Is Universal Banking the way to go?

The crisis has killed the standalone i-bank model with all the big names gone. Lehman is no more, Merril takeover by Bank of America, Morgan Stanley and Goldman converted into banks. This has led to the belief that Universal banks (all services under one bank) is the way to go.

I cam across this interesting paperby Asli Demirguc-Kunt of World Bank and Harry Huizinga of Tilburg University. The authors say:

The main contribution of this paper is to provide evidence on what bank income and funding strategies perform well in terms of producing profitable and stable banks. In particular, we examine  how a bank’s income and funding mixes affect the rate of return on its assets and Z-score or distance to default. Our basic regressions suggest that at low levels of non-interest income and non-deposit funding, there may be some risk diversification benefits of increasing these shares, although at higher levels of non-interest income and non-deposit funding shares, further increases result in higher bank risk.

Traditionally a bank funds itself via deposits from public and earns by giving those deposits as loans at a higher interest rate than deposits. In this crisis we saw banks using repo market for funding (non-deposit) and earned via investment in other financial instruments (non-interest income). This paper uses a sample of 1334 banks in 101 countries to show that this strategy leads to higher return on assets but the risk also rises.

They says the collapse of i-bank model is an example of this strategy (non deposit / non income) going wrong:

The collapse of the U.S. investment banking sector shows that the market can weed out banks that have chosen an apparently unviable business model. All the same, there is an important role for policy as well, as bank collapses, such as in the U.S. investment banking case, can have important real side effects and impose high costs on the taxpayers through the financial safety net. The observed variation in policies regarding banking powers and restrictions over time and across countries, also suggests that policy makers are experimenting with different banking models, searching for an optimal model for banks. The evidence presented in paper suggests that traditional banks – with a heavy reliance on interest-income generating and deposit funding – are safer than banks that go very far in the direction of non-interest income generation and funding through the wholesale capital market.

The question is what is the threshold level non deposit / non income where you say – this is enough. This paper also suggest that one needs to look at the financial system holistically once again. The same strategies – non deposit / non income- were considered to be the strategies for banks a while ago. Especially non deposit or wholesale market funding was considered to be very safe.

Finally for U-banking:

However, our results do not suggest that banks with systemic importance should completely eschew non-interest income generating and non-deposit funding, suggesting that universal banking can be beneficial. Nevertheless, evidence of diversification benefits is weak. Hence, while the universal banking model may be the best way to conduct investment banking business in a safe and sound manner, our results also suggest that there may limits to how far banks can steer away from the traditional model of interest income generation and deposit taking.

So, if C-Banks start doing I-banking under its Universal bank umbrella it should ensure that it does not allow non deposit / non income to grow. This is interesting bit and one can see the implications already. There are quite a few U-banks bleeding right now – Citi, UBS etc. All of them seem to have gone too far allowing i-banks within them to get real big on non deposit / non income. This inturn has led all their businesses to bleed. When BoA took over Merill similar thing happened. They underestimated (it is BoA’s fault) the losses from Merrill’s i-banking division.

 Interesting paper with lots of insights. How does a policymaker organise its banking systems? What all should it allow banks to do? These are very important questions especially for emerging markets which still are developing their financial markets.

Fed’s Mondustrial policy

John Taylor (of the famous Taylor Rule) has criticised Fed severely in this crisis.

It began with this paper presented in Kansas Fed Symposium in 2007 where he said Fed should have raised rates higher and faster in the period 2002-06 .  This would have minimised the effects of the crisis.

He then presented another paper taking a critical review of Fed’s policies to pump liquidity in the system. He said the crisis was never really a liquidity problem but a solvency problem. The rates in money markets had risen not because of former but because of latter. Fed had got it wrong.

In the next paper he summarises the two above papers and also adds why initial fiscal stimulus die not work, Fed cut rates sharper than Taylor rule suggested etc. This paper was quoted quite a bit in the media.

Taylor has upped his criticism further calling Fed’s Monetary Policy as Mondustrial (Using Monetary Policy for Industrial Policy Goals). This was pointed in WSJ Blog and Taylor has written a new paper on the same which he sarcastically titles  – The need to return to a monetary framework. In this Taylor says monetary policy is being used to help certain sectors and institutions which is the job of a industrial policy. He points to number of questions Fed should answer:

• What justification is there for an independent government agency to engage in such industrial policy?
• What is the role of District Bank presidents versus Board members in making such decisions?
• How can one continue to apply the section 13(3) “unusual and exigent” clause of the Federal Reserve Act when firms and people assisted can get credit but at a rate that seems too high?
• Will such interventions only take place in recessions, or will Fed officials use them in the future to try to make economic expansions stronger or to assist certain sectors and industries for other reasons?

Very important questions all of them. Like I have said in numeorus posts – central bankers have a long way to go. The crisis will (should) end in sometime but then will begin a series of questions.

How bad is the recession in UK?

I had pointedto two research notes from St Louis Fed and Minneapolis Fed comparing this recession with previous recessions in US. In another post I had asked it would be interesting to compare and analyse  the crisis in other economies as well.

Andrew Sentance of Bank of England in a speech helps understand and compare current recession in UK with previous recessions in UK. He only includes post war recessions and so we don’t have great depression stats in UK.

He has a nice table (on page 7 )

	Growth peak	Period of Falling GDP	Drop in output during recession	pre-recession GDP level recovered
Mid-70s	1973Q1	1973Q3-1975Q3	-3.32	1976Q4
Early-80s	1979Q2	1980Q1-1981Q1	-4.61	1983Q1
Early-90s	1988Q1	1990Q3-1991Q3	-2.54	1993Q3
Late-2000s	2007Q3	2008Q3-?	?	?

He says BoE has forecasted4% drop in GDP which is not as bad as early 1980s recession. THis is in line with what research has shown in US as well- the current recession is yet to see negative figures seen in previous recessions.

He also points what is surprising (though common) is that economy has moved from highs to lows in a very quick fashion:

Another similarity between our current experience and the more distant recessions in the mid-1970s and the early-1980s is the speed with which the economy has moved from reasonably healthy growth into recession. Many people have commented that in the current cycle, the economy has moved in less than a year from reasonably healthy growth in late 2007 and early 2008 to outright recession. But that was also very much the pattern we saw in 1973/4 and 1979/80, as Chart 4 shows.

In early 1973, GDP growth peaked at a staggering year-on-year growth rate of 10% – with the Barber boom was in full swing. And yet by the year-end, the UK economy was in recession as the first oil price shock took its toll, a wave of industrial unrest swept the country and workplaces were on a three-day week. Similarly, in 1979/80 it took the economy just a year to move from healthy growth in the first half of 1979 to full-blown recession in early 1980.

He also says that in previous recession there was high inflation (this was actually a case with most previous recessions as well). This was the case with this recession as well but inflation has declined sharply since then.

Nice insight into UK recession history.

Assorted Links

1. ASB points to some good stuff on fin regulation

2. ACB points do we need t have a fiscal stimulus target?

3. Urbanomics points to some key economists forecasting when will it end

4. MR points nationalisation of banks is not the answer

5. WSJ Blog summarises the latest BIS quarterly review. It also points that annual treat- Warren Buffet’s annual letter to shareholders – has been released. It also points to a new paper that criticises Fed

6. Mankiw asks what should a deficit hawk do?

7. FCB points to a graph which shows equity markets in the crisis. It also has a nice graph on house prices still too high

8. MIB writesan open letter to Krugman. Expect some fireworks from hereon