Fri, Jan 04, 2013 - Page 9 News List

Time to address unfinished agenda for financial-sector reform

Structural reform of banks will not solve all the problems; however, at least for the UK and the rest of Europe, it is a key part of an overall reform package

By John Vickers

IMF managing director Christine Lagarde 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 EU banking reform, that debate has finally begun.

The Liikanen proposals have much in common with those made in 2011 by the UK’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.

LIONS

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 US. 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.

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