Back in 1933, a banking act was passed in the US which mandated the separation of the commercial and the investment interests of US banks. This was in response to the 1929 stock market crash, where contagion from the universal banks’ failures in securities dealing had seeped into their commercial and retail arms. A financial disaster occurred the like of which has not been seen since — although some may argue the 2007/2008 global financial crisis eclipsed it, but many feel it is too early to tell. What is clear is it took more than a decade for the US to recover from the crash of ‘29.
The act in 1933 took on the sobriquet of Glass-Steagall, named after the two congressmen Senator Glass and Representative Steagall who had been instrumental in pushing it through the legislature. It remained in force for sixty years until 1999 when the Gramm-Leach-Bliley act (similarly named after its main protagonists) repealed most of it. GLBA revoked the main issue at stake — whether a financial institution could act as an investment bank and a commercial bank at the same time.
The reasons for the repeal were varied. One was the acknowledgment that investment knowledge was more widespread amongst non-banking professionals, and they were seemingly more likely to spread asset classes within their portfolios, removing investor risk. A second reason was that in good times interest in securities were high, whilst in worse times, the commercial and retail sectors took the bulk of investment — resulting in a real imbalance for the two strands depending on financial sentiment. Perhaps more of a driver was the spate of high profile banking M&A that went on around that time. Glass-Steagall was seemingly ‘more honored in the breach than the observance’ in any case. So, there we have it — GLBA was a form of deregulation that has allowed the re-emergence of the banking colossi we see today in the US and around the world.
There was never such an act in the UK, and banks there have been free to operate as both investment and commercial banking entities. However, ten years ago that was at risk. The 2007/2008 global financial crisis saw a run on Northern Rock, a building society that had pivoted a long way from its roots and moved into risky subprime mortgages. It also saw the UK government stepping in to rescue two High Street banks, Lloyds and RBS, who had undertaken massive loan liabilities, unwise acquisitions, and poor overall risk management. In subsequent years, the UK government has been working on legislation which it believes will reduce the likelihood of a repeat of the crisis. Moves such as adequate capital allocation, Basel III, and others have all been enacted in an attempt to ensure that the ’too big to fail’ moniker is never tested again.
But this is changing now, with a piece of this new regulation not yet in force called ringfencing. Although the legislation has been enacted, banks have just under two years to comply with it. The aim is to deliver structural reform within the largest banks in the UK, specifically those with retail deposits of more than £25bn. By 1 January 2019, any bank with deposits of that size must have “ring-fenced” its core retail services from any other services the bank offers. In effect, this is similar to what the GSA strove to do nearly 100 years ago: namely avoid risk contagion from the operating divisions or companies within the universal banks that focus on non-core retail. In reality, this level of deposits makes it a very select group of banks — no more than the biggest 6 or 7 — but, given that the majority of the population rely on these institutions in one way or another, the impact will be widespread.
With ringfencing, each of these large banks must split their investment arm from their retail arm into separate entities that have no dependencies or preferential commercial ties with each other which could allow contagion to spread across te businesses. This means all the relationships the banks currently have will need to be assigned to one side or the other. The assets they hold must be divided up (e.g. leases, buildings, IT systems, etc.) between ring-fenced core retail services and the rest. The cost to do all this for each bank is estimated to be around £200m as a one-off cost, and a £120m in operating cost per annum.
Banking relationships are ultimately instantiated in law via contracts, and those documents which will need to be located, examined, renegotiated in some cases, and repapered. Most large banks have hundreds of thousands of contracts, some approaching millions. Those contracts are in multiple repositories and data stores around the bank’s IT infrastructure and will need to be discovered and categorized. They will then need to be individually read and analyzed for terms that can help determine whether it relates to the investment or the retail side. Think about lease agreements, for example, and determining which side of the fence they should be moved to.
Given the scale of this task, it would be nearly impossible for every contract to be processed in this way by humans. There just isn’t the time or resources generally available, which is why artificial intelligence (AI) can be a major weapon in this endeavor. The process will have to be automated if timeframes are to be met, and ‘virtual robots’ are a compelling solution. Imagine being able to locate and process over 10,000 contracts a day, and in the end, know where each contract should go, and if it needs to be re-papered or renegotiated. That is a perfectly feasible and realistic solution today.
Using including Deep Learning and Latent Semantic Indexing (LSI), AI-based software can discover contracts, extract metadata from them, analyze their terms, and then feed that data into line of business applications or decision support systems so the appropriate action for each contract can be taken. This technology is highly sophisticated and capable in its ability to work out what a contract might represent, even if the terms used are not exact.
Most of the large UK banks see more regulation as a bane, and ringfencing as just another impediment to profit. But with the right technology, at least the contractual aspects of the relationship they have with their clients and their suppliers can be brought under control and help them meet the Jan 1st 2019 deadline.