A framework for banking structural reform

A framework for banking structural reform

The 2007-08 crisis revealed regulatory failures that had allowed the shadow bank operating system and systemic risk to grow unchecked. This column evaluates recent proposals to reform the banking industry. Although appropriate pricing of risk should make activity restrictions redundant, there may nevertheless be complementarities between both of these approaches. Ring-fencing could make banking groups easier resolvable and for that reason lower the price of imposing market discipline.

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Today’s crisis has made evident the failure of the three pillars of the Basel II system. Disclosure and risk assessment have already been deficient (think for instance about the issues with rating agencies), and market discipline has been ineffective due to the blanket insurance provided by ‘too big to fail’ policies. To the a collective moral hazard issue of ‘too many to fail’ might have been added, because when many institutions choose correlated risks, as in the 2007-08 crisis with high direct and indirect contact with property, the central bank and/or the regulator are compelled to bail out failing banks ex post. The incentives to herd are particularly strong for small banks (see Acharya and Yorulmazer 2007, Farhi and Tirole 2012). Furthermore, capital regulation hasn’t considered systemic effects (the social cost of failure), and capital requirements have already been softened and asset restrictions lifted, likely beneath the pressure of industry lobbies. 1 Supervision has proved ineffective because it allowed a shadow bank operating system and systemic risk to grow unchecked. In conclusion, the crisis uncovered massive regulatory failure.

Post-crisis banking regulation

The regulatory response has gone to take part in the Basel III procedure for increasing capital and liquidity requirements also to propose a structural reform of banking. Several initiatives post-crisis have already been taken up to regulate banking structure: the Independent Commission on Banking (ICB) in the united kingdom (or Vickers Commission), the Dodd-Frank Act in america, and the Liikanen Commission in the EU. The ICB launched the thought of ring-fencing retail activities from investment banking activities in separately capitalised divisions of a bank holding company. The retail part will be at the mercy of higher capital requirements. That is a compromise to ease the gambling problem with public insurance while allowing some scope economies within banking activities (see ICB 2011). This structural measure happens to be being implemented and you will be effective in January 2019.

In america the Volcker Rule adopted in Dodd-Frank forbids proprietary trading by banks independently account but allows it in a few permitted activities (market-making, trading in government securities, hedging, and underwriting) and its own implementation continues to be in process. The Dodd-Frank Act was said to be the present day version of the Glass-Steagall Act of 1933 (repealed in 1999), that was itself a reply to the banking crisis of the first 1930s. According to Glass-Steagall, commercial and investment banking are separated – commercial banks cannot cope with securities and their deposits are insured up to specific amount, and investment banks cannot take deposits.

The Liikanen Commission (October 2012) took an intermediate route between your proposals of Vickers and Volcker. Vickers pushes most investment banking activities beyond your ring-fenced retail division. Volcker separates proprietary trading and hedge and private equity fund investment. In both Liikanen and Vickers proposals, however, not in Dodd-Frank, banks may create a holding company with banking and trading subsidiaries. According to those proposals, the deposit-taking subsidiary cannot provide market-making services or hedge and private equity fund investment, but other group companies can do so. Liikanen’s proposal also adds a strengthened leverage limit for the trading subsidiary, and Dodd-Frank adds one on designated systemic institutions. 2 In January 2014 the European Commission published the lender Structural Reform proposal, which is partially predicated on the Liikanen report. It proposes the ban and separation of proprietary trading (but more narrowly defined than in Dodd-Frank) and fosters ring-fencing of wholesale market operations. 3

Resources of excessive risk-taking

The resources of potential excessive risk-taking in banking are: limited liability (for shareholders and managers); moral hazard (for managers and investors); explicit and implicit insurance (‘too big to fail’); and excessive competition (eroding banks’ charter value). To the we should add the capability of modern banking to leverage the insured deposit base in high-risk bets available on the market. 4 Traditional banks can lose cash by making bad loans but, typically, the procedure is relatively slow. However, the weight of trading in the total amount sheet of banks has increased because of the more extensive usage of hard information, which erodes traditional relationship banking predicated on soft information. A bank with usage of complex derivative products can bet the complete balance sheet overnight and induce the failure of the institution. Indeed, single traders at Barings (N. Leeson), Société Générale (J. Kerviel), or JP Morgan Chase (the ‘London whale’) have resulted in huge losses (in the vast amounts of euros) for all those institutions.

