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Comparative Banking: UK Government and Big Banks
Should the UK government listen to the claims that large banks "too big to fail" should be broken down? In this essay, we will look through the current situation of the UK banking system and analyzing the benefits and costs of having a universal banking structure. Considering the future of UK banking, will debate on whether these banks "too big to fail" should or shouldn't be broken down and the impact they will have on the UK economy.
First, universal banking are type of banking system that includes commercial, investment, and other whole range of banking activities, such as insurance, all under one roof. These kinds of concentration results in a high size and power institutions, those only big banks can create. Generally, they are accounted to perform certain principles of corporate governance of the public interest, but sadly they display unimpressive record and unproven promises. These institutions receive special treatment from the governments because they form a huge part in the economy's income and also they are known to be "too big to fail". Big banks failure causes the government's huge amount of costs in bailouts and financial damages. The argument to whether to break down these big banks started many years ago, for instance in the United States they passed the Glass- Steagall act 1933 to stop their bank failures. The pressure of deregulation, competition, financial innovation, and global reach caused them to withdraw the act, but the recent crisis is causing a debate on whether to bring the act back. The idea of breaking the big banks had been rumbling since the crisis causing the UK Government to consider the claims and propose a solution.
Looking at the current situation of the UK's economy, a serious intervention is needed. The banking industry is still in recovery from the 2008 financial crisis that was caused by the complexity of these big banks and their underestimation of risk, the crisis that brought the whole global economy and most importantly lost the public confidence and faith. Additionally, the critical situation caused by continues manipulations and shocks that universal banks are causing. Such as the recent LIBOR scandals (Barclays) that showed how big banks bend and break rules with impunity even when they are under intense regulatory assessment, additionally for insistence money laundering, which increasingly added further record of additional losses. Such scandals show that the size of these banks allows them to commit such massive manipulations and insider dealings. UK economy can't afford any unsuspected crisis that will lead to a multi-million pound bailout and consequent bank panics. Not just affecting the banking sector, the whole market, even working class employees tend to lose their jobs. However, any decision will result in some costs and the future of the industry will depend on an immediate solution that will help recover UK's economy into a stable one.
The separation, narrow, or structural separation of the big banks has both benefits and costs; the debate will discuss these main points to reflect the impact either ones will have on the UK economy:
Economies of scale and scope
The costs of overlooking the advantage of economies of scale and scope stand strongly against the separation of the universal banks, and encourage mergers. Economies of scale leads to the shrinking of information and transaction costs by achieving higher efficiency, through sharing the monitoring activities based on the same client information, use the same information technology platform, and the spread of the management operating costs. Example: when the lender and broker share the same market risk for the loan portfolio and corporate bond trading, the management can generate synergies for cost sharing. Also, it can lead to other types of cost savings such as marketing savings (using the same brand for multiple products), bank client's search, contracts, switching costs, etc. Economies of scope are achieved through "cross-selling". The universal bank benefits from the insider information gained from their client's relationship. By this their clients get to choose from a basket of products provided by the same bank to meet their financial needs, example: offer their corporate client a suited loan to finance their investment project. They provide the public with convenience, innovation, and efficiency, by capably allocating and utilizing resources through matching the needs of their customers in different functions. These banks don't only provide these different financial products and services domestically; they have many branches all over the world.
However, based on the empirical evidence by Walter (2003), economics of scale and scope only exists in small-medium size financial institutions. The large institutions, such as the universal banks, actually suffers diseconomy because of their size the management inefficiently runs the complex large-scale business (as the below diagram displays); leading to uncompetitive monopoly market, and engaging in complex independent divisions, they are decreasing their efficiency and increasing additional costs. Inefficiency is also caused by the over paying for resources, for insistence universal banks pays and rewards their managers higher than needed to secure their services. Also, after the crisis it became costly for universal banks to give loans to consumers as they are still engaged in the pay off of bad derivates gambling debts. In result, big banks don't show that much efficiency that smaller banks can't show. Furthermore, the big banks engagement in different and new exotic instruments leads to diseconomies of scope. It does them harm more than good, their increase of scope doesn't enhance their value and distracts them away.
Diversification and financial stability
Another major argument point is diversification, as it leads to risk reduction. Universal banks enjoy such benefit from the different business lines it provides to the market. Due to the low correlation of revenues from the different functions, leads to a stable earning and decreases the bankruptcy risk leading to a higher credit rating and lower refinancing costs. Also, from a macroeconomic perspective, the risk reduction will promote financial stability as due to the consistency of the funds, decrease of the counterparty risk in inter-bank markets, and lower probability of bank-runs. For instance, because the investment banking is volatile to the market fluctuations their failure could be absorbed by the profits of the lending activities, whereas if it was not diversified it will cause the bank to bankruptcy that will affect the stability of the whole financial system. Not just investment banks other many specialized banks (savings and loans banks) failed because they were not well-diversified in their assets, liabilities, and operations. The greatest example is the mergers of pure investment banks during the crisis because they couldn't afford to stand alone.
