The Separation of Retail and Investment Banking Makes Only a Small Contribution to Reducing Systemic Risk

The activities of the investment banking sector are frequently criticised as one of the reasons of the recent global financial crisis. The current debate on restructuring the European banking sector is thus concentrating on the introduction of a new system, where the activities of retail banks and investment banks would be broadly separated, legally as well as economically. A current study conducted by the Centre for European Economic Research (ZEW) on behalf of the Association of German Public Banks (VÖB) is now providing a comprehensive picture of such a banking system. Simultaneously, the study questions the existing considerations and illustrates the consequences of a possible implementation in Germany.

The analysis makes clear that the separation of retail banking and investment banking cannot contribute to reducing systemic risk. Systemic risk exists when a shock, which initially had affected only one bank, starts spreading to further institutes, thereby affecting a large part of the entire banking sector. Systemic risk first and foremost arises from strong credit growth, an insufficient equity capital base, and a high degree of short-term capital market financing. The study concludes that splitting up banks does not address these main risk factors. “The discussion on the introduction of such a banking system is thus only a sideline in the debate on reducing systemic risk”, says Prof. Michael Schröder, head of the ZEW Research Department “International Finance and Financial Management”.

In addition, the results show that a strict separation of investment and retail banking can lead to a loss of valuable risk-reducing effects in the banking business. A relatively small share of investment banking can reduce the risk of the entire bank and improve the relation between revenue and risk. A strict separation would cause a loss of stability for retail and investment banks, compared to the situation prior to a split up. The results also indicate that such a system is not necessary to avoid a conflict of interests within banks. Such conflicts may exist when a bank offers customer consulting on investment products which have been created by the same bank.

For further information please contact

Prof. Dr. Michael Schröder, Phone +49 621/1235-140, Email  schroeder@zew.de