Is regulation killing banking… for nothing? The importance of intragroup funding

Last week, Barclays, the large UK-based bank, announced massive job cuts and asset reductions in its investment banking division which effectively signal the end of its ambition to compete with Tier 1 US banks. One of the main causes of that withdrawal is clear: regulations now make it a lot more costly to sustain capital market activities as Basel 3 has increased market risk capital requirements. But also, UK-specific rules, which advocate a ring-fencing of retail activities, also played a role in disadvantaging British banks. By ring-fencing retail banks from their sister investment ones, banks have to set up separate funding structures and look for separate funding sources, which makes it more expensive to fund investment banking divisions. Some would say that this is a good thing, as investment banking is “risky and caused the crisis”. This is wrong. In the UK and most of the world, it is mostly retail banks that failed as their asset quality strongly declined following the lending boom*.

This clampdown on investment banking is unfortunate, but wouldn’t undermine the whole banking system by itself. Regrettably, all aspects of banking are now being revisited and harmonised to please ‘out of control’ (in the words of one of my friends) regulators. Often though, the measures they take actually make banks weaker.

A brand new study published last month by the Bank of England itself (does the BoE read its own reports?) highlighted this very contradiction (see summarised post on Vox). What did it find?

The left-hand side panel of Figure 3 shows that interbank funding fell on average across our sample of BIS reporters by almost 30% between September 2008 and the end of 2009. Yet, in contrast, intragroup funding increased in the immediate aftermath of the collapse of Lehman Brothers and was stable for the remainder of the crisis period.

The contrasting behaviour of interbank and intragroup flows is not limited, however, to the recent global financial crisis. To see this, in the right-hand side panel of Figure 3, we present the distributional relationship across time between cross-border bank-to-bank funding and the VIX index.

We find that on average, between 1998 and 2011, interbank funding contracted by 2% during quarters when the VIX index was at an elevated level (upper-25th percentile), while during the same quarters intragroup funding expanded by over 2%. In the quarters when the VIX index was particularly low (lower-25th percentile), both intragroup and interbank funding expanded by approximately 4%.

This is self-explanatory. Globalisation of banking led to increased stability of funding flows. Local subsidiaries with excess liquidity were able to transfer some reserves to sister subsidiaries in other countries (or within the same country) and parent banks were also able to retrieve some of those excess funds in case they were under pressure at home. Banking system whose interbank funding comprises high share of intragroup experienced much lower drop in funding during the crisis**.

But, wait a minute… What’s the current regulatory logic? In the UK, the goal of ring-fencing is clear: ‘insulation’ (see the UK Commission report on banking reform). Globally, Basel 3 regulations now require each subsidiary of international banking groups to hold high levels of liquid assets and comply with a Net Stable Funding Ratio. By itself, this means that subsidiaries have a limited power to transfer liquidity intragroup even if they don’t need it at a given moment. Only liquidity/funding in excess of those (already high) limits could be transferred. In theory, local regulators can decide to supersede the original Basel framework. In practice, regulators are often reluctant to allow cross-border intragroup support, as they narrowly focus on their own national banking system and actually raise extra barriers, including capital controls. This happened during the crisis and potentially made it worse. This is what a BIS survey reported:

Respondents indicated that in some jurisdictions a banking parent can easily and almost without limit support its subsidiaries provided the parent continues to meet its liquidity standards. However, banking subsidiaries face legal lending limits on the amount of liquidity they can upstream to their parent even when they have excess liquidity.

Certain respondents claimed that these legal lending limits are inefficient when managing the liquidity and funding position of a banking group overall and advised that they expect future banking regulation to further institutionalise these inefficiencies. As such, in their view, subsidiaries will need a liquidity buffer for their own positions that the greater group is not able to use.

Furthermore, since the survey, financial nationalism has increased. As Bloomberg reported in February:

The Federal Reserve approved new standards for foreign banks that will require the biggest to hold more capital in the U.S., joining other countries in erecting walls around domestic financial systems.

In turn, European regulators threatened to retaliate… In short, regulators throughout the world, in an attempt to make their own financial system safer, are raising barriers and fragmenting the global financial system. But as this new research demonstrates, reducing the ability of banking groups to move funds around is weakening both global and domestic financial systems, not strengthening them.

I find bewildering that regulators don’t seem to get that logic. Let’s imagine that Bank X, based in the UK, has a subsidiary that shares the same name in the US. The US authorities believe that by making the US-based subsidiary stronger it will make it less likely to fail. Fair enough. Let’s now imagine that Bank X in the UK is experiencing difficulties and need to recover some funds located in its US sub to ensure its survival. Unfortunately, US rules prevent this transfer and Bank X effectively collapses. Do US regulators really believe that the US sub will remain untouched? Even if looking solid locally, this sub suffers massive reputational and operational damages from the collapse of its parent. This is likely to trigger a downward spiral, if not an outright bank run on those US operations. The original goal of the US authorities was thus self-defeating.

While such regulations can indeed make domestic subsidiaries look stronger, this isn’t the case on a consolidated basis. We have another fallacy of composition example here. None of those regulatory requirements can ever make banks fully crisis-proof. Consequently, when a truly large crisis strikes, healthy banks won’t be able to support their struggling sister banks, which can potentially even endanger their own existence through indirect contagion.

Even during non-crisis times, banks, and in turn economies, get penalised by those measures as banks’ cost of funding rises to reflect the inherent higher riskiness of each subsidiary/parent companies, making credit either more scarce and/or expensive.

Coincidentally, I am currently reading Fragile by Design, a new book by Calomiris and Haber, which argues that nations’ political frameworks influence the design of local banking systems and that some political arrangements (including the one in the US) are more prone to banking collapses. I guess current events are proving them right…

There are other, ‘counterintuitive’, solutions to stability in banking (which, guess what, involve less government intervention in banking, not more). Unfortunately, what we are currently witnessing is the sacrifice of competition in banking on the altar of instability… In the end, everybody loses.

* I should add that a lot of losses in investment banking divisions actually emanated from structured products (RMBS, CDOs) based on… dodgy retail lending. Nonetheless, those losses were marked-to-market and only few structured products outright defaulted (see also here). But mark-to-market losses, even when temporary, are enough to make a bank insolvent, according to current IFRS and US GAAP accounting rules.

** I am however a little curious about the claim of the authors that this result contradicts economic theory. I don’t know what ‘economic theory’ they are referring to, but those results look fully logical to me. Banking groups know what part of the group lacks liquidity. Because of reputational reasons, they have a clear incentive to transfer extra liquidity to struggling subsidiaries/divisions/holding companies. Letting a part of the group collapse is likely to trigger a dangerous chain reaction for the whole group.

Update: I modified the title of this post to more accurately reflect the content and the follow-up posts