Warning as EU report into crisis released

The separation of proprietary trading from retail banking functions is one of the most contentious recommendations of the high level expert group into the reforms of the European banking sector, which was released yesterday.

But some market sources warn that this may backfire because it will mean less liquidity in equity and bond markets and increase the cost of funding in the future. But others say it is necessary measure to protect deposits and prevent a financial crisis, on a scale similar to the past few years from happening again.

The Liikanen report is the EU’s response to the financial crisis which erupted in 2008. The former chairman of the US Federal Reserve Paul Volcker compiled the US’s report into the banking crisis while in Britain, the Vickers report was released earlier this year.

All three share the same crucial recommendation: bank deposits must be ring-fenced from investment banking activities such as proprietary trading and other high-risk activities.

The US Glass-Steagall Act was introduced in the 1930s to prevent the sort of speculation that caused the 1929 stock market crash, but this was repealed in the mid-1990s. This allowed investment banks to use deposits collected by their retail arms to trade the markets in an effort to maximise profits.

Deposits are a very cheap source of funding, which encouraged investment banks to increase their trading activities. In other words, in the years leading up to the financial crisis, investment banks were taking greater risks with ordinary deposits.

When the markets went into meltdown in 2008, many of the banks had to be bailed out using taxpayers money to prevent them collapsing. In other words, ordinary taxpayers had to fork over billions to protect their deposits because of massive speculative losses.

The move now is to reintroduce the Glass-Steagall Act to protect deposits in the future. It is certainly going to mean that investment banks will face a much higher cost of capital, which will increase the cost of their services. But it does mean a much more stable retail banking environment.

One investment fund manager the Irish Examiner spoke to said it was a welcome move. He argues that it will mean that retail deposits will be used to lend into the real economy, which will have much more beneficial effects. Moreover, it will mean that there will be much less short term speculation and much more long term investment across the markets.

But lower trading volumes will also mean less fees for stock exchanges and stockbroking firms as well as profits for investment banks.

There is likely to be massive backlash from the financial services sector against this proposal.