Bank breakups, red herrings and elephants

The Independent Commission on Banking (ICB) is expected to produce its interim (well, final really except for the horse trading) report on 11th April 2011. The twittersphere, egged on by various newsblogs, is full of people attempting to pre-empt its findings by shouting for the banks to be broken up.  They seem to think that if the banks are broken up into smaller units it will ensure that no bank can ever be too big (or too important) to fail.  And in particular, they believe that if banks are forced to specialise in either retail (clearing) banking or investment banking, there will be no repeat of the financial crisis.  They are wrong.

Let's consider the case of Bank A.  Bank A is a clearing bank.  Its business consists of transactional banking - current accounts, ATMS, cheque processing, automated payments.  It is big, because it needs economies of scale in order to provide streamlined processing, and it has thousands if not millions of customers worldwide.  It accepts deposits from its customers into a variety of interest-bearing savings accounts, and it provides a range of secured and unsecured loans to individuals and businesses.  This is traditional retail banking as we understand it.

Now let's look at Bank B. Bank B is an investment bank.  It trades actively on the international financial markets, both on behalf of its customers who are predominantly institutional investors such as pension funds and "high net worth" individuals (very rich people), and also on its own account - this is called market making.  It may accept deposits into interest-bearing savings accounts particularly from its rich individual customers, and use these funds for trading on the financial markets, but it doesn't lend to its customers.

Clearly these are very different forms of banking activity, and prior to the repeal of the Glass-Steagall Act in the US, they would have been conducted by completely separate institutions.  The UK was not subject to this Act of course and therefore has had an integrated banking system for much longer than the US.  But under current legislation in both countries Bank A and Bank B can be exactly the same bank - let's call it Bank AB.  Banks like to have both forms of activity under one roof, as it were, because then the investment banking benefits from access to clearing facilities for settlement (particularly international payments facilities such as SWIFT), and retail banking benefits from being able to access the international financial markets.

But why would a retail bank benefit from access to the international financial markets? Aren't its lending commitments supported by money from its depositors, and aren't its clearing activities self-supporting (after all, it's only moving money around, isn't it?).  Wrong, on both counts.

In fact all retail banking activities are underwritten by government.  Transactional banking (clearing) is supported by central bank reserves. Deposits benefit from an unlimited taxpayers' guarantee. Lending benefits from the "fractional reserve lending" system in which banks can effectively invent the money they wish to lend and the depositors' guarantee ensures that the central bank will bail them out if it all goes wrong.    The whole retail banking system depends on government support from end to end.  It is not a business at all but a public service.  Breaking it up will simply make it clunky and inefficient - as retail banking was in the US in the 1980s and 90s (I speak from personal experience).

Investment banking, on the other hand, is supposedly self-supporting.  Investors knowingly put their money at risk in the hopes of gaining a return, and similarly the bank itself knowingly accepts risk.  Understanding and managing risk is the whole business of investment banks. 

Banks that integrate retail and investment banking obviously benefit from the government guarantee of retail banking spilling over into investment banking through funding of investment banking activity from retail deposits.  Because banks can invent the money they lend to customers, they don't need to lend out depositors' money directly to customers.  Instead, they use this money to fund their investment banking activities.  Doing this alllows them to make money directly from financial trading using savers' money while at the same time earning interest payments on invented money (loans).  That is lots more money than they would earn if they could only lend out money they have received in deposits.  No wonder the banks like the fractional reserve lending system - and no wonder they don't want investment and retail banking separated.

However, let's suppose that the ICB recommends that Bank AB should be split into its component parts - a government-supported retail bank, A, and an independent investment bank, B.  Would this prevent a future financial crisis?

The trouble is that as I mentioned above, clearing and investment banks can trade with each other.  Supposing that Bank B gets into difficulty because it has invested in some very dodgy financial products which it was hoping to sell later at a profit but the market for them has collapsed.  "Tough luck" would be the normal response, wouldn't it?  Well, no, apparently not.  You see, Bank B settles its trades through Bank A, and Bank A lends to Bank B (interbank lending) to fund its trades. Nothing illegal about this - in fact Bank B, as it is not a clearing bank, has no alternative but to settle through Bank A as it needs access to the international payments system.  Remember I said that clearing banking is supported by central bank reserves?  Bank A's interbank lending activity is effectively underwritten by government, either because it is lending depositors' money (since it now can't trade directly on the financial markets) - and retail deposits are guaranteed by government - or because it is inventing money underwritten by central bank reserves. So in effect Bank B has access to government funds to settle its trades, even though it is supposed to be self-financing.

