Erkki Liikanen: Banking after the regulatory reforms - business as
usual?
Speech by Mr Erkki Liikanen, Governor of the Bank of Finland and Chairman of the Highlevel
Expert Group on the structure of the EU banking sector, at the Bank of Finland SUERF
Conference, Helsinki, 13 June 2013.
* * *
Slides (PPT)
Slides (PDF)
On the size and structure of the banking sector
[Page 1: On the size and structure of the banking sector]
Research findings
Before the financial crisis, the consensus view from the finance and growth research was
that financial development not only follows economic growth but contributes to it.1
However, after the financial crisis, the other side of the financial sector growth has received
increasing attention.
Now it is recognised that before the crisis, the financial sector had grown to quite massive
proportions in many countries. And at the same time, the sector had become more and more
concentrated as the biggest institutions had increased their market share.
[Page 2: Rapid growth in the EU banking sector]
Let me start with the benign view of the financial sector expansion, and the emergence of
increasingly large banks, that prevailed before the crisis.
The main point in the benign story is that growth of the financial sector improves overall
economic growth opportunities by mobilising resources to finance investment projects and by
facilitating risk management.2 The key assumption is that a well developed financial system
helps allocate productive resources more efficiently, both by channelling funds to growth
sectors and by pulling resources from declining ones.
At the level of individual financial institutions, the growth of bank balance sheets was seen as
reflecting increasing returns to scale and scope from combining a wide variety of financial
services and providing them also cross-border to internationally active clients.
However, the events of the financial crisis have led us to also consider the malign diagnosis
of the massive size of the financial sector and of the single financial institutions that dominate
the banking sector.
Some recent research at the BIS suggests that finance does indeed contribute to economic
growth but only up to a point.3 A too large financial sector may imply too high risk-taking,
which results from over-investment and too much leverage in some sectors of the economy,
typically the real estate related sector. This increases the frequency of crises which involve
heavy output losses. Moreover, returns to scale may have accrued to bankers in the form of
high compensation rather than to the stakeholders with "skin in the game", i.e. a bank's
owners.4 A too large and a very well paid financial sector may also have deprived other
sectors of some of the most productive human resources.5
What makes the financial sector grow too big?
Researchers have suggested reasons ranging from banks' failure to internalize systemic
risks that stem from growth of leverage and ballooning balance sheets to rent-extraction in
opaque OTC markets.6
However, the most natural explanation may be the explicit and implicit public guarantees
which have led to lower funding costs to the largest institutions which the markets expect to
be too-big-to-fail.
Pursuing such a status in the eyes of the market, and the ensuing cheaper funding, can give
a strong incentive to grow. Given the size of the largest banks' balance sheets, even a
relatively small advantage in the funding spread means a big hidden flow of subsidy from the
taxpayers to those banks.7
Recent research suggests that the increasing returns to scale in banking, beyond a certain
size range, may largely result from the cheaper funding costs of the presumedly
too-big-tofail banks.8 An interesting aspect of the research is also that the social cost of too-big-to-fail
banks, due to increased systemic risk, appears to be significantly higher than the benefits
from the economies of scale.9
However, not only the size of the financial sector and that of the banks is important, but also
what the sector actually does.
In the run-up to the crisis there was a trend among the biggest banks to move their focus
towards investment banking, including trading operations.
