Commercial banks' participation in investment banking

Until recently commercial banks have been involved in the capital markets mainly through ownership of brokerage businesses. Seventeen banks operate brokerage businesses as members of the Dhaka Stock Exchange (DSE). Historically revenue from securities business was low compared to a bank's core business of deposit-taking and term-lending. With a rising share market, contribution to revenue from the brokerage businesses has risen significantly. This has provided a much needed respite to many banks in the midst of reduced lending and trading activities. Most banks generated this extra revenue by lending to Beneficial Ownership (BO) accounts of investors against their stock portfolios at high interest rates (margin loans).

Because of a perception of easy profits, commercial banks are preparing to enter into the securities market on a larger scale. Many banks have either received or applied for merchant banking licenses, which would allow them to manage issues, underwrite public offerings, and offer wealth management services. Currently, banks hold 10, out of a total 31 merchant banking licenses. While diversification of revenue is desirable for banks, it is also important to note that the business of securities is different from that of banking, and presents different risks. The foray of commercial banks into the securities market raises some concerns, both from risk management and competitiveness perspectives.

Risk perspective: As new issues are few and far between, margin lending and trading remain the focus for merchant banking operations. Merchant banks are allowed to provide as much as 150% of the portfolio value in margin loans. Margin lending increased significantly in the last year. According to a report published in an English daily in its issue on July 14, 2009, two commercial banks increased their brokerage profit during first half of 2009 by 20% and 300% respectively, compared to last year.

Supposing margin interest rate and borrowing costs remained fairly same, it could be assumed that most commercial banks increased their margin-lending volume in similar degrees. During that period, market capitalisation of the Dhaka Stock Exchange (DSE) increased 21%, from Tk. 776.4 billion in June, 2008 to Tk. 938.0 billion in July 2009. New issues (a total of 16) accounted for only Tk. 4.1 billion of this increase. It can be safely assumed that margin lending played a role in this significant advance; excess liquidity drove up the share prices in a market that experienced limited security supply.

Margin lending is attractive to banks for two reasons; first, it earns interest income and second, it generates trading revenue. This is also true for independent merchant banks not affiliated with a commercial bank. However, banks can bring to bear enormous amounts of funds from their deposit base at a low cost. Consequently, they also have the ability to render a much larger impact on the market. In contrast, independent merchant banks have higher costs of capital and hence are more selective in margin lending. In a rising market, margin lending encourages speculative trading and creates significant risk for investors, for banks and for the market.

Risk to investors: A portfolio created out of borrowed funds magnifies the risk of losses. A 10% market correction causes as much as 25% loss to an investor who is leveraged 150%. An investor not only absorbs losses incurred on his own money, but also on the money borrowed, as the lender does not assume any market risk. If significantly leveraged, an investor may lose a large part of his savings during a big market correction.

Risk to banks: Although margin loans are secured by shares purchased, banks take on significant risk through such lending. A 40% correction in the market would wipe off the entire equity of the investor and expose the margin lender to losses. This risk is reflected in the new banking supervision rules; under Basel II framework, investment in equity should be risk weighted at 100%. In other words, no matter the quality of share, the margin loan disbursed against such security would have to be fully risk-weighted.

Risk to the market: Margin lending exacerbates market volatility. A rising market lowers margin ratio allows further borrowing and encourages more buying. This in turn drives up the share prices. In a falling market, brokers call for more collateral to cover margin, often forces investors to sell, which pushes prices down, and creates further selling pressure. Such increase in volatility is detrimental to market stability.

Competition perspective: Merchant or investment banks serve an important role in a capitalist economy. It ensures efficient capital allocation to profitable businesses, improves market liquidity, facilitates price discovery through vigorous trading and reduces cost of capital by innovative structuring. In such a skill-driven business, intellectual capital is much more important than financial capital. Such intellectual capital is developed through incessant focus on the market by capital market professionals. The same quality may not develop in a large organisation engaged in a multitude of businesses.

Banks are important players in capital market, but their unrestrained expansion would deter the growth of independent merchant banks. If size and easy access to capital become the only criteria in awarding merchant banking mandates, we will never see a rise of independent merchant banks that lead their respective markets in innovation and service quality.

Case for limiting bank participation in the capital markets: Regulators in many countries favour separation of banking and securities businesses. An early example of this approach is the Glass Steagall Act of the US Congress of 1933. This Act separated investment and commercial banking activities, preventing overzealous commercial bank involvement in stock market. It was deemed that such involvement caused the banking crisis of 1929 when commercial banks took on too much risk with depositors' money. The core banking practices of deposit taking, term lending and risk management took a backseat. In many cases, banks would issue unsound loans to companies in which it had invested. Clients would also be encouraged to invest in those same stocks. Separation of banking and securities businesses removed such practices.

The Act was repealed in 1999 under pressure from the financial services industry who argued that by preventing diversification, the Act made banks riskier. Overnight, commercial banks, merchant banks and insurance companies merged under the same umbrella, creating financial behemoths. The most famous example was Citigroup, created through the merger of Citibank and the Travellers Group. The subsequent misfortune of Citigroup and other financial omnibuses highlights the relevance of the separation of banks and securities business. China, the new financial powerhouse, still maintains a separation between the two businesses.

As we are still developing our financial markets, we need to take a prudent approach to this issue. Banks should still be allowed to participate in merchant banking, but the practice of banks' margin lending should be limited with a keen eye on regulatory capital requirement. This would stop certain institutions from cornering the market by putting in huge capital in select securities or pulling out; a practice that creates huge volatility.

Also, in order to ensure the growth of independent merchant banks, it must be ensured that mandates such as issue management and underwriting offerings are equitably awarded to these institutions. The government can take a proactive role by selecting independent firms for management of government issues. Currently, Investment Corporation of Bangladesh (ICB) seems to have the sole mandate of such issues, which is not conducive to a competitive market. We need to develop various counter and competitive forces in order to ensure a competitive and efficient market.