BREAK ‘EM UP Reason #10: Only the Biggest Are Both Investment and Commercial Banks

Only the largest banks engage in both commercial and investment banking. Each business has its unique attributes and therefore regulatory challenges.

Dodd-Frank categorizes banks with balance sheet assets of $50 billion and larger as systemic. But when one looks at the bank holding companies (BHCs) with $50 billion or more in assets and also looks at their derivatives portfolios, it is obvious that only the largest engage substantially in derivatives. These same largest banks also were the ones “securitizing” and selling residential mortgage-backed securities. Derivatives and securitizations contained the trading risks that expanded in a bubble, leading to its catastrophic collapse.

The federal deposit insurance (“FDIC”) taxpayer guarantee could be restricted to commercial banks with no more than $500 billion in balance sheet assets. Major benefits would be 1) shielding taxpayers from investment bank trading risks; 2) freeing truly commercial banks to serve small businesses, individuals, and therefore the economy; and 3) allowing bank regulation to become more targeted and efficient for each of these financial sectors. This approach also allows better product and service innovation on the investment banking side, also essential to complex markets. What resulted from Dodd-Frank was massive layers of regulation that “solved” the taxpayer’s exposure more by suffocation than separation.


Looking at Large Bank Holding Companies

The Federal Reserve publishes a list of the top 50 bank holding companies. Just do a search — “Top 50 bank holding companies”. It will be the first result. Each name on the list is a hyperlink to the BHC’s regulatory reports. Very easy to use. Kudos to the Fed’s technology gurus. Click on the following link to see the Fed’s BHC list as of December 31, 2016.


The site also has a link to earlier dates of the report. It has been interesting to observe since the bubble’s bursting the addition of various other large financial institutions, for example from the insurance industry or General Motor’s financing subsidiary GMAC. (GMAC was heavily involved in residential mortgage securitization.) However, I removed both non-bank (in my mind) BHCs and ones that are subsidiaries of foreign-based large banks for the purpose here. The subsidiaries of foreign-based banks do not include all their assets or derivatives. Only those assets under the jurisdiction of the Federal Reserve appear on the Fed’s list.

Click on the next link for my resulting list of those BHCs with $50 billion or greater in assets. As you will see, I’ve added columns with the notional value of their derivatives, the notional value of their credit derivatives for which they are guarantor, and the five-year history of their derivatives as a percentage of their assets.


Any way you look at it, the largest are the only ones truly engaged in derivatives. Even Wells Fargo isn’t that involved in derivatives or investment banking. Since investment banking and its trading revenues can be quite profitable, one wonders if their recent scandal involving the creation of fake accounts might not have been influenced by pressures to keep up with the other five.

Commercial and Investment Banking: Fundamentally Different Businesses

Commercial and investment banking are similar in only one very broad facet. Each occupies a position in the economy between those who have money and those who need money.

Commercial banking contains two essential functions: the payments system and lending. Both of these functions arise out of deposits.

Commercial banks take deposits — checking and savings accounts for individuals and businesses. The Federal Reserve manages the flow of payments made by individuals and businesses into and out of checking accounts. Because checking and savings accounts always have positive balances, a percentage of these funds are lent by commercial banks.

Anyone who has watched the movie It’s a Wonderful Life can see the importance of public confidence in the banks where their money is deposited. In a panic, depositors cannot get their money out of the bank without risking the bank’s having to call for immediate loan repayment. As George Bailey explained, the deposits were lent to neighbors for mortgages to buy homes.

Today, deposits continue to be lent to smaller businesses without access to public capital markets. The FDIC taxpayer guarantee was instituted in 1933 to provide that confidence. At the same time, regulation provided oversight to prevent careless or even fraudulent lending at the expense of taxpayers or other banks who contribute premiums to the deposit insurance program.

Commercial banking involves a long time horizon. Some small business loans can be ten years in length. It’s a conservative environment for a good reason. Compensation is more salary-based than bonus-based.

In contrast, investment banking involves underwriting and trading securities for major corporations, financial corporations, and governments. All of these are very well known and have public information that facilitates investment decisions. Equities, bonds, and now securities arising from mortgage securitizations and from derivatives are traded in large amounts. Small movements in prices can lead to large losses for trading firms. The securities are intended to be sold to investors, not retained on the investment bank’s books.

Investment banking involves much shorter time horizons. Its compensation practices are therefore much less salary-oriented and are instead bonus-driven.

The Simplest Solution Is Also the Least Politically Popular

Removing the FDIC taxpayer guarantee from the risks of investment banking is rather simple in concept. As will be illustrated in subsequent posts, what to do with derivatives is the major execution challenge.

The biggest commercial banks weren’t always involved in both. But they are very powerful. A regulator of Paul Volcker’s stature couldn’t prevent the swamping of common sense by waves of political donations from the industry to political candidates and politicians of both parties.

Other posts will reveal that the taxpayer is still heavily subsidizing and incentivizing trading risks despite deceptive press from Congressional leadership and Presidential candidates. It is one of many contributing factors in the election of a Donald Trump. It’s time to arrest the slide.


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