Essay: Impacts on risk and return on separation of commercial and investment banks

Evidence from Globally Systemically Important Bank
ABSTRACT
This purpose of this dissertation is to examine the risk-return effects of separating universal banks by gathering empirical evidence from globally systemically important banks. The thesis focuses on exploring changes in profitability, return volatility and whether universal banking models of globally systematically important banks (GSIB) are beneficial for shareholders. By synthetically separating universal banks into two groups of retail and commercial banking and investment banking and financial conglomerate services, we find that a separation of universal banks is disadvantageous for profitability. The informative risk-reward ratios suggests that combination of investment and commercial banking offer higher returns for risk taken.
CHAPTER ONE
INTRODUCTION
Introduction
Universal banks are financial conglomerates that provide a universe of financial services. A bank is considered a financial conglomerate when it undertakes at least two out of three operations; conventional retail and commercial intermediation, security related activities and insurance (Bentson, 1994; Baele, De Jonghe and Vennet, 2007). For the purpose of this study a syntactical separation of universal banking operation has been undertaken to measure the risk and return for shareholders by separating universal banking operation into two segments; retail and commercial banking and investment banking and financial conglomerate services.
The Gramm-Leach Bliley Act of 1999 removed the firewalls between commercial and investment banking subsequently allowing integration of financial and non-financial institution to form financial conglomerates. Prior to the GLBA, the Glass-Steagall Act of 1933 as a result of the Great Depression prohibited universal banking throughout most of the 1920s in the USA. In addition to the Glass-Steagall Act, the Bank Holding Company Act of 1956 separated commercial banking with insurance companies (Akhigbe and Whyte, 2004). The passage of the Glass-Steagall act was in part triggered by the collapse of large financial institutions and banks in the United States.
In contrast to the United States, the Second Banking Directive of 1989 allowed European banks to undertake functional activities and diversification across financial institutions. Unlike the United States, European banks did not have banking limitations prohibiting integrated activities across financial institutions hence allowing for financial conglomerates.
Recently The Vickers Rule ””
Aims and objectives
This dissertation aims at investigating the complex nature of universal banks and the effects on risk and return of separating commercial and investment banking operation with empirical evidence from the globally systematically important banks for the period of 2009-2014. The overall objective is to examine whether there is empirical evidence to support the UK’s regulators proposal of ring-fencing commercial and investment activities of banks and how such a separation will impact the banks’ profitability. The risk-reward analysis explores if it beneficial for globally systematically important banks to operate as ring-fenced entities or as diversified financial conglomerates. universal banks.
Research question/hypotheses to be tested
H_0A The returns of Universal banks are equal to the returns of Investment banking and Financial Services.
H_0B The returns of Universal banks are equal to the returns of Retail and Commercial Banking.
H_1A The Risk-Reward ratio of Universal banks is not equal to the Risk-Reward Ratio of Investment banking and Financial Services.
H_1B The Risk-Reward Ratio of Universal banks is not equal to the Risk-Reward Ratio of Retail banking and Financial Services.
Methodology and data
Structural summary of the dissertation
The dissertation is structured as follows: Chapter two reviews the previous literature and findings related to the topic. Chapter three explains gathering of data and samples as well as methodologies applied for accomplishing measurements of the aims and objectives. Chapter four presents and analyses the results of the current study compared to previous studies. Chapter five finally concludes the dissertation by summarising the findings, provides suggestion for further studies as well as states the limitation(s) of the current research.
2. LITTERATURE REVIEW
2.1 RATIONAL FOR SEPERATING FINANCIAL CONGLOMORATES
2.1.1 HISTORICAL BACKGROUND FOR SEPERATION OF COMMERCIAL AND INVESTMENT BANKING
As a result of the market Crash on ‘Black Thursday’, October 24, 1929 The ‘Pecora Hearings’ held in 1932 investigated the cause of the market crash of 1929 accusing commercial banks of misleading the public into investing in risky securities with poor quality (Calomiris, 2010)
The Glass-Steagall Act (GSA), a part of the Banking Act of 1933 consisting of section 16, 20, 21 and 32 was enacted to correct the crippled financial system in the US. Senator Carter Glass advocated in favour of separation arguing that involvement of commercial banks with corporate securities caused conflict of interest. The GSA prohibited commercial banks or any member of the Federal Reserve from underwriting, trading or holding corporate securities for their own account or through affiliates (Kroszner and Rajan, 1994).
