In today’s news we are hearing that George Osborne is endorsing the UK’s Independent Commission on Banking (ICB) interim recommendations for ring-fencing Retail & Investment Banking. This is being couched as a tentative step towards the re-instatement of Glass-Steagal type separation of banking practices. On Radio 4’s Today programme Robert Peston declared the move one of the most fundamental aspects of financial sector reform in recent decades. However, this conclusion might be a little hasty on his part, for in reality the reforms do not tackle the fundamantal operating structure of modern banking, and instead mask more profound issues.
Deregulation of the banking sector since the 1990s has led to the feasibility of banks selling-on loans, known as the “originate and distribute model”. This has led to a fundamentally different market structure whereby an increasing proportion of loans are packaged up and traded as securities on a secondary market (e.g. Asset Backed Securities such as Collateralised Debt Obligations – CDOs).
The importance of securitisation to the ICB was clearly outlined in their opening position paper:
“It was argued and widely accepted during the pre-crisis period that diversifying exposure to credit risk through securitisation made the financial system more stable…the events of the financial crisis showed the opposite.” (ICB Calls for Evidence Paper 2010, Section 2.9)
Yet they seem to have glossed over this issue in their interim report. The important shift in modern banking is not the emergence of the universal banks per se, but the fragmentation of the loan process, i.e. the principle of Securitisation itself.
Under this regime, tasks that would normally be the integrated responsibility of banks become dissected, with one of the most critical aspects, the pricing of risk and the supervision of borrower behaviour, being placed within the hands of secondary markets. However, with credit risk assessment (by the Originating bank) becoming separated from credit risk responsibility (resting with the Holding institution) it seems highly unlikely that the quality of loan evaluation would improve. Indeed evidence collected and published on the cusp of the crisis in 2008 demonstrates that securitised loans severely underperformed!
The very structure of securitisation could be facilitating the exploitation of moral hazard and asymmetric information concerns that have dogged banking for centuries. Borrowers themselves may be making inferior loan judgements (with easy credit enabling an “extend and pretend” lifestyle which they can’t realistically sustain), and/or loan originating firms could develop a tendency to ignore weak borrower circumstances (such as the spate of “self certification” mortgages).
The Independent Commission on Banking may well conclude that firewalls should be erected between Retail and Investment banks. However, the role of securitisation both maintains a mutually interdependent link between the two types of institution, plus places the overall system at higher risk by creating perverse incentives for lower quality lending within the economy. This is no longer a closed system, but instead an open system where risk ownership and responsibility can become complex and obfuscated.
At the time of the crisis in 2007/2008 both Northern Rock & Lehman Bros already sat either side of the notional banking firewall. This argument has been used to dismiss the potential effectiveness of such a compulsory demarcation. Such a split would indeed be little more than a Potemkin firewall; a flimsy masquerade that would provide no genuine safeguards at all. But this should not be concluded at the expense of ignoring a more fundamental point. These two fragile institutions shared in common a heavy reliance on Securitisation. Much of the debate about the market structure of banking seems to ignore this crucial issue, yet it seems certain that this was the underlying cause of their financial distress.
We mustn’t forget that the practice of Originate and Distribute is still new territory, and currently one with a very patchy record. Given that the vertical fragmentation preserves an umbilical link between two distinct systems (one required to be totally watertight, the other free to be more risky), it seems that we can’t yet declare that the future of banking is as safe as houses, until we confront this specific issue head-on.