The retail funding myth – why the investment banks aren’t to blame

Frances Coppola
BANKS used retail deposits to gamble on the investment banking casino!” That is the common perception of the cause behind the 2007-2008 financial crisis.

The popular belief is that retail deposits, instead of being used to fund “safe” traditional retail lending like mortgages, were used to fund high-risk derivatives trading on the international capital markets. This belief is now driving calls – including yesterday from George Osborne – for the structural separation of retail and investment banks. Separate retail and investment banking, so the thinking goes, and retail deposits will be safe.

Nothing could be further from the truth. At the time of the crisis, only three UK banks had investment banking arms – Barclays, HSBC and RBS. The rest were retail banks. Northern Rock, Bradford & Bingley and HBOS/Lloyds – all three were bailed out, but none had a significant investment bank. But that didn’t mean they were isolated from wholesale and investment banking activity, or from the capital markets. Far from it. They were dependent on them. You could say the dependence of retail banking on securities issuance and overnight wholesale funding was the banks’ real problem in the crisis.

This can be seen by examining banks’ loan-to-deposit ratios. This measure indicates the proportion of loans that are backed by deposits rather than wholesale funding, interbank borrowing, or the proceeds of bonds issuance. Most small banks and building societies operate on a loan-to-deposit ratio of under 100 per cent: Kingdom Bank, for example, says its target ratio is 95 per cent. It will not “lend out” more than 95 per cent of the total amount of deposits on its books. We would regard that as a prudent approach to lending.

But the majority of large banks have far higher loan-to-deposit ratios. At the time of the financial crisis, the average ratio in UK banks was 137 per cent. In other words, 37 per cent of the funding they required for ordinary lending – not high-risk derivatives trading – came from sources other than retail deposits. And the ratio was much higher in banks that were bailed out: in Northern Rock, for example, it was approximately 175 per cent at the time of its collapse.

Since the financial crisis, banks have been actively reducing their loan-to-deposit ratios. The introduction of the bank levy, coupled with a general perception that an over-reliance on overnight funding for longer-term loan commitments increases risk and instability, has encouraged banks to look more to retail deposits to fund lending. The average ratio is down to about 105 per cent. So even now, with the possible exception of HSBC, which has a ratio of about 78 per cent, retail banking does not fund investment banking. It is the other way round.

But the price we are paying for increased safety in retail banking from reduced loan-to-deposit ratios is a serious decline in bank lending. Reducing the loan-to-deposit ratio can only be done in two ways: either the amount of deposits must increase, or the amount of lending must fall. Retail deposits have been declining for many years, as people move long-term savings into pensions and Isas. Current accounts have been hit by a decline in wages, and inflation has led to increasing expenditure on essential goods. Very low interest rates also discourage people from saving. And general distrust of banks has encouraged people to put money in other institutions, like credit unions and building societies. One large building society is even running an advertising campaign to attract depositors from banks on the basis that it isn’t a bank. So the only way banks can reduce their loan-to-deposit ratios is by lending less. We don’t like that, do we?

But if we want banks to lend more, despite the decline in deposits, we have to accept that retail banks need to obtain funding from wholesale and investment bank sources, and from capital markets. Full structural separation, with measures to prevent retail banks from using wholesale funding, would cause even more of a credit crunch. And ring-fencing won’t address the loan-to-deposit imbalance that forces retail banks into dependence on wholesale funding.

Retail banks have lent too much and received too little. Unless we can persuade people to put their money back into banks, we have to accept either interdependence of retail and investment banking, or continued decline in bank lending with associated disastrous consequences for the economy. I know which I would choose.

Frances Coppola is a former banker. She blogs at