Add more to this part
2.2.2 CONFLICT OF INTEREST
One of the main arguments for separation of commercial and investment banks following the Great Depression and during the 2007-9 financial crisis is that conflict of interest may arise as universal banks can exploit information it obtains to its own advantage when commercial an investment banking operations are integrated.
A conflict of interest may occur when combing commercial banking and underwriting to a bank whose risk of default has increased on the outstanding loan. The bank can underwrite bonds for the defaulting company and require the corporation to repay the outstanding effectively shifting the increased default risk from the bank to the market (Kroszner and Rajan, 1994; Hebb and Fraser, 2003; Stigliz, 2010).
The main supporting evidence advocating in favour of the Glass-Steagall Act was based on the Pecora congressional hearings. The hearings put forward the conflict of interest argument mainly accusing two banks (The First National Bank and The Chase Bank) for intentionally attempting to manipulate the market into investing in poor quality offerings
Similar to the arguments for introducing a firewall between commercial banks and underwriters during the Great Depression, the public and academics have argued that conflict of interest was also at the heart of the recent 2007-9 financial crisis. Post the repeal of the GSA the complexity of banks has rapidly evolved thus increased the number of financial conglomerates offering financial and non- financial services under the same corporation umbrella. More recent studies have been conducted on the conflict of interest hypothesis with various results from different countries.
In contrast to US, Canada and the UK, evidence from Japan and Germany indicate different result. Kang and Liu (2007) found that commercial banks engaging in underwriting securities in Japan significantly discounted underwritten bonds to attract investors. Likewise, empirical evidence from Germany’s universal banks point out that analyst that are in joint operation with lead-underwriters are biased in stock recommendations (Bessler and Stanzel, 2009).
Empirical evidence from various banking systems tested in different countries does not merely indicate that the hypothesis of conflict of interest within universal banking does not hold true and allegation of conflict of interest cannot be fully rejected. Notably, studies that argue against conflict of interest have data samples from the period prior to the rapid growth of financial conglomerates which merely took place post 2000s and thus does not appear to address the complexity of financial conglomerate services an universal bank provide.
2.2.3 THE TOO BIG TO FAIL OF FINANCIAL CONGLOMORATES (for separation arugments)
A bank becomes too big to fail when its failure can trigger liquid freeze in the financial market. Due to interconnetedness and size the impact of the insolvent bank may cause market contagion and create systemic banking failure (Find references)
The TBTF can cause moral hazards in universal banks as the safety net of deposit insurance may cause motivation for excessive risk taking The rescue of Continental1984, First Republic 1988 and Long Term Capital Management 1998 in the US as well as government recues of financial institutions in Japan and Scandinavian countries suggest that the phenomenon of TBTF dogma is not unfamiliar(Grant 2010; Stiglitz 2010).
Deregulation of the financial services industry provided opportunities of synergies and diversification consequently financial conglomerates grew rapidly in the 2000s. From 2001-2005 financial conglomerates increased from 57% to 69% and in 2009 70% of banking and insurance businesses in EU were defined as financial conglomerates (Schilder, 2007).
Prior to the 2007-9 financial crises the US regulators considered 11 banks to be too big to fail (Grant, 2010). In 2014 the BIS identified 30 globally systemically banks that are too big and important to fail and 50 banks on global scale report assets over $200 billion and are thereby also considered to be too big to fail. In Post the financial crisis, Stiglitz (2010) argues that the Bush and Obama administration had allowed mergers and takeover of failing banks by large stable banks thus increasing the number of too big to fail banks. Academics point out that the TBTF is a concerning systemic risk issue, however having too small banks have also proven to create systemic failure as witnessed during the fall of unit banks during the Great Depression.
Several factors indicate that the TBTF was rapidly escalating. In the western countries the financial sector grew faster than GDP. Leverage in the financial sector from 2002-2007 grew by approximately 30 percent in the US and UK (Moenninghoff and Wieandt 2011). These indicators signalised rapid growth of banks and thereby excessive risk taking which was one of the main drivers behind the recent crisis.
The solution appears to create a balanced banking system which is neither dominated by too many too big to fail banks nor too small to withstand systemic shocks.
