They say good fences make good neighbors. Whether ring fences would have the same effect on the European banking sector and its corporate clients is another question. Earlier this month, the U.K. government published draft legislation based on last year’s Vickers Commission report, which recommended that financial institutions’ retail bank operations be ring-fenced from their riskier proprietary trading and investment-bank operations.
The European Commission released a report this month detailing similar proposals from a committee chaired by Erkki Liikanen, governor of the Bank of Finland. This report notes that, having evaluated the banks, “no particular business model fared particularly well, or particularly poorly, in the financial crisis. Rather, the analysis conducted revealed excessive risk-taking — often in trading highly-complex instruments or real estate–related lending — and excessive reliance on short-term funding in the run-up to the financial crisis.”
Put another way, you don’t have to be an investment bank to take excessive risks. British taxpayers know this lesson well: the first bank to fail, Northern Rock, was a former building society, a supposedly conservative savings and mortgages institution that was far more active in the securitization market than its total balance-sheet size would have led anyone to believe. Similarly, HBOS was forced into the arms of what is now Lloyds Banking Group — and into partial state ownership — without having had the benefit of Lehman Brothers–style trading desks.
François Masquelier, chairman of the Luxembourg treasury association ATEL, acknowledges that, with the Liikanen report, a real effort is being made to engage people to think about how best to strengthen European banks. But he is not convinced that the mandatory separation of proprietary trading and other high-risk activities will be enough to protect them. “The extreme segregation of activities can sometimes be counterproductive by reducing all-in profit and the potential for economies of scale,” he says.
Ring-fencing is one of those ideas that perhaps sounds good at inception but isn’t so good when the details are analyzed, Masquelier says. “The question of how to separate trading from other activities will remain extremely complex in practice. In fact, how to define ‘trading activities’ is a key question and extremely difficult to answer.”
It’s a moot point as to how such divisions would affect corporate clients. “The aim is worthy and respectable, but the consequences are hard to assess and to measure for corporates,” Masquelier says. The truth is, corporate banking just isn’t such a large part of a large, integrated bank’s profits when compared with its other businesses, especially its trading arms. Splitting activities could, therefore, “reduce economies of scale, increase costs, and increase [banks’] reporting workload. Transparency and regulations have a high cost to be paid,” he says.
The ATEL chairman adds that the regulatory model will only work if banks’ business models change. Proprietary trading has been growing and effectively cross-subsidizing banks’ other, lower-earning activities — a strategy that, he says, “is not completely sane.” Much better, he argues, that banks “properly price their services according to risks and costs, and corporates will have to be prepared for this.”
Andrew Sawers is editor of CFO European Briefing, a CFO online publication.