separating the banks - looking at the arguments in more detail

Why Regulation will not be enough
CSM strongly supports the strengthening of regulation and the other reforms the government is proposing, but regulation on its own will not be enough. Regulation on its own will fail to prevent massive losses on the casino operations of any “combined” bank(s) for one or more of three reasons:
1. Regulation no matter how well drawn up will never be always applied perfectly, (eg Northern Rock by the FSA). Any failure to properly regulate the casino/investment side of a combined bank would then bring down the traditional/retail side as well, necessitating a large scale government/taxpayers rescue to protect depositors (If the mingling of casino/investment and traditional retail banking continues it will also be harder to properly implement the new regulation of combined banks rather than separate regulation of two very different types of bank, perhaps by two different regulators.)
2. The casino/investment operations of banks will have an army of highly paid people trying at best to introduce new financial instruments that are not covered by the regulations and at worst trying to circumvent the regulations. If their operations were still combined with traditional retail banking they would know that the bank would be regarded as unable to be allowed to fail, thus effectively eliminating any major downside risk of their speculative activities.
3. As memories of this crisis fade, and the costs to individual bankers of this crisis, except in reputation, have been negligible, demands for less regulation particularly of casino/investment banking activities will grow. This would encourage the casino side of these combined banks to take greater and greater risks particularly as the personal rewards of “casino” banking have been and continue to be so high.
Arguments in favour of separation
A. The splitting of existing banks into two completely separate legal entities, one handling traditional retail banking (payments, deposits and lending) and the other an investment/casino bank handling financial instruments, would mean that any huge losses in the future from investment/casino banking would not adversely impact traditional retail banking services including deposits.
B. While the government would provide a strong regulatory framework for both types of banks it would be explicitly understood that the government and taxpayers would only stand behind the banks in the traditional retail banking sector. In times of difficulty the investment/casino banks would have to rely solely on their shareholders, private investors etc. not the government and taxpayers.
C. It would be clear to UK taxpayers that in future their money would only ever be used to back banks operating solely in the traditional retail banking areas and not ones involved in any way in highly risky financial instruments.
D. Customers of traditional retail banks would know that there was no danger, unlike now, of their bank, and their deposits in it, being undermined by the “casino” activities of another part of the same bank. There would still be risks from the bank’s lending but these would be more easily handled and they would have full confidence that the UK government could meet its guarantee to their bank.
E. Employees involved in the traditional retail banking part of current banks (branches etc), the overwhelming majority of financial sector employees, would know that there was no danger, unlike now, of their bank being undermined by the “casino” activities of others in their bank.
F. If banks in the traditional retail banking sector no longer sold off their home loans, they would return to the previous situation where they made their profits by the long term servicing of a home loan, not in the origination of it. This would encourage them to return to the more prudent lending policies, ratios and practices of the past and would help prevent future housing bubbles.
G. The investment/casino banks, while still pioneering innovation and risk taking, would be more prudent in managing the risks they were taking knowing that there was no longer a UK government/taxpayers guarantee behind them.
H. The UK, especially London, would still host both types of bank and would continue to prosper as a major financial centre and centre for financial innovation and risk taking. The difference would be that the UK investment/casino banks involved would have to operate in an environment where there was no longer an unlimited guarantee from the British government behind them because of a traditional retail banking side of their business.
Arguments against separation and our responses
(These points can be found in paragraphs 5.31-5.35, “Reforming financial markets” UK Treasury, July 2009)
J. “Some institutions that failed engaged solely in commercial lending or investment banking activity, while one of the most significant failures of all –AIG in the US- was not even a bank.”
Response: While it is true that some of the banks that failed, such as Northern Rock and IndyMac, were traditional retail banks with no investment banking side, their failure was a failure of regulation, as admitted by the FSA in the case of Northern Rock. That is why CSM is backing the changes in regulation proposed by the government. The failure of AIG was because it was allowed by its regulators to build up massive positions on credit default swaps (CDSs) on collaterised debt obligations (CDOs) linked to poorly performing mortgages.
