Separation of Retail and Investment Banking Operations - Essay Example

?Topic: Separation of Retail and Investment Banking Operations Affiliation: Introduction The banking sector is a crucial component of the economy. Provision of financial and consumption of financial services is essential in pursuit of economic and social growth and development. However, certain scenarios observed in that pursuit negatively affects the economy, spreading these effects to the entire public. The interest of this paper is to evaluate and assess the banking sector in that context. Specifically, retail and investment banking operations are considered. The need to separate the two operations is the central focus of this paper, presenting arguments for and against the move in detail. Arguments in support of separation of retail and investment banking operations Financial crisis is not a new phenomenon for the banking sector in U.K and beyond. From time to time, economic hardships that have resulted in financial crisis have been observed around the world. Year 2008 global financial crisis adversely affected financial systems in various economies. This necessitated the need to manage risks in the financial sector, which is primarily dominated by banks. Following this and other affecting factors, regulation, control and reforming the banking sector is essential. Separation of retail and investment banking operations is a positive move to take in the context of the above pursuit. That is, regulation, control and reforming financial services providers. Separating retail and investment banks would mean that the each of the two becomes a standalone legal entity. It is important to note that retail banks handle short term and long term payments, accept deposits and offer credit services by lending funds (De Jonghe, 2010, p. 387). On the other hand, investment banks primarily deal with financial instruments. In this regard, they are also referred to as casino banks. With the separation, it would mean that adverse effects experienced by either of the banks would hardly affect the other. That is to say that if the investment banking operations experience huge losses, the resultant negative effects would hardly affect retail banking operations especially deposits. Splitting the retail and investment banking operations is an activity that would bring forth intensive regulatory frameworks in a bid to achieve the desired outcome. The regulatory frame work adopted would be one that addresses each of the two banks as a unit independent of the other. In the situation of financial hardships, the retail banking sector would receive the attention of both the government and the taxpayers. The investment banking sector on the other hand would be accounted for by shareholders and investors in the same context. As a result, the adverse effects of financial crisis can neither be transferred to the retail bankers nor the government when the investment banking sector is affected. Investment banks engage in highly risky financial instruments (Upper, 2007, p.64). Tax revenues are normally used to back banking operations with or without operational risks. However, separating retail and investment banking operations would ensure that the taxpayers’ money only backs retail banking operations. The involvement of investment banks in risky financial instruments and related activities would therefore not constitute any financial burden to the taxpayers. Over and above the alleviation of financial burdens to taxpayers in times of financial crisis, individual customers to both retail and investment banks would be at an advantage. In absence of the separation, deposits in retail banks are highly influenced by investment activities. This is more so if different parts of the same bank handles both retail and investment banking operations. With the separation, the opposite of this scenario is true. However, lending risks are inevitable, but they are relatively easy to address (Modigliani and Miller, 1958, p.261–297). Separation of retail and investment banking operations is bound to address housing bubbles that result from banking operations. Making the two banking operations independent of one another would reap off the retail banking operation of selling off home loans. This means that for the retail banks to make significant profits from lending activities, they would result to servicing home loans in the long run. The profits would no longer emerge from the origination of homes loans but from servicing the loans over time. In that regard, prudent lending policies, ratios and practices would have to be adopted (De Jonghe, 2010, p. 390-417). By so doing, the occurrence of housing bubbles in current times or in future is minimized. London and U.K in general would still house both banks even after the separation. Financial innovation would not cease and risk taking activities would still be observed. However, operational aspects of both banks would have to change. The government’s concern and consequent involvement of taxpayers in investment banking operations are based on the retail side of business. When the two are separated, the unlimited government’s guarantee would no longer be there for the investment banks. However, investment banking operations would still continue. Arguments against separation of retail and investment banking operations Financial institutions in U.K and beyond have been characterized by operational failures. While, financial crisis has been cited as one of the primary