Separation of Retail Banking from Investment Banking - Essay Example

Separation of retail banking from investment banking Introduction Since the crisis of 2007-08, international discussion regarding banking structure and its effectiveness has taken place at different level. The argument regarding banking structure in the United States focussed on implementation of Volcker rule that prevents banks from participating in proprietary trading that is not associated with customers. The discussion focuses on ring fencing of retail banking from investment banking in the United Kingdom while in countries such as Germany and France, hybridization of ring fencing and proprietary trading has been proposed. The concept was highlighted for the first time in Liikanen report where the structural reform was proposed for banks within the European Union (Vickers, 2013). Arguments in favour of structuralism suggest that risk level is very low in retail banking and these facilities are essential while investment banking is inessential and also relatively risky in terms of transaction. Further arguments point that the separation will ensure that public safety is retained by means of low risk and essential activities while market forces freely regulate risk taking activities in investment banking (Vickers, 2013). However, things are not as simple as these arguments because retail banking is equally risky for it is prone to credit risk due to lending activities. A number of authors argued that mere separation will not protect the banking sector from risk externalities (Peston, 2011; Halligan, 2014). Consequently, the paper evaluates the current situation in this regard, effectiveness and consequences of the separation of banking sector on consumers and the economic system. Current outlook of the banking sector and development of separation concept The proposal of banking separation is result of financial crisis and reckless risk appetite of banking and consequently, it is imperative to briefly discuss the crisis and its impact which led to the ongoing situation. According to Wehinger (2013), players of private sector noted that profound improvements have been undertaken in the asset management industry and banking sector in terms of risk management as a result of the crisis. Post crisis, significant planned changes have been brought in European banks while structural changes in business models have been brought in by various global banks. Several regulatory rules have been proposed for improving effectiveness of risk capital model and treat the issue of capital scarcity with utmost sincerity. It has already been mentioned that commercial banking is not devoid of flaws and risks and consequently, it was established that commercial and investment banking require high level of loss absorbency capabilities at the roots. The crisis unveiled two serious issues associated with the banking sectors. First, the level of equity capital at various banks is extremely low and as a result, leverage level is very high. Second, government depends heavily on the revenue generated in the form of tax for rescuing bondholders as the investment banks bankrupted (Vickers, 2013). The various proposed reforms for salvaging the banking sector and preventing the same from any future crises are discussed as follows (Lang and Schröder, 2013): OECD Proposal OECD researchers such as Blundell-Wignall, Wehinger and Slovik (2010) proposed in 2009 regarding creation of non-operating holding company structure for the banking sector. The authors critically assessed the need of restructuring and its impact on banking stabilisation (especially in the context of the too-big-to fail issue). Based on their assessment, they concluded that reforms such as Basel I, II and III are insufficient for improving financial market stability. The proposed NOHC structure discusses that an universal bank under one umbrella corporation should be created where individual business areas shall be separated as independent entity. Each of the entities will have separate capital base which is theoretically non-transferrable among the entities. In this regard, only the umbrella corporation will be accountable for borrowing and investing in the capital market but will not be eligible for pursuing banking activities. The idea behind this structure is that when consumer deposits will be excluded from the capital market liabilities, the problem of too-big-to-fail will be addressed. Vickers Commission and White Paper The White Paper was published in the UK in 2010 by the Vickers Commission for making proposal regarding development of stable banking system and securitisation of customers’ deposits. The commission proposed ‘ring fencing’ where retail banking will be limited to traditional process of lending and depositing. The virtual ring will prevent investment banking segment from passing on the capital losses to retail banking segment. A number of rules were stipulated in the White Paper for developing ring fenced banks. Alongside, the commission classified various financial services in three categories, namely, exclusively permissible for ring-fenced banks, prohibited for ring-fenced banks and permitted financial services which will bear the possibility of being offered to ring-fenced banks (White Paper, 2012; Vickers, 2013). Volcker Rule The Volcker rule was proposed on the basis of Consumer Protection Act and Dodd-Frank Wall Street Reform in the United States in 2010. The proposal suggested that retail banking sector is subject to great degree of regulation. Compliance with the discussed regulations is considered essential for inclusion in the Federal Deposit Insurance Scheme. These regulations