Prior to the 2008 financial crisis and the Great Recession, global banks were big, broad and borderless. They operated as integrated groups. Separate legal entities within a group were an afterthought: The results that mattered were those for lines of business and for the group as a whole. Global banks were also considered good for growth, facilitating the allocation of capital to its most efficient uses.
The financial crisis changed that judgment. Governments bailed out global banks, and global banks came to be seen as a source of instability. Consequently, in 2009, G-20 leaders mandated officials to devise a new regime, one that would assure financial stability without burdening the taxpayer. That regime is now largely in place and does three things. It makes banks less likely to fail. It makes banks resolvable, or “safe to fail.” And it reduces reliance on banks, in particular with respect to derivatives. Implicitly, these reforms point toward a new business model for banks, one where they are small(er), simple(r) and separable.
Resolvability is central to this new regime. The introduction of TLAC (total loss absorbing capacity), together with the bail-in and the ordering of the creditor hierarchy under the resolution regime, goes a long way toward assuring resolvability. These changes also transform the liability side of the bank balance sheet into something akin to that found in a securitisation structure. Losses are absorbed in reverse order of seniority, starting with Common Equity Tier 1 (“CET1”) capital and then progressing to the so-called gone concern elements of TLAC (Additional Tier 1 and Tier 2 capital, plus qualifying senior debt, which is explicitly subordinated to operating liabilities). These gone concern elements are subject to write-down or conversion into CET1 capital at the point of non-viability. This effectively recapitalises the bank and facilitates its stabilisation and restructuring. Only if losses exceed the amount of TLAC is it necessary to extend bail-in (write down) to operating liabilities such as derivatives and deposits.
In this new environment, separability complements resolvability. Banking organisations increasingly have to put specific activities into separate legal vehicles subject to regulation and supervision by local authorities. To various degrees such subsidiaries are required to be independent from the grourp. To this end, such subsidiaries must increasingly have a separate board with a number of directors who are independent, in the sense that their primary obligation is to the subsidiary itself rather than to the group. In addition, such subsidiaries face restrictions on transactions with other affiliates within the group, including in some cases the ability to use other affiliates to make payments or settle securities transactions.
There is a desire to be sure that each material legal entity can stand on its own, even if some or all of the affiliates in the rest of the group fail. Host country supervisors are likely to want material legal entities within their jurisdiction to have TLAC “pre-positioned,” so that an appreciable amount of gone-concern capital is already in place, available for write-down or conversion, should the host-country authority be required to put that entity into resolution. Consequently, in this new regime banking groups will have to manage on a legal vehicle basis as well as on a line of business and group-wide basis.
If global banks have to be managed as a collection of independent subsidiaries, will this mean good-bye to global banks? Certainly, the drive toward separability threatens to diminish the economies of scale and scope that global banks have enjoyed. And, in a digital age, it will certainly be easier for new entrants to compete in specific lines of business, particularly if they can take advantage of the infrastructure that banks collectively provide or if the authorities fail to impose on the new entrants the same requirements that they impose on banks.
Can new entrants also employ new forms of organisation as well as new technology to challenge global banks? We offer three possibilities for consideration. The first is a unit bank model. In a digital age, it should be as possible for clients to go to the bank as for the bank to go to clients. From a legal vehicle standpoint, the unit bank would be the simplest structure of all: one vehicle, one jurisdiction, no branches and no subsidiaries. It would comply with relevant capital and liquidity requirements. In particular, bail-in and TLAC would apply, so that the bank itself would be resolvable. Assets would generally remain unencumbered but available to pledge to lenders (private or government) should a need for immediate liquidity arise. Such a model is already the basis for a new entrant to consumer banking in the UK. Such a model may be particularly appropriate for wholesale business. Indeed, it may give the jurisdiction that allows it some advantage in acting as a financial centre.
The second model is essentially a private equity model. If banking regulation forces groups to treat their own subsidiaries as independent entities, much if not all of the rationale for a group goes away. It may therefore make sense to consider what might be called a private equity model, in which a private equity firm manages a fund on behalf of investors that takes stakes in various banks, each of which is independent from the others. As the manager of the fund that makes the investment in the bank, the private equity firm may exert a certain degree of control (such as appointing directors to the board) commensurate with the size of its stake in the bank.
Of particular interest is the possibility that firms could implement such a PE model on a contingent basis, i.e. as investors in gone-concern capital instruments such as Tier 2 capital or qualifying subordinated debt that banking groups will issue to meet TLAC requirements. Such a fund might be particularly effective in monitoring and disciplining the bank, for it would in fact be prepared to step in and take control of the bank, if the bank were to enter resolution and its debt were converted into equity in the bank.
A third possible model is a limited liability partnership (“LLP”). This entity would own the bank and be integrated for tax purposes with the tax returns of the limited partners. Note that the LLP need not manage the bank itself. That task can fall to a general partner which concludes a contract with the LLP to manage the bank. The LLP structure effectively eliminates the double taxation of corporate profits and very significantly reduces the incentive for the entity owning the bank (the LLP) to use debt to finance its investment in the bank. This would strengthen the banking group’s CET1 capital and reduce the risk that the bank would fail. Consideration might therefore be given to allowing such structures to own banks, particularly if leverage at the LLP level were limited.
In the face of new entrants using new technology and new business models, how might global banks respond? They are already seeking to make the existing model more efficient, to exit jurisdictions or lines of business in which they do not have a competitive advantage or in which the risk outweighs the reward. But this is not likely to be enough to protect them against new entrants employing new technology and new forms of organisation.
Global banks already recognise that they need to adapt to the new technology. Should they be looking at new forms of organisation as well, ones more in accord with the new regulatory mantra of “small(er), simple(r), separable”? That could enable global banks to continue to promote greater growth through the efficient intermediation of capital; in other words, to facilitate the good.
This post comes to us from Thomas F. Huertas, a partner in EY’s Financial Services Risk Practice and chair of the firm’s Global Regulatory Network, and represents his personal views. It is based on his recent article, “Global Banks: Good or Good-Bye?” available here.