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05 December 2023

Death knell to super universal bank

By Darren Stubing

Although in a very large way politically motivated, the latest move to rein in banking activities will certainly have far-reaching consequences. The proposed rules by the US authorities on US banks will, if agreed and passed, put significant pressure on large financial institutions and in particular the big universal bank type players which have activities across retail, commercial, corporate and, most pertinently, investment banking.

At the core of President Obama and his financial advisory expert team is the targeting of proprietary trading where banks trade on their own accounts using their own money. The proposals call for the banning of proprietary trading for retail banks, in essence harking back to the Glass-Steagall model of the 1930s that first separated investment from commercial banking. Proprietary trading can be risky and volatile but can also help diversify a bank’s earnings stream and therein strengthen the profile of operating profits.

If properly and prudently managed and governed by both internal risk controls and by limits set and monitored by the regulators, then in itself proprietary trading does not generate excessive or aggressive risk positions. It is too simplistic and certainly not the case that proprietary trading caused the global financial crisis. For sure there was too much leverage at many institutions but the ultimate weakness was in liquidity and funding profiles and positions. It is also wishful thinking to believe that banning retail banks from proprietary trading will prevent a further financial crisis.

Apart from the focus on trading, the other major target is financial institution’s size. This inevitably elicits the issue of too big to fail whereby the consequences of allowing a large bank relative to the economy to fail is just too calamitous to allow and, unfortunately, the authorities and taxpayers have to step in to support it. The ultimate comfort of being supported by the authorities at the end of the day if required has long been a dilemma for regulators and those taking on exposure to banks, including depositors.

It is questionable and very unlikely though, to believe that bank directors and management wantonly go down the route of aggressive and reckless strategies and positions due to the belief that they will be rescued in the end. However, many of the authorities of the large economies from around the world believe that banks have been abusing these ‘special privileges’. Restricting the size and importance of banks to an economy does however, have some merit. Overly dominant and large financial institutions can distort the market and potentially create huge problems if weakness or solvency issues arise. The biggest risk is systemic risk, and this was acknowledged in the financial crisis which ultimately drove authorities to adopt a concerted and consensus rescue.

Larger banks will probably pay for their market share going forward, most likely in higher capital charge through an enhanced capital adequacy requirement, a legacy and penalty at least in the large industrialised countries of government bailouts.

Current banking regulations in the US prevent institutions from holding more than 10 per cent of total US deposits. Proposed rules will be less specific metric wise, preventing banks becoming too big and thus pose a systemic risk, but will also consider a bank’s other funding sources such as wholesale type.

The systemic risk issue will see it become far more difficult for banks to make significant investments in or establish associated financial activities such as hedge funds, investment houses and private equity.  However, the rules will not prevent a systemic crisis as this can occur in the most unlikely and often indiscernible times.

This all provides the likely demise of the universal banking model where firms indulged in all banking and financial activities. The franchise models of the likes of JP Morgan and Bank of America will disappear. These types of firms may well be split to segregate the “safer” plain vanilla commercial banking activities from the higher risk trading and investment arms.

Again, if this move occurs, it will still not guarantee that a future financial crisis will be averted. Bank consolidation is also likely to practically disappear, unless at the small scale operation end of the sector. Any proposed large scale banking acquisition will be prevented.

What are the likely consequences? The ultimate impact could be more expensive banking products for consumers. Less or no contribution from investment and trading activities, in additional to increased capital and liquidity costs, will probably see customers paying more for loan and deposit products.

Market liquidity at the wholesale end may also tighten as volumes are restricted. Credit ratings may be impacted if authorities are really trying to move away from the premise that large or important banks will be ultimately supported by the authorities. All this once again points to lower profitability going forward for banks.

It will also be interesting to see how the international financial arena plays out. The proposed tough rules is aimed at US institutions, although other countries such as the UK, and most likely those in the EU, will probably follow suit.

However, there is not a co-ordinated approach internationally. This could provide competitive benefits for example for those financial institutions in Asia or indeed the Middle East. Arbitrage is likely to be created and moreover it is difficult to see how banks can be prevented from taking separately structured positions in, say hedge funds, licenced and domiciled elsewhere in the world.

 - The writer is a US-based commentator on business issues


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