As the US Treasury and regulators attempt to stop the financial meltdown, they are also redefining the banking model in unintended ways that may sow the seeds of financial turbulence in the future. By encouraging or allowing banks such as JPMorgan, Bank of America and Barclays to rescue weaker banks, useful as it is in the short term, they are also nurturing bigger universal banks. Their sheer size will not only strengthen the unwritten TBTF principle (“too big to fail”). The emerging banking model, based on financial conglomerates with a high degree of diversification, also creates problems for banking stability.
Financial history tells us conglomerates are complex to manage. They usually run profitable business whose margins fund other underperforming units, which is one of the reasons why investors put a discount on their share price. But financial conglomerates also involve additional problems related to risk management, conflicts of interest and capital allocation, which create huge challenges for regulators and banking stability as a whole.
The first basic problem that universal banks face is risk management. On the one hand, these banks offer low-risk, traditional banking services – such as deposit-taking and commercial lending – with guaranteed deposits and an insurance mechanism set up by governments. Yet they also run trading units, lend money for mergers and acquisition, manage individuals' portfolios, invest their savings in exotic products and design complex structured loans. These banks look more stable because they are more diversified, but in this diversification lies the problem.