Tag: retail banking

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Bank braking work

President Obama has proposed a major reform of the US banking system. This follows on from the proposed levy to be imposed on banks’ assets announced a few days ago (see “We want our money back and we’re going to get it”).

There are two elements to the new proposals. The first is to limit the size of banks’ market share. Currently, banks’ deposits are not permitted to exceed 10% of total retail deposits in the USA. This 10% limit would be extended to cover wholesale deposits and other liabilities. The idea is to reduce concentration and increase competition. At present the largest four banks hold over half the total assets of banks in the USA.

The second element involves separating casino banking from retail banking. This would be achieved by barring retail banks from owning or investing in private equity or hedge funds or from engaging in ‘proprietary trading operations’. As the second BBC article below states:

Proprietary trading involves a firm making bets on financial markets with its own money, rather just than carrying out a trade for a client in which only the client’s money is at risk.

This comes close to restoring the Glass-Steagall Act, which was repealed in 1999. The Act, which was passed in 1933 in the wake of the 1929 Wall Street cash and the subsequent Great Depression, separated commercial banking and investment banking. It was designed to prevent customers’ deposits being exposed to the riskier activities of investment banking.

What have been the reactions to President Obama’s announcement? Are these reactions justified? Will the proposals prevent another banking crisis and credit crunch? The following articles explore these questions.

Obama hammers the banks Financial Times, Tom Braithwaite and Francesco Guerrera (22/1/10)
Obama pushes new bank regulation (including video) BBC News (21/1/10)
Q&A: Obama’s bank curbs BBC News, Martin Webber (21/1/10)
Obama announces dramatic crackdown on Wall Street banks (including video) Guardian, Jill Treanor (21/1/10)
Barack Obama bank reforms: Trying to fix a broker society Telegraph, Louise Armitstead and Helia Ebrahimi (23/1/10)
Glass-Steagall lite The Economist (22/1/10)
Obama’s Plan Finally Attacks “Too Big to Fail” The Huffington Post, Neil K. Shenai (21/1/10)
Obama Sizes Handcuffs For Banks Forbes, Liz Moyer (21/1/10)
Obama’s Showdown With Wall Street Forbes, Richard Murphy (22/1/10)
President Obama shows the way Independent (23/1/10)
Wall Street’s $26m lobbyists gear up to fight Obama banks reform The Observer, Andrew Clark (24/1/10)
Obama’s drawn first blood – now it’s the UK’s turn The Observer, Ruth Sunderland (24/1/10)
Gordon Brown to push for ‘Tobin tax’ after Wall Street crackdown Guardian, Larry Elliott and Jill Treanor (22/1/10)
Myners: UK does not need to copy Obama banking reforms Guardian, Andrew Clark, Jill Treanor, Paul Owen (22/1/10)
Debate on London’s banking system The Observer, Will Hutton and Boris Johnson (24/1/10)
What Obama’s bank reforms really mean BBC News blogs, Peston’s Picks, Robert Peston (22/1/10)
Davos 2010: Central bankers seethe behind closed doors BBC News, Tim Weber (29/1/10)

Questions

  1. What are the arguments for and against separating retail banking from the more risky elements of investment banking?
  2. Should banks be allowed to fail? Explain your answer and whether it is necessary to distinguish different types of banks.
  3. Would putting a limit on the market share of banks prevent them from achieving full economies of scale?
  4. Why did banking shares fall after President Obama’s announcement? Was this a ‘good sign’ or a ‘bad sign’?
  5. What is meant by the ‘broker-dealer’ function of banks? Explain each of the specific types of broker-dealer function.
  6. Compare recent UK measures to control banks with those in the USA.
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A splitting headache

In a speech to Scottish business organisations, Mervyn King, the Governor of the Bank of England, argued that it might be necessary to split banks up. The aim would be to separate the core retail banking business, of receving deposits and lending to individuals and businesses, from the more risky and exotic wholesale acitivites of banks, such as securitisation, speculation and hedging – so-called ‘casino banking’.

Governments around the world, as represented at the G20 meeting at Pittsburg in September, have favoured tougher regulation of banks. But Mervyn King believes that this is not enough. It may not prevent the reckless behaviour that resulted in the credit crunch and bank bailouts by the government. “Never has so much money been owed by so few to so many. And, one might add, so far with little real reform.” And if regulation were to fail and banks were to get into difficulties, what would happen? There would have to be another bailout. As Mervyn King said, “The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.”

There are two key problems.

The first is Goodhart’s Law. If rules are set for bank behaviour, banks may adhere to the letter of the rules, but find ways around them to continue behaving in risky ways. The rules may cease to be a good measure of prudent behaviour.

The second is moral hazard. If banks know that they will be bailed out if they get into difficulties because they are too big to fail, then this encourages them to take the risks. As Mervyn King said in his speech, “The massive support extended to the banking sector around the world, while necessary to avert economic disaster, has created possibly the biggest moral hazard in history. The ‘too important to fail’ problem is too important to ignore.”

So should the banks be split? Is there any likelihood that they will? Or are Mervyn King’s proposals merely another headache for the government? The following articles looks at the issues. The first link below is to his speech.

Speech by Mervyn King, Governor to Scottish business organisations, Edinburgh (20/10/09)
Mervyn King: bail-outs created ‘biggest moral hazard in history’ (including video of part of speech) Telegraph (20/10/09)
Governor warns bank split needed BBC News (20/10/09)
A sombre warning BBC News, Stephanomics (20/10/09)
Alistair Darling rebuffs Mervyn King’s attack over timidity of banking reforms Guardian (21/10/09)
King and Brown in rift over whether to split the banks Independent (22/10/09)
Tucker set to join calls for stricter controls on banks Scotsman (22/10/09)
Testing times for bank regulators Financial Times (21/10/09)
Mervyn King is right – the economy is changing and we’re blindfolded, without a map Telegraph, Edmund Conway (22/10/09)

Questions

  1. Explain what is meant by ‘moral hazard’ in the context of bank bailouts. Are the any ways in which banks could be prevented from failing during a crisis without creating a moral hazard?
  2. Does regulation necessarily involve Goodhart’s Law? To what extent is it possible to devise regulation and avoid Goodnart’s Law?
  3. What are the arguments for and against splitting banks’ core business from more risky ‘casino banking’?
  4. Does the separation of retail and investment banking necessarily involve splitting banks into separate organisations? If they are not split, how can the government or central bank underwrite retail banking without underwriting riskier investment banking?