Bank regulation is based on the idea of protecting ordinary depositors and preserving systemic stability. This idea is an important and necessary one, given that having a bank account is, for most people, not optional. Where individuals are required to use a particular service, it is entirely appropriate that government should regulate the risk/cost-profile of that service, as is done with railways, utilities and other providers the use of whose services is effectively compulsory.
Banks, however, do more than simply operate payment systems along with the necessary sight deposit facilities. They provide deposit customers with a wide range of investments, make loans and engage in a wide variety of sophisticated financial operations – a substantial subset of which are labelled investment banking. Recent turmoil has broadly affected the latter and has provoked a debate as to whether deposit-taking institutions should be permitted to engage in these activities.
The Glass-Steagall model in the US operated for many years on the basis that they should not, and mandated a separation of investment and commercial banking. However, this proved to be unsustainable, there being in reality no bright line between commercial and investment banking. The distinctions in many respects came down to legal names – a holder of a fixed-rate, fixed-term bank deposit is economically in no different position from the holder of a fixed- term, fixed-rate bank security. Attempts to preserve a regulatory distinction based on legal characterisation eventually collapsed under the weight of its own contradictions, and even in the light of recent events no one argues for the return of Glass-Steagall.
The proposed UK special resolution regime is a step in the direction of Glass-Steagall. It is based on the concept of depositor preference – that is, the idea that the bank may do broadly what it likes, but in the event of a failure the bank will be divided in two, depositors will be paid first and other creditors (including the whole of the investment banking business) will take what is left over. They will become, in effect, subordinated creditors.
Subordinated creditors require a higher risk premium before they will deal with an institution and the more they are subordinated the higher the premium they will charge. Perhaps more importantly, a creditor whose claim is subordinated is less likely to agree to deal at all than one that is not.
It follows that restricting a bank’s access to the funding markets is likely to increase the risk of bank failure, as well as increasing its cost of funds and handicapping it in the investment banking business. The long-term effect of this policy may therefore be to implement in the UK a variant of the policy explicitly espoused by Glass-Steagall.
Some may argue that this is a good thing. However, it should be remembered that the essence of an investment banking business is to operate a market for financial assets. A classical commercial bank raises very short-term money, in the form of retail deposits, and lends it to commercial borrowers on terms that it will not be repaid for years. It is therefore subject to a high level of liquidity mismatch. It can reduce this mismatch by borrowing in the commercial loan markets, financing itself with instruments repayable after weeks or months. Its liquidity exposure is structurally significant.
An investment bank, by contrast, is likely to raise more of its financing through the wholesale markets. It will use the money raised not to make loans, but to buy securities of various types. In theory, this is much safer, since securities can be easily liquidated and greater exposures supported.
It is this last proposition that so spectacularly failed in the recent turbulence.
However, this does not disprove the fundamental truth that markets are, in general, a better source of liquidity than other sources. The fallacy is not relying on markets in general, but relying on markets to be perpetually present in all circumstances.
The liquidity that can be provided by a market is simply the sum of the liquidity provided by all the dealers in that market, and in a general liquidity crisis the totality will shrink as the components shrink. However, the basis of market analysis – that it is better to approach all of the market participants publicly than to approach each privately – remains valid. The proposition that commercial banks will in some way benefit from having their access to markets inhibited or barred is not only unproven, but demonstrably fallacious.
Simon Gleeson is a partner at Clifford Chance