The Future of Banking
Lead Research Organisation:
National Institute of Economic and Social Research
Department Name: National Institute of Economic & Soc Res
Abstract
SUMMARY
The global financial crisis is the most important economic event in the West for two generations. The challenge this presents to our thinking in economics and finance is only just beginning to be understood. The foundations of much of our current theory, efficient markets and rational expectations, have been shown to be inappropriate. Even behavioural finance was poor in signalling the locus of crisis.
This matters because how we think about finance determines how we approach regulating institutions and markets. This in turn impacts on the ability of the financial system to perform its key functions of intermediating between borrowers and lenders and best managing the associated risks. We contend that performance was undermined before, during and after the crisis due to failures of regulation rooted in an inadequate understanding of the nature of finance.
Governments have been active in responding to the crisis with both prudential and structural regulatory initiatives but in our view do not show enough understanding of the underlying issues. Too many initiatives take banks to be the same institutions as in the past, rather than how they operate today. In this context, the main policy document which this study will address is the Independent Commission on Banking (ICB) study on stability and competition in the UK banking sector, which has counterparts in the US (Volcker Rule) and EU (Liikanen High Level report on banking separation).
NIESR has repeatedly challenged the ICB approach as partial and incomplete.[1] The ICB fails to recognise: (a) the information problems inherent in the complexity of new universal banks (e.g. HSBC has over two thousand entities), (b) that reputation matters to banks and so competition and stability may not always be complements, and (c) bank stability cannot be assured without a robust infrastructure in key funding markets. Our concerns have sadly been vindicated by the stream of governance failures coming to light in banks since the report was published.
We aim to undertake three separate studies which address the shortcomings in current thinking regarding financial regulation. First, we consider whether there is empirical evidence to support the combination or separation of retail banking and investment banking in a single firm. Second, we examine the relationship between competition and stability in the financial sector, including the potential impact of reputation of an individual firm. Finally, we will look anew at the infrastructure of finance (including the regulatory environment, legal and accounting procedures and key trading markets) and consider its appropriateness in the light of recent experience and the efficiency with which the key functions of the financial system are performed.
[1] See National Institute Economic Reviews, issues 218,219 and 220 for articles.
The global financial crisis is the most important economic event in the West for two generations. The challenge this presents to our thinking in economics and finance is only just beginning to be understood. The foundations of much of our current theory, efficient markets and rational expectations, have been shown to be inappropriate. Even behavioural finance was poor in signalling the locus of crisis.
This matters because how we think about finance determines how we approach regulating institutions and markets. This in turn impacts on the ability of the financial system to perform its key functions of intermediating between borrowers and lenders and best managing the associated risks. We contend that performance was undermined before, during and after the crisis due to failures of regulation rooted in an inadequate understanding of the nature of finance.
Governments have been active in responding to the crisis with both prudential and structural regulatory initiatives but in our view do not show enough understanding of the underlying issues. Too many initiatives take banks to be the same institutions as in the past, rather than how they operate today. In this context, the main policy document which this study will address is the Independent Commission on Banking (ICB) study on stability and competition in the UK banking sector, which has counterparts in the US (Volcker Rule) and EU (Liikanen High Level report on banking separation).
NIESR has repeatedly challenged the ICB approach as partial and incomplete.[1] The ICB fails to recognise: (a) the information problems inherent in the complexity of new universal banks (e.g. HSBC has over two thousand entities), (b) that reputation matters to banks and so competition and stability may not always be complements, and (c) bank stability cannot be assured without a robust infrastructure in key funding markets. Our concerns have sadly been vindicated by the stream of governance failures coming to light in banks since the report was published.
We aim to undertake three separate studies which address the shortcomings in current thinking regarding financial regulation. First, we consider whether there is empirical evidence to support the combination or separation of retail banking and investment banking in a single firm. Second, we examine the relationship between competition and stability in the financial sector, including the potential impact of reputation of an individual firm. Finally, we will look anew at the infrastructure of finance (including the regulatory environment, legal and accounting procedures and key trading markets) and consider its appropriateness in the light of recent experience and the efficiency with which the key functions of the financial system are performed.
[1] See National Institute Economic Reviews, issues 218,219 and 220 for articles.
Planned Impact
IMPACT SUMMARY
The following is a list of some of the likely beneficiaries from this research project. A short description of how they will benefit is included.
1. HM Treasury
The Treasury is responsible for implementing the Independent Commission on Banking's (ICB) recommendations. The ring-fencing of retail bank operations is at a conceptual level and this research project will identify the benefits and limits of diversification of businesses within a single institution. The Treasury may also benefit from an independent assessment of the macro-financial strengths and weaknesses of the UK banking system.
