Britain’s fuzzy dividing line between bank and non-bank

Here is a simple question about London Capital & Finance, the £236m bond scheme that collapsed last year, taking with it the savings of nearly 12,000 customers. Why was it not a bank?

LC&F had, after all, many of the characteristics you’d normally associate with a banking institution. Here was a business that borrowed from its customers, promising to pay them both a fixed income and return their capital at par.

The money wasn’t used to fund its own commercial activities, but lent out to other businesses. And if that weren’t sufficient, LC&F was also involved in so-called “maturity transformation”, meaning the risky game of borrowing money on shorter timeframes than it lent the stuff out. In short, you’d think: a bank.

Of course, back in the real world that wasn’t the conclusion. LC&F never acquired formal bank status, lurking in the penumbra of the “shadow” financial sector, where it was easier to prey on passing savers. How this happened is instructive, and demonstrates the weakness of modern legalistic regulation. It shows how well-intended rules can fail to serve their purpose, leading not just to unintended outcomes but ones their originators specifically sought to avert.

Britain has since the late-1970s had laws about what constitutes a bank; rules conceived to avoid a repetition of the 1973-4 secondary banking crisis, which emerged from a proliferation of lightly-regulated shadow banks.

These aim to stop unsupervised entities behaving like banking institutions, which take deposits and lend them on. If you do this, you must get a licence, raise lots of capital, and submit to ongoing supervision by the Prudential Regulation Authority.

So why wasn’t LC&F caught in this mesh of statute and regulation? The short answer is that it was able to use exemptions embedded in the law’s fine grain, notably the definition of what constitutes a “deposit”. Issue bonds with maturities of more than one year, as LC&F did, and — go figure — you’re somehow not seen as behaving like a bank. (This so-called “bond exemption” exists to allow commercial companies such as Vodafone to issue their own bonds periodically without becoming a regulated institution).

True, that didn’t wholly get it off the hook. LC&F could still have been classified as a “dealer in investments as principal”, that is, an investment bank; a designation that would have exposed it to greater regulation. For while UK law is indulgent, letting it off this dealership status because the only bonds it “dealt” in were its own paper, EU law is more stringent.

But even here there was a get-out to grasp at. The rules under the Mifid 2 regulation arguably only bite if the bonds were “transferable”. LC&F stated its bonds were not, so it was off the hook again (although some lawyers argue that this get-out is not as strong as it looks).

What this ultimately meant was that an entity running a banking book worth hundreds of millions had no banking licence or supervision, and subscribed equity capital of a piffling £50,000. Would the directors have passed the more stringent requirements of the senior management regime? We’ll never know.

Much of the debate over LC&F’s status has been driven by the question of compensation. Are its customers entitled to restitution from the Financial Services Compensation Scheme (FSCS)? This hinges on whether the authorities failed to regulate an entity that they should have supervised.

It is troubling how long the FSCS has taken to unpick this fundamental question, which has taken its legal brains more than a year.

The Bank of England likes to claim that it has tamed the sort of shadow banking that ran rampant before the financial crisis. There is little doubt that the authorities now monitor much more closely what goes on in the informal non-bank sector. But confidence in the system surely depends on those whose activities have the economic substance of banking being caught in its regulatory net.

In the aftermath of the 1970s banking crisis, supervisors put the onus on market players to prove their bona fides. The emphasis was on principles, and infringing firms were proactively taken to court, establishing precedents. More recently this common-law approach has been replaced with an addiction to new statute, especially that of the highly prescriptive and rules-based kind. (If you doubt this I suggest perusing the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001.)

There will always be financiers who try to structure their affairs to avoid unwanted rules and oversight. One must expect their number to contain a reasonable sprinkling of rogues. The lessons from LC&F are not just about compensation, or closing down the marketing of mini-bond schemes. They are much more fundamental, and concern ensuring those who do banking business are held to banking rules.



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