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Banking Commission – PART 1

Banking Commission – PART 1

How are Retail and Investment Banking connected and how did this come about (Bank Group Treasury)?

Money Markets

Let us consider the simplest retail bank imaginable, a small credit union or building society (a savings and loans bank in international banking jargon). At any moment in time it will have slightly more savings than loans outstanding. It therefore will need to do something with that surplus. It will place it with another bank to get some interest on the surplus. Thus it is participating in the interbank money markets, creating quite legitimately “deal flow” in the Money Markets. This is not Casino banking rather prudent management of surplus funds. Likewise small lending organisations (such as micro finance companies) borrow from other banks in order to find funds to lend out. Since the imbalances between customer deposits and loans fluctuate on a daily basis, so the bank has to be quite active in managing the cash flow and surplus funds to maximise interest income and minimise interest costs to the organisation.

Interest Rate Derivatives

The next step for a small retail banking organisation is to consider its exposure to interest rate changes in the future. If some of the loans are fixed rate (typical for consumer loans) the organisation is vulnerable to interest rate changes. It can go into the financial markets to buy interest rate hedging contracts (such as Interest Rate Options or Total Return Swap) to minimise its exposure to changes in the future. Again this is not “Casino banking” but prudent risk management on the part of the small retail bank.

FX

A larger retail banking organisation might offer foreign exchange (e.g. holiday travel money) services to its customers. Or some of its customers might be small businesses who have some overseas suppliers/customers who want paying to/from foreign currency. To supply this service, the bank has to go to other banks to buy/sell currency in order to fulfil their customer requirements. This generates a very valid need for participation in the interbank FX markets to cope with the surpluses and shortfalls in foreign currency generated by supporting these customer services.

Large SME’s and Corporations

Some large companies want loans that are too big for one bank to take on by themselves (see article on Loan Markets and how they work). Other larger companies want to “cut out the middle man” and take on more risk by having market price (e.g. LIBOR) based loans.

Large companies often want to hedge their exposure to a variable such as an FX rate, interest rate or a commodity price.

What all these requirements have in common is that a specific customer contract is written with a “Back to Back” contract into the interbank market in mind. (The previous examples had a small retail bank pooling customer contracts which generated a surplus or shortfall that needed to be taken to interbank market. Large companies typically generate a surplus or shortfall of sufficient size in individual contracts that the bank has to take them to the interbank market directly, a corporate customer contract at a time. This is still not “Casino Banking”, just fulfilling the needs of large companies.

Group Treasury

All banks have a group treasury function whose job is to obtain a picture of these surpluses and shortfalls and place contracts with the interbank financial markets. The way this works illustrated in this variation on the HowBanksWork framework diagram

 

 

The product engines (e.g. bank accounts, mortgages, credit cards, systems) generate information on current and future surpluses and shortfalls (e.g. loan run off projections). Group Treasury then use this information to plan and execute deals in the money markets etc to fund/place these overall positions. These positions are constantly moving because of customer activity and so Group Treasury will have to deal many times a day in the market to cover the changing positions (e.g. the drawdown of a large corporate loan will trigger market activity).

Evolution of Group Treasury into Trading Areas

It was a small step for large UK retail banks such as Barclays or NatWest to move beyond just executing Group Treasury to proprietary trading. Imagine you were in NatWest Group Treasury in the 1970’s or Abbey Treasury in the 1990’s (both now defunct). You have executed a deal to close out a surplus of some kind (e.g. in one month’s time). A few hours later you see that you could have sold the contract for a better price, and what is more you know someone in the market who has to sell but does not know of the availability of the better price. Are you not just doing your group treasury job better by doing a better version of a deal you were always going to do by buying from the person who does not know the new price and selling it straight on again? The end result would be the same as if you had done the original deal at the later better price.

All the large UK banks built up large dealing operations out of their “natural” Group Treasury activities. They built up big trading teams where increasingly the proportion of deals done were speculative, but at their core was always a natural volume of Group Treasury customer driven needs. Thus it would be better to describe the investment banking activities of large groups such as RBS and Barclays as a gas cloud of “casino banking” swathed around a hard planetary core of Group Treasury real need.

To separate the “casino banking” from the vital Group Treasury work is what is needed to make the Independent Commission on banking and the “living wills” work; it is the subject of the “How to separate Investment and Retail Banking” article.

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