not get involved in consultation early on. If not, once again, client segmentation strategies and the UK value proposition will be more strongly dictated by regulatory requirements than by what really matters: client needs.

Will policymakers rise to the challenge of credibly containing the Greek debt contagion? Will ringfencing prevent future trouble in the UK banking sector? Only time will tell.

Bill Yelverton is executive director at wealth management think-tank Scorpio Partnership