Financial Market & Risk Management

Anonymous No. Z0921745

Introduction
In this essay the main issue is to focus on the relationship between retail and investment bank. Form 1933, US has taken Glass-Steagall Act to separated commercial and investment banking, in order to reduce risk and conflicts of interest. But this act stopped at 1999 and then recently UK government publishes a ring-fence policy to limit and try to separate their retail and investment bank in a certain extent. So now we would like to analysis and discuss the advantages and disadvantages to separate the investment and retail banking operations by using relevant academic literature to support. Retail banking This bank mainly activities on consumer banking relationships, the retail customers would have demanded in their financial transactions, therefore, banking operation in retail sector are heavily on deposits to fund their activities due to it have a very large number of accounts with small average size of accounts. But, the large number of accounts would bring for very stable behavior among depositors and there is no risk, only fixed interest rates gained in activity of deposit taking. Despite there is small risk for borrowed funds and commercial lending, retail banking is always safety and have a large capital. (Whitfield, 2008) Investment banks In contrast with retail banking, investment banks do not take any deposits, it are heavily involved in trading securities. Services offered both issuing and buying securities. The mix activities in investment banking are increased the conflicts of interest by the analysts in bank would wishing to obtain the soft dollars. (Whitfield, 2008) But in another side, their clients want to pay the lowest commission and advice fees. In other words, there is much higher risk for investment banking as they may consider having higher return, the separation of investment and retail banking has been considered and some relevant policy have been used in several countries to avoid too big risk to fail.

Benefit and against for separation retail and investment banking

Evidence finding of Kroszner and Rajan(1994) that combined deposit and investment banking were safer than deposit banks without affiliated, and they issued more higher quality securities than did independent investment bank.

In 1986, White has examined the failure rate in 1930-1933 of national banks without security affiliates and national banks with security affiliates. He finds that banks without security affiliates were four times as likely to fail, as were those with affiliates. The simple reason is at most of the time government will guarantee the safety of commercial banking, there will be no bankrupt take place, however, those government institution will limit and supervise many trading and services in retail banks, so it is also hard to have high return and profits. Conversely, the investment banking would be easier to making huge revenue with high risk, because the financial bubbles increase when the profit arise. Also, no government guarantee and protect to the investment banking. (Figure 5) Consequently, only the combining of commercial and investment banking would be more stable and profitable. (Michael Konczal, 2010)

Another example given by Alexander academic journal (1998) is that Morgan group using interlocking directorates for both retail and investment banking, therefore, Morgan could economize transaction and information costs as well as overcome problems of adverse selection and moral hazard. More competitive than other separate retail or investment banks, which only have lack capital and unable to finance large security issues. Therefore, the widely banks diversification bring the banks and their consumers benefits in economic of scope, then the policies would allow banks to become larger or provide more services, which would reduce costs and increase 3

efficiency and to be more competitive among financial institutions. As they could gain the more profits and offers consumers lower prices. However, Michelle (1995) provided another argument against is that banking withaffiliates has a conflict of interest and abusive practices. The marriage of investment and retail banking will destabilize the banking system by unambiguously the distinction between noninsured and insured activities. Because the bad news about a bankaffiliate or parent company will bring a bank excessive dividend payments from the bank to the parent will jeopardize the bank's financial health. As far back to the US stock market crash, approximately 10,000 banks failed between 1930-1933. The investigating established the cause of this cash is the riskiness and conflicts of interest that arise when investment and retail banking activities are linked together. (Saunders, 2004) Due to this reason, a new legislation: Glass-Steagall Act is carrying out in US and imposes a rigid separation between this two type of banks. Unfortunately, GlassSteagall Act was repealed in 1999, because the complicate political problems and the incessancy of banking industry lobbying. At the end of 2011, one of largest national economy country UK, has announced that the British government will decide to separate retail and investment banking, arms to ring-fence their top retail banks from the risker investment banking. (BBC News) Thewealthnews reports that banks may increase minimum amount of capital and hold to protect themselves against any future losses. Because once investment banking and retail banking not be separated, the investment banking would like to transfer the money from their retail banking and using it to invest high risk project as they believes that the large capital of retail banking can support their any behavior and decision. The asset portfolios of insure depositories had been steadly forced by non-bank competition into the most risky, most volatile corners of the business. Described by Raj Date and Michael Konczal, they indicated that if the banks make poor credit decision, they can and will be allowed to fail, because they have government guarantee. This is the main moral hazard problem. If the investment banking failed in their high-risk investment, the loss of capital is costs by the taxpayers and the banks loss is directly induce the financial crisis. Hence, splitting retail and investment banking could be a better protection way to protect British economy and their taxpayers stand in a more safety position. (The BBC News) To separate retail and investment banking, the big UK banks will have to be set up so that they run into any trouble with the investment side of their business, their saving and loans divisions would not be affected.