K. Separation “does not guard against systemic risk contagion between firms, which as recent events show can easily travel between pure deposit taking institutions (large or small) and large investment banking institutions”
Response: The contagion did not travel from pure deposit taking institutions, like Northern Rock and IndyMac, to large investment banks. It travelled from a large investment bank, Lehmans, to the rest of the banking sector. Lehmans was systemically important because its operations, on a massive scale, had been allowed to become so entwined with the traditional retail banks that Lehmans failure posed a risk to the solvency of those banks and therefore a systemic risk to the whole banking system. Lehman’s was also systemically important because the financial instruments that led to its failure were ones that the traditional retail banks had been allowed to get involved with, thus generating a crisis of confidence in those banks as well.
L. “While many large universal banks lost money on their trading activities, they also suffered losses as a result of bad lending, poor corporate governance and risk management procedures. The latter are examples of basic problems that can exist across both ‘narrow’ and ‘broad’ banks”
Response: Absolutely true, that’s why CSM is backing the changes in regulation that the government is proposing to help deal with these issues in the future.
M. “aggregate economic costs in the event of failure would not necessarily be reduced. Separating commercial banks from investment banks would not address counterparty risk exposures between banks, nor tackle liquidity problems arising from the cessation of interbank lending in the event of a single firm failing. Lehman Brothers was an investment bank, but its failure led to wide and varied knock-on effects to the rest of the financial system”
Response: One of the main benefits of separation is that it would virtually eliminate counterparty risks between casino/investment banks and traditional retail deposit taking banks. The counterparties of casino banks will be other casino banks and the counterparties of traditional retail banks will be other traditional retail banks. In the event of a failure of a casino bank, interbank lending among traditional retail banks would therefore be unaffected. For the reasons for the Lehmans effect on the financial system see the response under K above.
N. “There are benefits to the economy in having access to the services of large, broad
institutions, which can use scale and scope to provide for risk diversification, as long as there are
sufficient regulation and other safeguards as discussed earlier. Additionally, some large or complex banks are by nature likely to be international in business coverage, facilitating more cross border investment and trade, and broader and larger banks provide a vital form of intermediation between the capital markets and the real economy, as a result some efficiency of allocation would be lost”
Response: As Andrew Haldane, the Bank of England’s Executive Director for financial stability noted in a speech in September “There is not a scrap of evidence of economies of scale or scope in banking – of bigger or broader being better- beyond a low size threshold. At least during this crisis big banks have if anything been found to be less stable than their smaller counterparts, requiring on average larger scale support”.
UK banks would still be large and international, and could still provide for risk diversification, after separation. As far as modern global corporations are concerned they are currently serviced by a range of different banks and there is no reason why in the future they couldn't be serviced by both traditional retail banks and casino/investment banks at the same time but offering different services. They do not need to rely on just one bank offering both sorts of services. A recent survey by the Association of Corporate Treasurers found that big businesses did not feel they needed big banks to supply their needs.
P. “There are practical challenges to implementing this approach. It would be extremely
difficult to identify any optimum threshold for the size or scope of financial institutions, let alone
to mitigate the moral hazard problems that come with specifying this threshold to the market.”
Response: It is fairly clear what banking activities would fall under the Investment /casino heading, such as trading in financial instruments and what would be traditional retail banking (Payments systems, safe repository for depositors, lending to businesses and individuals). One very large American bank, Citigroup has already started to do something similar when it announced in early 2009 that it would split into two companies, Citicorp dealing with its traditional banking business and Citi holdings Inc dealing with its more risky investment banking side. On moral hazard there would only be this type of moral hazard if size was limited not if it is just scope that is limited.
Q. “A Glass-Steagall-style separation would need to be applied across all countries to be
effective. In the absence of any global consensus on this approach, and on what the appropriate
threshold for bank size or breadth might be, the introduction of these restrictions could inhibit
the growth and continued competitiveness of the UK financial market, and might encourage
even sound UK financial institutions to move to other countries.”
Response: A separation in banking is under consideration in the US, (see the comments by Paul Volcker, chair of PERAB elsewhere). If the UK provided the leadership to move in this direction, first the Eurozone and then the US would not want to be left with combined banks and all the risks this would mean for retail deposits and taxpayer support. The UK, especially London, would still host both types of bank and would continue to prosper as a major financial centre and centre for financial innovation and risk taking.
(Author: CSM)

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