However, the concern of the "spill-over" effect of the operations of the riskier investment banking - the so-called "casino banking", over the retail banking arm, the safe side. Having a casino banking means when a commercial bank arm gets engaged in pure risk taking projects and investments, through speculative trading in wholesale financial markets; trading in assets, securities, derivatives and other speculative bets, to exploit profit. Taking advantage of the retail funds and use information of their customers, information asymmetry, this shows no transparency and disrupts the free market. While in contrast, commercial banking are suppose to be restricted from engaging in risky activities due to strict regulations and trust to their customer's deposits. However temptations will always encourage the big banks to find ways to overlook and find loop holes to go around regulations, showing misusage of the individual consumer that leads to financial losses and moral issues, considering that they have nothing to do with traditional depository functions. The task of avoiding the spill-over of the riskier security trading business to the safety of the deposit taking is still crucial to the regulators. Especially that the effect can cause reputation risk, a scandal that will lead to loss of the over-all brand and the loss of the customers to other banks. The act will result in conflict of interest which acts as a major obvious disadvantage of growing universal banks and leads to the loss of the public interest. It can arise in different ways; such as among lender, underwriter, equity holder, sales broker, asset manager, or insurer. For example: using private information to remove loans with poorer quality from the balance sheet by converting the loans into public securities. Such lack of transparency puts the loss of the client's confidence on the edge and encourages the bank managers to take on more risks for profit maximization. Considering their "too big to fail" guarantee and deposit insurance, the central bank has to act as the lender of last resort, which increases the moral hazard problems.
Considering the financial stability the size and power of the universal banks directs to a concentrated monopoly market players, resulting in a high market authority and hard to regulate. To be able to recover, UK financial system needs a healthy and successful stable economy. Universal banks existing might not help, because it needs two important elements freedom and competition. The monopoly structure that these banks have eliminates such stability and harms the economy. The smaller banks haven't been able to expand and flourish because of the big banks concentration, even though they are well capitalized institutions that have the ability to show prospects and gain the UK economy.
The other type of reform is narrowing and limiting the functions of the bank, and so-called narrow banking, which is a proposed banking solution type. It is a banking type that is way too safe and guaranteed. The idea seems as the perfect structure; however it is not the suitable reform to heal the economy. Because they are heavily regulated they don't offer the same return as the loosely-regulated wider bank competitors, and there are limits to their development reach. As a result, it will cause the depositors, fund providers, to switch to the less regulated banks for higher return, because at the end profit is more important than guarantees. They will not provide tools to prevent any further financial crisis.
The future of UK economy
The recovery and rebalance of the economy will be taking a long time in process. As the growth will be relatively subdued by the historic standards for the upcoming years as the banking system remains damaged. So the UK economy future will depend on the government decision to reform their banking system. The banking system and economy can't afford any more damage, so that is why the Independent Commission in Britain had proposed to the government the idea of "ring fence". It is a reform of the universal banks to not split them up but to avoid the arms of the casino banking; separate legal entity within the group (structural separation). It will be implemented around 2019, but both non-risky and risky activities will still be remaining under the ring. However, there are banks starting to ask for flexibility in implementing the ring fence showing early indication that such reform might not even work. Additionally, considering the new rules from the upcoming Basel III, this will require banks to hold a three times as much capital as they presently do, might still not be sufficient enough to be used as a cushion in the event of a collapse.
Universal banks are "too big to fail" and their unpredictable fail causes a massive impact and distress to the banking system, economy, and confidence of the public. The recent crisis causes that were known because of the ill-managed, highly concentrated and undercapitalized financial sector made the public demand a separation of these big banks. However, whatever reform (separation, narrow banking, or structural separation) the UK government decides to take has both benefits and costs that should be considered. Through the essay a debate were displayed to trade-off between these benefits and costs, through looking at the economies of scale and scope, diversification, and financial stability. The over-all result shows no superiority of one system over the others. Whatever the reform results in, the most important aspect is that the banking system needs an internal capital market (high quality capital and liquidity management) in case if an external financing distortion in the market. It is important that a problem in a particular area don't disrupt across the system, because it will end in an every lasting uncertainty of a systemic collapse and failure can't be eliminated. Most importantly people need to have confidence that their financial system is safe and stable, and that it will function right to provide stable service to the UK economy. Also, ensuring that the UK economy remain an attractive market, such as for the foreign banks.
References & readings
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