Are banks stable? Have we got the right regulatory structure? These are fundamental questions that need to be addressed if investment banks are to become strong and safe enough to weather the next 20 years. The onus is on our industry to demonstrate that when structured and run properly, with appropriate regulation, banks can be socially essential — not just socially useful.
It seems that with every passing month there is sufficient evidence to answer either question in the affirmative or negative.
Neel Kashkari, the president and chief executive officer of the Federal Reserve Bank of Minneapolis, made a splash in early 2016 by arguing that much more radical action was required to ensure that no bank was too big to fail. Not only are his comments notable because of his role at the Fed, but also because as assistant secretary of the Treasury in 2008, he oversaw the successful recapitalisation of U.S. banks, yet eight years later, he seems to believe that US banks need still more supervision.
Not quite as radical, but equally important, were the public exchanges of views, between Sir John Vickers, chairman of the Independent Commission on Banking and two deputy governors of the Bank of England, debating whether proposed capital buffers were sufficient.
Then perhaps most noteworthy of all was the response of the markets to the Brexit referendum. Ahead of time, volatility was notable and investment was negligible. Following the vote, markets settled more quickly than was maybe anticipated, but fragility and volatility remained heightened and somewhat in flux. Among other measures, regulators in the UK responded by postponing the requirement for British banks to introduce the countercyclical capital buffer in order to stimulate the economic growth via the banking sector.
I am well aware that for many, the bogeymen of this debate are investment banks. They are the ones that are perceived to have laden society with too much risk and with little reward, that can best be summed up with the cry of “what has an investment bank ever done for us?”. However, as the weight of recent and future regulation makes clear, regulators take a more pragmatic view, heavily regulating retail and commercial banks, as well as investment banks. A reflection that taking deposits and making loans is not as risk-free as some might like to think.
Nonetheless, some people want to be rid of investment banks entirely. They feel investment banking does not provide any sort of useful social purpose. They argue that it allows unworthy people to earn a lot of money and it puts the rest of society at undue risk. But as Kashkari’s comments show, the critics cannot be dismissed as anti-capitalist, neo-Luddites. They are people who know our industry well and will be listened to by a broad cross-section of society.
For more predictions from the big names in finance see Financial News’ Future of Finance report
As a career investment banker and one whose clients have historically been predominantly banks, I feel it is important to put forward the other side. You may think I am talking up my own book, but we need to demonstrate that investment banks in particular and banks more generally can be socially as well as economically essential.
Concerns about the protection of savings are reasonable, especially given demographic trends, particularly ageing populations, in many developed markets. But the risk to savings today comes predominantly from lack of economic growth and the current ultra-low interest rate environment, which has boosted asset prices and increased temporarily the wealth of the asset-rich but has destroyed returns for savers holding cash. This problem becomes particularly acute when extreme market events take place.
To highlight a few examples, in October 2014 there was the flash crash rally where 10 year U.S. treasury yields fell by 29 basis points in over an hour, the SNB de-pegging in January 2015 that resulted in the Swiss franc appreciating nearly 30% against the euro in a day with ripple effects globally, and the bund tantrum last spring, when yields on 30 year German debt rose by 110 basis points over 50 days based on almost no new data, just fear.
Trying to regulate for these events is remarkably difficult. It is hard to predict when they will happen or what the consequences might be. A meaningful and synchronised global economic recovery, an improvement in internal market liquidity and a normalisation of global interest rates may provide a solution, but no one knows and to date it appears very difficult to achieve.
These problems demonstrate that the financial instabilities we face are increasingly disconnected from the banking sector and investment banks.
In the future we need to get away from solely arguing whether the current levels of bank capital requirements and supervision are sufficient. It risks missing the point. Rather than solely relying on further tightening and ever more stringent generalised regulation, the focus needs to increasingly shift towards establishing strong leadership and developing the right culture and structure for each individual investment bank. This requires reviewing the DNA and model of these institutions, how they are run and understanding the role they can play in society, how they can be both socially and economically useful.
Prior to the repeal of the Glass-Steagall Act, separating investment banking from commercial banking, the “traditional” role of investment banks was to be financial intermediaries providing financial advice, capital and liquidity to corporates, financial institutions, investors and governments, spurring economic activity which help foster corporate efficiency, economic development, jobs creation and a smooth functioning of the financial services sector. With the repeal of Glass-Steagall, most investment banks — and many commercial banks — deviated from their original core purpose and took excessive risk on shareholders’ capital and customers’ deposits to boost return on equity, ultimately resulting in the financial crisis in 2008.
Since then, investment banks were forced by regulators, shareholders and public pressure to change their structure.
For any company, its model is a function of its leadership and their culture and strategy. One of the consequences of post-financial crisis regulation is that there is far greater variety in the structure of investment banks than before the crisis. Some institutions look much as they did in 2006, others have changed dramatically. UBS Investment Bank UBS, -3.00% is one of those that has changed the most and, in my opinion, for the better to return to the original roots of investment banking, although we still have further to go.
It is true that we had little choice but to do things differently. When I joined in 2012, the rumour mill had it that following its restructuring UBS Investment Bank would cease to be relevant and possibly to exist. It was clear to me and our chief executive Sergio Ermotti that was not the case, but the problems were fundamental and required serious change.
Our approach has been to create a structure that is appropriate for the current regulatory, customer and shareholder environment. We have a much smaller balance sheet and our operations are focused on business areas that help our clients and in which we believe we can add value, we can lead.
Restructuring is becoming an event more obvious and necessary for investment banks. The move from universal banking to more specialist offerings is becoming more prevalent. Over the longer term, banks will need to focus on what they are good at, and, in our increasingly competitive market where the fight for market share is ever more intense, compete only in those areas where they can lead. By finding a structure that limits the need for capital, it is far simpler for regulators to understand, for shareholders to understand, and even for bankers internally to understand. It also helps to create a culture defined by integrity, quality, ownership and determination.
This, I believe, is a sustainable model for the future of investment banking.
Of course I know that when it comes to structure, there is not a one size fits all approach. Each institution has its own history, its own processes and most importantly its own staff and clients, which make its own culture. Everyone will tackle the issue in their own way. But what is clear is that they need to tackle it. There is no longer the option to wait and see, or to rely just on corporate history as justification for current strategy and structure.
If other banks continue to take these steps, when done, we will have created a stronger and safer industry, working in the interests of clients, regulators, society and shareholders.