UK Banking After Deregulation (RLE: Banking & Finance)

Andy Mullineux

• Publisher: Routledge
• Year: 2012
• Print ISBN: 9780415526722
• eBook ISBN: 9781136300905
• Edition: 1
• Topic: Economics
• Subtopic: Business General
• Index: Economics

How does financial deregulation affect the operation of the banking system in the UK? What are the consequences of the development of an electronic banking system? This book addresses these and other important questions in a survey of UK change in the financial sector and in banking in particular.

Attention is given to the role of building societies after the 'big bang' and the implications for retail banking of competition in the housing finance market. Both the long and short term implications of regulatory reform for banks are dealt with together with the role of the Bank of England and what the changes have meant in terms of international banking. Concentrating on the three main areas of change deregulation, regulatory reform and technical innovation the book is an important pointer to the shape of banking in the late 1980s and early 1990s.

Chapter One

DEREGULATION : AN INTERNATIONAL PERSPECTIVE

1.1Introduction

At the outset it is worth stressing that the terra deregulation, in the context of banking and financial systems, has adopted a wider meaning than its literal one. Historically, banking systems have been among the most heavily regulated sectors of most economies. This is because they have come to be regarded as unstable as a result of historical episodes such as the Great Crash in 1929 and the bank failures in the US in the 1930s. There is, however, a difference of opinion concerning the extent to which banking and financial systems are inherently unstable. Some economists (1) argue, for example, that periods of financial instability merely reflect underlying economic instability and that it is the economic, rather than the financial, system that is inherently unstable. The financial revolution that is spreading across the globe admittedly involves a sighificant amount of genuine deregulation or liberalisation, in the sense of the relaxation of restrictions, imposed by monetary authorities, on the provision of financial services and the freedom of movement of money and capital across national borders. The term deregulation has also come to be used to cover financial innovations (2), or what is sometimes called product deregulation. These innovations have been made possible by technological innovations in the financial sector, which have made use of rapidly advancing data processing capabilities and developments in international telecommunications systems. Incentives to introduce new financial instruments have come from the high inflation rates of the 1970s and the interest rate instability that resulted from the increased emphasis given by the monetary authorities of the major industrial countries, in the second half of the 1970s and the first half of the 1980s, to controlling the money supply as a means of reducing inflation. Another incentive has been the variability in exchange rates, following the introduction of floating exchange rates in the early 1970s (3), which in turn has added to interest rate instability because some countries have manipulated interest rates to influence their exchange rates, especially in times of crisis. The causes of financial innovation will be discussed further in Section 1.4

Financial innovation has led to an unbundling of services allowing banks to pursue more fee earning business in place of their traditional lending. Banks have progressed; from lending to placing first Eurobonds, then fixed rate Euronotes, then Floating Rate Notes (FRNs), and then offering Nifs, Rufs and Swaps (4) and ultimately to placing commercial paper. This process has become known as securitisation and it has led banks into closer involvement with the capital markets and allowed them effectively to make their loans tradable. It is a feature of the 1980s and was encouraged by the revised assessment of country risks following the 1982 Mexican debt crisis. Another contributory factor has been the growing sophistication of the treasury departments of their major, especially the multinational, corporate clients, which have sought instruments that will hedge against exchange and interest rate fluctuations. The process of securitisation has led to the development by banks of off balance sheet risks (5) because instruments such as Nifs involve contingent liabilities and they have thus explicitly or implicitly been underwriting these instruments. This has been of great concern to bank regulators (6) who have encouraged banks to provide capital backing for some of their off balance sheet risks, see Chapter 5. The rapidly developing US and Euro commercial paper markets, as well as the nascent (7) UK market, raise the possibility that major corporate clients may increasingly bypass the banking system altogether. The banks have so far managed to gain fee earning business by placing the paper (8) and by providing back up credit lines, which again involves them in off balance sheet risks.

These developments have led to a decline in the international syndicated loan market (9) and a merging of the capital and banking markets into a global pool. The banks have been losing their close relationships with corporate clients as competition has increased, between international financial institutions, for business. To retain corporate custom the major international banks have had to develop new financial instruments to match increasingly sophisticated corporate needs. Their international operations, developed significantly in the 1970s (10) have had to adopt an increasingly global perspective. Financial futures markets have been developed and the money and capital markets have become increasingly globalised, as twenty four hour trading, revolving around Tokyo, London and New York, has evolved. This first became a reality in the foreign exchange markets but latterly the capital markets have been considering the possibility of developing twenty four hour global trading in the shares of major companies.