MANAGING FINANCIAL CONGLOMORATES
Less complex management
Easy risk assessment for regulators
2.3 RATIONAL FOR KEEPING FINANCIAL CONGLOMORATES UNDER ONE ENTITY
2.2.1 POLITICAL MOTIVATION
Financial historians have disputed the rational for reforming the banking system in the US as a result of the 1920s banking crisis. Calomiris (2010) argue that there may have been political self-interest incentives as to why the Glass-Steagall Act was enacted. Firstly Steagall had bargaining power as Chairman of the banking committee in the House of Representatives. Second, the Pecora Hearings populist politicians including Henry Steagall advocated in favour of small banks contributing in making large bank disliked amongst the public. And finally deposit insurance was introduced as a temporary system allowing for easy approval in the Congress.
Thought the Great Depression the Federal Reserve followed the real bills doctrine which according to White (2010) worsened the Depression. The real bills doctrine indirectly advocated in favour of separating investment and commercial banks which Senator Carter Glass strongly encouraged. Cargill (1988) points out that the collapse of the US banking system during the 1920s were more due to fallacies in policies of the Federal Reserve rather than the combination of commercial and investment banks.
Federal Reserve Act of 1913 and Banking Act of 1933 and 1935 did little to address the fundamental issues of the cause of banking failures. Incentives for reforming the banking system during the 1920s appears to be self-motivated by politicians partially to secure re-election. Additionally Calomiris (2010) point out the similarities of the banking reforming acts in the 1920s with the post 2007-9 financial crisis Dodd-Frank Act. Firstly, as a result of the collapse of Lehaman Brother, the public was inevitably blaming investment banks for triggering the financial crisis demanding quick actions to stabilise the financial system. The Obama Administration acted quickly insisting on a complete reform package introducing the Dodd-Frank Act. A comprehensive reform signalised an Administration of action thus increasing popularity amongst the crisis-framed public. Secondly, the enactment of the Act was heavily influenced by powerful individuals such as previous Federal Reserve Chairman Paul Volker. Particularly the Volker’s Rule which prohibits investment banks from proprietary trading was passed. Clomiris (2010) argue that the changes passed were unrelated to the core issues of the financial crisis and that the Act does little to address the core issues of the crisis ‘ a political motivation of government substitution of mortgage risk in the US financial system.
Like the 1920s reforms, the recent structural banking reforms Dodd-Frank Act in the US and Vicker’s rule in the UK does not significantly address the core issues of systemic risk and appears to be based on an Administration seeking public popularity acting according to the public’s expectations. Similar to the Great Depression, the public in the wake of the financial crisis of 2007-9 cheered for a re-modelling of the regulatory framework. The re-modelling of regulatory frameworks in the post crisis period may deliver changes that does not capture the main sources of the crisis.
Notably Ram��rez and Long (2001) point out that proving political self-motivation is difficult and it is therefore hard to argue that the implementation of the Glass-Steagall Act was a symbolic attempt to ease the public and gain popularity. Similar to the reforms following the Great Depression, it challenging to prove that the Dodd-Frank Act had political motivation.
CONFLICT OF INTEREST
Academics find little evidence to support the conflict of interest hypothesis as presented in the Pecora hearings and empirically conclude that the performance of two banks is an insignificant sample to condemn an entire industry and justify a firewall between commercial and investment banks (Puri, 1994; Ang and Richardson 1994; White 1986, Benston 1990)
In 1987 Canada opened up for mergers of commercial and investment banks. Hebb and Fraser (2002) empirically suggest that there is no supporting evidence of conflict of interest by commercial banks that underwrote corporate bonds in the Canadian banking system. Similarly, until 1986 joint activities of commercial and investment banks were prohibited in the UK as well. Hebb and Fraser (2003) concluded based on investigation of the UK banking system from 1986-1997, there is no significant long-term differences in performance of bonds issued by commercial banks compared to bonds issued by investment banks and therefore there is no supporting evidence of conflict of interest.
Ber et al. (2001) empirically concludes that merged operations of commercial lending and security underwriting does not prove to be damaging and may in fact be beneficial. However, the combination of lending, underwriting and asset management results in conflict of interest. Johnson and Merietta-Westberg (2009) support these finding and also find that there is evidence of conflict of interest when banks underwrite IPO’s and manage client funds. In fact commercial banks avoid conflict of interest by only underwriting IPO to high-quality corporations (Bezoni and Schenone, 2010).
2.3.1 REPEAL OF GLASS STEAGALL IN THE US
For forty years the GSA remained effectively in force until early 1970’s when lobbyist from commercial banking attempted to weaken the Act by encouraging a relaxation of the law (White, 2010). In addition to active lobbying and political activity Bath et al. (2000) shed light on three significant factors causing the repeal of the Glass-Steagall.