Moreover, the Investment side also would be more carefully to their credit decision, as they no longer have large capital chain support form their retail banking and government guarantee. Unfortunately, reported by Thewealth News, when the ring-fence policy has been announced in UK, the constraints would cost banks between 3.5bn to 8bn a year. Funding costs for the bank lenders would be raised as well due to the limits of a bank use their money in its retail arm for its investment bank. There is a finance researcher Lydia Prieg point out this reforms would not protect the taxpayers from any future banking crisis, it is impossible to separate banks become individually with asset ratios equal to approximately hundred percentage of the UKs GDP. Otherwise, the public against and characterized UK financial crisis as a domino effect, they think this policy is not useful, because the main problem is one bank (bank of England) affect all other banks, they borrow large amounts from each other. Heinzman analysis nowadays, most investment banks has highly leverage technology to identify and proactively solve the potential conflicts of interest across the enterprise and within specific businesses. In addition, Karl Shell announced their research model in 2009, which proved that the investment and retail banking should not be separate, because they through the model found out that unified bank have more ex-ante welfare as they have less constraints than separate bank. It will be more stable in the face of panic-based on shocks and provide wide and convertibility than separate bank. If the bank has been restricted, there will be overinvest isin liquidity assets and high risk of running out cash.

Conclusion
When two banking mixing, it would take on too much risk with depositors' money in hopes of scoring big investment rewards. The credit bubble and crisis would be easy to take place due to the Banks greedy. Due to this result, the separation of retail and investment banking could protect taxpayers and ensuring their national economy health, nothing to big to fail. However, no country have completely separated this two banking system at yet, this is difficult to carrying out because of many barriers and against in the real economy situation. There are still have many problems and breaks should be fixed, many new regulations will be enacting in the future.

Reference
1. Ian Whitfield (2008) Financial Markets and Risk Management, 2nd ed, pp6368 2. Alexander Tabarrok (1998) The Separation of Commercial and Investment Banking: The Morgans vs. the Rockefellers The Quarterly Journal of Austrian Economics, vol.1, no.1, pp1-18 3. BBC business News (Dec 2011) Osborn confirms banks must ringfence retail banking http://www.bbc.co.uk/news/business-16239255 4. UK Chancellor Wants Banks To separate Retail From Investment Banking Website, thewealthnews.com 5. Saunders, Cornett (2004) FINANCIAL and INSTITUTIONS, International ed, pp368-470 6. Karl Shell, James Peck (2009) Journal of Economic LiteratureCould Making Banks Hold Only Liquid Assets Induce Bank Run? pp1-25 7. White, Eugene N (1986) "Before the Glass-Steagall Act: An Analysis of the Investment Banking Activities of National Banks." Explorations in Fconomic History 23 pp33-55. 8. Michelle Clark Neely (1995) Commercial & Investment Banking: Should this Divorce Be Saved? http://www.stlouisfed.org/publications/re/articles/?id=1823 9. Jim Heinzman( 2010) Conflicts of interest in investment banking: what is the right answer?Sramana Mitra. http://www.sramanamitra.com/2010/05/29/conflicts-of- interest-ininvestment-banking-what-is-the-right-answer/ 10. Lydia Prieg (2011) The banks are not only too big to fail, they're too big for the economy The Guardian News. http://www.guardian.co.uk/commentisfree/2011/sep/12/banks-too-big-faileconomy 11. Raj Date and Michael Konczal (2010) out of the shadows: creating a 21st century Glass-Steagall, Roosevelt Institute, pp61-69 http://www.rooseveltinstitute.org/policy-and-ideas/ideas-database/outshadows-creating-21st-century-glass-steagall