There has thus been a certain amount of deregulation, in the sense of financial liberalisation, but there has also been a great deal of financial innovation involved in the financial revolution. The term deregulation will, in line with current usage, sometimes be used to cover both liberalisation and product deregulation, or innovation. Elsewhere it will be necessary to draw a distinction between deregulation and innovation. It should be stressed that there is a certain amount of re-regulation, or regulatory reform, going on. The regulatory apparatus for the financial system is receiving a major refurbishment in the UK for example, see Chapter 5. Also, as noted above, new regulatory requirements are being developed to cover off balance sheet risks. Deregulation does not therefore entail the abandonment of regulation and supervision of the financial system. It certainly makes supervision more difficult, by increasing the risk of incidence of fraud and bad practices, such as insider trading (11). The supervisors are, however, doing their best to keep abreast with developments by bolstering supervisory departments (12), increasing bad debt and capital requirements, and co-ordinating their efforts (13). The banking supervisors have made most progress towards co-ordination and exchange of information but the supervisors of the securities exchanges have also woken up to the need for increased co-operation (14). Given the merging of capital and banking markets these two groups of supervisors will also need to co-ordinate their efforts in the future and seem to be aware of this (15). They have the common objective of increasing the efficiency of the financial system whilst ensuring that crises do not occur which would force them to provide lender of last resort cover.

1.2Deregulation of International Banking

White and Vittas (1986) review the deregulation, in the sense of the removal of long standing barriers to trade in financial services, in the international financial system that has occurred so far and assess future prospects for further deregulation. They note that the barriers being eroded includes those relating to domestic operations (16); restrictions on capital markets and exchange controls; and restrictions on foreign bank entry and the activities of foreign banks in domestic markets. Despite the various advances, the issue of restrictions on trade in services, financial or otherwise, has become a live one in international politics and has generated a great deed of wrangling in the preparation for the next round of multilateral Gatt negotiations. In September 1986 the participating nations agreed that the forthcoming Gatt negotiations would cover trade in services for the first time. Even within the European Community, restrictions on trade in, especially non-banking, financial services remain and the European Commission (1985) introduced proposals for further liberalisation.

The financial liberalisation that has so far occurred has not resulted from multilateral negotiations. There have been sane bilateral negotiations, however. The most notable were those involving Japan and the US in 1983 and 1984. The US encouraged Japan to introduce deregulatory measures designed to promote the yen as an international currency in order to encourage a depreciation of the dollar with respect to the yen. There have also been negotiations involving British and Japanese monetary authorities concerning the access of financial institutions from one country to the other's financial markets (17). In general the deregulation has been prompted by concern about loss of business to less regulated, and especially offshore, centres and to the major financial centres, Tokyo, London and New York. But monetary authorities have also wished to encourage the development of more efficient financial systems.

Entry restrictions are the most visible examples of protectionism. Until the 1980s a number of major OECD (18) countries prohibited entry to domestic banking markets by foreign banks. Such controls have been removed in Norway (1985), Sweden (1985), Australia (1985), New Zealand (1985) and Canada (1980) and Japan, which granted securities licences, to a number of foreign investment and merchant banks and brokers, and trust banking licences, to nine foreign banks, in 1985. Blanket entry restrictions are now rare amongst industrialised countries, Iceland being the only OECD member country maintaining such restrictions. They are more prevalent amongst developing countries and, of course, remain intact in the Soviet bloc. Some industrialised countries continue, however, to restrict, formally or informally, the size of the foreign banking sector. Australia granted a total of 16 licences in 1985, for example, and Canada's foreign banking sector's assets are restricted to 16% of those of the domestic banking sector. There are proposals to remove the latter restriction. Elsewhere, in countries such as Italy, whose banking system is largely publicly owned, branching restrictions have inhibited foreign bank involvement. In 1985, however, Citibank (19) was permitted to buy into a small Italian bank. It thereby became the first foreign bank with a significant share in a branch network.

Once established, and often regardless of whether or not they are locally incorporated, which they are sometimes required to be, foreign banks still have restrictions imposed on the range of business they can undertake in some industrial countries. These too have been reduced. Germany allowed foreign banks to lead manage D.Mark Eurobond issues in 1985, for example, and Holland permitted foreign banks to lead manage Guilder Eurobond issues in 1986. Then in 1986 Germany invited foreign banks (20) to participate in the Federal Bond Consortium, which places government and other public sector bonds.

Additionally, foreign banks may face relatively strict regulatory requirements because they are often treated as self contained institutions in the enforcement of prudential liquidity and capital requirements by monetary authorities. They also have to comply with local regulations, which may be stricter than those in their country of origin. Canada, Japan and the US separate investment banking, which involves the provision of corporate advice, securities trading, underwriting and fund management, from commercial banking, which involves deposit taking and lending. The Japanese also separate investment banking from trust banking, which largely involves fund management. In contrast, Germany and Switzerland have long established universal banks which combine commercial and investment banking functions and banks in many European countries, most notably France and the UK, have been becoming more like universal “banks since the 1970s. The restrictions in Japan, Canada and the US make entry into investment or commercial banking difficult for foreign banks which directly, or through subsidiaries, offer both investment and commercial banking services.

