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Banking Commission – PART 2

Banking Commission – PART 2

Independent Banking Commission Separation

In order to satisfy the Banking Commission’s spirit (as opposed to the letter of whatever the commission comes up with) there appear to be four levels of separation required.

  1. Legal Entity Separation;
  2. Operational Separation;
  3. Customer Partitioning;
  4. Retail Treasury Commercial Partitioning.

These are described in sequence as they build on each other, and then some conclusions are presented for regulatory implications.

1. Legal Entity Separation (and its consequences)

The Banking Commission talks about subsidiarisation, with a view to ensuring there is adequate capital ring fenced for the Retail bank to protect it against the bankruptcy of the Investment banking operation. In the opinion of the author it seems implausible that any arrangement other than a full legal entity split would give the necessary certainty in the event of a bankruptcy. (Regulatory processes of division of capital work fine when the bank is going well but extreme movements of capital happen just before bankruptcy as was seen in the Lehmans failure).

Thus a universal banking group such as HSBC or Barclays would have to create a UK retail banking company and an investment banking company within a holding company. Each would have separate banking licences and would hold separate capital. They would have to maintain and publish separate financial accounts.

2. Operational Separation

As described in “How are Retail and Investment Banking connected and how did this come about (Bank Group Treasury)?” the Retail Bank’s Group Treasury function will still need to make investment type banking deals on its own behalf or because of customer requests. The separation should be aimed at removing the speculative trading from the basic needs of Retail Bank and its customers. This actually happens a lot already in large universal banks where a division (or a geography) takes a position with a customer or group of customers. The division then creates an equal sized internal trade between itself and the trading arm of the group. The central trading arm of the group is empowered to take the position into the market or incur position risk whereas the division is not and must always flatten out its market risk.

After the Banking Commission Separation the only difference is that the process of transferring risk from parts of the UK retail bank would;

  1. only be allowed with the Retail Bank Treasury Department, and
  2. the only deals the Retail Bank Treasury Department would be allowed to do would be to “demonstrably” flatten risk position with the market and not enter into proprietary deals for the sake of making money. In accounting terms, Retail Bank Treasury has to become a cost centre, not a profit centre. This would need regulatory supervision to make sure that the Retail Group Treasury does not start evolving into a Trading bank again.

In practice, today, Retail Bank Treasury deals and speculative market deals are all mixed up in the same legal entity’s books. These transaction types need to be split between the Retail Bank legal entity and the Trading legal entity.

Operationally this may require a degree of “cloning” of the underlying systems for booking these deals; a set of systems for booking these deals for the Retail Bank Treasury Department and a set for the trading company. Again many UK universal banks have a degree of this separation already but it is more in the form of a Group Treasury function which is looking to hedge position or fund balance sheets from subsidiaries all over the world. For the aims of the Independent Banking Commission, the Retail Bank Treasury would have to work at arm’s length from the rest of the Group, including the overall Group Treasury. A typical example might be a UK Banking Group having a subsidiary in the euro zone and hence hedging Euro FX positions between the UK arm and its European subsidiary, without recourse to the interbank markets. This sort of process would have to become much more formalised and transparent.

3. Customer Partitioning

A more complex area is deciding whether a customer who requires a service is a customer of the Retail Bank or the trading company. For true retail customers this is very easy but there are a variety of mid-sized organisations where the distribution is not so clear;

  • Credit Unions and mid-sized Building Societies
  • Foreign Exchange Bureaux
  • Large Multinational Corporation.

A guide would be who is taking the credit risk for the Credit sanction. It is perfectly feasible that the trading company provide a services to a corporate or commercial customer (e.g. an FX quotes API to the FX bureau’s dealing desk) in return for an income share with the Retail Bank which takes the credit risk of the bureau.

However it is achieved, it must be clear whether a customer is dealing with the Retail Bank or the Investment Bank.

4. Retail Treasury Commercial Partitioning

Up to this point most UK banking groups would grumble about the hassle involved in creating separate legal entities and the possible extra capital required but actually there is not such a big difference with how they operate.

The big challenge would come when one then analyses the risks to the Retail Bank of putting too much Treasury business with one provider, i.e. the trading arm of the banking group. At the minute, by default a 100% market share of the Retail Bank’s Treasury business is placed with the trading arm of the Group.

From the point of view of sustainability of the UK Retail Bank this is an untenable risk. If the Investment Banking arm went bust with 100% of the Retail Bank’s Treasury business, the retail bank may have sufficient capital to generally carry on but its exposure to the Investment Banking arm would be too high.

The logical consequence of this would be for the Retail Bank Treasury function to spread its risk by contracting some of its funding and hedging with other banks; e.g. Barclays UK putting portions of its Treasury business with HSBC Investment Bank, RBS Investment Bank and others.

This creates a conflict of interest for the Banking Group as a whole:

  • The Group would prefer to keep as much of the Treasury business in house as possible to maximise income.
  • The UK regulators would want the UK Retail Bank to diversify its Treasury contracts to reduce concentration risk with the Group’s investment banking arm.

Conclusions

If UK Retail Banking Group are to implement the spirit of the Independent Banking Commission’s report then they will be faced with some technical work to create the separation needed but in the opinion of the author nothing like the volume of technical change required when BASEL II was introduced.

More importantly three aspects of the process will require close regulatory scrutiny and supervision on an ongoing basis.

  • The dealings of the Retail Bank Treasury are only those needed for the good running of a UK Retail Bank and do not stretch into proprietary trading.
  • That the customers are correctly partitioned; i.e. that retail bank customers are not trading counterparties (Citigroup would not count as a customer).
  • That the Retail Bank has diversified enough of its Treasury business away from the parent group’s own Trading arm.

These regulatory requirements will drive information sharing on the matters between the Retail Bank and the regulator.

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