Wrong lessons are learned from the UBS losses at Delta One trading: ring-fencing is not the answer

Wrong lessons are learned from the UBS losses at Delta One trading: ring-fencing is not the answer
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The supporters of the UK Independent Commission on Banking's report saw the $2 bn. losses last week at UBS from the allegedly fraudulent behaviour of their Delta One trader Kweku Adoboli as vindication of the report's ring-fencing proposal at universal banks like UBS. According to the ring-fencing argument, with ring-fencing, the losses at the investment banking activities will not be allowed harm the utility services at retail banking. This then will prevent costly bank bail outs that we have experienced after the recent banking crisis.

The problem with the ring-fencing proposal is that it does not question why in the first place investment banks are allowed to take bets like Delta One and like. The recent banking crisis has clearly shown that most of investment banking activity today is socially useless and is primarily designed to generate bonuses for investment bankers themselves. Ring-fencing argument fails to question the economic and social usefulness of most investment banking activity that takes place today.

The Independent Banking Commission (ICB) report reduces the choices into two unconvincingly argued technical options.

a)Full separation of retail from investment banking

b)Ring-fencing retail from investment banking in a universal banking business model.

The political and social dimensions of both choices - the power of the financial elite at failed banks and the inability of banks to allocate capital to employment generating real economy activities- are ignored. It is not desirable to have a competitive retail banking sector if it is going to create a bubble in real estate and undeserved bonuses for investment bankers. As the Chairman of the Financial Services Authority (FSA) Lord Turner has argued, after analysing comprehensive long-term data on UK banking, the sector in the UK has become socially useless and its links with the real economy have broken. The fact that Project Merlin is not working even when the Bank of England (BoE) flushes banks with cheap liquidity is the most obvious evidence of this dysfunctionality. The escalating EU sovereign debt crisis and the after-shocks of the US losing its AAA rating mean the global outlook is not going to help the UK government exit profitably its investments in the UK universal banks. In the meantime the UK banks off-load their risks to the BoE under the collateral management programme with no democratic or market scrutiny. The ring-fencing argument in this kind of environment is simply out of touch with the reality.

The ICB's argument that universal banking creates efficiencies is not supported by facts or research. The ICB's policy recommendations are based on a stylized picture of the UK banking that lacks factual detail and insight into the individual bank cases in the UK. The debate should be about radically re-structuring bank business models and creating financial institutions and markets that meet the long-term needs of the post-crisis economic landscape.

The ICB's report lacks evidence to support the benefits of universal banking, its analysis is not informed by how in practice current banking business models work, and the impact of shareholder pressure on bank management is totally ignored. Increased capital for retail operations and ring-fencing are likely to subsidize bonuses and risks at investment banking and will disadvantage standalone investment banks. To achieve the shareholder demand for high and unrealistic and unsustainable return on equity, higher capitalized retail banking divisions will charge higher fees and interest to retail customers that include SMEs.

A true structural reform is therefore needed, where the utility services of retail banks are protected from disruption either through mutual ownership and bond financing, or through stock markets demanding utility returns, not technology returns, from retail bank shares.

A new regulator should be set up to protect retail customers against mis-selling by fee driven retail banks. Not only should investment banking be totally separated from retail banking, it should also be split into traditional investment banking and hedge fund operations, where proprietary and risky activities take place. There should be a new regulator that oversees such hedge fund activities and licence each financial innovation only if

•it is convinced that they are not likely to cause systemic risk,

•they are transparent,

•unexpected losses as well as statistically estimated losses can be met by the hedge fund shareholders and managers without any cost to the taxpayer.

Given the current economic situation, the priority should be to create a banking system that can allocate capital efficiently toward long term economic activities that generate growth and employment. We need a banking system that works for the society - not for the alchemists in the stock market and hedge fund type investment banking.

p.s. the full version of this article is available at:

http://goodbanking.org.uk/archives/309