A framework for understanding regulatory failure and reform

So as to understand both regulatory failure and the explanation of the reform proposals, I propose a framework predicated on Matutes and Vives (2000). 5 The framework considers that the three main frictions in banking will be the limited liability charter of banks, imperfect competition (due tell differentiation and/or switching costs among banks), and a social cost of failure of an entity beyond its private cost. Banks compete for deposits and pick the riskiness of their portfolio of loans.

Different possible banking regimes, the incentives for risk-taking, and the correct regulation in a context with low charter values and a higher social cost of failure are depicted in Table 1. With limited liability, banks will assume excessive risks on the asset side, unless the chance position is observable and market discipline becomes effective. Disclosure requirements help uncover the bank’s risk position (or, more realistically, ensure an improved assessment). That is represented by the banking regime in the first row of the table, where in fact the incentives to take risk are absent on the asset side and moderate on the liability side. If the asset risk position of the lender isn’t observable (second row of the table), then incentives to assume more risk increase considerably on the liability side and so are maximal on the asset side. Those incentives become maximal on both sides of the total amount sheet with risk-insensitive insurance (third row in the table), because it destroys investors’ monitoring incentives. Properly priced risk-based deposit insurance (bottom row in the table) moderates risk-taking incentives and compensates for the bank’s limited liability charter, but banks may still take an excessive amount of risk in the current presence of a big non-internalised social cost of failure. In the very best and bottom rows, a musical instrument such as for example capital requirements may effectively control risk-taking, as the incentives to assume risk on the asset side are disciplined by the marketplace, but in the center rows asset restrictions have to complement capital requirements. Asset restrictions basically imply that the number of risk that the lender may take on the asset side is bounded.

Table 1 . Possible banking regimes, the incentives to take risk on the liability and asset sides, and the required regulatory instruments, when charter values are low and the social cost of failure is high

The introduction of competition in banking in the 1980s was accompanied by checking risk-taking with capital requirements, allowing banks to depend on their own internal models to assess and control risk, and including disclosure requirements for finance institutions so that you can increase transparency and foster market discipline. A flexible view of capital requirements, supervision, and market discipline were the three pillars of the Basel II framework. The explanation of the framework was to supply more risk-sensitivity to capital requirements. Advanced economies tried to go towards the most notable and underneath rows of the table. Supervisors would assess how well banks were matching their capital to the risks assumed (substituting risk-based deposit insurance by risk-sensitive capital requirements) and banks would disclose information on the capital structures, accounting practices, and risk exposures. Risk-sensitive capital requirements and internal capital models proved ineffective because of the complexity and likelihood of being gamed. 6 This regulatory strategy failed.

Evaluating the reform proposals

Will today’s structural banking reform proposals succeed? The assessment of the proposals is complex being that they are bound to have mixed effects. They’ll have a tendency to lower the complexity of financial institutions and improve resolvability, in addition to reducing the scope for conflicts of interest and interdependencies within groups and with financial markets. They might be important in increasing the credibility of resolution procedures. Concurrently some versions of the proposed reforms may raise the burden on the supervisor and raise the threat of misidentifying prohibited or permitted activities, and limit scope and diversification economies. And the chance of migration of risky activities to the shadow bank operating system or other jurisdictions where regulation is lax is always present. The results could be that the investment bank part might need to be rescued if it becomes systemic. A proposal to counteract such incentives is to create a ‘wired’ ring-fence in a way that if the boundary fails strict separation of activities will be imposed (which is contemplated in the united kingdom proposal).

