One banker contrives a metaphor to defend the universal banking model. If you set two BMW 5 Series cars to race around a track and only one makes it back, that tells you that one of the drivers made a mistake, not that the BMW is a bad car. So don’t junk universal banking, through a forced separation into utility banking, comprising retail deposit-taking and commercial lending, away from trading in securities, just to punish the mistakes of poor chief executives who drove their banks into a wall in the reckless pursuit of profits in complex instruments that they didn’t understand, using leveraged proprietary risk-taking they couldn’t control.
That wasn’t a flaw in the model: it was human failure.
This is the argument now being taken to investors in the stocks of large universal banks that have survived the seizures in the financial system. JPMorgan, HSBC and Barclays made good profits in their investment banking divisions in the first quarter of 2009. These earnings will bolster the banks’ capacity to absorb losses on conventional credit card, overdraft and unsecured personal loans, as well as mortgages and commercial and industrial loans, as the recession plays out. Forget RBS, UBS and Citi. Well-managed universal banks can benefit from the diversification of earnings and spread of risks. These have survived, while narrow banks such as Northern Rock and Washington Mutual were the victims that had no hope of resuscitation.
Regulators, policymakers and taxpayers will require some convincing. But stress tests have been administered and most banks have either passed or been given a manageable revision course to brush up their capital ratios before their re-sits. Investors and creditors have grown used to the notion that no more large banks will be allowed to fail in this crisis. Equity capital markets have reopened to the banks and Libor and other key funding rates have come down. The worst moment for the banks might – just might – have passed.
Regulators and lawmakers are now turning to the longer-term rebuilding of the financial system. But even before they act, change is already apparent. Banks are committing less capital to proprietary risk-taking, closing businesses that required warehousing of collateral before securitization, paying traders less. Proprietary traders are leaving the banks, setting up new boutiques or joining hedge funds, accepting that these might give them less capital to play with than the subsidy of banks’ low-cost funding once provided, but reasoning that at least they can keep a high share of any profits they make without asking the government’s permission.
Does this presage an end of universal banking? Almost certainly not.
The Basle Committee put the global banking system on notice in March that the overall capital in the system must rise and that this must mostly be good quality capital: common equity.
Regulators are right to be picking out some very blunt instruments with which to limit the potential of risk from proprietary trading infecting deposit-taking banks, so exposing the taxpayer. These should go beyond higher capital charges and include absolute limits on the amount of capital and proportion of risk-weighted assets on the balance sheet that banks are allowed to allocate to trading risk.
If regulators, acting together, devise a new regime properly and enforce it effectively, the need to impose a new Glass-Steagall separation – something that Europe never had and that would have to be copied around the world to be workable – will diminish. Enlightened self-interest will push governments and lawmakers to the same conclusion. Higher requirements of increasingly costly capital are already passing rising funding costs on to borrowers when policymakers want to improve borrowing conditions for companies and individuals.
And governments have such huge funding requirements of their own to steer through the debt capital markets that questions of whether sufficient investor appetite exists to absorb them are quickly turning into questions about governments’ own credit ratings. The public sector’s appetite to regulate the capital markets into submission and to legislate large distributors and traders out will soon be sated, when their own interests are threatened.
It’s not clear that enforced narrow banking would make the system much safer anyway. Entities outside the banking system – Lehman Brothers, Long-Term Capital Management – can pose systemic risk that might require consideration of taxpayer rescue. Universal banking will survive the regulatory and legal onslaught. The problem for investors remains that it is a shame so few are any good at it.