2. Financial Conduct Authority (FCA)
As the successor to the FSA the FCA must ensure the efficiency of financial markets. The role of competition in the efficiency of retail and wholesale markets is central to meeting this mandate. Whether different types of banks choose to operate with higher capital ratios will also be of interest. The analysis of 'trust' in UK banks may also influence the agenda.
3. Bank of England
The structure of the financial sector can influence the industrial structure of an economy. The analysis and policy proposals around financial structure therefore has implications for the UK economic performance and Monetary Policy Committee. The stability of correlations between different types of banking will be of interest to the Financial Policy Committee.
4. Parliamentary Commission on Banking Standards
While the Commission is likely to have completed its work before this research project concludes, the early findings are likely to be of interest. In particular, quantification of the factors which are correlated with different levels of trust in banks will be of interest.
We will engage with these public sector institutions on a regular, informal and private basis. We anticipate sharing our findings as they emerge and ahead of other stakeholders.
5. Banking sector
A central element of this research project is the Consultation Forum of small banks and similar financial institutions. The Forum is an opportunity for participants to exchange views of the changing regulatory environment, comment on the direction of the research (although the analysis will remain fully independent), and discuss implications for organisations on a confidential basis.
6. European Banking Authority (EBA)
The Banking Stakeholder Group of the EBA is likely to benefit from the analysis of the drivers of bank trust. While the sample does not extend to Euro area banks, the finding from studying UK banks are likely to be informative. The analysis of the diversification of the banking system will include Euro area banks.
7. Competition commission
This project will provide evidence on whether competition has declined in the banking sector beyond simply observing that the number of banks has declined. The analysis of competition and stability as complements or substitutes will also be of interest.
The Consultation Forum is for smaller banks with perhaps one larger institution. However, we expect to invite the competition commission and regulatory authorities and sub-groups of the EBA to meetings where appropriate.
8. General Public
The failures of bank governance and the Libor scandal since the ICB recommendations have re-opened the debate on the future of the UK banking industry. This research project will provide an empirical basis to inform this debate well ahead of the ICB changes in 2019. The functional analysis of the financial system and alternative institutional arrangements may also be of interest to the general public.
9. International Monetary Fund
The issues addressed in this research project are likely to be of interest to other countries and institutions charged with overseeing the international financial system.
Engagement with the public is most likely to be through our publications and reporting through the media and in particular social media.
The following is a list of some of the likely beneficiaries from this research project. A short description of how they will benefit is included.
1. HM Treasury
The Treasury is responsible for implementing the Independent Commission on Banking's (ICB) recommendations. The ring-fencing of retail bank operations is at a conceptual level and this research project will identify the benefits and limits of diversification of businesses within a single institution. The Treasury may also benefit from an independent assessment of the macro-financial strengths and weaknesses of the UK banking system.
2. Financial Conduct Authority (FCA)
As the successor to the FSA the FCA must ensure the efficiency of financial markets. The role of competition in the efficiency of retail and wholesale markets is central to meeting this mandate. Whether different types of banks choose to operate with higher capital ratios will also be of interest. The analysis of 'trust' in UK banks may also influence the agenda.
3. Bank of England
The structure of the financial sector can influence the industrial structure of an economy. The analysis and policy proposals around financial structure therefore has implications for the UK economic performance and Monetary Policy Committee. The stability of correlations between different types of banking will be of interest to the Financial Policy Committee.
4. Parliamentary Commission on Banking Standards
While the Commission is likely to have completed its work before this research project concludes, the early findings are likely to be of interest. In particular, quantification of the factors which are correlated with different levels of trust in banks will be of interest.
We will engage with these public sector institutions on a regular, informal and private basis. We anticipate sharing our findings as they emerge and ahead of other stakeholders.
5. Banking sector
A central element of this research project is the Consultation Forum of small banks and similar financial institutions. The Forum is an opportunity for participants to exchange views of the changing regulatory environment, comment on the direction of the research (although the analysis will remain fully independent), and discuss implications for organisations on a confidential basis.
6. European Banking Authority (EBA)
The Banking Stakeholder Group of the EBA is likely to benefit from the analysis of the drivers of bank trust. While the sample does not extend to Euro area banks, the finding from studying UK banks are likely to be informative. The analysis of the diversification of the banking system will include Euro area banks.
7. Competition commission
This project will provide evidence on whether competition has declined in the banking sector beyond simply observing that the number of banks has declined. The analysis of competition and stability as complements or substitutes will also be of interest.
The Consultation Forum is for smaller banks with perhaps one larger institution. However, we expect to invite the competition commission and regulatory authorities and sub-groups of the EBA to meetings where appropriate.