Suppose that the (unscrupulous) management of Bank B knows that the funding it receives from Bank A is effectively guaranteed by government? Well, it's obvious actually - the bank clearing system can't be allowed to fail, because it's used to pay people's wages, and their tax bills, and their council tax, and their mortgages, get the idea.  And even if it doesn't have enough depositors'money to fund Bank B, Bank A can simply invent some more money, because although there are supposed to be rules requiring it to hold a certain amount of capital reserves to support its lending, it's been years since anyone bothered to enforce them.  So Bank B knows that Bank A will ALWAYS fund it, and it knows that if Bank A gets into trouble because of the support it is giving to Bank B, the government will ALWAYS bail it out.  Knowing that, Bank B can take on ridiculous risks. In fact it doesn't even need to know what the risks are.  All the financial instruments it trades can have a triple-A credit rating, even if they are complete junk.

If you think this scenario is imaginary, or could never happen because no government would be so stupid as to allow unlimited funding of investment banks by clearing banks, you would be totally and completely wrong.  This is EXACTLY what happened in the US - as is evident in this after-the-event analysis by Susan Krieger.  Investment banks took on more and more risk in the search for higher yields for their investors.  Neither they nor the investors had any idea what the real risks underpinning the fancy financial instruments they were trading were, and they didn't care.  When the whole mortgage-backed securities pyramid collapsed, they were bailed out by the Fed, as they expected.  Well, except for Lehmann Brothers, that is.  The US govt allowed this one to fail.  And there were HOWLS of outrage from the other banks.  The US government hadn't honoured its implicit guarantee!  TREASON!

Now, in this nightmare scenario there is NO legal relationship between Bank A and Bank B.  There doesn't need to be.  They can trade with each other openly and unrestrictedly.  So breaking up banks that do both retail (clearing) and investment banking is a complete red herring.  It will achieve precisely nothing.  The retail banks will remain "too important to fail" and underwritten by government, and the investment banks will continue to be funded by them.  And there will be another financial crisis within a few years, and more taxpayers' money poured into failing banks.  Because there is effectively an open conduit of government funds to investment banks indulging in high-risk financial trading.  Unless this is closed, investment banks will continue to gamble on the financial markets with impunity, and pay themselves obscene amounts of money for doing it.

One option that has been mooted is to prevent retail banks from lending to investment banks (and vice versa, presumably) - Mervyn King is thought to prefer this idea.  The price retail customers would pay for this would be lower returns to bank depositors (as if they aren't low enough already) and probably a much more restricted range of retail savings accounts - in fact, rather as things used to be before the massive expansion of financial services in the last 20 years.  However, the investment banking effect would be much more interesting. Investment banks have to borrow on the international money markets to fund settlements. But the money markets would be much less liquid than they are at present because retail depositors' funds would no longer be available to them. Evidently the cost of funding settlements would soar. This would significantly reduce the retuns to investors, both individuals and institutional investors such as pension funds.  Pension fund returns are already pathetic. How much lower can they go before people give up putting money into pensions and stuff the money under the mattress instead? (See my previous blogpost on savings).

An alternative would be to continue to alllow clearing banks to fund investment banks, but in a much more transparent and regulated way.  This seems to be the preferred option of the Fed's Ben Bernanke. The issue here is really the extent of regulation and its enforceability.  Imposing much more extensive requirements for reporting of market risk and liquidity would permit the funds conduit to remain open - provided that the regulations were rigorously enforced.  But regulation of banks has historically been far too lax. The regulators don't enforce the rules that already exist, not least because of major conflicts of interest.  How can someone who is CEO of a bank also be on the board of the body regulating that bank?  That is exactly what happened in the UK, and the bank concerned - HBOS - was eventually brought down through years of fraud and mismanagement to which the regulator turned a blind eye.  Personally I am not convinced that regulators can be sufficiently knowledgeable and independent - and resourced - to undertake the task of enforcing detailed risk management procedures and reporting in all investment banks. 

And finally - the elephant in the room.  People like to believe that it was the evil derivatives traders on the financial markets who brought down the banks and caused the financial crisis.  Retail banks of course are much too well-behaved to do anything to cause them to fail, so they can be trusted with an unlimited taxpayers' guarantee across all parts of their business, can't they?  Let's go back to the good old days of traditional retail banking and get rid of these fancy financial markets. Who needs them, anyway?