[Page 3: Shifts in focus of operations as illustrated by shifts in assets structures]
Part of this trend was driven by the growing demand by corporate customers for risk
management services. To a significant extent, however, the growth in investment banking
activities was driven by the banks themselves in search for new revenue streams and higher
profitability. In many banks the proportion of trading assets in the balance sheet increased
substantially as securities and derivatives trading provided a relatively fast and flexible way
to grow.10
The relative importance of customer loans fell over time and the importance of interbank
lending grew. Moreover the customer loan business was transformed as many banks
particularly in the US moved away from the "originate and hold until maturity" model to the
"originate and distribute" model where granted loans were pooled, then securitized, and sold
4
Anderson and Joeveer (2012), Bankers and bank investors: reconsidering the economies of scale in banking,
CEPR Discussion Paper 9146
5
Philippon and Reshef (2012), Skilled biased financial development: Education, wages and occupations in the
U.S. financial sector, NBER Working Paper Series 13437
6
Stein (2012) and Bolton, Santos, and Scheinkman (2012), respectively
7
Noss and Sowerbutts (2012), Bank of England FS Papers Series, FS Paper No 15
8
Davies and Tracey (2012), Too big to be efficient? The impact of implicit funding subsidies on scale
economies in banking, Bank of England mimeo
9
Boyd and Heitz (2012), The social costs and benefits of too-big-to-fail banks: a 'bounding' exercise, University
of Minnesota working paper, February
10
Boot and Ratnovski (2012), Banking and trading, IMF Working Paper 12/238
to investors, including European banks. Securitization was motivated by the desire to
economize on capital buffers, but it turned out later that the assumed benefits of
diversification were vastly outweighed by the increasing propensity to contagion. The
increasingly long and opaque chains of claims and the exposures to entities in the shadow
banking system made banks and the financial sector as a whole vulnerable to shocks.11
Big risks followed, also at the systemic level, as balance sheet growth was often matched
with dramatic changes in the liability side of banks' balance sheet. Firstly, banks became
increasingly leveraged as the solvency rules allowed this to happen without a proportionate
addition of fresh capital. This was particularly true in the case of capital requirements for
market and counterparty risk. Furthermore, the more frequent use of internal models resulted
in lower capital requirements. The loss absorption capacity weakened. Second, banks relied
increasingly on short-term wholesale funding, typically from the repo market, which made
them more vulnerable to market disruptions. Thirdly, the rapid balance sheet growth also
required more interbank financing, which resulted in more interconnectedness in the financial
network, thus creating even more contagion channels.12
[Page 4: Increased leverage as illustrated by shifts in funding structures]
Another risk of a systemic nature is that diversification along similar lines can make financial
institutions more alike by exposing them to the same risks.13
And indeed, the benefits of diversification appear to have been offset by the greater risk
banks were exposed to as the share of activities outside the traditional retail banking
operations was increasing.14
Some potential benefits of diversification may also have been lost as implementing a
diversification strategy is a big managerial challenge.15 It is particularly challenging in a
banking group because of the differences in management cultures and risk profiles of the
different entities.
The challenge at hand is to reform the financial sector and banks towards a more healthy
size and structure in order to redirect banking activities to support the society and the real
sector in the best way possible.
No one knows what the right size of the financial sector is, but what we can do is remove any
perverse incentives which could lead to an excessive growth of the sector. For example, the
safety nets needed to protect depositors must not lead to the kind of moral hazard which
would undermine the stability of the financial system and entire economies.
How the HLEG proposals came about?
In the High-level Expert Group on reforming the structure of the EU banking sector, we
detailed the different phases of the crises, analysed the characteristics of the banking sector,
and identified a number of weaknesses which we thought the ongoing regulatory reform
would resolve only partially.
[Page 5: Summary of the problems in the EU banking sector identified by HLEG]
We also identified strengths that needed to be maintained in the prospective structural
changes of European banks. For example, we thought it would be very important to
accommodate the diversity of business models of banks in the European market place.
In our deliberations we considered two avenues as possible ways forward. In the two
avenues we put different emphasis on the most promising measures to end the too-big-to-fail
problem; capital requirements, resolution regimes, and structural reform.
[Page 6: Two avenues as possible ways forward were considered]
In the first avenue, additional, non-risk-weighted capital requirements on trading activities
and credible recovery and resolution plans for banks would have been the main instruments.
We acknowledged that the measurement of risks inherent in trading assets is prone to a
significant "model risk". Robust capital requirements which do not rely on complicated
models are one way to tackle this issue (as are limits on risk concentrations and counterparty
exposures). Avenue 1 was based on this approach.
The possibility of structural measures did enter Avenue 1, but only as a conditional
instrument. The idea was that if a bank was not able to prove that the required recovery and
resolution plans were credible, separation of trading activities was to be imposed by
authorities.
In the second avenue, by contrast, any significant trading activities would be required to be
separated from retail deposit banking. The separation proposal outlined in Avenue 2 was
based on the notion that capital requirements are not by themselves sufficient to limit
excessive risk-taking incentives induced by deposit insurance if risks are difficult to measure
and risk profiles can be changed rapidly, as in trading activities. Avenue 2 also
acknowledges the risk of heterogeneous application of tailor-made separation based on the
credibility of the recovery and resolution plans of individual banks. Thus avenue 2 includes
uniform separation ex ante in order to facilitate resolution of large and complex banks without
public funds and hence reduce the too-big-to-fail problem.
Further, a sufficiently broad separation of trading activities from deposit banking would avoid
definitional problems which would arise, for example, if the dividing line had to be drawn
between proprietary trading and market making.
