Monday, November 24, 2014
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The Great Bank Debate

OXFORD – Christine Lagarde, the International Monetary Fund’s managing director, recently said of the unfinished agenda for global financial-sector reform: “To start, we need concrete progress with the too-important-to-fail conundrum. We need a global-level discussion of the pros and cons of direct restrictions on business models.” Five years on from the start of the crisis, with the publication of the Liikanen report on European Union banking reform, that debate has finally begun.

The Liikanen proposals have much in common with those made in 2011 by the United Kingdom’s Independent Commission on Banking (ICB), which I chaired. Both sets of recommendations stress the importance of an interlocking package of measures that combine much greater loss-absorbency with structural reform. And both make the same economic case for such reforms: to insulate basic banking services from investment banking risks; to make resolution easier and thus more credible; to shield taxpayers from risks that belong in the private sector; and hence to ensure that banks’ risk-taking is subject to adequate market discipline.

Moreover, both Liikanen and the ICB favor structured universal banking – legally separate entities with separate capital, management, and so forth – rather than calling for its demise, as urged by those who want to split commercial from investment banking fully. For large banks, Liikanen would separate trading from deposit banking, while the ICB’s proposals, which are now incorporated in draft legislation in Britain, would ring-fence retail banking.

This by itself is a distinction without a difference. After all, a fence to protect the deer from the lions is the same as a fence to keep the lions away from the deer. Unlike their cousin the Volcker Rule, neither Liikanen nor the UK approach attempts to draw a line between types of trading. Judging whether trading is proprietary might not quite require “windows into men’s souls” (which in another context Queen Elizabeth I wisely avoided), but America’s experience shows that it is difficult all the same.

Still, the Liikanen and UK designs are not identical. Nor should they be. The UK has a much larger banking system relative to its economy’s size than does Europe as a whole – let alone the United States. The UK’s system is exposed to different risks, which it is in Europe’s interest to have well managed. Moreover, Liikanen is not a one-size-fits-all approach, as it explicitly proposes powers to require wider separation, if needed, to ensure resolvability.

One clear difference, though, is that Liikanen, unlike the UK proposals, allows securities underwriting in deposit banks. This contrasts with the US, even after the 1999 repeal of the Glass-Steagall Act’s ban on affiliation between banks and companies engaged principally in underwriting securities.

And it sits oddly with separating trading and derivatives from deposit banking, since underwriting is akin to selling a large put option, and typically riskier than normal market-making. With underwriting on the trading side of the fence, the deposit bank could still supply the service to customers, but as a broker, not as a dealer. Underwriting belongs with the lions.

Aside from its implementation difficulties, there are good reasons not to introduce the Volcker rule, rather than the ICB/Liikanen proposals, in the UK and Europe. First, it does not do enough to shield retail banking from investment-banking risks, of which only a small share relate to proprietary trading. Second, the US has a very different banking system to begin with, including various regulations on how depository institutions can relate to affiliated trading entities.

This suggests that a better question is whether to introduce the Volcker rule in addition to, rather than instead of, ring-fencing. In the interest of simplicity, I would say no.

Enforcing total separation instead of ring-fencing would provide a stronger barrier, but at a potentially high cost, including a risk to financial stability. After all, full separation implies that resources from elsewhere in a given banking group are unavailable to address a retail-banking crisis resulting from, say, a slump in residential and commercial property prices.

Such crises can happen. So the ICB concluded that its reform package for the UK would achieve the main aims of full separation at a lower cost, and without creating the risk to financial stability that could come from having undiversified, correlated, stand-alone domestic retail banking. To be sure, the success of this approach depends on the fence staying strong. That requires good initial design and constant regulatory vigilance, but so does full separation.

Structural reform of banks does not solve all problems. But, at least for the UK and the rest of Europe, it is a key part of the overall reform package, along with much stronger capital and liquidity standards, loss-absorbent debt (including “bail-ins” by creditors), real resolvability, and so on. There is also the question of how to protect financial stability from risks arising from shadow banking, including the risk of contagion to traditional banking, which ring-fencing helps to contain.

Structural reform is also fundamental to the moves toward a European banking union, for a union with well-capitalized and safely structured banks has much better prospects than one without. Otherwise, mutualization of contingent liabilities could exacerbate the too-important-to-fail problem.

Now that structural reform is explicitly on the agenda, the debate about European banking reform is entering a new phase. But, as the IMF has stressed, the debate needs to go beyond Europe. Moreover, it is more than a debate about public policy, because, in the post-crisis world, market incentives might point toward forms of separation between retail and investment banking.

But market incentives surrounding various business models will remain distorted so long as taxpayers are liable for bank losses. That provides all the more reason to get them off the hook via structural and other banking reforms.

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