Basel-endorsed centralised credit models and too-big-to-fail banks will not provide European economies with what they need, such as an increase in working capital for SMEs. Only deconglomerated banks unbound from Basel III risk management models can do this.

In the years preceding the 2008 financial crisis, banks across the globe were encouraged to grow larger, thereby increasing their share prices. The flurry of merger and acquisition activity, exemplified by the RBS-led purchase of ABN Amro before the crisis, and Bank of America's acquisition of Merrill Lynch after, demonstrates just how determined banking bosses were to scale up in a bid to increase their assets and feel the reward at stock exchanges across the world.

Yet the crash showed precisely what was wrong with big bank conglomerates. Banks that were deemed 'too big to fail' were bailed out by governments concerned that they could bring down the entire financial system. It is not just a question of size, either, but of the riskier investment banking activities carried out by these conglomerate institutions.

Over the past year or so, these banking conglomerates have begun to contract. Banks in the eurozone have shrunk by about one-tenth since mid-2012, with many writing off bad debt or selling off non-core operations. Perhaps the best example can be seen in Switzerland, where UBS is unwinding some of its investment banking operations in fixed-income markets. Nevertheless, both UBS and JPMorgan Chase suffered large losses from trading activities after the crisis, demonstrating that big conglomerates are still not fully in control of their complex operations. The fraudulent behaviour of a single UBS trader in 2011 cost about $2bn, and risky credit derivative bets by JPMorgan traders in London cost about $6bn a year later.

Stifling competition

However, the regulations designed to ensure that the banking sector is better able to support the economy could in fact be preventing the move to 'deconglomeration' of the industry. Until now, UK policy has been to protect and subsidise banking conglomerates. However, injecting subsidised cheap liquidity into the UK banking industry via quantitative easing by the Bank of England has not achieved its objective of channelling credit to small and medium-sized enterprises (SMEs). As a result, conglomerates are not investing in long-term, regional job-creating projects and in working capital for SMEs, which employ the majority of private sector employees in the UK.

Basel III regulation, which has increased capital requirements and introduced a minimum leverage ratio, has made it more expensive for banks to lend to small businesses. At the heart of the regulation, the complex risk-weighted capital adequacy rules mean that banks focusing on providing residential mortgages will have to hold less capital than a bank which provides small business loans. The regulation is also open to gaming by the existing conglomerates that have enough resources to get around any rules that hold them back. For example, banks in London are now planning to pay fixed London allowances to their employees to circumvent the EU rules on capping bonuses.

We hear plenty of rhetoric from the industry, including the British Bankers' Association, that the answer to the problem is more competition in the form of challenger banks. However, the reality is far more complex. The regulatory difficulties and costs in setting up a UK branch network, or creating the necessary online platforms, are insurmountable for a brand new entrant. Add to this the fact that it is still difficult to compare prices between banks, due to what are often deliberately complex pricing structures, and the fact that customer behaviour studies show a person is more likely to get divorced than change bank accounts. It all means that increasing competition in the market seems less and less like the necessary silver bullet.

We need deconglomerated banks which use credit for social and economic purposes, and which do not follow Basel-endorsed, centralised credit risk management models. While we allow conglomerate banks to continue pursuing complex and risky investment banking, and we do not reform how Basel III measures the riskiness of certain banking activity, then we will not see true banking reform that can support an economic recovery in the long-term. 

Ismail Erturk is a Senior Lecturer in Banking at Manchester Business School.

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