Firstly increased empirical evidence supported by academics found little support for the hypothesis that banks operating with securities caused the market crash of 1929 which lead to failure of 9000 banks in the United States (Bentson 1994; Puri 1996; Kroszner and Rajan 1994). Bentson (1994) argues that a universal banking system can in fact offer considerable benefits and pose little threat to the economy. Kroszner and Rajan (1994) conclude that merged operations of commercial and investment banks did not cause defaults of investors and there is no evidence of universal banking prior to the GSA causing conflict of interest. Instead, Kroszner and Rajan (1994) argue that the perception of the public have limited banks to underwrite high-quality securities.
Secondly the U.S regulators had relaxed the Glass-Stegall Act by allowing a few banks to set up ‘section 20 subsidiaries’ allowing security underwritings. These banks were however subject to ‘firewalls’ prohibiting any communication between the banks and the underwriting subsidiaries thus eliminating the conflict of interest element. Consequently by the end of the 1990’s there were little evidence of banking troubles being caused by the relaxation of the Glass-Steagall Act. However on the other hand, only 50 banks holding companies existed under the Section 20 subsidiaries (Hebb and Fraser, 2003).
Thirdly emerging advanced technology indicated cost reduction allowing for economic of scale and increased profitability and thereby permitting mergers of financial services consequently consenting commercial banks and investment banks to operate under one roof.
Additionally other developed countries such as the European banks which under the Second Banking Directive of 1989 were permitted to combine financial services including banks, insurance and securities in one institution were not constrained by such limitations. Advocates of the repeal of the GSA argued that the separation weakened the US banks’ competitiveness compared to European banks (Calomiris,2000; De Jonghe 2010)
2.3.3 BENEFITS OF THE MODERNIZATION ACT
The Financial Modernization Act enforced in 1999 allowed for diversification across the financial industry. The Act aimed at deregulating the financial service industry inducing financial institutions to expand activities beyond traditional operations and to engage in cross sectional activities thereby increasing the US’ ability to compete with financial institutions globally (Neale et al. 2010). Moreover, the Act repealed parts of the Bank Holding Company Act of 1956 that prevented commercial banking from the insurance business. Effectively the GLBA legalised cross-sectional activities and holding companies to offer banking, securities and insurance as prior to the great depression.
Advantages of keeping financial conglomerates together may involve as discussed; Economic of scale, institutional efficiencies and one-stop shopping for consumers as well as reputational effects where merging with institutions with recognised brand names may contribute in cross-selling of products (Neale et al. 2010; Johnston and Madura 2000). A combination of institutional efficiencies and cross-selling may result in increased profitability for financial conglomerates. From the consumers perspective multiple researchers provide evidence that consumers prefer one-stop shopping where products are customised to the individual (Herring and Santomero 1990; Berger 2000; Berger, Cummins, Weiss and Zi 2000). These findings indicate that from both the consumer and efficiency perspective, a separation of financial conglomerates does not appear to be beneficial.
In general the market reaction to the Modernization Act perceived the Act to be good news. Share prices increased for all financial services industries as a response to the Act and especially Bank Holding Companies that diversified demonstrated significantly better abnormal returns compared to those who did not (Neale et al. 2010). The findings of Neale et al. (2010) signalise that financial conglomerates have positive wealth effects.
Multiple recent studies and empirical evidence conclude that there are clear positive wealth benefits of merging financial services. Ten out of eleven selected studies with sample data from early 1990s to mid-2000s tested the impacts on shareholder wealth after the passage of the Modernization Act and found that diversification across financial industry services yielded positive capital effects (Akhigbe and Whyte, 2004; Carow, 2001; Carow and Heron, 2002; Hendershott, Lee andTompkins, 2002; Lown, Osler, Strahan and Sufi, 2000; Mamun, Hassan, Karels and Maroney, 2005; Mamun, Hassan and Lai, 2004; Narayanan, Rangan and Sundaram, 2002; Neale and Peterson, 2005; Strahan and Sufi, 2001; Yeager, Yeager and Harshman, 2007). Both Carow (2001) and Hendershott, Lee and Tompkins (2002) tested for impacts on wealth by merging banks, investment banks and insurance companies and found positive wealth reactions.
A separation of financial conglomerates and thereby commercial and investment banks as suggested by UK regulators will potentially eradicate capital benefits financial conglomerates have obtained through the synergise gained through diversification across the financial industry.