HLEG proposal for mandatory separation
After a long discussion, where both avenues were supported, the group decided to propose
mandatory separation (or subsidiarisation as it has been labelled in the international
discussion).
[Page 7: The High-level Expert Group's proposal for mandatory separation within a banking
group]
First, the group wanted to limit the spill-over of the benefits from the deposit guarantee
system and any implicit government guarantees to certain trading activities of banks. Even
though the deposit bank and the trading entity, to which the above mentioned activities are to
be separated, could operate within the same banking group, restrictions on transfers and
exposures between the separated entities are imposed. Moreover, the deposit bank and the
trading entity are to stand on their own merits also in terms of capitalisation and funding.
Without separation, the explicit and implicit guarantees would distort the market mechanism
and spur the deposit banks to unhealthy risk-taking and expansion in their trading activities.
[Page 8: Rationale for mandatory separation]
Second, we saw the need to simplify the structure of large, complex banks. Reducing
complexity by means of separation facilitates management. Steering effort to the right
direction by means of incentive schemes, for example, is easier in a less complex
organisation, where the organisational units are more homogeneous. Separation also
facilitates supervision and monitoring by outside stakeholders such as shareholders, bank
creditors and other market participants, thus reinforcing market discipline. Finally, separation
makes it easier to impose recovery and resolution measures on failing banks.
Hence, simplification of the structure of large, complex banks by means of separation
facilitates the application of the ongoing regulatory initiatives in the area of corporate
governance, disclosure procedures and the crucially important bank recovery and resolution
framework.
Of particular interest is naturally whether an EU wide structural reform could have
implications for the functioning of the banking union currently under construction. First of all, I
think it is safe to say that the simplification of the large, complex European banks would
facilitate the task of the Single Supervisory Mechanism. Secondly, resolution of banks
currently seen as too-big-to-fail, needs to become a credible option, whether or not the
responsibility for resolution lies on a national or European authority. Third, we saw the need
to shield the deposit taking bank from excessive risk-taking in trading activity and from
exposures to entities in the shadow banking system.
Fourth, we emphasised the need to strengthen the governance of banks by altering the
management culture. Separating retail banking and trading activity would reduce the mixing
of two very different management cultures. They are intrinsically different in the
customerbased deposit and commercial banking field and in the "transaction-based" trading activities.
In the former, the relevant horizon is long and the role of the customer relationships is
essential. The latter has a different logic - that of beating the market and collecting
transaction fees. Profits often come from counterparts instead of customers.
The choice of where to draw the line between the deposit bank and the trading entity was
aimed so as to enable banks to service the real economy in the best way possible. We
concluded that allowing the deposit bank to provide non-banking clients with
customerinitiated hedging services with basic instruments such as forex and interest rate futures and
swaps as well as to undertake securities underwriting for them would leave sufficient room
for deposit banks to service corporate customers and thus fulfil their role in financing the real
economy.
Moreover, while seeking to correct the problems which result from the mixing of trading with
deposit banking, we wanted to preserve the universal banking model at group level. Hence,
we would allow the separated entities to operate under the same roof. This would keep the
trading units within the supervisory umbrella of the bank supervisors. It would also be less
disruptive of the European banking market than a complete forced divestment of certain
trading activities and would allow "one-stop banking" to continue where it is to the benefit of
customers.
Our work was facilitated by the structural proposals which had been previously made in the
US and the UK. The general orientation of all three proposals - the American Volcker rule,
the British Independent Commission on Banking (Vickers) proposal, which is taken forward in
the form of draft legislation, and our proposal is similar. However, they do differ in some
respects.
[Page 9: Comparison of suggested structural reforms]
The Volcker rule is the most narrow, but also most radical in that it targets mainly proprietary
trading, and requires of banking groups to wholly divest their proprietary trading activities -
they cannot be continued even in separate subsidiaries of banking groups. The Vickers and
High-level Expert Group proposals are wider in scope, seeking to regulate more trading
activities than the Volcker rule, but are in a sense less radical in the implementation of the
separation as they allow separation in the form of subsidiarisation within the banking group.
However, the UK government has proposed to give authorities reserve powers to call for full
separation, meaning disallowing even the group structure, in case banks try to circumvent
the ring-fence.
The EU High-level group wants to separate not only proprietary trading in the narrow sense,
but also market making. So, avoiding the difficult segregation of proprietary trading and
market making is one way our proposal differs from the Volcker Rule. Our proposal prevents
market making to become a way to circumvent the prohibition of proprietary position-taking in
securities market.
