UK: Banks' ring-fencing - a step in the wrong direction
By Alexander Chepakovich, CFA 2011-09-12The British government makes plans to ring-fence retail operations of banks from their investment banking operations. They proclaim that it is the ultimate solution for future financial crises, asserting that with the ring-fencing in place no bail-outs of banks will be needed.
To me, the creators and proponents of this idea are confused. The retail banking is operations of the bank with individuals: opening and maintaining of personal accounts, taking deposits and providing personal (or consumer) loans and mortgages. Similar operations with companies are classified as wholesale banking. So, what is the plan: to separate just retail banking or all of commercial banking from investment banking? If just retail, then it does not make any sense, as banks would be required to basically to create a retail bank within a bank, which in effect would be almost the same as spinning-off retail banking operations. This is unlikely to make the financial system more secure and stable. It would just lead to less efficiency in deployment of capital received from deposits, less capital available and higher costs of funding for wholesale banks, which in its turn will lead to more costly loans for corporations. The disbalance in allocation of funds with time could lead to all kind of excesses in the retail sector.
If, on the other hand, the plan is to separate all of the commercial banking from the investment banking, just like it was done in the USA during the Great Depression era in the past century (the Banking Act of 1933 most commonly known as the Glass–Steagall Act was repealed only in 1999), then there is some rationale in this. The classic investment banking, which is arranging issuance of bonds, does not require that banks have a lot of capital. It is only risky when banks decide to underwrite, i.e. take on its books yet unsold bonds and stocks. If the market goes against them when they have large amounts of unsold paper, they bear large losses. In order to do large underwriting deals, banks need to have very large amount of own capital to be able to absorb these potential losses. Investment banks need the balance sheet of commercial banks for this.
Underwriting is quite risky, but the bank's exposure usually is very short in duration – only until the issue is fully sold. However, nowadays full underwriting is very rare, as banks prefer to lower their risk by taking an obligation to sell the bond or equity issue on the best-effort basis, meaning that they do not guarantee neither the price nor the amount of the paper to be placed on the market.
Today, the investment banking is mostly consulting and brokerage business and as such is less risky than commercial banking operations. It should be noted that investment in securities (the source of the greatest loses of the past few years) should not be part of investment banking. By its nature, it is akin to lending and should be subject to the sane scrutiny as any loan.
The greatest risk in banking operations come from proprietary trading. But this area of operations is relatively small in most banks and is closely monitored for outstanding exposure after much-publicized cases of banks failures because of 'rogue' traders in the past.
The ring-fencing of retail banking operations is not going to solve any problems. It would only lead to higher inefficiency and much less competitiveness of British banks. Unfortunately, as in so many cases in the past (school reform is the latest example), the British government is all too eager to change the appearance rather then the substance. These 'reforms' do not resolve existing problems, they just create new ones. What is needed is not more regulation, but less of explicit and implicit government support and guarantee, so that banks' owners/shareholders force management to think more about risk and less about bonuses.