2.3.2 DIVERSIFICATION
One of the rationales for repealing the GSA was based on the theory of diversification. According to portfolio theory diversification spread risk and should accordingly reduce risk. If the theory holds true, commercial banks diversifying into investment banks may be beneficial as the diversification effect allows for a spread of operations and thus reduce the overall risk of failure.
There is a consensus amongst academics that the disjointed structure of ‘unit banking’ system in the US contributed in the systemic banking failure in 1930 for multiple reasons. Unit banks were poorly diversified thus significantly exposed to financial shocks. Loan portfolios of unit banks reflected the local economy and in the agricultural dominated regions the income of banks were significantly correlated to the volatility of prices in harvest of crops. Overall the unit banking system contributed in making banks less competitive, cost efficient and as a result, less profitable as well. The entry barriers prevented effective competition therefore unit banks only faced competition from other unit banks. (Calomiris, 2000, 2010; White, 1986).
The case of unit banks in the US demonstrated that concentrated banks could not withstand systemic shockwaves due to lack of diversification. The diversification argument contributed to the repeal of the GSA as academics pointed out benefits of allowing joint operations of commercial and investment banks.
First diversification benefits contribute in effective competition making banks less likely to fail. Allowing globally large and diversified banks to undertake various functions can contribute in stabilising the financial system as the diversification benefits allows the financial sector to take over failing institutions regardless of their core financial activity (Wieandt and Moenninghoff, 2011). Ram��rez (1999) suggest that separation of universal banking activities and reduction of diversification possibilities as a result of implementation of the GSA led to increased costs of financing for corporations in the US. Bentson (1994) initiated this statement by finding that universal banks offer many benefits and cost reduction for consumers. Furthermore Ursel (2000) lays out empirical evidence from Canada stating that corporations benefitted lower costs from using an underwriter that was operating in a universal bank compared to an independent investment bank. Additionally by examining evidence from 60 countries (Barth et al. 2010) find that tightened regulation and restrictions on bank operations will cause inefficiency and increased probability of banking catastrophes.
Second banks can offer a wide range of services that contribute to economic growth through economic of scale by sharing infrastructure and other information and systems. Third, universal banks offer a wider range of products to a discounted price as a result of the factors discussed above (Barth et al., 2000; Neale et al., 2010).
The problem of diversification of banking activities occurs if one of the affiliates are riskier than the other therefore diversifying into riskier activities eradicates the benefits of diversification and may indeed increase overall risk of failure compared to if the banks’ affiliates are on a stand-alone basis
On the contrary evidence from Swiss Universal banks indicate that diversification lead to higher costs and profit inefficiencies thus universal banks do not seem to benefit from product mixes indicating that diversification does not necessarily result in benefits. Increased product offers and economic of scale may as well lead to increased costs and complexity which does not lead to increased profits (Rime and Stiroh, 2003). Berger and Humphrey (1997) find that there is no predominant evidence of either for or against economic of scale based on 130 empirical studies from 21 countries
The failure of providing consistent evidence shows that diversification benefits within universal banking is hard to prove.
2.4 RE-IMPLEMENTATION OF SEPERATION
STRUCTURAL REGULATORY CHANGES IMPACTING FINACNAIAL CONGLOMORATES
BACKGROUND
A small number of large financial institutions (i.e globally systemically important banks) account for a large sum of global financial corporations and therefore the Basel Committee on Banking Supervision (BCBS) has identified institutions that are too big to fail due to their interconnectedness with other financial institutions on a global scale. As a result of complex structures and cross-border financial intermediation such entities have proven to be difficult to regulate and supervise. Regulators argue that business operations that are too complex for an accurate risk measurement and effective supervision requires separation.
Size, complexity and interconnectedness of globally systemically important institutions led to a wave of regulatory changes in the wake of the recent 2007-9 global financial crisis. Regulatory reactions allowed for stricter supervision and upgrade of Basel II to Basel III by raising capital requirements for banks. G20 leaders anticipated multiple tools to be implemented globally to increase global financial stability thereby a tighten focus on ‘proactive and intensive supervision, effective resolution framework, enhanced transparency and disclosure and strengthened market infrastructure’ (Brab and Hack 2014, p.1). In addition to increased capital requirements, proposals of the Vickers, Volcker and Liikanen rules aim at restructuring the size and scope of activities of financial institutions consequently with intentions to change the existing structure and business models of too big to fail institutions thereby including globally systemically important banks (Brab and Hack, 2014).
