March 5, 2012 3:49PM

New Bill to Reform the UK Banking System

On Wednesday February 29, UK Member of Parliament Steve Baker introduced a Bill to the UK Parliament to reform the UK banking system. The purpose of this Bill is to implement a series of measures to resolve the financial crisis in the UK. The underlying principle of this Bill is to minimize moral hazards within banking, by making those who make or preside over risk-taking as liable as possible for the consequences of that risk-taking. Since rules are usually gameable, the Bill also includes mutually reinforcing measures that minimize scope for evasion.

The key provisions of the Bill are as follows:

First, board members of banks would be subject to strict and unlimited personal liability for any bank losses.  They would also be subject to stringent provisions to provide personal bonds that would be potentially forfeit in the event their banks posted losses.

These measures would create the strongest possible personal incentive for board members to ensure that their banks are managed responsibly. This is the most important requirement to resolving the crisis: with the key decision-makers’ own wealth most at risk, they would ensure that the excess risk-taking would soon disappear.

Second, the payments of any bonuses that are awarded in any given year would be deferred for a period of 5 years. The amounts involved (‘bonus pool’) would be invested on beneficiaries’ behalf in an escrow account.

Third, should a bank report losses over any period, these losses would be made good in the first instance by drawing from the bonus pool. Should a bank report losses that exceed the value of the bonus pool, then the whole of the bonus pool would be forfeit to the bank to make good the losses. The difference remaining - the difference between the reported loss and the value of the bonus pool - would then be made good by drawing from the board members’ personal bonds. Should their bonds prove insufficient to meet the whole of the remaining loss, then all their bonds would liquidated to offset that loss, and any subsequently remaining losses would be passed to shareholders.

Thus, the bonus pool and the personal bonds would provide additional levels of capital to protect shareholders and other stakeholders against losses, and the fact that both the bonus pool and the personal bonds would be at-risk before shareholders’ capital would provide a very strong incentive for key decision makers to ensure that the bank takes risks responsibly.

Fourth, for the purposes of this Bill, all relevant figures (measures of profit, loss, capital, bonuses, personal bonds posted, etc.) would be obtained using the parallel accounting rules (i.e., in effect, old UK GAAP under Companies Act legislation) proposed under the 2011 Baker Bill. This would put a stop to the manufacture of ‘fake profits’ and other accounting abuses that have become prevalent under the current International Financial Reporting Standards (IFRS) used in the UK.

Fifth, the Bill sets out a proposed solvency standard: a bank is deemed to be insolvent if its ratio of core capital to assets should fall below 3%, where its core capital is defined to be equal to the sum of the value of the bonus pool, directors’ personal bonds and shareholder capital. This definition of core capital is far better (and far less fiddleable) than the capital definitions in the Basel II capital adequacy regime, which have been widely abused by banks.

Sixth, the Bill calls for the government to bring before Parliament measures to create a fast track bankruptcy regime for banks and to end all state support for banks. This would include: all bailout support, all lender of last resort support, all public shareholdings in banks, all central bank holdings of any bank assets and any form of state-supported deposit insurance. Any future state or central bank support for financial institutions is also to be prohibited.

Finally, the Bill calls for the government to establish a new Financial Crimes Investigation Unit that will investigate financial crimes, and whose focus will be crimes committed by senior bankers and financiers. This new unit will also begin investigations into possible criminal offenses committed in all financial institutions that have failed since 2007 and/or been in receipt of state support (e.g., bailouts).

Taken together, these measures would remove the most flagrant abuses and restore the integrity of the UK financial system; they would also address the widespread indignation over bankers’ behavior and meet the public demand for accountability and justice in modern UK banking.