Essay on Operations and Strategy of Financial Institutions
Today, the idea of the separation of the retail banking from the investment banking grows more and more popular. However, this idea is inspired not just by the common sense of policy makers but rather by effects of the economic recession in the US, followed by the global financial crisis in 2008. The global financial crisis affected many banks, including Northern Rock, the UK-based retail bank, which operated internationally. The global financial crisis had struck especially those banks, which had either poor or risky assets and which policies were ineffective. Northern Bank turned out to be incapable to cope with the crisis strike and now the bank is run by Virgin Money. The idea of the separation of the retail banking and the investment banking may still affect the profitability and performance of Northern Rock Bank because this decision will affect the financial sector at large. However, the seemingly positive impact of the separation may bring doubtful results since the stability of the banking industry and financial markets depends not only on the separation of retail banks from investment banks but also and mainly from policies conducted by banks, because banks conducting risky operations will face the downturn in their business development regardless of whether they are retail, investment or universal banks.
Background of the emergence of the idea of separation of the retail banking from investment banking
The emergence of the idea of the separation of the retail banking from the investment banking dates back to the economic recession in the US that triggered the global financial crisis of 2008. In the aftermath of the financial crisis, which peaked with the collapse of investment bank Lehman Brothers, there has been a search for ways to increase the stability of the banking system (Gorton, 2012). One of the frequently suggested options is the potential separation of banks into a retail part and an investment banking part, or high-risk part (Haldane, 2009). In such a situation, the idea of the separation of the retail banking from the investment banking was the natural response because this decision was supposed to secure the retail banking and the banking industry at large. The idea of the separation was suggest as the remedy against crises in the banking industry because such separation could allow ‘localising’ the crisis in certain retail banks only or, in the worst case, in the retail banking sector alone, while other banks and the banking industry would maintain the stable performance.
Alternatively, experts (Mishkin, 2011) offered other possibilities to manage crises in the banking industry and prevent such problems as occurred in 2008. Other possibilities include a further increase in the buffers to be held by the banks, investment in better risk management, more, and especially more effective, supervision and the removal of incentives in the system that can lead to taking excessive risk (French, et al., 2010).
Nevertheless, the separation of the retail banking from the investment banking became the mainstream idea that was supposed to save the banking industry from the possible collapse in the future. In this regard, given the consequences of the collapse of Lehman Brothers for the banking system, the search for measures to reduce the exposure of retail banking to the risks of investment banking is entirely understandable (Hoshi, 2011). As a result, governments of the US, the UK and other countries of the EU have started to consider the possibility of the introduction of the separation of the retail banking from the investment banking.
The essence of the separation of the retail banking from the investment banking
To understand possible effects of the separation on the profitability and performance of the Northern Rock as well as on the banking industry, at large, it is important to understand the essence of this policy. In fact, the ‘retail banking’ in this context refers to banking that supports the real economy (Hanson, Kashyap, & Stein, 2011). An investment bank is a bank engaging in other banking activities, such as proprietary trading (Gorton & Metrick, 2011).
Under the Volcker Rule applied to the US banking system, a retail bank is restricted with regard to trading for its own account (or ‘proprietary trading’), and may only invest in hedge funds and private equity to a limited extent (Issing, 2009). One serious problem in this approach is how does one distinguish between proprietary trading and market making or operations relating to management of the balance sheet (Issing, 2009)?
The Liikanen Committee operating in Europe proposes that banks with more than EUR 100 billion in “assets for trading activities” or for whom these assets represent at least 15% to 25% of the total assets should be obliged to segregate these trading activities in a separate legal entity (the “trading bank”) (Hoshi, 2011).
Specificities of the separation of the retail banking from the investment banking in the US and the EU are important factors for Northern Rock, as the bank that operates internationally. At this point, the different approach to the separation was determined by the difference of the banking system in the US is very different to that in Europe, where there is more bank intermediation (Mishkin, 2011). On the other hand, researchers (Mishkin, 2011) insist that if banks in the EU are somehow forced to divest their investment banking businesses and incorporate them in separate entities, is that these entities will very likely be too small to be able to continue to exist independently.
Risks and possible effects associated with the separation of the retail banking from the investment banking
Proponents (Hoshi, 2011) of the separation insist that this policy is essential to secure the banking industry from new crises. However, the major reason for this policy in the US and the EU was the excessive risk-taking has been behind the problems (Larosiere, 2012). In other words, the problem was not in retail or investment banks’ specialisation. Instead, the problem was their risky policy. In case of the 2008 global financial crisis, retail banks were particularly vulnerable to the negative economic trend and faced a particularly deep crisis, but the problem was not in their specialisation but in their risky assets and policies.
In addition, complex financial products, often poorly designed (such as the subprime-based products that emerged in the United States, but became widespread around the world), and their securitisation and trading triggered the crisis (Larosiere, 2012). Banks could not manage those complex financial products, which they had at hand. As a result, they finally slipped to the downturn in their development and faced a profound crisis.
Researchers (Larosiere, 2012) point out that banking “models” have not been a decisive factor. In fact, specialised institutions (pure retail banks or pure corporate and investment banks) have been among the worst affected (Larosiere, 2012). For instance, this is the case of Northern Rock, which is focused exclusively on retail and whose dramatic fate is well-known (this bank had to be fully nationalised, with costs covered by British taxpayers) (Larosiere, 2012).
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