BASEL III
VICKERS
In December 2013 the Financial Services (Banking Reform) Act received Royal Assent in the UK. With implementations of the recommendation of the Independent Commission on Banking ( the ‘Vickers Report’), the regulators aim at restructuring the banking industry in the UK by pushing most investment banking activities outside of UK’s globally systemically important ring-fenced banks.
The controversial concept of ring-fenced banks suggests that by 2019 globally systemically important banks in the UK will have to legally, economically and operationally establish an entity which undertakes only retail and commercial banking services
The purpose of imposing a separation of financial conglomerates is to protect retail and commercial operations from risker financial activities which are associated with investment banking and other financial conglomerate operations, and in the event of failure mitigate bail out costs for tax-payers as well as and risk of failure of too big to fail institutions. Ring-fenced banks will be entitled to undertake; conventional deposit taking and lending to individuals and SMEs, provide trade finance, project finance and advisory on products from non-ring-fenced banks (which does not impact the exposure of the ring-fenced bank), engage in transactions only with the ring-fenced bank’s group (Shearman and Sterling LLP, 2011). The Vickers Report however suggests that some non-core activities within the ring-fenced bank would be permitted including ‘simple derivatives trading, debt-equity swaps, securitisation of own assets and certain ancillary activities’ (Brab and Hack 2014, p.2).
VOLCKER
In the US regulators are reforming the banking industry mainly by adopting the Dodd-Frank Wall Street Reform and Consumer Protection Act which includes what is commonly known as the Volcker Rule. The final rule prohibits proprietary trading i.e ‘engaging in short-term proprietary trading of securities, derivatives, commodity futures and options on these instruments for their own account’ (Brab and Hack 2014, p.2). Unlike the Vickers Rule which aims at reducing the cost of failure, the Volcker Rule attempts to reshape the banking culture in the US by removing investment banking culture from commercial banking (Brab and Hack, 2014).
LIIKANEN
Conceptually similar to the Vickers and the Volcker, the proposals of the Liikanen report are aimed at Europe’s globally systemically important banks. The overall objective of a structural reform in EU would be to minimise the risk of systemic instability by reducing banks that are to become too big to fail (TBTF), Too connected to fail (TCTF) and too systemically important to fail (TSITF). The main proposals of the report include banning proprietary trading, market-making and investments in hedge funds and private equity. Furthermore, the rule suggests a separation of trading activities where banks that are protected under the Deposit Guarantee Directive (deposit taking banks ‘core banks’) are only to undertake conventional banking activities i.e; deposit taking, lending, financial leasing, payment services, money-broking, custody of securities and other assets, credit references services and issuing electronic money (Freshfields Bruckhaus Deringer, 2014).
HOW STRUCTURAL CHANGES CAN IMPACT PROFITABILITY OF GLOBALLY SYSTEMICALLY IMPORTANT BANKS
The structural bank reforms as proposed by UK, US and EU regulators seek to decrease the probability of bank failure by reducing TBTF, TCTF and TSITF. Imposing ban on proprietary trading and high-risk investments may increase the effectiveness of capital requirements thus reduce the culture of risk apatite investment banks commonly are known for. The main adventage of ring-fencing operations is to reduce global interconnectedness of GSIB and to secure deposits.
The costs of regulatory changes to the GSIB may on the other hand lead to opposing impacts on market liquidity, efficiency, risk management capacity, implementations costs and lower diversification benefits which may as this paper proposes reduce profitability of financial conglomerates.
First, distinguishing what is defined as proprietary trading from permitted trading particularly relevant for the Volcker rule impose implementation costs for GSIBs. It will be challenging to differentiate if the risk exposure of the bank is due to hedging or proprietary trading. As a result, the Liikanen group recommend that market making along with proprietary trading remain outside the ring-fenced banks.
Second, liquidity might be adversely impacted as banks will be prevented from trading equites and other liquid assets on a proprietary basis under the Volcker rule. Third, the possibility of diversification under the Vickers will be substantially reduced which accordingly impact profitability. The ability to move liquidity in the group will also be prevented consequently amplifying idiosyncratic risk to the group (IMF, 2013).
REGULATORS RISK ASSESEMENT
WHAT THIS STUDY IS DOING
Rather than measuring agency and regulatory issues, this paper investigates whether a forced separation of globally systemically important banks influence their profitability. More specifically, the study examines if the profitability (return on assets) to risk of G-SIB is higher or lower than the risk-reward if G-SIB were separated into independent entities which specialize in the individual activities of the conglomerate.
