Ring fencing of bank deposits

While it sounds like a good enough idea I\’m not so sure.

The practise of using capital from NatWest, which is predominantly a retail bank, to fund other parts of the group has soared under the Mr Hester\’s leadership of RBS.

In 2008, when Sir Fred Goodwin was chief executive of RBS, Natwest lent £19.6bn to the holding company, according to figure\’s in the high-street bank\’s report and accounts.

The filings show that this figure leapt to £78.3bn in 2009, the year Mr Hester took over from Sir Fred as group chief executive.


RBS confirmed the rise in the transfer of funds from NatWest to the rest of the group. However, it said the funds were not being channelled solely into RBS\’s investment banking division. The bank said the rise was in part due to a £24bn increase in retail deposits at NatWest between 2008 and 2010. It added there had been a significant drop in funds leaving NatWest to go to NatWest Home Loans.

In 2008 £45bn was transferred from the bank to its separate home loans subsidiary. Last year this was reduced to just £8bn. Taken into account, NatWest\’s net lending to the rest of the group has gone from £48.9bn in 2008 to £79.2bn last year.

At one end we\’ve the simpletons. But of course retail deposits which have a government guarantee (which deposits up to what, £50k? £90k? now do) should not be used to fund casino banking.

Well, yes, but what is this casino banking which shouldn\’t be funded? Where\’s the dividing line?

We could say that retail deposits can only be lent to retail customers. But that\’s not actually what we want banks to do at all: we don\’t want them to just recycle personal deposits into personal loans. We\’d really rather like they do more than that: that maturity transformation trick for example of transforming short term deposits from individuals into long term loans, mortgages for example.

But as we see above, that means moving money across the bank, from the retail deposit side to the mortgage side. So we\’ve already broken a strict form of ring fencing. And it\’s worth noting that even this relaxation of the strictest form wouldn\’t have stopped the recent crisis. It was mortgages which brought down the US banking system, nothing else.

No, it wasn\’t derivatives, high frequency trading (CDOs were rarely traded, that was one of the problems with them), commodities, currencies or any of that lot. It was lending to people to buy houses that brought it all down.

But OK, we agree that we do want banks to be doing that plain vanilla stuff, just like the Building Societies. Turning retail deposits into mortgages.

We\’d also rather like them to be funding companies. At least we\’ve got the entire chorus of simpletons insisting that banks should be lending more to companies. So presumably commercial loans are just fine, can be funded from those retail deposits.

So where\’s the dividing line here between allowable and casino banking? Smaller firms generally do get direct loans. Larger companies either get syndicated loans (which are done by investment banks) or they raise money from bonds and commercial paper (ish ish, short term bonds). This is again done by the investment bank parts of banks.

Is this casino banking? Not allowed? Or is this the very point and purpose of having a banking system: to move retail deposits into funding the productive side of the economy?

And if we\’re to allow bonds and commercial paper, then on\’t we also need to allow the derivatives, the futures and options that allow banks to protect themselves from, say as an example, interest rate movements on the bonds they\’ve just bought (buying a bond is equal to extending a loan to the company that issued the bond).

How about interest rate swaps? The bank might be borrowing floating rate money (the interest rate on deposit accounts can change) or fixed rate (fixed term deposits with fixed interest rates) but desire to lend it as fixed or floating respectively. So should they be allowed to make a swap to cover that risk?

But interest rate swaps are definitely casino banking.

Or how about currencies? A UK company might get a contract to build something in Germany. Their expenses will be partly in euro as they go build, they need a loan in euro (for as a company you really do want to borrow in the currency you\’ll eventually get paid in) to fund activity until they make their stage payments. Should their bank be able to lend to them in euro against their sterling deposit base? Now we\’re into the FX market, swaps and futures and forwards there.

In one sense everyone knows what the answer is. There\’s casino banking and there\’s good wholesome banking. Those guaranteed retail deposits should only be used for the good wholesome banking, not the casino sort.

Partly this distinction fails because banks have for generations been bankrupting themselves by screwing up at that good wholesome banking anyway. The latest casualty was the Dunfermline Building Society (yes, a mutual) which quite simply fucked up over commercial mortgages (hey, lending to companies to build factories! This is good, right?). Or Northern Rock who were funding nothing but mortgages. Just with the retail deposits of other institutions rather than their own, which they got through the wholesale markets.

But over and above that, while everyone knows where the dividing line is: well, what exactly is the dividing line? What, other than \”I know it when I see it\” is the definition of casino banking?

6 thoughts on “Ring fencing of bank deposits”

  1. Most banks have managed to separate themselves into a retail and an investment division all by themselves, no?

  2. Offshore Observer

    I have no idea what “Casino Banking” is other than a useful shorthand for “evil bastard banks”. I think you hit the nail on the head with the statement that banks make money through maturity transformation, they borrow short and lend long. That is an inherently risky business model no matter which way you look at it because the whole house of cards collapses as soon as people wake up to the fact that “thier money” is not thiers but they are mere creditors and if everyone asks for thier money back at once the bank is bust.

    Anyone who really thinks about what banking is must realise that all banks are insolvent all the time unless the assumption is that not everyone will want thier money back at once. That assumption is perfectly reasonable most of the time except in times of exiges.

    The other issues is that due to banks being involved in maturity transformation they have to either carry a large amount of cash and capital (which means they are not ver profitable), or they rely on the interbank market to tide them over in the short term. What bought NR down was not the mortgage business they were in, but the fact that once Lehman collapsed the interbank market closed and that was that, they simply couldnt get the short term cash to meet thier funding requirements because everyone decided that NR was Kaput and wanted thier money back.

    Yet investment banks that were well run (Goldman Sachs anyone) sailed through the crisis with people like Warren Buffett investing in them. I accept is wasn’t all plain sailing for GS.

    The problem is not whether a bank is an investment bank, retail bank, building society, none of that really matters provided the people running them know what they are doing and understand risk. The problem is that the people running the banks thought they were actually in a casino where the dice was loaded in thier favour. There are many bankers who got paid massive amounts of money for generating massive returns where all they were doing was generating beta thanks to the massive bubble generated by the Fed keeping interest rates too low for two long and creating a credit fueled bubble that everyone thought was a new paradigm.

    Its all the fault of spivs, morons, gamblers and a federal reserve that was too busy not wanting to upset the white house or congress to take a tough decision.

    rant over!

  3. It’s not difficult. The US Glass-Steagall Act got the split of permissible business about right, but it may require a little updating. Just allow the protected parts of the bank to own certain types of asset and be exposed to certain types of risk, and let all (permitted) exposures to other parts of the bank count as third party exposures and the whole system is pretty watertight.

  4. Tim seems to argue, convincingly, that there is no way of drawing a line. Alex states, authoritatively, that there is such a way and Glass & Steagall got it about right.

    Tim: what’s the problem with G-S’s definitions?

    Tim adds: They’re from a different time. Over here we’ve the boring retail business and the mortgages. Over there we’ve got equities and bonds. Derivatives are in an entirely different box.

    But now we use derivatives in association with issuing mortgages, in th e retail business, swaps are everywhere, including commercial loans etc. Part of my argument is that the distinctions that GS makes just aren’t there any more.

    By the time it was repealed it was being honoured in name only anyway….for that very reason

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