On Monday, U.K. banks will learn their fate at the hands of a commission established to recommend a sweeping financial-industry rewrite. U.S. banks may start to sing, “Proud to be an American” when they see the shape of things to come across the pond. At the least, they may have to shelve their complaints about competitiveness, giving U.K. banks a turn to sing from that songbook.
The Vickers Commission is wrestling with several factors that differentiate the U.K. banking industry from its U.S. confreres.
For all the focus on huge U.S. banks, the three largest U. K. banks have assets well above the U. K.’s total economic output. It’s not yet Iceland, but the U. K. is more a creature of its banks than the other way around. The U. S. debate about big banks focuses on their share of total U. S. financial assets, not the overall economy. Here, banks, big and small, remain subservient to the state. Also, in the U.K. two of the largest banks remain effectively nationalized; in the U.S., of course, TARP is an old bad dream for the surviving big banks.
Does this mean that what happens in the U.K. stays in the U.K.?
We don’t think so. The proposed firewall around investment banking in universal banks would ring-fence all investment banking operations, not just the proprietary trading ones banned under the Volcker Rule. The proposal is different – activities aren’t per se barred as in Volcker – but it is in some ways more sweeping. Instead of finding a class of activities to sanction, the U.K. proposal goes beyond proprietary trading and puts all investment-banking operations – trading for clients, underwriting and the like – in a chamber walled off from the bank. This is even more stringent than the long-forgotten Glass-Steagall Act of 1933, designed at the time to separate Morgan from Morgan and, as a result, divide banking into separate investment and commercial pieces. In the U. K., trading operations couldn’t benefit from any of the benefits of being a bank, nor could investment-advisory work and all the other – very lucrative – activities now housed in U.S. bank holding companies. Instead, they would need to fund themselves in the market just like everyone else.
The scope of this separation would make the Volcker Rule’s ban look negligible, especially for companies with large legacy investment operations. Goldman and Morgan Stanley have – even under Volcker – figured out how to capture the benefits of also being a bank, sticking with the BHC even post-Volcker. Why? Quite simply there’s nothing like a bank for raising cheap funding and, if you can spread it around through the holding company, even buccaneers can learn to be quite content.
But, cut off investment banking from the bank and this strategy – the fundamental premise of many big BHCs – is undone. Is this possible in the U.S. even though Dodd-Frank didn’t go as far as the U.K. proposal?
Yes, even if Britain fails to proceed as proposed. While the U.S. law doesn’t wall off investment banking through a clear statutory mandate, it includes several provisions that could well have this effect. If regulators use the powers granted to them in Dodd-Frank to limit inter-affiliate transactions and credit exposures, they can come very, very close to the U.K. concept.
When we looked at this part of the law last year, we advised clients of its strategic impact, so we won’t go into details here. Suffice it now to say that businesses like derivatives dealing and securities finance will be shadows of themselves if the U.S. regulators go as far here as Dodd-Frank allows.