Too Pig To Fail: "Banks Need Far More Structural Reform To Be Safe" (Financial Times)

On the third anniversary of the passage of the Dodd-Frank Act, banking reform remains a work in progress across the world. In the US key provisions of the law, including the Volcker rule to limit proprietary trading, have still to be implemented and the authorities only recently published new rules on capital standards. In the EU, last month’s agreement by finance ministers on rules to govern what happens in the case of bank failures was an important step but many questions remain. And on both sides of the Atlantic, much more needs to be done on a fundamental issue – the structure of banking entities.

This is crucial for three reasons.

First, having a clear sense of who is in charge of what is vital when it comes to management and supervision, especially in times of stress. Structural reform and “living wills” can be used to help clarify lines of authority, align business risk with organisational form and simplify structures of complex financial institutions.

Second, structural reform can help bolster “horizontal buffers”, which can help stop crises spreading. Limits on the activities of retail deposit banks, restrictions on transactions between retail banks and their affiliates, independent capital and caps on counterparty credit exposures can help minimise contagion. The core banking services upon which everyday economic life depends would be better protected.

Third, paying attention to structure would help resolve companies when they get into distress. In the US, the Federal Deposit Insurance Corporation is developing a “single point of entry” model for resolution that would allow it to wind down a complex financial conglomerate by separating it into a holding company with “resolution-ready” capital and equity, and solvent subsidiaries permitted to continue to operate. Similar approaches are being pursued in Europe. Structural reform will make it much more likely that such resolution plans would work in a crisis. Indeed, it is hard to see how complex financial companies can be credibly resolved without prior measures of structural reform.

But isn’t the world diverging on issues of structure, with the US, UK and the eurozone going in different directions?

In a word, no. There is, in fact, growing convergence on structural reform.

The US has long used the bank holding company structure to try to separate banking from other financial activities within a complex group. Recent reforms under theDodd-Frank Act strengthened the wall between banks and other parts of a financial group, moved more dangerous derivatives activities to affiliates, and pushed proprietary trading and significant hedge fund investing outside the group entirely.

In the UK, the House of Lords will this week debate legislation based on the recommendations of the Independent Commission on Banking, which will move Britain more towards the US approach of using bank holding companies with separate subsidiaries. The retail banking subsidiary would have more restricted activities and would be ringfenced from other units.

Europe is considering similar reforms proposed by the Expert Group chaired by Erkki Liikanen. These proposals would separate trading and market-making from banking activities within the company. As in the US and UK proposals, bank transactions with affiliates would need to be at arm’s length and subject to quantitative caps.

None of these approaches is perfect, or perfectly aligned, and all are evolving. Structural reform involves difficult trade-offs: introducing rigidity may decrease efficiency and increase the risks faced by individual banks, while reducing the potential harm done to the system as a whole. In response to these trade-offs, the US, UK and Liikanen approaches all accept that universal banking can be efficient but see the need for it to have structural safeguards. Further global progress on these measures – on structured universal banking – would be well warranted.

Ringfencing by itself, of course, will not bring financial stability. We had forms of ringfencing before the crisis, as in the US, where it blinded regulators to the dangers of shadow banking. As a result, non-bank financial institutions engaged in increasingly risky activities with too little oversight and far too much leverage.

So structural reforms need to be part of a broader change in supervision and capital requirements, including resolution procedures for large financial companies regardless of their corporate form, and much-needed reforms to derivatives markets.

Ringfencing is no excuse to avoid regulating non-bank firms and markets that can pose a risk the financial system.

At the same time, Europe should embrace structural reform as an essential feature of banking reform. And the prospect of eurozone banking union makes this all the more important.