A comment made by a recent panelist caught our attention: would brokers be better off if they were forced to spin off from banks? So far the attention seems to be the other way around – banks are arguing to keep their brokerage divisions. But there are some strong reasons to think that although banks may see reduced revenues longer-term, their brokerage divisions would actually be better off. Let’s look at some of the ideas.
1) The Vickers Commission and Liikanen Group proposals want banks to separate traditional retail banking (High Street operations) from investment banking.
This is a complete separation of functions that should make the retail bank safer and would reduce or eliminate interconnectedness between the retail and investment bank side of the business. Banks would continue to be subject to Basel III and regional and domestic regulators.
But the brokerages? They would still have to follow every exchange and regional regulation on market behavior, but would not be beholden to bank capital regulations as far as we can see. This would be awfully freeing on the one hand. On the other, brokers would no longer benefit from their big bank credit ratings that generate so much (relatively) cheap cash to fund their business operations. Even an internal treasury desk may charge a lot less than cash providers to repo for a smaller broker, if the broker could even get rated high enough to generate funding that way.
Arguably though they would be alright getting funding with whatever business model they chose – Interactive Brokers for example has an A- rating from S&P and their Timber Hill group does plenty of prop trading/market making. And if smaller brokers had trouble getting funding as independent entities, this may just push the brokerage industry towards more agency business and away from prop trading anyhow. That’s one way to support risk reduction in financial markets.
The negatives of a Vickers or Liikanen style separation are also all valid – competitiveness, building of global champions, etc. But we’ll put these issues aside for the moment as none of them play to our core concern – would brokers be better off as separate entities.
2) The Volckers Rule would, by comparison, keep all the parts of a bank together but just limit what the investment bank side could do. That’s the pesky part of Volckers – no prop trading or otherwise riskier activities that generate so much market liquidity. But in the Volckers model brokers are still firmly part of banks and subject to bank capital rules. We’re starting to see this as more constrictive for the brokers than the Vickers plan. While Volckers also reduces risk to banks, it does so at the expense of the brokerage industry that must curtain its activities.
3) This brings us back to the 21st Century Glass-Steagal Act of 2013. We looked closely at the funding-related issues of the bill in a July 2013 article. We continue to think that while funding options will be reduced (how could they not be?), brokers themselves will have substantially more market flexibility.
Regulators are focused on banks becoming more robust entities, and retail investors having the greatest possible security in their investments. Further, regulators don’t want bank retail deposits facilitating more speculative brokerage activities. The mere thought of Mom and Pop’s retirement savings funding a hedge fund’s leveraged CDO position fills them with dread. We wince at the thought too.
But meanwhile, separating brokers from banking, while requiring all sorts of re-figuring out of funding models, provides substantial freedom to the brokerage community. Unless we hear some strong arguments otherwise, we are inclined to support Vickers from the brokerage perspective.