Such restrictions have raised the question of reciprocity, given that Japanese and US banks are permitted to engage in both investment and commercial banking, regardless of their domestic restrictions, in the UK and Germany for example. It was this that led to the negotiations between the UK and Japanese monetary authorities. Japanese securities houses were applying for UK banking licences which would have permitted them to undertake commercial banking business in the UK whilst UK banks were applying for securities licences in Japan. The Bank of England, in accordance with the Basle Concordat (21), wished to ensure that the investment banks were supervised by their domestic banking authorities. They were, however, regulated and supervised by the Ministry of Finance's Securities Division, rather than its Banking Division. Meanwhile UK banks and broking institutions were experiencing problems in their attempts to gain securities trading licences in Japan, the former because of the separation of investment and commercial banks there. An agreement was eventually reached between the monetary authorities of the two countries in 1986. UK commercial banks managed to gain entry by establishing subsidiaries that were part owned by non-banking companies (22). Reciprocity is currently actively pursued by Canada, the UK, Switzerland, Germany. In the UK a reciprocity clause was included in the Financial Services Bill, which is due to became law in 1987. During negotiations with the Japanese monetary authorities, the Department of Trade and Industry threatened to bring legislation on the relevant clause forward. Germany, meanwhile, has only invited foreign banks from countries offering reciprocal access to its own banks to lead manage D. Mark Eurobond issues and participate in the Federal Bond Consortium. Japanese banks have consequently not been invited to join the consortium.

The threat of losing business may eventually force convergence on Japan, Canada and the US. Japanese monetary officials have made statements encouraging further domestic liberalisation, and especially the removal of restrictions separating various types of banking business, which indicate that they are acutely aware of this possibility. The Deputy Governor of the Bank of Japan, for example, has warned that the rapid expansion of the international business enjoyed by the Japanese institutions may in the future be inhibited by the proliferation of reciprocity clauses, and that business may be lost to offshore centres, unless further domestic deregulation is achieved. In particular the opposition from the various groups of domestic banks to the relaxation of the regulations separating them must be overcome and interest rate controls must be further liberalised. There has been a liberalisation of controls on interest rates paid on large short term and long term deposits but this should, he urged, be extended to smaller savings deposits - despite opposition from some banks and the post office saving system, which enjoys tax advantages and is very popular, and government officials, who want to protect the latter because it provides a useful stream of funds for the government. From a prudential point of view he argued that it was desirable to encourage the return of business lost to offshore centres, especially relating to the Euroyen, in order to regulate it. Towards this end the authorities have also considered the promotion of Tokyo as an offshore financial centre. The US had experienced a similar loss of business offshore in the 1970s, as the Eurodollar markets grew apace, and was forced to respond by introducing International Banking Facilities (IBFs) , see below, to win back some of the lost business. Reciprocity itself has given an impetus to more rapid liberalisation but it also carries the danger that in a period of retrenchment it might have the reverse effect.

Credit controls, on the growth of bank lending for example, can also discriminate against foreign banks. Restrictions on the growth permitted are naturally related to past reference points and this can hinder foreign banks which naturally start from relatively low lending positions. Credit controls are often combined with interest rate controls. Most of the industrialised countries have, after a period of encouraging the development of their money markets, moved away from credit controls towards a system of monetary control based on open market operations and allowed interest rates to become more responsive to market conditions. In 1985, for example, the French Socialist government replaced the Encaderment System with a more liberal regime of credit controls and in May 1986 the newly elected non-Socialist government promised to relax the remaining credit controls. Also in 1985 Sweden and Norway freed banks from restrictions on lending and administered interest rates and so too did Italy, as part of an attempt to generate competition within the state controlled banking sector.

In France too access and competition between banks has been restricted by the level of state involvement. The big three banks have been nationalised since the war and there are other large state sponsored financial institutions. The Socialist government of the early 1980s nationalised most of the rest of the banking system in 1982. This followed a period in which the authorities had encouraged competition and diversification in the highly regulated banking system. It was felt at the end of the 1970s that rationalisation was urgently required. The Socialist government hop...

Table of contents

• Front Cover
• Half Title
• Title Page
• Copyright
• Title Page
• Original Copyright
• Dedication
• CONTENTS
• PREFACE
• CHAPTER 1: DEREGULATION: AN INTERNATIONAL PERSPECTIVE
• CHAPTER 2: REFORMING THE BRITISH CLEARING BANKS
• CHAPTER 3: THE DEVELOPMENT OF AN ELECTRONIC PAYMENTS SYSTEM IN THE UK
• CHAPTER 4: UK FINANCIAL DEREGULATION IN THE 1980s
• CHAPTER 5: SUPERVISORY RESPONSES AND REGULATORY REFORM
• CHAPTER 6: UK BANKING AFTER DEREGULATION
• REFERENCES
• INDEX