The main prudential issue is not so much the size of banks but the nature of what they do - the separation issue. Optimal size in the banking industry, on the other hand, needs to balance competition issues against diversification in terms of geographic reach and product mix. So other aspects of regulatory reform would also need to be brought to bear on this issue.
Commercial banks provide the loans and services to households and companies that are the life-blood of business activity and job creation. Investment banks, by contrast, often engage in activities that make more intensive use of complex instruments subject to high-risk volatility and liquidity issues, including trading on their own account. Investing bank capital in hedge funds and private equity firms runs similar risks.
The crisis of 2008 exploded when losses from such activities led to contagion effects and a loss of confidence between banks. Nor were these problems limited to the United States - banks in other countries were also hit. More generally, banks in OECD countries that focused on core customer needs did much better than those firms where contagion risk from complex products was more extreme.
With hindsight, it is possible to trace the origins of the crisis to a shift over time away from the ‘credit culture’ of commercial banking towards an ‘equity culture’ focused on generating profits for shareholders and management by exploiting new financial innovations and leveraging them while taking advantage of regulatory and tax loopholes. Own account trading was a key part of this process.
In the run up to the crisis, the leverage and risks that banks took on became excessive, in part because they benefited from guarantees and other forms of taxpayer support which reduced outsiders’ perception of the risks involved in dealing with them. Risks were not fully-priced and the cost of capital was too low. Excess leverage resulted in ballooning balance sheets and other exposures to the point where some banks were seen as too big to fail.
Looking ahead, the financial crisis provides a clear lesson against allowing excess leverage and risk-taking through financial innovations that do not correspond to corporate and retail customers’ banking needs. ‘Equity culture’ activities, particularly where structured products are concerned, should not be subsidized by public support: separating these from mainstream activities like deposit-taking and lending, as well as some investment banking activities that correspond to customer needs, such as underwriting, market-making, broking and some derivatives services, could bring important benefits for commercial banking.
Firstly, it could significantly reduce contagion risk, whereby losses from high-risk activities undermine the viability of all activities of a banking conglomerate, eating up its capital. Second, it could reduce counterparty risk, as any losses from counterpart failure will be borne by the risk-taking financial firms without affecting core commercial banking activities. Third, it will help sustainable growth by focusing management attention on the core needs of bank clients without major distractions and disruptions.
There are many practical issues in implementing the separation proposal, most notably detail and timing. As markets have recovered in 2009, higher-risk activities have improved banking profits, helping to pay back money to taxpayers and to recapitalize banks. Now, however, commercial banking losses on unpaid loans are beginning to rise, due to the slump in economic activity caused by the crisis.
There are also technical and legislative details to be worked out. If banks are required to sell their higher-risk operations, this should be done over an appropriately long period in order to avoid losses from a ‘fire sale’ or ‘bunched’ process. Alternatively, separation can be achieved through ‘firewall’ structures under which commercial and some investment banking activities are separately managed and capitalised, avoiding the issue of fire sales. On balance, the OECD favours the latter approach, but either would improve stability in the longer run by eliminating contagion risk.
