Marking out the territory

The financial crisis led to renewed calls for the separation of retail banking from investment banking. But to what extent will regulatory proposals lead to a safer baking system?

I can see how the separation of retail and investment bank activity might please the tax payer but will it improve the confidence of the investor too? 

The financial crisis showed that investment banking and retail banking can be incompatible, with drastic effects.

Although different types of financial institutions foundered during the crisis, much of the scrutiny that followed focused on the retail-investment bank relationship.

The starkest example to date was the Royal Bank of Scotland’s failure to successfully integrate the investment banking operations of ABN Amro, leading to a collapse that eventually hit the man on the street.

But this wasn’t the only model that failed in the crisis. Other firms that relied heavily on capital markets for funding, such as Northern Rock, the UK mortgage provider were unable to support their operations as credit was crunched, while investment banks such as Bear Stearns got into trouble through bad hedge fund investments, which ultimately resulted in a funding shortfall.

Where governments viewed the collapse of financial institutions as having dire consequences for the wider economy, bailouts were granted, where taxpayer funds weren’t forthcoming, the systemic effects of collapse were considerable.

Systemic stability is the key to investor confidence. If financial institutions can be made safer and systemic risk is lowered, through measures such as separating investment and retail banking, investor confidence will grow.

To what extent have we tried this kind of separation before? 

Many see current reform proposals as resurrecting the Glass-Steagall Act, introduced under US president Franklin Roosevelt after the 1929 Wall Street Crash.

The law required the separation between retail and investment banking activity, but was repealed via the Gramm-Leach-Bliley Act in 1999 under president Bill Clinton following a period of intense lobbying by banks.

The aftermath of the collapse of Lehman Brothers in 2008 put the issues that Glass-Steagall tried to resolve back into the spotlight, with policy makers reigniting the debate through related proposals.

Last year, Bank of England governor Mervyn King spoke of “casino-style” investment banking running counter to the “utility” of retail banking services, while just last week, the UK chancellor George Osborne threw his weight behind a report by the Independent Commission on Banking (ICB) that called for the ringfencing of retail businesses from higher risk activities undertaken by units within the same group.

Draft UK legislation based on the ICB report will be announced in the autumn, with final rules expected to be in place by 2015.

The US has taken a slightly different stance, preferring instead to prohibit proprietary trading by deposit taking institutions, and banning them from making hedge fund and private equity investments, via the Volcker rule in the Dodd-Frank Act.

How have these proposals been received by the financial industry? 

In an opportunity to pose questions to Sir John Vickers, ICB chair, at a recent conference held by the European Parliament in Brussels, banks posited that plans to ringfence certain activities failed the cost/benefit analysis.

They argued that a separation of activities would cost a huge amount to achieve but probably would still leave the taxpayer with a huge sum to pay should a systematically important bank topple over in the future.

Speaking last week after his paper was adopted by the UK Treasury, Vickers claimed the reforms would cost £600m to £1.4bn a year, which he said was 100 times less the amount that the financial crisis had already cost the UK economy.

Banks argue that the most recent crisis would not have been prevented with rules that separate different types of financial activity, and that retail banks can mitigate some of the risks associated with lending through investment banking.

What kind of a banking system do we face in the future? 

Although policy makers are keen on delineating between retail and investment banking activity, final legislation is likely to be watered down.

In the US, the Volcker rule is close to being torn up and rewritten after intense lobbying by some banks over its complexity and the scope of exemptions it allows. Vickers claimed that his proposals had been watered down before receiving government endorsement.

While popular sentiment holds a greater delineation between investment and retail banking to be entirely prudent, shades of grey between the two may yet prevail.

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