Separating Banking Activities Isn’t A Good Idea

Barack Obama’s proposed banking reform, which aims to separate commercial banking activity from investment banking, could paradoxically exacerbate the kind of manipulation of information that was at the root of the sub-prime mortgage crisis. The fact that several banks had separated these activities hardly helped them evade the consequences.

President Obama is proposing to separate commercial banks (collecting deposits and granting loans) from investment banks (operating in the market). This proposition is derived from an idea that seems natural enough. Since it is in the state’s general interest to support commercial banks in case of trouble, it makes sense to ask them to end their speculative activity. Unfortunately, as is often the case with regulation, things are not so simple.

Take for example the sub-prime mortgage crisis, which is really what this is all about. We can see the macroeconomic factors at the origin of this crisis, like monetary policy or the state of the real estate market, but there are also a number of microeconomic causes, all of which have in common the manipulation of information between different financial institutions (accounting agencies, portfolio managers, issuers, credit brokers, etc.). And there’s the rub. Once you separate the activities of commercial and investment banks, you also open the door to the manipulation of information between the two universes and take the risk of reinforcing precisely what we are fighting.

To understand, remember the financial context at the start of the crisis. In the United States, securities backed by mortgages, whose probability of defaulting was largely underestimated, were traded in the markets. When the markets realize they’re dealing with fraudulent merchandise, panic breaks out. Everybody loses confidence. Banks stop lending and companies suffer from a drastic rationing of their credit.

How could the markets be so easily abused? The answer to this question takes us to the heart of the matter. It is a question of mortgages, granted by commercial banks to individuals, which have then been transformed by investment banks into negotiable financial securities. The commercial bank has an informational advantage over investment banks in that it knows the characteristics of its borrowers and is therefore better equipped to evaluate risk. The deceit lies in the fact that commercial banks, in the process of peddling loans, haven’t always relayed this information to the investment banks.

Banks were expected to behave this way especially when the information was damaging to the reputation of the borrower, thus depreciating the resale value of the credit. In this way, the withholding of information was one of the main causes of the failure of the investment bank Lehman Brothers. Within a single bank, active in both investment and commercial activities, we can imagine that such information registered in computer files by the loans department could be readily accessed by the securitization department. This exchange of information therefore ultimately depends on the strength of the group as a whole.

The idea of separating commercial and market activities is nothing new. A strict separation was legislated in the United States in 1933 following the 1929 crash, but was ultimately repealed in 1999 to encourage competition and allow mergers in order to respond to the race for growth led by European and Japanese banks. Thus, in the lead up to the sub-prime mortgage crisis, certain American banks limited themselves to only one of the two activities, while others have established diversified groups. It should be noted that the Lehman Brothers investment bank didn’t hold a single deposit and the commercial bank that granted most of the mortgages entrusted their securitization to other institutions.

Should we forget about these proposed reforms entirely? Not necessarily. But we should have a good idea of the range of scenarios that might independently generate this reform before we go about adopting it.