26 February 2013

Bank of Finland/Hakkarainen: Remarks at the Future of Banking Summit

Thoughts on the reasons why the universal bank model exists, i.e. why it is valuable 

• There are a number of reasons why banks combine several business lines under one roof:
  • strive for optimal use of capital
  • diversification of risk as distribution of profits and losses of different business lines are less than fully correlated
  • synergies from combination of different expertises
  • servicing the multiple needs of clients, especially in the case of corporate clients (one-stop-shopping)
• There is now one way of structuring a universal bank. E.g. some universal banks have numerous business lines under one legal unit, whereas other universal banks operate as a holding group of separate companies. The business lines or legal units can be defined based on e.g. business areas or functions and/or geographical reach.
• The way banks aim to be structured is crystallised in the strategy, but e.g. M&A history and ability to achieve organic growth has had a great impact on how universal banks are structured today.

Even without regulation requiring so, many banks already manage different business lines separately, which closely resembles a structure with different legal units.

• Banks find management, risk management and HR/recruiting easier if the business is separated along logical units, i.e. functions/activities which fall naturally together.
• From a risk management perspective, portfolios are already managed separately.
• In some cases an important driver for legal separation of businesses is “Disaster management”, i.e. keeping particularly risky or vulnerable business in a separate legal unit thus making it easier to divest/withdraw without exposing the rest of the operations for contagion by cutting linkages rapidly.

There are also benefits of being organised along separated business lines.

• The pricing of internal funding of business units can be arranged at arm’s length with risk-adjusted transfer pricing.
• Allocation of economic capital can be done by business line and even at the level of individual customers, which support decision making and carrying out the business in an optimal way.

In my view legal separation would benefit in particular the governance and risk management of banks.

• As the HLEG report states, I have also experienced that the cultures of traditional retail banking and investment banking/trading activities are very different and blended cultures can cause problems.
• The nature of the business and the attitude towards risk-taking are different. In investment banking and trading activities profits are generated by actively seeking risk-taking opportunities by opening risky positions. Whether these risk exposures had good risk-adjusted return prospects, has often been of secondary importance. Models and warning signs flagged by risk management were often disregarded; high risks were taken even if the probability of success was low and the potential downside was significant. In traditional retail banking, profits are mainly earned from interest rate margin income from long term customer relationships in a more stable manner. Credit quality assessment and pricing policy lie at the core of the business.
• Also the time horizon differs markedly. In the trading activity the results settled and assessed every single day. In retail banking profits are generated over several years time period.
• The responsibility and independence of the management is enhanced if business lines are separated to legal entities.
• Separation also facilitates management, risk management and HR/recruiting, as the objective and needs are clearer in a separately defined business unit. Aligning incentives to the strategy of the business line by means of targets included in remuneration schemes will also be easier.
• If the operations to be separated are logical units then it is most probable that required reporting systems to support governance are already in place.

Differences between the proposals of Independent Commission on Banking and High-level Expert Group

• ICB and HLEG proposals started from different directions; the approach taken by ICB started from the narrow banking philosophy, whereas HLEG focused on the most volatile parts of banking business. However, the groups ended up with qualitatively similar proposals.
• As John Vickers has stated already, the main question as regards the position of the ring-fence is “Where should securities underwriting be; in the investment bank (such as in ICB) or in the deposit bank (as in HLEG)?” Another difference is that ICB’s proposal includes geographical restrictions as non-EEA customers cannot be served by the deposit bank. This highlights the focus on the viability of the UK banking sector in the ICB.
• HLEG is based on the view that underwriting is closely connected with corporate banking and thus naturally belongs to the deposit bank. From the corporate client’s perspective, issuing a bond is an alternative way of financing to taking a bank loan. From the bank’s perspective, there are similar elements in both, because both involve a customer credit quality assessment, although in underwriting the bank’s own position taking is normally quite limited.
• It is true that a promise of market making can be an important complement to a successful underwriting of a bond. However, separate entities within the bank group can well provide the underwriting and market making services without any additional cost to the customer.

However, in my view the fundamental difference between the two proposals is the difference in capital requirements.

• ICB imposes an extra capital requirement on the ring-fenced retail bank (~deposit bank).
• The HLEG was more concerned of strengthening the capitalisation of the trading entity and therefore suggested a review of capital requirements on trading book requirements. It also suggested a review on capital requirements on real estate related lending. HLEG did, however, not make any explicit requirement on imposing higher capital requirements.
• I do recognise that the requirement to issue designated bail-in instruments can be interpreted as higher capital requirements. These would, however, apply across business lines not only to the deposit bank.

Proprietary trading and market making – is the question whether they are separable or whether they should be separated?

• The first argument for the approach taken by HLEG is based on the desired scope of the safety net.
• The second argument underlying the HLEG proposal relates to whether it is possible to make the distinction between proprietary trading and market making.

Full information

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