Difference between I-Banks and Commercial Banks

After Bear Stearns rescue, there was debate on whether I-Banks should also come under Fed surveillance. There was also news that Goldman Sachs does not want to be regulated as it has not been affected during the crisis.

There was a hearing at US House Financial Services Committee and SEC Chairman – Christopher Cox and New York Fed President- Timothy F. Geithner presented their views.

Cox argues that I-banks should stay within SEC and it should be given more powers to regulate the same. I like the difference between I banks and C-banks. It takes me back to those basic finance classes:

The core business of investment banking is facilitating capital raising – whether through trading, underwriting, or ancillary services – while the core business of commercial banks is taking deposits and making loans.

As a result, investment banks’ assets are overwhelmingly securities and other financial instruments that must be financed (often through repurchase agreements). These assets are marked-to-market daily. In addition to deposits, commercial banks have larger portfolios of loans which, under applicable accounting standards, are treated as held at the originating institution until maturity or for investment.

This means that while investment banks must mark their assets based on an exit price or market conditions, commercial banks value their loans on, for instance, the performance of the loan itself. In addition, investment banks are prohibited from financing their investment bank activities with customer funds or fully-paid securities held in a broker-dealer. Commercial banks, however, can fund their banking business with customer deposits.

Given these business, accounting, and regulatory differences, imposing the existing commercial bank regulatory regime on investment banks would be a mistake. It is conceivable that Congress could create a framework for investment banking that would intentionally discourage risk taking, reduce leverage, and restrict lines of business, but this would  fundamentally alter the role that investment banks play in the capital formation that has fueled economic growth and innovation domestically and abroad.

So, what is the way out? If I-banks have to take Fed’s help for liquidity, how do we tell Fed not to regulate i-banks? Alternatively, do we let i-banks collapse? (Frankly, I am all for this thought, as costs of moral hazard are simply going to be too much to handle). Cox says provide SEC more authority rather than shift the regulation function to Fed:

The mandatory consolidated supervision regime for investment banks should provide the SEC with several specific authorities. Broadly, these include authority, with respect to the holding company, to: set capital and liquidity standards; set recordkeeping and reporting standards; set risk management and internal control standards; apply progressively more significant restrictions on operations if capital or liquidity adequacy falls, including requiring divestiture of lines of business; conduct examinations and generally enforce the rules; and share information with other regulators.

Read the speech for more details.

 

 

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4 Responses to “Difference between I-Banks and Commercial Banks”

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