Besides controlling for impacts on profitability of separation of G-SIBs, this paper contributes to the broader regulatory changes of financial conglomerates literature by examining regulators relational for separation of financial conglomerates.As disused in previous sections numerous studies have investigated issues emerging from banks including risk, political motivation, conflict of interest and diversification amongst many more. This thesis contributes to the literature by obtaining empirical evidence from globally systemically important banks. This is particularly interesting due the importance and power of G-SIBs. The G-SIBs are under legislator loop and various regulatory proposals are reshaping the banking industry. It is therefore professionally and academically interesting to undertake a research on the profitability impacts of a separation of the world’s most important banks and whether it is justifiable to do so from the perspective of profitability.
The thesis addressed a gap’.
3. METHODOLOGY AND DATA
3.1 DATA
Globally systemically important banks have been considered in examining the risk and return implications of separation of commercial and investment banks. The data is collected from Bloomberg and annual reports of the selected sample banks to gather consolidated and separate accounting information of the selected banks. Bloomberg serves as an appropriate source of data as it reports financial data according to the companies’ reports and thus the potential biased effect of Bloomberg is removed. To test Bloomberg’s accuracy of information reporting, a random sample on various variables for the chosen banks were The investigation confirmed that Bloomberg reporting accuracy is correct and according to the banks’ financial reports. Furthermore, other resources of financial data was not considered as they do not provide information by segment.
There are special complexities with assessing the impacts on separation of G-SIBs. First, the G-SIB are financial conglomerates and most of the sampled banks undertake all three activities associated with financial conglomerate activities. Following, a key complexity with examining the data of G-SIBs is the difficulty related to measuring and separating the distinct activities and operations of the banks. Due to data constraints and data reporting, unbiased separation of investment banking operating and retail banking activities challenging. Most banks do not report data based on financial versus non-financial (insurance) operations thus this paper does not strictly differentiate between security underwritings, insurance and lending etc. The segments are distinguished based on lending versus non-lending by (i) loans to total assets of each segment and (ii) interest income versus non-interest income. Such a differentiation is in line with expectation of the primary activities the individual segments undertake. This rough separation oppose challenges of precision and may therefore provide insignificant results.
Bank sample:
To enhance the focus of the thesis globally systemically important banks are chosen as data sample for the purpose of this research. Only banks that are considered to be systemically important as defined by BIS or hold more than $200 billion in assets are considered for samples. Two out of three financial conglomerates activities have to be fulfilled in order to be included in the sample. Banks that neither engage in investment banking nor deposit taking and lending are excluded. Banks that are missing basic and essential accounting data including segment assets, loans, interest income, and non-interest income are also excluded. Furthermore banks that do not report data including the variables mentioned above for each segments of operations (retail banking, investment banking and other financial conglomerate activities) are also excluded from the sample selection.
All the selected banks have been synthetically separated in two segments; retail and commercial banking and investment banking and financial conglomerates. The criteria’s for the retail and commercial banking division is a) 50% or more of the segments total assets have to be loans to consumers and institutions b) 50% or more of net revenues have to derive from interest income . If these criteria’s were not met, it is assumed that the remaining activities are investment banking and financial conglomerate services.
Out of 50 banks that report assets over $200 billion in 2014, 25 banks fulfilled the selection criteria from 10 different countries. Tough regulation and reporting differ for the sampled nations (Barth et al.,2013), all countries in the selected sample allow for investment banking and other non-lending activities. The differences in regulatory restrictions is not crucial for the analysis of the results. For this topic it is essential that the particular banks engage in a spectrum of operations ranging from financial to non-lending activities. However, the regulatory aspect is significant in respects to current and future regulatory changes that will impact the scope of activities for the G-SIBs.
METHODOLOGY
With respect to the methodology there are multiple ways in measuring the risk and return effects for diversification and separation across financial and non-financial activities. Tabarrok (1998) and Barth et al. (2000) apply descriptive and theoretical reasoning to evaluate the impacts on profitability effects of diversification across financial services industries. This approach lacks empirical evidence to support arguments of separation and is therefore not sufficient to support actual impacts of separation of universal banks.
Another common approach applies event study methodology where market data is examined to measure abnormal changes in stock prices of public companies that occur in combination with an event such as regulatory requirement of separation of financial conglomerates Similar to the descriptive methodology, this approach has constrains.
