Is ring-fencing UK banks really necessary?

03 May 2019

By John Thanassoulis

In 1931, at the height of the Great Depression in the US, a company called General Theatres Equipment Inc (GTE). collapsed. Its bankruptcy erupted a scandal that reached such a frenzy its affect is still being felt today.

For it is from GTE's sudden demise that the intellectual origins of the UK’s bank ring-fencing regulation, which came into force in January 2019, can be traced back to.

GTE was a scandal of universal banking, that is where banks provide a whole service including retail and investments. Chase National Bank had offered a $15 million loan to GTE to finance its purchase of troubled Fox Motion Pictures. A year later GTE launched an IPO that was underwritten by Chase National, raising $30 million from investors and depositors. That money was partly used to pay off Chase National. But one year later GTE collapsed with those shares being wiped out.

When the public found their shares to be worthless there was uproar, with US politicians and the media identifying a clear conflict of interest. After all, Chase National had lent money to a firm and then used its reputation to persuade people, including its own customers, to invest in that firm and so pay back the loan. This looked and felt like a conflict of interest in which the vulnerable depositor had suffered the worst end of the deal.

The scandal helped persuade the US Government to introduce the Glass-Steagall Act, which decreed that banks' investment activities and retail banking had to be kept separate.

The financial crash of 2007-08, which saw the UK Government forced to spend £45.5 billion bailing out RBS when really it only wanted to protect depositors and save the smaller retail side of the business, produced a similar public uproar. It was clear large banks could again use depositors to their wider advantage.

The UK Government’s ring-fencing is a similar response to the US Government's in the 1930s as it looks to prevent large banks causing society-wide problems.

Ring-fencing means the UK retail operation of any bank needs to be its own legal entity, with money on its own balance sheet and its own dedicated management. This means that the retail bank is insulated from problems at the wider bank, and it means that the retail operation can be carved out into a separate company quickly.

But the ring-fence idea has not been adopted by all economies. Ironically, the US has taken a different approach this time as, after many years of lobbying, the Glass-Steagall Act was repealed by President Bill Clinton in 1999.

And so after the crash regulators in the US focused instead on the probability of banks failing. They have tried to reduce the probability of trouble by implementing the Volcker Rule as part of the 2010 Dodd-Frank Act. This rule means US banks can’t speculate with their own funds. 

So is the ring-fence the best way of dealing with banks’ riskier activities? Or is ring-fencing deficient in some way? These are the sort of questions I delve into on the MSc Global Central Banking and Financial Regulation.

Watch the webinar on MSc Global Central Banking and Financial Regulation

A famous study by Randall Kroszner and Raghuram Rajan gives us some insight into the ‘conflict of interest' argument. It looked at the bonds being underwritten by affiliate banks, that is what we today call universal banks, and those sold by just investment banks.

The conflict of interest hypothesis is that bonds sold by universal banks should perform poorly because they are taking advantage of unsophisticated depositors and selling bad quality bonds. Meanwhile, investment banks are selling to sophisticated investors, so won’t be able to sell bad bonds.

Under this hypothesis universal banks’ bonds should be defaulting more, but the study found the direct opposite – universal banks were in fact selling better performing bonds. This is not consistent with the ‘conflict of interest’ theory.

More conflicting evidence was found when a study by MIguel Ferreira, Pedro Matos and Pedro Pires discovered that investment funds that have no retail side and so no financial relationship with the firms they buy shares in outperform banks who invest in firms they lend to – universal banks – by 0.7 per cent a year.

However, a second argument against the safety of universal banking is the volatility of cash flows from risky investing. If a bank has a big loss on the investment side it could coincide with a difficult year in its retail operation and pull the whole institution down.

Research has found that investment banks’ revenues are indeed volatile, but there is no positive correlation between the two cash flows of retail and investment banking. It follows that universal banks are actually gaining diversification benefits.

So the global evidence that splitting up the banks will make them less likely to get into, or be the source of, trouble is pretty weak.

But there is at least one major benefit to splitting up the banks: the ease of resolution of retail banking.

A global universal bank is expensive to bail out, but if legally the Government could only focus on the retail entity that would be easier and cheaper to resolve in a weekend. That helps to explain why the UK went for ring-fencing, because it was always about resolution, trying to protect the payment system and retail banking.

But ease of resolution doesn’t reduce the probability of a system failing in the first place. However in the UK the Independent Commission on Banking, set up by the Government in the wake of the financial crisis, did not interpret its remit as making the system safer, but rather if there is a disaster how can we make it less costly to the taxpayer?

How will ring-fencing affect UK banks?

Ring-fencing leaves one further question hanging: what happens to the part of a bank outside the ring-fence?

The last financial crisis really got going in the US when Lehman Brothers was left to collapse. Note Lehman was not a retail bank. It was solely an investment bank, and yet still its bankruptcy turned out to be a disaster, having a huge effect on the US economy. So is it credible that the UK Government would let the investment side of a bank fail? If not, then the ring-fence doesn’t make resolution easier and would be a costly distraction.

Ring-fencing has, perhaps, one more weakness: it can make it harder for smaller banks to grow. Small domestic banks, inside the ring-fence, need to compete for a small pool of permitted assets with the capital of the larger banks which is also trapped in the same pool. This can hinder the small banks' profitability, creating a glass ceiling to growth.

It is a difficult balance for Governments, but after the financial crash it might again be many years of lobbying before the banks have the regulations removed again.

 

Find out more about banking regulation on the MSc Global Central Banking and Financial Regulation or download a brochure.

John Thanassoulis is Professor of Financial Economics and is a Panel Member for the UK Competition and Markets Authority. He also teaches Financial Regulation and Supervision in Practice on the MSc Global Central Banking and Financial Regulation.

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