causes of such failures, this is not always the case. Regulation and management are critical determinants of organizational success. On the same note, financial institutions that have failed in the past did not necessarily undertake combined retail and investment banking operations. Commercial lending institutions or investment banking institutions have been observed to fail (Gropp, Grundl and Guettler, 2010, p.10). Therefore, the separation is not a guarantee that retail and investment banks would do well independently. Financial firms will always face contagions of systemic risks, with or without separation of retail and investment banking operations. The separation would not therefore act as a guard against such risks. The contagion can take any direction, affecting pure retail and pure investment banks. For instance, Northern Rock is a financial institution that purely takes deposits. On the other hand, Lehman Brothers is an investment bank. The most recent contagion originated from Lehman Brothers and consequently affected the entire banking sector including Northern Rock (Wagner, 2010, p.373-386). Therefore, the separation would not account for such contagions of systemic risks. Some retail and investment banks are universal. They therefore trade across borders. The profitability and occurrence of loss depends on diverse factors that are over and above separation context. These factors include: lending policies, corporate governance and scope of trading activities, regulation and control by law and procedures of risk management. In the account of the highlighted factors, it does not really matter whether the bank in question is purely deposit taking or purely an investment bank. Diverse and dynamic financial services are vital in the economy. With sufficient regulation of the said diversity and dynamism, risk diversification is set to be achieved through the use of both scale and scope of participating financial institutions (Acharya and Yorulmazer, 2008, p.215-231). As earlier mentioned, significant retail and investments banks have local and international presence. Their trading activities therefore take place internally and externally. With this, capital markets-real economy intermediation is easily achieved. Separating retail and investment banking operations at the local level would therefore jeopardize allocation efficiency locally and internationally. Implementing the separation is likely to face practical and technical challenges. The right threshold in terms of size and scope of each separated financial institution should be effectively determined (Laeven and Valencia, 2008, p.250). On the same note, it would be necessary to account for measures with which to mitigate problems associated with moral hazard. Moral hazard is likely to emerge in the pursuit of specifying the aforementioned threshold. The optimal threshold for separation purposes is hard to establish. Finally, effective separation of retail and investment banking operations would require both local and international treatment. A Glass-Steagall-style separation would require an international application for efficiency concerns (Schmid and Walter, 2009, p.193-216). This approach of separation therefore calls for an international consensus, failure to which dire consequences are expected. The separation is highly likely to inhibit financial market growth and competitiveness, both locally and internationally. For example, in the context of the U.K, financial markets’ growth might take a low rate. Competitiveness of U.K-based financial institutions would also be threatened, making it necessary to consider moving to other countries. Conclusion Separation of retail and investment banking operations has been argued for and against. It is clear that there are diverse and dynamic factors that surround the issue over time. Consequences of the separation are however inevitable and they must be accounted for. What is important in that pursuit is to weigh both advantages and disadvantages of the move, and further assess the achievements realized if the two banks are treated independently prior to operating as combined units. Role of regulation that comes with the separation should be defined. Whatever the case, the retail and investment banks should not be made worse off as a result of the separation. References Acharya, V. and Yorulmazer, T., 2008, Information contagion and bank herding, Journal of Money, Credit and Banking, 40, pp. 215–231. De Jonghe, O., 2010, Back to the basics in banking? A micro-analysis of banking system stability, Journal of Financial Intermediation, 19(3), pp. 387-417. Gropp, R., Grundl, C. and Guettler, A., 2010, The impact of public guarantees on bank risk taking: evidence from a natural experiment, European Business School Research Paper 10(10). Laeven, L. and Valencia, F., 2008, The use of blanket guarantees in banking crises, IMF Working Paper No. 08/250. Modigliani, F. and Miller, M., 1958, The cost of capital, corporation finance and the theory of investment, American Economic Review, 48(3), pp. 261–297. Schmid, M. M. and Walter, I., 2009, Do financial conglomerates create or destroy economic value?, Journal of Financial Intermediation, 18(2), pp. 193–216. Upper, C., 2007, Using counterfactual simulations to assess the danger of contagion in interbank markets, BIS Working Paper No. 234. Wagner, W., 2010, Diversification at financial institutions and systemic crises, Journal of Financial Intermediation, 19(3), pp. 373-386. Read More