Following the emergency takeover of Credit Suisse by UBS, an old idea is experiencing a boom again: the system of separating commercial and investment banking. In Switzerland, the Green Party has again come out in favor of it, and in Italy, Prime Minister Giorgia Meloni’s party is pushing for the separation of commercial and investment banks. In both cases, the hope is that separation will create a more resilient financial system. But will it?
Difficult regulatory demarcation
First, it should be noted that a system of separate commercial and investment banks is not clearly defined (see box). There’s a great deal of political discretion in its design. This should trigger alarm bells. As is already the case with today’s banking regulation, in a system where commercial and investment banking operations are separated, the risks also have to be defined, delimited, and regulated – a task with which the Basel Committee on Banking Supervision has struggled since the 1980s with its Basel I to III regulatory frameworks.
A single model of separating commercial and investment banking does not exist
When most people think of the notion of separating commercial and investment banking, the system that existed in the United States between 1933 and 1999 springs to mind. In response to widespread bank failures during the Great Depression, the Glass-Steagall Act was passed. As a result, the U.S. banking system was split in two. Either a bank operated largely in the traditional business of customer deposits and loans – with no more than 10 percent of its total income permitted to come from securities business – or it provided investment banking services, in other words it underwrote and traded securities or derivatives. To prevent conflicts of interest between the two spheres, overlapping directorships or joint ownership were also prohibited.
It is also possible to separate banking operations without the strict separation of ownership described above. Models involving such functional separation were intensively discussed, for example, in the aftermath of the 2008 financial crisis. In 2012, for instance, a group of experts from the EU Commission proposed spinning off high-risk banking activities into a legally separate entity above a certain level. The problem was that what constituted “high risk” was completely unclear and uncomfortably reminiscent of the problematic risk weights of the Basel banking regulations. To avoid affecting the system of universal (full-service) banks that had been long established in Europe, entities were also to be allowed to remain under a holding company umbrella. In the end, the EU Commission decided not to implement the proposal at all.
Despite these practical problems, policymakers still like to paint things in black and white. This should not be surprising, because the separation narrative holds a captious political message: investment banks are “bad” because they take big risks; commercial banks are “good” because they take small risks. But even if such a division into commercial and investment banks were so simple, the characterization as good and bad would still be incorrect. This can be seen simply by looking at the past few weeks.
For example, the turmoil in the U.S. banking sector in March 2023 had its origins in the supposedly “good” commercial banking sector; neither Silicon Valley nor Signature Bank were “bad” investment banks. This did not prevent the collapse from occurring a few weeks ago. There are also risks lurking in the supposedly boring commercial banking sector.
Given that risks quickly take on a systemic dimension in today’s financial system, even though the situation involved commercial banks, the choice ultimately had to be made to again commit a breach of the law: Contrary to the existing legislation, the U.S. authorities decided to guarantee all demand deposits of the two banks. Again, private losses were borne by the taxpayer – although in this case it was not shareholders but lenders who profited.
What would be gained by separation?
So commercial banks, like investment banks, can also create systemic risk. But let’s pretend commercial banks come without risks. What would be gained by separating them? Even in the logic of the advocates of separation, the investment banks take great risks. Why, in their system, the taxpayer should suddenly no longer be liable is not clear.
The emergency takeover of Credit Suisse by UBS in particular showed that the systemic risks in the non-commercial banking business were the reason for government intervention. The Switzerland business, it is commonly said, could have been spun off relatively easily and continued independently. In other words, the commercial bank would not have been affected by a winding-up, just as it wouldn’t have been affected in a system where commercial and investment banking were separate – and yet billions in guarantees had to be issued and emergency legislation imposed.
The 2008 financial crisis also illustrates that the problem is the existence of systemic risks, not where in the system these risks arise. Lehman Brothers, for example, was a pure (and only medium-sized) investment bank with no deposit-taking business. Nevertheless, its collapse brought the system to the brink of collapse, and even insurance groups like AIG suddenly had to be bailed out by the government.
Label regulation does not work
The idea of separating commercial and investment banking is an excellent illustration of why regulation with an institutional label can’t work. For example, such regulation focuses far too much on the terms “bank,” “investment bank,” and “insurance group.” That may make sense for certain regulations. But when it comes to controlling systemic risks, the approach is misguided. These risks can’t contained institutionally – the U.S. economist Gary Gorton has coined the appropriate term for this: the “boundary problem of financial regulation.”
Interestingly, this lesson is over a hundred years old. For example, the financial crisis of 1907 – the crisis that led to the creation of the Federal Reserve – began not with a bank, but with the Knickerbocker Trust Company. Mutated from a trust to a finance company, it was barely regulated but engaged in high-risk maturity transformation, creating systemic risk. The label thus concealed the actual risks: Behind a “trust company” stood a shadow bank.
The boundary problem of financial regulation has intensified massively in the recent past. The digital financial system in the 21st century is interconnected via multilayered financial products and institutions. Whereas in the past simply labeling individual firms was misleading, today systemic risks can be taken in the interplay of thousands of balance sheets. Political attempts to label individual financial institutions and regulate them accordingly are therefore doomed to fail. To solve the problem of systemic risks in the digital age, new approaches are needed – the warmed-over idea of separating commercial and investment banking won’t help.