Breaking Up the Banks

0

Nomura’s billion dollar retrenchment from investment banking was notable in its magnitude, but not shocking given Nomura’s past risk-on/risk-off behavior.  Will other financial institutions radically restructure their investment banks?  Not willingly, but regulators are pressuring the universal banking model.  Regulatory pruning will make investment research even harder to fund, increasing the chances of research exits.

We recently heard a rumor that Deutsche Bank will be forced to give up its universal banking model.  An article in yesterday’s Der Spiegel discussed the likelihood of such a bellwether event.

The European Commissioner for Internal Market and Services, Michel Barnier, who has already authored 30 EU regulations impacting banks and other financial market players, recently appointed Erkki Liikanen, the governor of Finland’s central bank, to lead a commission to investigate structural reforms that could lead to the splitting up of major banks.

The EU move came in the wake of the UK’s Vickers Commission, which recommended last year the most extensive bank restructuring yet suggested by regulators.  The Vickers Commission was originally set up to investigate the implementation of a UK equivalent to the “Swiss Finish”, additional capital requirements imposed by Swiss regulators over and above the Basel III capital requirements.  Switzerland requires its banks to hold 10 per cent of risk-weighted assets as “common equity”, the strictest form of capital which is three percentage points above Basel III’s requirements.

The Vickers Commission recommendations went beyond the Swiss requirements, however.  They would require British banks to ‘ring-fence’ their retail operations from investment banking.  The report stopped short of full separation, requiring instead that the retail portion of the banks have a separate board of directors, in addition to a capital reserve of 10% common equity (equivalent to the Swiss Finish).  The recommendations are expected to be put into law next year, and implemented by 2019.

Consequently, the EU now feels its banking regulations are behind the curve.  Under current German restructuring law, when a bank is in trouble the most critical parts of the institution can be transferred to a bridge bank, allowing the remainder to be liquidated.  In the United States, global financial companies are required to submit to regulators liquidation plans.   A law proposed by the European Commission this summer would also require European banks to submit such plans.

However, it is unclear how practical these plans would be in the event of a crisis.  The 29-page executive summary of the liquidation plan Deutsche Bank submitted to US regulators includes 1,113 subsidiaries and 1,504 special-purpose entities which would have to be disentangled in the event of a crisis.  Not something easily done in a weekend.

There is much speculation in Europe about what the Liikanen Commission will recommend.  Will it go so far as to recommend the breakup of the universal bank model, including poster child Deutsche Bank?  Not likely.  Der Spiegel quotes a source in Brussels as saying, “A compromise is taking shape that amounts to the isolation of investment banking within the companies.”  Which sounds similar to the Vickers Commission recommendations.

The question then becomes what the US will do.  Despite Sandy Weill’s about-face on Glass-Steagall, there seems to be little momentum for a major restructuring of banks, at least prior to the coming election.  Nevertheless, the so-called Volcker rules were shown to be ineffective by the JP Morgan Whale episode.  And if the UK and the EU have already gone the ring-fenced route, it is likely that the US will at least go that far.

The consequences of banks having to corral their investment banking operations will be significant. With the elimination of the implicit government guarantee and cross-subsidization through deposit customers, the funding costs for investment banking will increase.  Combined with market pressures, it is likely that more banks will reevaluate whether the expense of full service equity research is justified.

Share.

About Author

Leave A Reply