Wrong again.  ALL FOUR of the banks that failed in the UK collapsed not because of risky trading on the financial markets but primarily because of very aggressive retail lending funded by short-term borrowing and  insufficiently supported by capital reserves.  In other words, in the UK it was the RETAIL banks that failed, not the investment banks. 

I believe that we must address the issue of lax regulation of retail banking.  Aggressive expansion of business activities funded through short-term debt is a high-risk strategy in any business, and in a retail bank - which as I said above is a public service, really - is absolutely unacceptable.  The FSA should have noticed that Northern Rock was funding its mortgage book in the overnight money market - completely inappropriate use of short-term funding to support long-term liabilities and a clear warning sign that the company was seriously short of liquidity.  Nor should HBOS have been allowed to leverage up its lending so much that its capital reserves only accounted for 3% of its total liability. And as for RBS - it was so overexposed across virtually all areas of its business that its eventual failure was inevitable, and I frankly wonder how it survived as long as it did.  Behind all of this was a conflicted and ineffective regulator and a Government that was only too happy for banks to make more and more money, never mind the risk, because it wanted the increased tax income to fund its spending programmes. Totally insane.

The present Chancellor seems to think that handing responsibility for bank regulation back to the Bank of England (BoE) will solve the regulation problem. I guess he's too young to remember BCCI, but you'd think someone would have told him about it. Personally I don't think the BoE is the appropriate body to regulate and supervise retail banking, though it may be ok for investment banking provided this industry is denied access to BoE funding (let's not have any MORE conflicts of interest, please!).  I would like to see a completely independent regulatory body - an OFFIN for retail banking, recognising that it is actually a public service in private ownership and therefore should be regulated in the same way as the privatised utilities. And I would like to see investment banking separately regulated by a body made up of people who REALLY understand financial risk management.

Obviously I don't know what the ICB will recommend.  I would like its recommendations to be comprehensive, achievable and effective, but I suspect that they will be partial and ineffective. 
I really hope, for everyone's sake, I am wrong.


  1. This, and your other recent post on the same subject, have really cleared up my understanding of the way that commercial and investment banks operate and interact. I'd previously accepted the narrative of blaming the investment banks, even though it now seems quite obvious that this was untrue. Thanks for clearing up my understanding.

    I must say, though, that I'm sceptical as to what extant the investment banks could have been ignorant of the conduct of the commercial banks (especially those that were part of integrated banks). Are you sure they weren't just happy to turn a blind eye to irresponsible lending as long as it brought them a profit in the short term, safe in the knowledge that they would always be insulated from any real harm done in the longer term?

    In any case, I'm not convinced that any amount of regulation (no matter how necessary) will be sufficient to prevent another crisis. The real causes of the crisis are the ideologically driven failures in macroeconomic policy that have dogged us for the last 30 years. It's these failures, in my view, that led to the demand for sub-prime lending in the first place: Namely, the abandonment of effective fiscal policy to maintain full employment, leading to widespread relative poverty and mass unemployment; and the misguided pursuit of budget surpluses as an indicator of "fiscal responsibility" when, given that we operate a non-exchangeable fiat currency, gvt surpluses only serve to drain the private sector of net financial assets, thereby increasing the demand for credit and reducing the ability of private actors to net save.

  2. The US banking system to this day is less integrated than the UK and it is quite possible that many investment banks genuinely did not know how toxic the stuff they were selling was. I agree that the big integrated banks really must have known but ignored it. Either way, it is evident that the investment banks didn't bother to investigate and manage their risks, and I believe this was because they knew they would be bailed out if it all went wrong. Krieger's speech supports this viewpoint.

    I also agree with you that policies to reduce govt debt over the last 20-30 years have effectively transferred the debt burden to individuals. As govt debt has fallen personal debt has risen. Current govt debt levels are not particularly high by historic standards, but personal debt is at an all-time high. This movt from govt to personal debt has been made possible by the massive expansion in bank lending, especially mortgages, since the 1980s, and there is some evidence that govts (of both colours) on both sides of the Atlantic have actually encouraged the growth of this lending - see Simon Magus's comment on the other blog. Excessive and highly risky bank lending causing unsustainably high personal debt levels are in my view a direct consequence of the supply-side economics of the last 30 years.


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