Wilfully misquoted report of the day

Various sources, including inevitably the banking shills at City AM are going in to bat for the banks:

FORCING structural reform on banks could slash the UK’s GDP growth by 0.3 per cent, according to an independent forecaster...

The Item Club, a body run by accountancy Ernst & Young, says in a new report today that proposals from John Vickers’ Independent Commission on Banking (ICB) will choke off credit to the UK economy, more-than-reversing last quarter’s anaemic growth of 0.2 per cent.

Vickers is preparing to release a report next Monday that will recommend forcing banks to ringfence their retail operations from their investment banking arms. Banks would have to capitalise the two subsidiaries separately, which the Item Club estimates will push up the cost of funding for investment banks by 100 basis points.

That in turn could cause “fragile” banks to increase the cost of their loans to corporates by 150 basis points...

For sure, the idea of splitting 'retail' banking from 'investment' banking is a nonsense because although you can probably define 'retail' banking (making loans to households and small and medium-sized enterprises; taking deposits), to bracket in everything else as 'investment' banking is insane, because that includes some activities which are nigh on risk-free and hugely lucrative as well as things which are insanely risky and anything in between. So it's administratively unenforceable anyway, even if there were any point to it.
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But Item Club didn't say anything of the sort. Their report makes it quite clear that an increase in interest charged to large corporates would only happen if the loans are outside the ringfence in the first place. it then works through a series of further estimates and assumptions (they also rely on logical or factual errors made by others), descending into guesswork to arrive at a possible figure for interest rate increases and the impact on the economy, and admits that banks are unlikely to be able to impose such higher interest rates on large corporates anyway.

The report also points out that interest being charged to people borrowing from the ringfenced division will pay slightly lower interest costs, so by and large this would all cancel out anyway (to the extent that any of it is even measurable). It's a bit long winded, but make up your own mind:

The rationale for the ringfence is that the authorities could credibly commit to allowing the riskier investment banking division to fail if it ran into trouble. These reforms could therefore lead to credit-rating downgrades for the investment banking divisions, given that the main credit-ratings agencies incorporate the impact of implicit government support within their main ratings of UK banks. Financial markets would also be likely to impose higher funding costs and demand higher capital levels, which could have a significant impact on the profitability of these divisions.

In contrast, funding costs within the retail ringfence could decline marginally, as investors perceive that the government has essentially confirmed that the retail businesses would not be allowed to fail under any circumstances.

For this exercise we have therefore assumed that any repricing of lending will only occur within loan books positioned outside the ringfence.

Although the interim report did not make any firm recommendations for the design of the ringfence, it would most likely include household lending and small business loans within the retail operation, while large corporate loans would sit outside the ringfence due to their close ties with the investment banking division. With this in mind, borrowing costs for these large companies could rise substantially.

A simple exercise can illustrate the potential impact on the UK economy.

First, we have assumed that the investment banking divisions face an increase in wholesale funding costs of around 100bp. Clearly, this estimate is subject to a high degree of uncertainty, as it is difficult to forecast the reaction of financial markets to the reforms, but we feel it is a reasonable assumption given the scope of ringfencing we have described.

Second, we assume that the loss of implicit government backing for the investment banking divisions and the restrictions on the ability of the ring fenced entity to fund other activities of the group prompts financial markets to demand that they maintain a core Tier One Capital ratio in the region of 14%. As all the universal banks in the UK already hold core Tier One Capital ratios in the region of 10%, it would represent a rise of around 4% points. Based on BIS estimates, the effect of a 1% rise in bank capital requirements would be a 13 basis point increase in borrowing costs facing the economy, so this 4% rise implies an increase in lending costs of around 50 basis points.

If we assume that the banks pass on all these lending costs through higher pricing of loans, the combined effect would be a 150bp rise in lending costs to large corporates. Using the HM Treasury Model, we have estimated that a 150 basis point increase in lending costs facing the whole economy would lower the level of GDP in the UK by around 1.2% in the absence of offsetting monetary policy actions. As large corporate loans represent less than 25% of overall lending, however, this implies a GDP loss in the region of just 0.3%.

This estimate may also be overstating the effect as large businesses have access to alternative sources of funds from debt and equity issuance in the capital markets, as well as being able to borrow from foreign
banks.

We can therefore conclude from this analysis that the impact of ringfencing on the wider UK economy isn’t likely to be vast.