The European “Universal banking model”:
A threat to economic, financial and social stability!
Banks are loudly complaining about the difficulties of ensuring an adequate level of profitability. Bankers are strongly resisting new requirements to reinforce their capital position. Many politicians and regulators, on the other hand, are anxious to impose such measures in order to avoid future “taxpayer” funded bail-outs of financial institutions.
The ECB, meanwhile, is actively pursuing policies that are meant to encourage loans to the “real economy” with, so far, limited success. Indeed, the combination of negative interest rates and recourse to quantitative easing on a massive scale, seems to yield outcomes that inhibit in part the smooth transmission of monetary policy: negative rates make deposit taking unprofitable and “charging” customers for the service is strongly resisted putting additional pressure on lending margins; increasing QE drives down rates further, creating new difficulties for pension funds and insurers, etc.
Simultaneously, le Commission continues to push for the creation of a “Capital Market’s Union” aimed at making the economy more reliant on “capital market” funding rather than its current excessive dependency on bank loans.
Encouraging bank lending (ECB) and capital market funding (EU) are incompatible objectives if the “universal banking model” is at the heart of the system: indeed to the extent that banks are encouraged to develop “investment banking” operations, they will need significantly larger capital buffers to account for these riskier activities. In turn, if they are not able (or willing) to raise additional capital (reducing their return on equity), they will be driven to curtail (rather than increase) their commercial lending activities, all the more that they have become less profitable.
There is also a fundamental “conflict of interest” within a “universal bank” if it is forced to choose between intermediating between “borrowers” and “depositors” while retaining the credit risk on its own books (commercial bank loans) and between “issuers” and “investors” where the credit risk is passed on to the latter (capital market funding).
Furthermore, within large “universal banks” that have significant (and profitable) asset management activities, there are also potential additional “conflicts of interest” in maintaining an adequate balance between the legitimate interests of “issuers” and “investors” managed “in house”. These conflicts are exacerbated if the “issuer” is simultaneously a commercial borrower from the bank.
These problems are not new and were addressed rather successfully in the United States from the 1930’s onwards, by enacting the “Glass Stiegel Act” separating commercial and investment banking activities, as well as a series of Securities laws aimed at the protection of investors. There is no doubt that these measures were key in allowing the spectacular growth of the US capital markets as distinct from its commercial banking sector, underpinning a sufficiently broad base for both to operate profitably.
It is hardly surprising that the progressive “deregulation” of American markets starting, in the 1980’s, including the repeal of the Glass, Stiegel Act (1998), led to the uncontrolled expansion of the financial sector culminating in the crisis of 2007/8. The American reaction was robust with the immediate intervention of the federal government (TARP program), followed by the “Dodd – Frank” legislation and still continuing, as more voices argue for re-imposing a version of Glass, Stiegel.
Nevertheless, the survival of both banking and capital markets funding activities and the continued preponderance of the latter (80% in the USA as opposed to 20% in Europe) is one of the reasons for the rapidity with which the USA restored its economy in the aftermath of the crisis. Indeed, the greater resilience of the financial system, due to the breadth of its capital markets, was the result of a wider diversification and distribution of risks while in Europe they were largely concentrated in the banking sector. Dealing with this problem in the EU required massive government intervention to protect depositors who remain exposed to this day, as the current Italian banking problems demonstrate.
Despite significant improvements in bank solvency in Europe since the crisis, the sector as a whole constitutes one of the most vulnerable segments of the European economy. Now is not the time to cow-tow to the European banking lobby which continues to exert undue influence resulting from years of a cosy incestuous relationship with national Governments. Restructuring the European banking sector should be conceived as an integral part of the indispensable and more inclusive reform of the European Monetary Union. “Ring fencing”, as being applied in the U.K., would be a step in the right direction.
Failing to address the root causes which lie at the heart of the structural weakness of Europe’s banking sector, will only postpone the day of reckoning and increase the dominance of American investment banks of European capital markets. A new banking crisis will put into jeopardy not only the financial sector but also have grave economic and social consequences capable of destabilising the foundations of European democracy.
Doing away with the “Universal Banking Model” should be a key element in dealing with this explosive situation!
Brussels, July 29th 2016
Paul N. Goldschmidt
Director, European Commission (ret.); Member of the Steering Committee of the Thomas More Institute.
Tel: +32 (02) 6475310 +33 (04) 94732015 Mob: +32 (0497) 549259