Splitting major universal banks makes sense; safer & more valuable

Banks are proving a tough match for regulators, pushing back strongly against more controls and higher capital ratios. They have argued that imposing rules which increase capital could hit recovery, and politicians are particularly sensitive to this.But banks’ very success in fighting against strong capital ratios – suggesting that restoring capital should take years – points to the need for a more radical solution.

The next challenge to the sector is not capital ratios, but the more fundamental question about whether banks should be broken up. On this subject, politicians, central banks, regulators and shareholders should all be on the same page. Shareholders and society would gain from breaking up banks.

Although investment banking has helped to regenerate capital over the past five years, politicians know there is little public appetite for casino banking. Investment banks and their huge bonuses create headlines that suggest nothing has changed. But, tinkering with capital ratios has not addressed the overall problem about complexity and size. The number of banks in the world with assets of more than $2 trillion has doubled since 2007. So confidence in the ability of regulators to curb systemic risk is waning.

Progress on more radical reform is painfully slow. In the UK, the Vickers Commission ring-fencing proposals, designed to separate commercial and retail banking from investment banking have yet to be implemented in legislation and the US campaign to restore America’s version of ring-fencing – Glass-Steagall is faltering.
Details of parts of its Dodd-Frank reforms have reached deadlock and, in Europe, the Liikanen Report, whose structural reforms include mandatory separation of proprietary trading and other high-risk trading is still under discussion.
While the European Commission has not yet taken up any of the Liikanen reform options, the sector should not underestimate Vickers, which is enjoying good political support despite bank lobbying.

Essentially, the bank reform debate has got nowhere fast in five years. Trading is now such a large portion of investment banking business, that the bonus culture pervades everything else. Alongside these excesses, it is hard to run the utility-like operations of commercial and retail banking. It makes little strategic sense to run combined groups which have attracted such divergent cultures. As trading arms of banks enter new areas such as metals and commodities, risks have grown.

The scale of bonuses in investment banking points to capital being too cheap, encouraged by complex group structures that mean depositors, creditors and shareholders are sceptical of accounts and thus have trouble assessing value. New plans for banking resolution are based round the concept that depositors should bear some pain in any bank collapse.

Yet the risks involved are unlikely to be priced correctly if depositors fail to understand them. Many creditors exposed to bail-ins simply do not have the transparency they need on investment banking risks to assess them properly. Exposing depositors to bail-ins – risking a Cyprus-like economic collapse – is not equitable if the accounts of a banking group fail to set out their risk profile clearly. Today, they are complex and opaque.

Universal banks currently attract low ratings relative to assets, demonstrating that shareholders are being discouraged by the risks being taken by their investment banks. And, it is clear that contingent capital bonds, designed to convert into shares to boost capital when needed, are also seen as too risky, even though providers of this capital have access to far more information than the average depositor.

We cannot wait a decade for the regulators ad politicians to build enough safety into megabanks. Restructuring is a better option.

Already, regulatory change is set to squeeze capital out of investment banking. As banks try to offset the impact of the leverage ratio, they will attempt to reduce their balance sheets. Derivatives and repo business – the core activity of financing via loan collateralisation – will likely see volumes shrink as they consume disproportionate regulatory capital.

The move by Basel to force disclosure of a bank’s exposure of its gross derivative position will not be introduced until 2015, but analysts are likely to require numbers before then.

This will make life more difficult for smaller investment banks. Faced with dull overall investment banking revenue, and a squeeze on capital, investment banking businesses will need genuine global scale in fixed-income, currencies and commodities; second tier operators will be challenged. This seismic industry restructuring could also push the global Tier One investment banking businesses to spin out of their universal banks.

The driving force for the next phase of change could well be shareholders themselves. Not only do the disparate activities of megabanks create internal cultural clashes, but the characteristics of the businesses appeal to quite different types of shareholders.

Utility-like retail banking might appeal to pension funds, widows and orphans. This type of business, paying growing dividends, could be priced as high as three times book value. Indeed, Lloyds Banking Group has already indicated it will distribute a high portion of its profits, offering an attractive dividend yield, and it has achieved a premium rating to tangible net assets as a result. The potential for this valuation might lie within the retail parts of Royal Bank of Scotland, but it is hard for investors to add up the value of the divisions. There is clearly a conglomerate discount on the sum of the parts.

The high octane investment banking businesses would attract braver investors. Profitability of these over the cycle might be a rollercoaster, but there would be potential for much bigger pay-outs in the boom years. Demerging and allowing those investment banking businesses to pay bonuses and incentivise the staff they need, could be the best way of achieving growth.

Splitting universal banks would at least give a clear delineation of relative banking risk for investors. Valuation and culture might achieve in a year what regulators and politicians have struggled with since 2007. It is time for radical action.

A version of this article appeared as the Op-Ed in Financial News on October 1st 2013

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