As we approach some form of bank separation, and the final building blocks of the G20 banking regulations come into play (BRRD for us EU members, and Basel 3), we see another effort to consider banking in the same light as utilities[1]
Utilities are based on networks of pipes and wires and the plant necessary to push and pull some essential service through them. As the UK is one of the few countries to trust our public utilities to commercial companies, we are near unique in having comparators to our commercial banks. The example I will use here are UK water companies which are near pure utilities: in nature the building societies of the utility world.
The problem with banks, well one of many problems with banks in 2008, was their ability to stop cash leaving when they are in trouble. Banking crises start as liquidity crises: cash leaves more quickly than loans can be called, or sold on, which some banks were in the habit of relying on in 2008.
It is for this reason that CRD IV requires “sticky” capital to be held by banks, and they have to hold financial assets they can readily sell in times of crisis. BRRD commits some lenders to have their loans converted to equity when crises overwhelm the capital buffer required by CRD IV.
Water utilities are economically regulated, as are all the network parts of our other utilities. We do this because they are monopolies. There have been attempts to build parallel networks but mature societies have learnt that is economically inefficient, as well as technically complex and unattractive.[2]
Now banks are economically regulated but we have yet to change their content. A large British commercial bank can be a retail deposit taker and domestic mortgage lender; a wholesale borrower; commercial lender; a securities and foreign exchange trader or an equities and bond promoter.
I am not going to enter into the debate over segregation here. We do not know where banking segregation will end but let us assume banks become more utility in nature, with their activities constrained to core borrowing and lending. How would investors need their capital structures to change to bring them into line with water companies?
The maths is not difficult for the equity investor. Severn Trent Plc’s PAT to capital employed (debt and equity) ratio is about 5% with a debt-to-total capital ratio of 80%. To turn a non-proprietary trading version of Barclays Bank plc[3] into an Ofwat model business like Severn Trent Plc with a comparable debt:equity ratio and a 5%+ return would, on simple math, require £100bn of additional equity[4] and £45bn per annum of additional annual profits, and not much different if it exchanged debt for equity at the current returns.
This serves to prove that achieving the liquidity and low cost debt our economies crave requires relatively risky banks (relative to utilities) and active and informed bank regulation, the thing missing during the decade leading up to 2008, and which we hope is in place now given that Russia spent seventy years proving the functionality nature of the only other large scale economic model we know.
Perhaps the challenger banks could target Ofwat style parameters, but to be that safe they would run very constrained businesses and their customers would have a sharp rise in lending costs. And for those who believe that banks can be made safe as utilities, remember Ofwat lost a water company on the way. See https://en.wikipedia.org/wiki/Welsh_Water for a succinct summary as to how even the seemingly safe economically regulated utility model could go wrong.
References
[1] http://www.telegraph.co.uk/finance/personalfinance/investing/12143115/Looking-for-income-Bank-shares-are-set-to-become-the-new-utilities.html
[2] https://www.google.co.uk/url?sa=i&rct=j&q=&esrc=s&source=images&cd=&cad=...
[3] Based on Barclays’ 2014 Annual Accounts and Severn Trent’s 2015 Annual Accounts
[4] Assumption: customer account balances are included in debt: Tier 1 cpaital is regarded as equity.
