Monday, October 17, 2011

Making Banks Safer: Can Volcker and Vickers Do It?

Making Banks Safer: Can Volcker and Vickers Do It?
Authors: Chow, Julian T.S. ; Surti, Jay 
IMF Working Paper
October 01, 2011

Summary: This paper assesses proposals to redefine the scope of activities of systemically important financial institutions. Alongside reform of prudential regulation and oversight, these have been offered as solutions to the too-important-to-fail problem. It is argued that while the more radical of these proposals such as narrow utility banking do not adequately address key policy objectives, two concrete policy measures - the Volcker Rule in the United States and retail ring-fencing in the United Kingdom - are more promising while still entailing significant implementation challenges. A risk factor common to all the measures is the potential for activities identified as too risky for retail banks to migrate to the unregulated parts of the financial system. Since this could lead to accumulation of systemic risk if left unchecked, it appears unlikely that any structural engineering will lessen the policing burden on prudential authorities and on the banks.

Section I, Why redefine scope?

The business of banking involves leveraged intermediation managed by people subject to limited liability and, typically, to profit sharing contracts. This combination is well-known to generate incentives for risk-taking that may be excessive from the perspective of bank creditors. Creditor guarantees such as deposit insurance are known to exacerbate this incentive problem because they weaken creditors’ incentive to monitor and discipline management.

These issues are magnified in the case of systemically important financial institutions (SIFIs). Owing to their size, interconnectedness, or complexity, the negative externalities emanating from financial distress at SIFIs makes them a source of systemic risk, leading to them being perceived to be too-important-to-fail (TITF). Consequently, the market implicitly—and often correctly—assumes that apart from explicit deposit insurance, creditor guarantees of a much wider nature would be extended when such firms are threatened by imminent failure.

This serves to weaken the mitigating force of market discipline. Prior to the crisis, the high likelihood of public support assumed in a distress situation contributed to the ability of SIFIs to carry thinner capital buffers at lower cost, acquire complex business models, and accumulate systemic risk. This trend was reinforced by the diversification premier attributed to universal banks by market participants and prudential authorities, enabling them to integrate the provision of retail, investment, and wholesale banking services without erecting the necessary firewalls there-between. These developments resulted in networks of financial interconnections within and across internationally active SIFIs that proved to be difficult, time consuming and costly to unravel. This made it seemingly less costly, during the crisis, to allocate tax payer resources to preventing SIFI failures than to allowing them, with subsequent resolution and restructuring of their businesses.

Diversification of business lines could serve to better protect a universal bank against idiosyncratic shocks that adversely impact individual lines of business. At the same time, the free flow of capital and liquidity and the associated growth in intra-group exposures would also increase the likelihood of intra-firm contagion in the event of an exogenous shock.  Unlike investment banking clients, retail banking customers typically have few options other than their banks for conducting vital financial transactions. Ensuring business continuity of services to such clients, therefore, serves a clear and important social welfare objective. But, complex business models and high levels of intra-group exposures present a barrier to quickly spinning off the retail parts of a universal bank which can ensure such business continuity.

Restricting the scope of a regulated bank’s business activities could, therefore, serve a number of important policy objectives. From a financial stability perspective, it could limit contagion within and across firms. From the perspective of consumer protection, it could ensure a more efficient provision of assurance of the continuity of retail banking services.  And, by more credibly restricting the ambit of tax-payer funded creditor guarantees to depositors it could furnish these benefits more efficiently and cheaply from a social cost perspective.

Accordingly, the official response to the crisis has, besides recognizing the need for strengthened regulation and oversight of SIFIs, also included complementary proposals to redesign and refocus their business activities. A number of concrete proposals have been made, including:

  • Narrow Utility Banking—essentially a reversion of deposit-funded banks into traditional payment function outfits with lending (and investment banking) being carried out by independent finance companies funded by non-deposit means.  
  • The Volcker Rule—prohibiting banks from carrying out certain types of investment banking activities if they are to continue to seek deposit funding and to retain banking licenses.  
  • A Retail Ring-fence—that, while not prohibiting banking groups from providing both retail and wholesale banking services, mandates legal subsidiarization of certain retail activities, prohibits this subsidiary from undertaking other businesses and risks, and establishes minimum capital and liquidity standards for it on a solo basis. While not limiting capital and liquidity benefits to the retail subsidiary from other affiliates when necessary, the ring-fence limits capital and liquidity transfers in the opposite direction, to non-ring-fenced affiliates. Such functional subsidiarization could enable continuation of retail operations under distress or failure of a SIFI’s other businesses.

This paper focuses on the motivation, content, operational challenges, and potential costs of these proposals to narrow the scope of banking business. The more radical proposals discussed under the narrow banking umbrella involve strict limits on what retail banks’ permissible activities ought to be and could entail significant dead-weight costs if implemented as recommended. By contrast, the design and motivation for the Volcker rule and retail ring-fence are more precisely targeted at the problems arising from the integrated business models used by SIFIs before the crisis.

The challenge facing these latter proposals lies in the feasibility and cost of their implementation. In the case of the Volcker rule, for example, it will be challenging for prudential authorities to tell apart permissible activities (market making and underwriting) from prohibited ones (proprietary trading) when assessing banks’ exposures to securities markets. Similar difficulties will be faced by supervisors assessing the nature of and purpose of hedging tools and contracts utilized by ring-fenced banks. This presents policy makers with a dilemma. Should they invest the financial cost and time towards gathering more contemporaneous information in order to create better filters and limit loopholes? Or, if this is viewed as being too costly or simply inefficient, should they move to outright prohibition of all activities related to securities markets?

The danger with the second option lies in generating incentives to push risk taking beyond the borders of the regulated financial system. If there are indeed no direct financial linkages between retail financial firms and such shadow banking entities, such risk taking may cease being a problem of regulation. However, systemic risk will continue to accumulate in the shadow banks, and since the participants in the regulated and shadow systems are the same, or are, in general linked, a crisis in that sector will continue to exercise a contagion impact on the regulated banking sector.