imply exclusion from short term proprietary trading, limiting investment in risky assets such as hedge fund and restriction on merger (Lang and Schröder, 2013). Liikanen Report The Liikanen Report was introduced in the European Union (excluding the UK) post introduction of Volcker Rule in the US. However, the report was developed particularly keeping in view the specific banking needs of the EU region. The presented report suggested that there is no specific model that can completely mitigate the issue. Nevertheless, the report insisted on excessive risk taking, short term funding and investment in complex derivatives as reason for crisis. The report proposed that compensation structure of bankers should be tightened and risk oriented trading components should be separated from general banking activities (UK Government, 2015). Critical discussion based on banking models and acts The market failure of 2007 and credit crisis dragged the global financial system on the verge of complete collapse but it was initiated with the enactment of Gramm-Leach-Bliley Act in 1999 which repealed the provisions made regarding banking business in Banking Act of 1933. The Banking Act of 1933 is also referred as the Glass-Steagall Act which was proposed in the wake of the stock market crash of 1929. This act essentially provided for regulations which ensured interbank control and separated commercial banking from investment banking. The provisions made under the Glass-Steagall Act prevented commercial banks that created loans and took deposits from engaging in underwriting and dealing of securities where the only exception was government-issued bonds (Saunders and Yourougou, 1990; Benston, 1990; Federal Reserve, 2013). In the wake of the crisis of 2008, the congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. The act was passed with the aim of creating sound economic system, reducing unemployment, controlling excessive flow of compensation and bonuses in Wall Street and preventing future financial crises by repealing the concept of too-big-to-fail and bailouts. The act proposed development of an independent body within the Federal Reserve that will be responsible for consumer protection in terms of mortgage information, deceptive practices and hidden fees. The act further suggested that the government will no more bailout bankrupt banks with the money of taxpayers and rigorous standards and supervision will be implemented for the entire banking sector irrespective of the size of the banks. However, effectiveness of this act was questioned by legislators and bank lobbyists due to several vaguely defined aspects. Consequently, only a certain aspects of the act were implemented (SEC, 2011). Critical assessment of both the acts suggests that both acts were proposed during two different financial crises but Glass-Steagall Act was determined to be more effective in separating commercial banking from investing banking till Gramm-Leach-Bliley Act was passed. The failure of Dodd Frank Act has been attributed to its inability to perform the right measures post market crash. The act took exact opposite measures of Glass-Steagall Act and allowed the Wall Street investment banks to hold greater amount of insured deposits. The Dodd Frank Act was not implemented completely in order to protect personal interest of bankers and lobbyists (Bailey, 2013). Empirical evidence regarding effectiveness of banking separation Banking separation has been proposed primarily as to ensure that in further crises, taxpayers only get to pay for their saving component in retail banking while the investment banking component can assume bankruptcy considering its less essential role in economic development. Liikanen report pointed that through banking separation transparency level at the bank can be raised while complexity is minimised. The report’s arguments invariably points toward a stable banking and financial system as a result of banking separation. However, in this regard, empirical; evidences suggest otherwise although most of these evidences support the fact that development of banking system with limited component of investment banking will be less prone to financial crises compared to pure retail banks or pure investment banks (Lang and Schröder, 2013). Adams, Füss and Gropp (2010) pointed that during crisis, significant level of negative financial effect can be instigated by hedge fund into the retail banking and insurance sector by means of various transmission channels. The authors argued that hedge fund is one of the critical risk factors in systematic crisis and suggested that investment banks will not only be affected by it but will also bear possibility of transmitting the same in other financial areas. Templeton and Severiens (1992) posited that diversification of banking activities in terms of retail and investment sectors only caused stability in share prices. Their analysis suggested that no significant direct impact was observed with respect to bank’s success. Nicoló, et al., (2003) observed that banks that have relatively broader array of services are prone to greater degree of risk. The authors assessed approximately 500 financial institutions across the world between 1995 and 2000 and concluded that larger banks with wide service spectrum are willing to take greater risk compared smaller and specialised organisation and thereby overcompensate the potential benefits of diversification. Demirgüç-Kunt and Huizinga (2010) analysed 1334 banks in around 101 countries between 1995 and 2007 and classified banking activities in interest and non-interest business. The authors concluded from the business model of risk and return that small share