Today’s regulatory reform is aiming at pricing risk, be it by the marketplace with disclosure and market discipline (e.g. bail-in of subordinated and even senior debt in cases of trouble) or by the regulator (with risk-based insurance), and at exactly the same time limiting activities of banks as in the structural banking reform proposals. Pricing risk corresponds to moving towards the very best and/or underneath rows of the table, where, paradoxically, activity restrictions aren’t needed. Put another way, imposing mechanisms to price risk correctly should make activity restrictions redundant.

However, it can be argued that there surely is a complementarity between your two types of measures, since separation of activities could make banking groups easier resolvable (reducing the social cost of failure) and for that reason lower the expense of imposing market discipline. Indeed, important efforts are being made as a way to improve resolution mechanisms in order that it is credible to impose market discipline and invest in bail-in procedures whenever a bank fails, but probably another residual cost of liquidation will exist.

Furthermore, scrapping deposit and creditor insurance (explicit or implicit, as in ‘too big to fail’ policies) may increase fragility by aggravating coordination failure and/or increase information-based runs when in conjunction with more disclosure. That’s, even maintaining a particular degree of deposit insurance for retail deposits, runs might occur for uninsured debt if credible bail-in procedures are set up. Activity restrictions are justified then if insurance must be provided and can’t be fully priced. Because of this to a certain degree flat insurance mechanisms and ‘too big to fail’ policies stay static in place. This is exactly what the regulatory reform process appears to have implicitly concluded by proposing both mechanisms to price risk and a particular amount of separation of activities.

Will this ‘carpet bombing’ strategy be adequate to deter, or at least alleviate substantially, financial crises? We will know the answer when another crisis strikes.

References

Acharya, V and T Yorulmazer (2007), “WAY TOO MANY to Fail – An Analysis of Time-inconsistency in Bank Closure Policies”, Journal of Financial Intermediation 16(1): 1-31.

Boot, A W and L Ratnovski (2013), “Banking and Trading”, mimeo.

Cordella, T and L Yeyati (2002), “Financial Opening, Deposit Insurance, and Risk in a Style of Banking Competition”, European Economic Review 46: 471-485.

Farhi, E and J Tirole (2012), “Collective Moral Hazard, Maturity Mismatch and Systemic Bailouts”, The American Economic Review 102(1): 60-93.

Haldane, A (2012), “YOUR DOG and the Frisbee”, Speech at the Federal Reserve Bank of Kansas City’s 366th economic policy symposium, Jackson Hole.

Hellman, T F, K Murdock, and J Stiglitz (2000), “Liberalization, Moral Hazard in Banking and Prudential Regulation: Are Capital Requirements Enough?”, The American Economic Review 90(1): 147-165.

ICB (2011), Final Report Recommendations, UK Independent Commission on Banking, London.

Kroszner, R and P Strahan (1999), “What Drives Deregulation? Economics and Politics of the Relaxation of Bank Branching Restrictions”, Quarterly Journal of Economics 114(4): 1436-1467.

Matutes, C and X Vives (2000), “Imperfect Competition, Risk taking and Regulation in Banking”, European Economic Review 44(1): 1-34.

Repullo, R (2004), “Capital Requirements, Market Power and Risk-Taking in Banking”, Journal of Financial Intermediation 13: 156-182.

Viñals, J, C Pazarbasioglu, J Surti, A Narain, M Erbenova, and J Chow (2013), “Creating a Safer ECONOMIC CLIMATE: Will the Volcker, Vickers, and Liikanen Structural Measures Help?”, IMF Staff Discussion Note 13/4.

Vives, X (2006), “Banking and Regulation in Emerging Markets”, World Bank Research Observer 21(2): 179-206.

Footnotes

1 Kroszner and Strahan (1999) document lobby pressure in the context of the abandonment of branching restrictions in america.

2 See Viñals et al. (2013).

3 Recent French and German reform proposals is seen as adaptations of the Liikanen proposal.

4 See Boot and Ratnovski (2013).

5 See also Hellmann et al. (2000), Cordella and Yeyati (2002), Repullo (2004), and Vives (2006).

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