Inside the UK’s Latest Banking Plan

Good news for the many, many UK small businesses that can’t get a bank loan: Regulators finally seem to realize their tougher capital requirements are (likely, at least in part) to blame. Better still, they’ve hatched a plan!

Bad news: It probably won’t quite work. Not the way they hope.

Our tale begins in January, when the Office of Fair Trading released its Review of the Personal Current Account Market—a 162-page investigation into competition within High-Street banking. Their findings: The four largest UK banks have a combined 75% market share, and high barriers-to-entry limit competition. Regulators have long believed upstart “challenger banks” are the solution to the UK’s lending woes—if the big four aren’t lending, smaller banks with more incentive to compete and grow probably will. But if new banks can’t get off the ground, they can’t, well, challenge.

This morning, outgoing Financial Services Authority (FSA) chief Lord Adair Turner announced the regulators’ solution: Moving forward, upstart banks can get off and running with a mere 4.5% capital-to-risk ratio—well below current requirements, which exceed the big four’s 10% ratio thanks to the heightened risk assumed inherent in a brand new lender.

At first blush, this seems grand: Easier capital requirements don’t just make it easier for banks to launch—theoretically, they make it easier to lend. I’ve often written of the impact of too-tough banking regulations on UK lending: With capital requirements high and soon to rise, the dreaded ring-fence looming and potential lending margins slim thanks to the flattish yield curve (a result of contractionary quantitative easing), banks have more incentive to park money at the BOE as excess reserves than to lend enthusiastically. That’s what’s been happening since March 2009, when Lord Turner announced the pending regulatory overhaul and the Asset Purchase Programme started—excess reserves are way up and lending’s still negative.

But reducing the capital requirements for new banks only poses myriad new problems. One could argue the tougher requirements they’ve faced until now are discriminatory, but the new regime is equally discriminatory. There’s nothing about a big bank that makes it inherently more risky than an upstart—big and small banks are equally capable of mismanaging balance sheets and making bad lending and investment decisions. Regulators point to assumed systemic risks due to their large size and the societal cost of failures, but small banks have proven equally adept at causing ripples through the financial system when they go belly up—Northern Rock, which kicked off the UK’s banking troubles in 2007, was essentially a thrift.

Moreover, punishing big banks for their size ignores the societal good big banks can do when allowed to operate freely. Small banks simply don’t have the clout and asset base to provide large loans to the biggest corporations—often necessary M&A financing tools. Big banks also have greater economies of scale and should be better positioned to continue offering credit when lending margins are tight. In fact, if regulatory uncertainty weren’t so great in the UK, we’d probably see more lending from the big four even with potential profits so low—there’d be less risk to offset that smaller potential reward.

The new rules also don’t do much to goad lending from challenger banks. The 4.5% ratio is temporary—banks could get off and running with low capital, but they’d have a set time to build their buffers up to the 7% standard enshrined in Basel III. So challenger banks would have the same problem the big four are grappling with today: Why lend more today when you know you must raise even more capital later to offset the added risk? Until they reach that 7% threshold, they’ll have every incentive to hoard capital and lend only to the most creditworthy borrowers, and lending likely won’t meaningfully improve in the short-term.

This is just one more piece of evidence demonstrating the failures of the UK’s patchwork approach to regulatory oversight—too many competing standards and ideas amount to a confusing, red tape-ridden mess. Instead of having arbitrary standards for banks of differing ages and sizes, regulators should start from scratch and devise an efficient system—one with enough oversight to prevent bad behavior and keep risk in check, but enough flexibility to keep capital moving freely.

Don’t get me wrong, I’m all in favor of challenger banks gaining market share—the more banks there are, the more competition there is, and the better the chances lending eventually increases. I just don’t think fiddling with arbitrary capital ratios is the way to do it. Better would be for regulators to cut red tape, like reducing the amount of time it takes to get a banking license—a change the government and FSA are deadlocked over, with the FSA calling it unworkable. Here’s hoping the government doesn’t back down and good sense soon prevails.