of investment banking and greater share of retail banking generally produced greater benefits from separation. Altunbas, Manganelli and Marques-Ibanez (2011) assessed around 1100 banks in the US and Europe. The banks were evaluated based on certain characteristics such as equity, size, loan volume and financing structure between 2003 and 2007. The authors observed that availability of limited equity capital, excessive credit expansion and less deposit funding caused high level of risk while high level of deposit reduced the risk level only disproportionately. The authors further determined that existence investment component in retail banking sector increased risk only marginally and complete separation will not exactly have beneficial impact. Beltratti and Stulz (2012) posited based on their assessment of various multinational banks during the crisis that banks with high equity ratio, control on credit business and high deposit rate performed better than others. Based on this these observation, they suggested that robustness of retail banking is not affected by minor share of investment banking. Expected impact of the separation process The separation of retail and investment banking is expected to generate significant impact on various economic activities. From corporate outlook, it was argued that ring fencing will mitigate certain challenges that are faced by creditors and regulators in terms of asset and liability transfer, often at an underestimated price. The amendments however will restrict a variety of banking activities and will also require financial support for ensuring the separation. From legal point of view, intra-group reorganisation will be necessary for effecting the separation. The regulatory landscape suggests that regulatory requirements of ring-fenced and non-ring fenced banks will be largely different in terms of capital quality, quantity and exposure, liquidity level and funding (Khan, 2012). The general citizen or the tax payers will have to reconsider their tax structure and associated costs. It is imperative that the separation of retail banking and investment banking will affect the taxation process. From the UK perspective, it is argued that possibility of tax neutral transfer exists only if both ring fenced and non-ring fenced banks come under the umbrella of same VAT group. With respect to taxation, it is also possible that ring fenced banks may need to pay certain de-grouping charges as a result of transfer of valuable assets. Possibility of tax charges with respect to intellectual property transfer is also expected with the separation. Significant uncertainty is associated with the banking separation in terms of operational continuity, employment, financial management and pension payment (Khan, 2012). The separation of one bank in two components will raise operational issues as the banking system is heavily dependent on combined layers of data. Questions can be raised regarding ownership, migration and protection of data as well as regarding availability of various operational services that are mostly share by retail and investment segments of a bank. Although the banking separation has been proposed to avoid future financial crises but effectiveness of the separation is still blur in terms of its ability to trigger different kinds of default. The separation will also call for separation of assets and liabilities resulting to unassured valuation and rating (Khan, 2012). The most critical aspect of the separation process is employment and pension. It has not yet been discussed in the reports related to banking separation regarding transfer of employees and their terms and conditions. Questions can be raised regarding the impact of the separation on the career and compensation of employees. From the perspective of pension provision, it is unclear whether the separation will result in both kinds of banks becoming participating employers in various pension schemes. Owing to the structural change, there is significant uncertainty regarding disbursement of benefit and pension as well. Arguably, it can be suggested that retail and investment bank separation will have significant consequence on lending and borrowing process in both kinds of banks (Khan, 2012; Peston, 2011). Conclusion and recommendation Based on the major findings and empirical evidences, it was concluded that banking separation or development of separate banking is unnecessary for avoiding future financial crises. The studies have been conducted based on arguments presented in Glass-Steagall Act and similar proposals in the recent times. The studies revealed that no significant difference was observed in risk level of banks by separating activities of a bank in commercial and investment segments. The main idea behind proposing separate banking system is to minimize risk in overall banking system. An alternative recommendation is this regard is greater implementation of banking supervision and minimization of debt leverage in capital structure. Reference list Adams, Z., Füss, R. and Gropp, R., 2010. Modeling spillover effects among financial institutions: a state-dependent sensitivity Value-at-Risk (SDSVaR) approach. European Business School Research Paper Series, pp. 10-12. Altunbas, Y., Manganelli, S. and Marques-Ibanez, D., 2011. Bank risk during the financial crisis: do business models matter?. Frankfurt: ECB Working Paper no. 1394. Bailey, D. K., 2013. Defence of the Doctrine of Pre-emption: Revealing the Fallacy That Federal Pre-emption Contributed to the Financial Crisis. Journal of Constitutional Law, 16(4), pp. 1041-1108. Beltratti, A. and Stulz, R. M., 2012. 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