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A misleading argument on bank separation – the “client facing” criterion

For believers in the good of the market, the arguments for bank separation are as simple as one-two-three:

  1. investment banking activities in universal banks receive a subsidy via an undeserved government guarantee,
  2. this subsidy distorts their activities and inflates financial markets,
  3. separation reduces this unwarranted subsidy.

Yet not everyone is convinced. Some argue that all “client facing” activity should remain inside a subsidised bank, one that can call on state support when it gets into trouble. They say that any proposals for bank separation should separate only non-client facing activities.

This would be a mistake.

The problem is that almost all bank business is “client facing”. Using this criterion will separate very little and will not remove the state support from activities which, in a market economy, should stand on their own two feet.

A better criterion for deciding which bank activities to separate would be whether or not their failure would unduly threaten society. On this basis, deposit-taking banks that handle our pay-checks, our mortgage payments, businesses working capital and so on and whose failure could cause enormous damage, should be separated from all market and trading activities, whose failure does not have to be so harmful. As we explain in our webinar “What large banks do” and in our policy note on bank separation, some market and trading activities are useful for the economy but there is no need for the state to protect and subsidise them.

To see why “client facing” is the wrong criterion to qualify for state-backing, one only has to look at some client facing activities that were popular in 2007. Constant Proportion Debt Obligations (CPDOs), labelled “the poster child for the excesses of financial engineering”, are client facing, their profitability boosted by the funding subsidy. Collateralised Debt Obligations (CDOs), synthetic CDOs and CDO-squared, the highly complex financial instruments constructed by banks that were at the core of the crisis, are also client facing. Like CPDOs, their profitability is artificially boosted by bank funding subsidies. When banks sell an agricultural commodity-linked swap to a hedge fund, diverting resources to speculation and discouraging long term investment, they are undertaking client facing activity. In fact, all ~ USD 600 trillion of OTC derivatives are client facing by definition, not just the 10% or less that face the real economy.

“Client facing” covers pretty much all banking activity, the good and the bad, without distinguishing between what has to be saved and what doesn’t. Separation on this basis achieves next to nothing. Indeed, two senior French bankers admitted that it would affect less than 1% of their respective banks’ business, under the bank structure reform proposed last year in France. Germany is discussing a very similar reform and the same will hold true there, according to our analysis.

As well as achieving very little, proposals based on the “client facing” criterion will force regulators to spend time drawing a line between client facing and so-called “proprietary” trading. As US lawmakers are finding out with their Volcker Rule, this is almost impossible and very time-consuming for regulators.

The “client facing” approach is good news for banks that want to maximise their funding subsidies but from all other viewpoints it make little sense. The best way to separate banks is between activities that need to be saved when a bank fails and those which don’t.

The EU’s own High-Level Expert Group led by Erkki Liikanen recommended very clearly that we should concentrate on separating deposit-taking banks from market activity. We should listen to them.

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