8. General Public
The failures of bank governance and the Libor scandal since the ICB recommendations have re-opened the debate on the future of the UK banking industry. This research project will provide an empirical basis to inform this debate well ahead of the ICB changes in 2019. The functional analysis of the financial system and alternative institutional arrangements may also be of interest to the general public.
9. International Monetary Fund
The issues addressed in this research project are likely to be of interest to other countries and institutions charged with overseeing the international financial system.
Engagement with the public is most likely to be through our publications and reporting through the media and in particular social media.
| Description | Our objective was to conduct primary research around the recommendations of the Independent Commission on Banking (ICB) intended to promote stability and competition in the banking sector. Our first paper investigated the relationship between competition and stability. There is a long standing debate about whether competition and stability are complements (as implied by the ICB's mandate) or substitutes. Davis and Karim (2013) used two measures of competition (the H and Lerner statistics) to see whether competition leads to greater or less bank specific risk (measured by a Z statistic for each bank of the return on assets plus leverage ratio scaled by the distribution of returns). The dataset covered EU banks between 1998-2012. It was found that different levels of competition across countries was not systematically related to risk. However, changes in competition were found to increase rather than reduce the riskiness of banks. We believe this is the first time this dynamic relationship has been measured. Our second paper considered the rationale for the recommendation to 'ring-fencing' retail from wholesale banking activities. Armstrong and Fic (2014) investigate whether banks with more diversified businesses trade at a premium (reduce risk) or discount (too complex) to other banks. This will indicate whether markets judge that simpler and more concentrated banking is likely to be consistent with greater stability. Business diversity is measured across assets and income and valuations by price-to-book and Tobin's Q. The dataset includes 831 listed banks across OECD between 1998-12. We found that for large banks greater diversity destroys value but for small banks diversity improves value. Diversified banks in Europe and the US banks seem at greatest risk of destroying value. Our findings provide some justification for the ICB recommendations. Our third paper examines the Basel II cyclical capital buffers that are endorsed by the ICB. The idea is that banks hold a buffer of capital to absorb expected losses in bad times and accumulate capital in good times. This is inconsistent with how risk (the variance of loan losses increases along with expected losses). Armstrong and Ebell (2014) create a dynamic stochastic partial equilibrium model to show that banks are more likely to choose to hoard rather than absorb capital in bad times. This is consistent with how banks tend to behave and the earlier credit rationing literature. This is one of the few micro-founded models of bank behavior. We use numerical methods to simulate the impact of changes in risk on capital holdings and verify the behavior. While the model has been solved, we aim to refine this paper to see whether the magnitude of this precautionary response is economically significant. |
| Exploitation Route | The motivation for carrying out this work was to inform the evolving policy towards the UK financial sector. We have already presented our initial findings at seminars and two of the papers have been released as discussion papers. However, we hope to develop two papers further and present at finance seminars at Imperial College and LSE. These papers will be submitted to journals. We also hope to present our work at the Bank of England (who are aware of the work we have done) and the European Banking Authority. We will be looking out for other opportunities to present in policy forums. One possibility is that we publish all three papers as a NIESR e-book, although that would take further time for the authors and is yet to be decided. Competition and the design of capital regulations are at the centre of UK and international banking policy. Our papers on competition challenge the conventional wisdom among policy makers that greater competition is always beneficial and provide a more nuanced view of 'ring-fencing' banks. This is important because the current view that more competition must lead to more efficiency is not consistent with recent or past history. There is a risk of creating more vulnerabilities. We hope this work will encourage a more considered approach. The consequences of the reform are far reaching not only for the banking sector but also everyone in our economy as banking is involved in so many of our everyday transactions. Our work on counter-cyclical capital buffers is important to the Basel II Capital Regulations which are at the heart of international banking. We are surprised at the lack of recognition of the 'hoarding' effect and why it occurs. While there is less weight put on the capital buffers than in the past, that we show capital is likely to track in the opposite way to regulations we hope will be important. Our methodology can be applied to other areas of bank regulation, such as the consequences of contingent liabilities for banks capital behavior. Our stakeholders include domestic and international financial regulatory bodies as well as policy makers and the financial community. |
| Sectors | Financial Services, and Management Consultancy,Government, Democracy and Justice |
| URL | http://niesr.ac.uk/research-theme/financial-economics-and-regulation |
| Description | One of our papers were used to influence the Parliamentary Commission on Bankiing, and the ongoing discussion on competition in banking. The three main papers were fairly technical in nature and so less suitable for making a direct impact beyond academics. However, two of the papers have been presented at academic and public conferences. |
| First Year Of Impact | 2013 |
| Sector | Financial Services, and Management Consultancy |
| Impact Types | Economic |