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INVESTMENT v. RETAIL BANKING

Below is a piece by Frances Coppola an ex-banker on why investment and retail banking should not
be split. It is the basis for misunderstandings about the nature of investment and retail banking which is
explained after the piece.

FRANCES COPPOLA 5th February 2013

The retail funding myth why the investment banks arent to blame

BANKS used retail deposits to gamble on the investment banking casino! That is the common
perception of the cause behind the 2007-2008 financial crisis.

The popular belief is that retail deposits, instead of being used to fund safe traditional retail
lending like mortgages, were used to fund high-risk derivatives trading on the international capital
markets. This belief is now driving calls including yesterday from George Osborne for the
structural separation of retail and investment banks. Separate retail and investment banking, so
the thinking goes, and retail deposits will be safe.

Nothing could be further from the truth. At the time of the crisis, only three UK banks had
investment banking arms Barclays, HSBC and RBS. The rest were retail banks. Northern Rock,
Bradford & Bingley and HBOS/Lloyds all three were bailed out, but none had a significant
investment bank. But that didnt mean they were isolated from wholesale and investment banking
activity, or from the capital markets. Far from it. They were dependent on them. You could say the
dependence of retail banking on securities issuance and overnight wholesale funding was the
banks real problem in the crisis.

This can be seen by examining banks loan-to-deposit ratios. This measure indicates the proportion
of loans that are backed by deposits rather than wholesale funding, interbank borrowing, or the
proceeds of bonds issuance. Most small banks and building societies operate on a loan-to-deposit
ratio of under 100 per cent: Kingdom Bank, for example, says its target ratio is 95 per cent. It will
not lend out more than 95 per cent of the total amount of deposits on its books. We would
regard that as a prudent approach to lending.

But the majority of large banks have far higher loan-to-deposit ratios. At the time of the financial
crisis, the average ratio in UK banks was 137 per cent. In other words, 37 per cent of the funding
they required for ordinary lending not high-risk derivatives trading came from sources other
than retail deposits. And the ratio was much higher in banks that were bailed out: in Northern
Rock, for example, it was approximately 175 per cent at the time of its collapse.

Since the financial crisis, banks have been actively reducing their loan-to-deposit ratios. The
introduction of the bank levy, coupled with a general perception that an over-reliance on overnight
funding for longer-term loan commitments increases risk and instability, has encouraged banks to
look more to retail deposits to fund lending. The average ratio is down to about 105 per cent. So
even now, with the possible exception of HSBC, which has a ratio of about 78 per cent, retail
banking does not fund investment banking. It is the other way round.

But the price we are paying for increased safety in retail banking from reduced loan-to-deposit
ratios is a serious decline in bank lending. Reducing the loan-to-deposit ratio can only be done in
two ways: either the amount of deposits must increase, or the amount of lending must fall. Retail
deposits have been declining for many years, as people move long-term savings into pensions and
Isas. Current accounts have been hit by a decline in wages, and inflation has led to increasing
expenditure on essential goods. Very low interest rates also discourage people from saving. And
general distrust of banks has encouraged people to put money in other institutions, like credit
unions and building societies. One large building society is even running an advertising campaign
to attract depositors from banks on the basis that it isnt a bank. So the only way banks can
reduce their loan-to-deposit ratios is by lending less. We dont like that, do we?

But if we want banks to lend more, despite the decline in deposits, we have to accept that retail
banks need to obtain funding from wholesale and investment bank sources, and from capital
markets. Full structural separation, with measures to prevent retail banks from using wholesale
funding, would cause even more of a credit crunch. And ring-fencing wont address the loan-to-
deposit imbalance that forces retail banks into dependence on wholesale funding.

Retail banks have lent too much and received too little. Unless we can persuade people to put their
money back into banks, we have to accept either interdependence of retail and investment
banking, or continued decline in bank lending with associated disastrous consequences for the
economy. I know which I would choose.

END

There is no profession easier than banking, as long as one can tell the difference between a
mortgage and a bill
The piece by Frances Coppola illustrates a well-held misunderstanding behind the origin of retail and
investment banking. Retail (commercial) banking had a completely different structure to investment
banking: the nature of liabilities was different and the assets held of a different nature. This is where the
crucial difference between a bill and a bond came in.

Retail banking was the domain of the real bill (bill of exchange). The real bill represented clearing or
naturally self-liquidating credit that matured in 91days or less. The maturity of any of the assets of a retail
bank would not have exceeded 91days and the assets themselves would have very little risk of maturing
(as they represented clearing). The duration behind any deposit at a retail bank, therefore, could not have
legitimately exceeded 91 days. The reason that bills were used on the asset leger of the retail bank was
because there could be no question of a potential deposit being compromised by an asset failing to mature.

Investment banking was the domain of the bond. The bond represented the deployment of savings. Bonds
are not naturally self-liquidating: for example a mortgage bond is not amortised by the sale of the house
after 30 years, but by the borrowers income during the 30 years. The maturity of the assets of an
investment bank could extend into the many decades, with the attendant liabilities likewise. The risk of a
bond not maturing (not representing clearing as they do) is much greater than with a bill.

Whilst in the modern day a mortgage bond is considered safe and suitable to be associated with retail
banking; nothing could have been further from the truth in origin. A mortgage bond is a long duration
asset wholly unsuitable to be accommodated by retail banks to back deposits: no one would willingly
deposit money for such an extended. The mortgage bond would originally have been accommodated by
the investment bank, not retail bank.

Turning to the concept of loan to deposit it can be seen, bearing in mind the above, that a ratio of X%
is meaningless (for determining supposed safety) without a regard for the structure of the maturity of
assets and liabilities (i.e. public and wholesale deposits). A loan to deposit ratio of 90% (meaning that only
90% of public deposits are lent with no recourse to the wholesale markets) could still be hiding a potential
catastrophe: for example if the maturity of the bonds held is 5 years, but the duration of the public deposits
5 months, say. Similarly, a loan to deposit ratio of 150% may not be a disaster in waiting, if the duration
of the public and wholesale deposits is greater than any of the assets held.
Conclusionthe nature of retail banking is supposed to be different to that of investment banking. The
former had its domain in the bill market and the later the bond market. The former had liabilities (public
deposits) not exceeding 91 days in maturity, whereas the latters liability maturity could run into the
decades. Accordingly, mixing up deposits between the two is not only a mistake, but fraud. The mixing of
the two different types of credit: naturally self-liquidating (and the concomitant bill market) and non-self-
liquidating (bond market) is the principle cause of panics and crashes: not per se the volume of credit
granted. The decried doctrine of the old bank directors of 1810: that so long as a (retail) bank issues its
notes (deposits) only in the discount of good bills, it cannot go wrong has been utterly forgottenand
it shows

Sandeep Jaitly,

5th February 2013.