Macroscope | Why being smaller makes sense for post-crisis banks

Ever since the global financial crisis seven years ago, the banking industry has had to deal with the seemingly never-ending march of regulation.

Banks complain of regulatory overkill as they face steep declines in return, yet the fundamental question facing the industry refuses to go away: should universal banks still be funding the balance sheet of investment banking operations with depositors’ money?

To understand how we got to the present situation, it is necessary to rewind to the immediate aftermath of the financial crisis. Early calls to break up the large bulge bracket banks by separating risky investment banking from the more mundane but safe task of deposit-taking were successfully fended off.

All other things being equal, shareholders and the banks themselves should have reaped the benefits of staying integrated because it kept the playing field tilted towards incumbents with global scale and access to retail deposits that lower the costs of capital.

However, the understandable need to protect taxpayers from future bailouts led governments and regulators around the world to build regulatory capital buffers around activities of the banks, which were perceived as putting bank balance sheets at risk.

This came in various forms from ending proprietary trading (Dodd-Frank), to making large banks hold more capital (Basel III), to reducing the use of some of the more complex derivatives (Basel III), amongst other measures. In addition, compensation structures were overhauled to cap and defer bonuses to prevent bankers being rewarded for taking aggressive bets.