First, this study investigates a synthetically separation of G-SIBs. An event methodology would examine the market reactions to an announcement of separation of the banks and whether the market perceives a separation as value creating or destroying and depending on that, the stock price will increase or decrase. Because this thesis looks at a hypothetical separation, there is no actual market information on separation of G-SIBs and thus the event study methodology is not applicable.
Second, the study relies on statistical assumptions such as the beta. The drawback of statistical assumptions is that past data is applied to predict future risk and returns (Wells, 2004).
Third, in contrast to classical finance which assumes that the capital market is efficient and investors are rational, behavioural finance argues that investment decisions are influenced by psychological and emotional factors including fear, panic, anxiety, euphoria, and greed amongst others (X). These factors are likely to interfere in financial decision making (Birau 2011) and is another draw back of the event study methodology.
This paper employs the empirical investigation of accounting measurement of the risk and return methodology
It is debatable whether accounting or market data of risk and return is optimal. Each has its advantages and disadvantages as discussed in the section above. The key problem with accounting data is (i) different reporting standards in different countries can lead to smoothing of profits depending on whether historical cost or market value has been stated (Greenwalt and Sinkey, 1998) and (ii) impacts of taxation. Whereas accounting imperfections might smooth out profit and volatility, market returns reflect information about a company when it becomes know to the public and therefore the market decides the volatility of the stock price thus the market does not smooth out risk and return (Boyd et al.,199; Nuruallah and Staikouras, 2008). However, an extensive reasoning to which methodology is optimal remains unexplained to this day and to proceed with the dissertation topic this paper employs accounting data as applied by Boyd et al. (1993) and Nurullah and Staikouras (2008) to empirically measure the risk and return of separation of financial conglomerates.
Unlike previous methodologies which applies return on equity and net return on assets, this study applies pre-tax return on assets (r) and the standard deviation (��) of returns.
Each segment’s returns are computed followed by the aggregate return when merging the segments into universal banking. The objective is to evaluate whether the aggregate returns display statistically significant returns compared to each segment post separation.
r_(t )=I_t/A_t (1)
Where I is the pre-tax income and A is the book value of total assets in time t.
The risk of the returns are calculated as the standard deviation of returns from the mean with the volatility indicating the risk. According to portfolio theory, the rational investor expects high returns for high risk.
SD= (2)
Similar to the Sharpe ratio which represent the average market returns in excess of the risk free rate per unit of total risk, this study adopts a modified accounting risk-reward ratio to better demonstrate the risk to the reward of combined financial conglomerates versus investment banking and commercial banking separated. The average return is computed as shown in equation (1) followed by the risk calculation as show in equation (2).
‘Risk-reward’_( )=r_t/’_t’ (3)
4. RESULT AND ANALYSIS
This study applies t-test analysis’.
The risk and return analysis
Schmid and Walter (2013) measure profitability of focused and diversified financial conglomerates. Their study suggests that focused firms have nearly twice as high profitability measured in ROA compared to diversified conglomerates. Consequently a separation of financial conglomerates appears rational. Similarly to (Schmid and Walter, 2013), when risk is not taken into consideration, retail banks appear more profitable compared to universal and investment banking and other financial services operations and support the findings of (Schmid and Walter, 2013). Nevertheless, an exclusion of risk represents an inaccurate picture of profitability as the consistency of returns cannot be ignored. Unlike X paper which does not take into consideration the risk of returns, this study measures the award to per unit of risk and demonstrated that financial conglomerates (diversified firms) yield higher returns to per unit of risk.
Demirguc-Kunt and Huizinga (2013) suggest that systemically important bank could benefit from splitting up and increase their value. Such a proposal is not consistent with the findings of this or IMF’s study which suggests the opposite.
By applying a sample of seven G-SIB including five US and two UK banks, IMF found that the risk-adjusted returns are higher for retail banks, followed by wholesale banking and trading segments for the period prior to financial crisis of 2003-2007. Unlike this study, IMF’s research employs financial data five years prior to the crisis and similar to this study, the results contradicts common expectations of investment banking activities being more profitable than retail activities.
The results are in line conglomerate benefits’..ecomomic of scope etc’.
The returns from retail and commercial banking and investment banking and other financial conglomerate services are complementing each other allowing diversification to increase profitability. If these operations are ring fenced there is a possibility that profitability will go down.