Banking on Reform: Can Volcker, Vickers and Liikanen Resolve the Too-Important-to-Fail Conundrum?

by José Viñals and Ceyla Pazarbasioglu

The global regulatory landscape governing banks has changed from its pre-crisis status quo.

In addition to the Group of Twenty advanced and emerging economies led global regulatory reforms, like Basel III, the United States and the United Kingdom have decided to directly impose limits on the scope of banks’ businesses. The European Union is contemplating a similar move.

We discussed these structural banking reforms a few weeks ago with officials from finance ministries, central banks, and supervisory authorities from around the world during the IMF and World Bank Spring Meetings. The design and implementation of these measures will have implications for global financial stability and sustainable growth, so we wanted to bring people together for the first global debate of the issue with G20 and other countries.

Our analysis  suggests that structural constraints on banks’ activities, well designed and implemented, can usefully complement traditional tools. As a first best strategy, a targeted approach, where structural measures—such as “living wills”—are tailored to the specific risk profiles of individual banks at a global, group-level would be preferable to an across-the-board approach. However, sufficient confidence in supervisors’ capacity to design and implement the targeted approach, along with strong political support, are key to the ultimate success of structural measures to reduce risks in the financial system. If this confidence is lacking then, as a second best, across-the-board measures, in addition to bank-specific measures, would be appropriate, provided their global benefits are assessed to match or exceed their costs.

A tandem tactic to reduce risk

The crisis has made many skeptical of the ability of traditional prudential tools, such as risk based capital requirements, to keep under control the risk transmitted to financial institutions and the system as a whole by trading and certain investment banking activities. The crisis has strengthened the argument for excluding these activities from banks and hence impeding their access to taxpayer-funded backstops enjoyed by deposit-taking financial institutions.

The structural measures to reform banks such as the U.S. Volcker rule, the U.K.’s Vickers ring-fence, and the EU’s Liikanen proposal, which would create functional separation of businesses, all reflect a deep sense of unease with the risk culture engendered by the assumption of trading and speculative investments by deposit taking banks.

Looking back, however, restrictions on proprietary trading or investments in private equity alone would not have prevented major bank failures such as Lehman Brothers. Nor would reorganizing the bank into separate subsidiaries in each host and home country have facilitated its global, group-wide resolution. Legally, Lehman had a subsidiary structure, yet its resolution has been long and costly.

Looking forward, structural constraints on banks can work in tandem with strengthened capital requirements to limit banks’ excessive risk taking. Combining these prudential tools can make a banking group easier to resolve and attenuate the too-important-to-fail problem.

For example, if the investment bank is systemically important, ring-fencing deposits and credit will not necessarily resolve the too-important-to-fail problem. The temptation to bail-out creditors of the non-ring-fenced businesses will still be present. This suggests the salience of combining structural measures with higher capital requirements on all the systemically important subsidiaries.

Combining the requirement for higher capital (for the ring-fenced entity) and leverage ratio (for trading activities of the non-ring fenced entity) under each of the Vickers and Liikanen proposals would result in a more robust policy to counter too-important-to-fail.

If successfully implemented, these structural measures would make banks and banking systems safer in the United States, the United Kingdom, and the European Union, which would have a positive effect on global financial stability.

Three things to think through

But our analysis also suggests these policies will exert global costs given that they will be imposed on internationally active and systemic financial institutions. This is due to a number of factors.

First, structural measures will be challenging to implement. How are supervisors to consistently and correctly identify the intent behind bankers’ trades? While difficult in practice, enhanced supervisory collaboration in banks’ home and host countries is critical to the success of the Volcker rule. A broad restriction on banks’ trading activities in these countries could end up inhibiting their ability to make markets and hedge risks, activities that are not restricted under the Volcker rule. This could have adverse implications on liquidity and costs in capital markets.

Second, as authorities reduce banks’ ability to take excessive risk through structural measures, they must recognize that such risks could migrate to other parts of the financial system, including shadow banking entities. Policymakers may need to judiciously enlarge the regulatory perimeter and enhance the monitoring of shadow banks and their interactions with regulated entities for structural measures to reduce—and not simply redistribute— systemic risk.

Third, imposing constraints on banks’ activities at a global level, and on group-wide risk management tools, could make banks more resolvable. But this would potentially come at a cost in terms of loss of diversification benefits and efficiencies in risk management. And these costs may be felt globally.

Our analysis highlights the need for a global cost-benefit exercise that would encompass the extra-territorial implications of structural measures. The case for introducing these policies at the national or regional level would be strengthened by confirming whether their global benefits match or exceed their global costs, given the potential for the spillover of both benefits and costs to many countries and areas other than the United States, the United Kingdom, and the European Union.

Subjecting a global institution to different structural measures in different jurisdictions could exert further pressure on consolidated supervision and cross-border resolution. The more resources are taken up policing compliance with multiple rules, the less is available for monitoring risk, which could increase the cumulative costs of these national initiatives.

Our view is that, as a first best, a targeted approach, where structural measures—such as “living wills”—are tailored to the specific risk profiles of individual banks at a global, group-level would be a more effective than an across-the-board approach.

However, sufficient confidence in supervisors’ capacity to design and implement the targeted approach, along with strong political support, are key to the ultimate success of structural measures to reduce risks in the financial system. If this confidence is lacking then, as a second best, across-the-board measures, in addition to bank-specific measures, would be appropriate, provided their global benefits are assessed to match or exceed their costs.

We suggest development of principles to evaluate the global implications of these measures. These principles would facilitate corrections by policy makers and thus mitigate adverse implications. These principles may also be useful for future measures that may be contemplated by other jurisdictions.

One Response

  1. By allowing minuscule capital requirements for banks whenever something was officially or privately perceived as “absolutely safe”, regulators have been feeding the banks with growth-hormones which turned some of these into too big to fail banks.

    Clearly a bank regulator who does not understand that lacks the capacity of solving the problem without perhaps making it all worse.

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