Banks/financial institutions: “Small is Beautiful”

On A Wing and A Prayer

Are any of our banks/financial institutions considered as being too big to fail? If so, is there any contingency plan to ring-fence them?

“Compartmentalization is the answer. Banking has become so complex that I doubt if there is one single board of directors which understands fully what it is overseeing. The solution is to break large banks into neat, easy to manage, easy to understand and easy to regulate parts. For example retail business could be one stand-alone unit, derivatives another, insurance business yet another, and so on — with bamboo curtains demarcating each operation, each one with its own capital and management structure.” (Mauritius Times – 24 Aug 2012)

When I wrote these lines, given the overriding “Big is Beautiful” (BIB) mantra imported from the USA that prevails throughout the capitalist world, it was really done on a wing and a prayer. Because any suggestion that advocated down-sizing sounded like total anathema to the BIB expansionist view that saw no limit to the size of banks’ balance sheets and, in particular, off-balance activities.

Changes – Ring-fencing

But how things have changed belatedly, in the wake of the salutary cataclysmic shock of the 2008 financial crisis! (Whilst welcoming them gladly, it would be presumptuous of me to take any credit for these changes.) Indeed in an effort to rein in the wild free-for-all game that prevailed pre-2008, regulators have been scurrying to put rules into place that in some cases prohibit any activity/ies that would put in peril their financial system. Yet others have gone the whole hog and forced banks to “ring-fence” their activities. Once these rules are functional, the financial world will never again experience the suicidal behaviour that managed to cripple the entire system from which we are still reeling eight years later.

Simply stated, the term ring-fencing refers to the removal of a set of assets from a set of accounts into a separate entity. For example, a certain part of a bank could be ring-fenced so as to ensure that losses in one part do not affect another.

United Kingdom

Back in 2013, Finance Minister George Osborne presented his Banking Reform Bill that aimed to separate the retail from the investment arms of British banks for the first time ever. However it was not until late last year (2015) that the process began to gather momentum with the authorities pushing the banks into ring-fencing their activities. The deadline for full compliance is set for 2019.

For the present however, the rule which one CEO has described as “seismic stuff” applies only to banks that have a customer deposit base of GBP 25bn and, as stated above, the deadline for compliance is set for 2019. Whist there are quite a good number of nitty-gritty details to be worked out between now and 2019, the twin aim of the reform is quite clear.

First, it aims to ensure that ring-fenced banks are protected from shocks that originate in the rest of their banking group and the financial sector at large, in order “to minimize any disruption to the provision of core banking services.” Thus it ensures that retail customer deposits are kept safe and “separate from risks (arising) elsewhere in the financial sector.” Second, having ensured the safety of the domestic retail operation, in future taxpayers will never again be called upon to bail out a failed/failing bank. Ring-fencing effectively means that no bank will ever be too big to fail.

After some initial head-shaking, the large British banks have now gotten round to making plans to comply with the rules and meet the deadline. As would be expected in a varied banking sector as the UK, each bank has its own strategy that is best suited to its specific general set-up.

Thus Barclays, reflecting its long-standing international presence throughout the dominions and colonies of the Empire, plans to ring-fence its activities by breaking the business into three distinct parts. So in future the Group will comprise of (1) Barclays Plc (2) Barclays Africa, and (3) Barclays UK.

Similarly another international bank, the HSBC intends to ring-fence its UK (mostly) retail operation — which it acquired through its purchase of Midland Bank — from its international operations through a new entity which it has baptized HSBC UK.

On the other hand, largely domestic banks like Lloyds and RBS plan to include as much as possible inside the ring-fence they are putting up around their deposit-taking operations.

For now it is not very clear whether UK banks will be allowed to indulge in propriety trading (that is trading for their own account with their own money). But if adopted, the proposed EU Rule will leave them with no choice in the matter.

European Union

In a proposal published in 2014, the EU recommends a total propriety trading ban on banks/financial institutions (BFI). This rule will apply to BFI with assets worth Eur 30bn and trading activities of Eur 70bn or above. In an effort to accommodate the different regimes being expounded in major member countries, the Union would allow member countries to operate their own version of ring-fencing, but they would need to obtain derogation from it, on a bank-to bank basis.

To further protect depositors, trading entities would be prohibited from accepting deposits that qualify to be covered by the EU Deposit Guarantee Scheme, which ensures that a customer of a failed bank receives a maximum compensation of Eur 100k. For couples this figure is doubled to Eur 200k.

USA

Unsurprisingly, the land of “Big is Beautiful” has not gone for any strict ring-fencing because it would presumably signal a denial of its entire business model. Nonetheless through the Volcker Rule it has brought changes to banks operations that would have been unimaginable a decade ago.

Named after former Federal Reserve Chairman, the Volcker Rule came into effect in April-2014, with full compliance following a year later in July 2015. Essentially this Rule prohibits banks from propriety dealing in securities, derivatives, commodity futures and options. Thus, unlike before, banks may not trade on these products to increase their profits because, whilst these activities may enhance the banks’ bottom lines, they do not necessarily benefit their customers. Quite the contrary in some cases, as the artificial demand they create may well increase the cost/premium of these products.

The Rule however does however allow banks “to continue market making, underwriting, hedging, trading in government securities, insurance company activities, offering hedge funds and private equity funds, and acting as agents, brokers or custodians.” Thus they can continue to service customer needs, and generate profits from the provision of these services. But no propriety dealings!

Furthermore, no bank may engage in the above activities if, in doing so, it would create any material conflict of interest, expose itself to potentially toxic assets, or “generate any instability within the bank or within the overall US financial system.”

Now, given the vast scope of this section of the Rule, it would indeed be a very brave banker who would dabble in risky dealings in future. Yet such a move would have been total anathema prior to the 2008 crunch that saw Leviathans like Lehman come crashing down to such a sorry end.

Mauritius

Well so much for the UK, the EU and the US. But what about Mauritius?

1. Are any of our BFI considered as being too big to fail? If so, is there any contingency plan to ring-fence them?
2. In the wake of several BFI failure — the latest being the infamous BAI — in the last 25 years ought we to take steps to protect the hard-working saving public?
3. Especially in these turbulent times when we do not know whence the storm may come, should we not institute a Deposit Guarantee Scheme so that in case of any BFI failure, the customer is guaranteed a decent amount of compensation?

We have to bear in mind that many of them (old-age pensioners, widows and orphans) have no other source of income — they rely totally on their lump sums, savings or inheritance money to live.

Here I go again on a wing and a prayer!

* Published in print edition on 19 February 2016

Tags:BAI, Banking Reform Bill, EU Deposit, George Osborne, Guarantee Scheme, TD Fuego, Volcker Rule