Banking Union and the evolution of the mega-bank

by George Hatjoullis

The most interesting recent development in banking is the explicit recognition of the implicit status of uninsured deposits. This is dramatically illustrated by events in Cyprus banking, the subject of many previous blog postings. Uninsured depositors were always unsecured creditors of the bank but this status was quietly ignored as governments intervened to ensure these creditors did not bear the cost of bank failure (by and large). Until the Cyprus banking crisis. The eurozone banking system will no longer automatically allow such protection of uninsured deposits. As Banking Union evolves and takes shape, banking within the eurozone and some non-eurozone EU countries will be materially different to that of the rest of the world.

Euro zone customers will need to be aware of the credit quality of the bank that they use for sums in excess of the insured amount. There will be a natural tendency for risk averse agents to converge on conservative, well capitalised, banks. This concentration effect will create a few very large banks. One consequence is thus likely to be the mega-bank. These mega-banks will take an ever-increasing share of transaction business. The discussion of banks and moral hazard has tended to see the institutions as giant investment vehicles. However, banks are also vital storage points for temporary liquidity that will be used for transactions. Selling(buying) a home or business, transferring a pension plan, settling an estate etc may all require temporary bank deposits in excess of the insured amount. If a bank should happen to go into resolution mid-transaction, the depositor will lose. Transactions business will thus naturally be driven towards the mega-bank that is deemed safe. These banks will pay very little interest on deposits and may even charge for transactions. Indeed specialist transactions banks could emerge, holding large capital reserves, holding excess liquidity with the Central Bank and earning a return through transaction charges. Such banks might provide short-term loans and overdrafts to facilitate transactions.

In the same way specialist savings banks could emerge. Such banks might pay an interest premium on deposits in excess of any insured amount to reflect the greater explicit credit risk. This is not happening at the moment because banks do not need to tap customers for deposits as the Central Banks are providing plenty of cheap cash. However, the CBs will not always be so keen to flood the system with cheap cash. These banks will most likely make long-term loans secured against collateral. The more secure they are deemed to be the lower the deposit rates they will be able to offer. Once again the emphasis on security may lead to deposit concentration and mega-savings banks.

Investment banking is likely to separate out from these other two types of bank as it is deemed inherently risky. These banks would not be deposit takers but manage security issuance and corporate finance activity and the provision of secondary markets for securities. Of course, with severe restrictions on proprietary trading, the degree of liquidity they will be able to provide will be limited and the liquidity provision function will fall to recognised speculators such as hedge funds. Other functions, e.g. custodial services, will emerge in institutions according to the risk profile they are deemed to offer.

The above, of course, simply conforms to a disaggregation of the main functional banking activities. The Euro zone Banking Union does not necessarily desire this disaggregation. However, the philosophical thrust implies such a disaggregation. Moreover, it also implies concentration of particular banking activities into mega-banks. Ironically, these mega-banks may be deemed too big to fail so the moral hazard problem may have been clarified but it will not go away.

The solution may lie in the formalisation of a role that Central Banks have been seen to be taking since the financial crisis; credit intermediation. Rather than limit this to crisis situations, the Central Bank should adopt this as a function. This certainly works in a situation in which the Central Bank is also to be the bank supervisor as is the case in the eurozone. No one knows the credit-worthiness of the banks better! This could take the role of a specific structural relationship with specialist transaction banks. Indeed maybe the Central Bank should ‘own’ such a bank offering 100% secure transaction facilities, at a price.

In any financial system there needs to be a ‘safe’ place for funds to go in times of uncertainty. If the authorities do not provide it the market will seek to create its own and the unintended consequences may create other problems. The safest place in a fiat money system is the Central Bank because it can print money. It is only safe in nominal terms but in the short-term that may be all that matters. The Banking Union is in danger of leaving the system without a safe place to hide for the risk averse agent.