Will HM Government's policy of 'ring-fencing' private and other retail banking from investment banking or 'casino banking', as the popular press calls it, hurt the interests of high-net-worth investors and the private banks that service them? Compliance Matters looks at what the experts (including Simon Ellis, pictured) say.

Will HM Government's policy of 'ring-fencing' private and other retail banking from investment banking or 'casino banking', as the popular press calls it, hurt the interests of high-net-worth investors and the private banks that service them? Compliance Matters looks at what the experts say.

As required by the Dodd-Frank legislation in the United States, Congress has voted on the so-called Volcker Rule, which bans banks from making flagrant bets on securities or other assets, although it has afforded them some discretion to make 'judgments' about such things as the volumes of assets they might buy in anticipation of customer demand. The same trend is happening in the UK and elsewhere in the world, but will it help or hinder the banking process and the HNW sector? Simon Ellis, the former managing director of investments at L&G and the principal at Strategies in Asset Management, was sceptical.

"I think there's a danger that people think that the structure and operating models of a business drive the way it works. There's little evidence of that being true over the decades. The crucial factors are (i) how it allocates its resources and (ii) culture. In terms of the ring-fencing or the separation of retail banking (a large slice of which services high-net-worth clients) and investment banking, I don't think that there's any evidence that having the two together creates what they call 'customer detriment'."

Ellis remarked that the Co-Op Bank, Bradford & Bingley and Northern Rock did not have an investment bank in the background and that Lehman Brothers was not a retail bank. He also thought that even when one has come up with a definite policy of separation, it is very difficult to draw the line between the two in the real world.

"The world is so complex that it is hard to tell when retail finishes and the 'casino' begins. Lehman suffered from retail mortgages in a way; they used CLOs and CDOs that were predicated on retail behaviour. So I think that the idea of ring-fencing retail banking from investment banking is a non-sequitur as far as the evidence is concerned.

"Many people in the banking world have also told me that there are great advantages to be had from being able to cross-subsidise between the two, which is not going to happen now. In the end, it's all down to the effectiveness of execution and culture. Look at what went wrong in the crash of '08: bonuses were riding on all the wrong things. There were bonuses for the CEOs, because they were ensuring that their banks and building societies were pleasing the shareholders by doing everything they could to retain market share. There were bonuses for the sales people, who were selling bad products well to hit short-term targets. There were dividends for the shareholders. That's culture!

"And the stock market wasn't asking the right questions. Insufficient questions being asked at deep-discounted prices that you can 'wholesale' onwards – that situation was like a tin of petrol standing in front of a lighted match."

Ellis thought that this was a good vindication of the FCA's obsession with the culture of firms. Other market experts are also of the opinion that the proposed ring-fence is too simplistic a remedy. Professor Charles Goodhart, director of the Financial Regulation Research Programme at the London School of Economics, said the same when he addressed a conference earlier this year. All references to retail banks include private banks according to UK regulatory terminology.

“How about the proposal from the Independent Commission on Banking, the Vickers Commission, to separate the desirable retail banking bit, which we all need, away from the casino, the investment bank? I tell you, this is likely to make both parts riskier. It's likely to cause the financial system of the UK to be riskier rather than less risky.

“How could a retail bank be made more risky? Well, what retail banks do now, primarily, when they lend to the private sector, is that they lend primarily to other households who are borrowing on mortgages, or they lend to construction or property companies. The idea that banks take in deposits from households and hand them on to manufacturing companies is a myth that we've all grown up with. They don't. They take deposits from households and lend primarily to commercial real-estate construction companies and households that want to borrow. It's mainly property-related lending. So the financing of the retail bank is likely to lead in this separation to an even greater concentration on the asset side, property-related assets.

“I've lived through four financial crises in the UK in my time. The one that wasn't related to property was the 1981-82 one. That was related to lending, particularly to emerging markets and especially in Latin America – Mexico, Argentina and Brazil. The other three – 1973-75, the fringe bank crisis; 1991-2; and the latest one were all related to the boom-bust in property, both residential and commercial.

“What is going to happen is that the retail banks will be much more focused – like Northern Rock, like Anglo-Irish, like most of the Irish banks – much more focused on property than they were in the past. And so the retail banks, which no longer have the option of diversification into what the commercial banks had been doing, will be even riskier than they were in the past.”

The professor said that a legal friend of his was predicting that the division between retail and investment would, among other things, serve to protect relatively safe investment banks from risky retail banks rather than the other way around.

“I might add that Lehman Bros, which was indeed a pure investment bank and not a retail bank, fell not because of taking proprietary bets in derivative markets – indeed, its derivative books were highly profitable – Lehman fell because it took the same kind of bet on the housing market, on mortgage-backed securities, as the others did.

“Investment banks will also be worse off, and not because their asset-side might be riskier; if anything, their asset-side might be safer because they can no longer invest in property, both commercial and residential. They will now be stripped of their relatively stable deposit-base. They will have to finance themselves either at a much higher cost through the long-term market, which is limited, or through much riskier wholesale short-term deposits. The investment bank will be made riskier because its liability side will be in worse shape. The retail bank will be made riskier because it won't have diversity on its asset-side.”

The debate, as always, rages on.