The treatment of market making in structural regulation has become a point of some
controversy. In addition to the problem of circumvention, the debate concerns a question of
principle: is there some market failure in the supply of liquidity through market making, which
justifies use of insured deposits to fund the market making inventory? It is not at all obvious
that there is.
When comparing our proposal with the proposal to be implemented in the UK, one can say
that the proposals started from different directions. The Vickers proposal started from the
narrow banking philosophy and sought to restrict the use of those funds. We on the other
hand focused on the most volatile parts of banking business and sought to cordon off those
so as to protect the traditional universal banking model, as we used to know it, from
engaging in excessive risk-taking. The end results as to where the line is drawn between the
entities to be separated are, however, not totally different.
The main difference in where the line between the separated entities is to be drawn is that
we would allow the deposit bank to engage in securities underwriting whereas this activity
would be separated in the UK. As I already mentioned, our solution is based on the view that
underwriting is closely connected with corporate finance.
About half a year ago the French and German governments published national proposals for
structural reform in the banking sectors of those countries. These initiatives can be seen as
adaptations of our proposal as they apply the same "subsidiarisation" model. The activities to
be separated are somewhat narrower as proprietary trading would to be separated to the
trading entity, but not market making. However, there would be supervisory powers to limit
the open positions taken in the course of market making.
During last spring, structural reforms were put on the agenda of the international regulatory
community. The issue has been discussed both at the Bank for International Settlements and
at the International Monetary Fund.16 Simultaneously, the European Commission has worked
on an impact assessment and recently launched a consultation where two alternative
scenarios for structural reform in EU are to be assessed by the banks; one scenario is close
to our proposal while the other is somewhat broader both in terms of its scope and the depth
of the gorge between the entities to be separated.17
[Page 10: Structural reform on the agenda of the international regulatory community]
On the other HLEG proposals
Now let me continue with a few words on the rest of our proposals.
[Page 11: The five proposals of the High-level Expert Group]
The proposal for an additional separation requirement supports the goal that supervisors
should have effective tools to make sure that banks' recovery and resolution plans can
actually work. If supervisors see that banks try to test the separating line, say, between
proprietary trading and the permitted parts of market making, hence also endangering the
resolution and recovery plans, a more far-reaching separation of trading activities could be
imposed on such banks. In the group we highlighted the importance of the European
Banking Authority's (EBA) role in ensuring that the recovery and resolution plans and the
integral resolvability assessments are applied uniformly across Member States.
Our analysis of capital requirements was also reflected in our final recommendations. Here
we acknowledged the important work done by the Basel Committee on Banking Supervision
in reviewing the trading book capital requirements. Moreover, we highlighted the importance
of the evaluation of the capital requirements on real estate related lending, an issue which is
currently on the agenda of for example EBA.
Investor bail-in lies at the core of tackling the too-big-to-fail problem as it improves the loss
absorbency of banks, ensures that investors rather than taxpayers take on the responsibility
for losses in the face of resolution, and further enhances creditors' incentives to monitor
banks. In the High-level Expert Group we foresaw a two tier system for the bailing in of
investors in bank debt.
The bail-in process which was outlined by the Commission in the proposed Bank Recovery
and Resolution Directive plays a key role in facilitating orderly restructuring or winding-up of
banks without the prolonged bankruptcy proceedings. We proposed that there would be an
additional layer of designated bail-in instruments to further improve the loss-absorption
capacity of banks. We believed that this would best combine loss absorbency and market
discipline with legal certainty and the stability of markets. The designated bail-in instruments
would have clear pre-specified terms and holding restrictions which would prevent other
banks from holding these debt instruments. The holding restrictions would reduce the risk of
contagion within the banking sector and thus constrain the fear of triggering a systemic crisis
at the time of a capital conversion or a write-down.
In addition, we proposed that the governance and control of banks ought to be strengthened
further. Particular attention ought to be given to the ability of management and boards to run
large and complex banks, the powers of the risk management function and the quality,
comparability and transparency of risk disclosure, the possibility to use designated bail-in
instruments in remuneration schemes, and the appropriateness of imposing caps on variable
as well as overall compensation. We also saw the need to enhance the sanctioning powers
of supervisors so as to ensure enforcement of risk management responsibilities.
How the HLEG proposals address the malign diagnosis of the size and structure of the
banking sector
Subsidiarisation of trading facilitates resolution by making bail-in rather than bail-out a more
credible option. The recommendation that banks should have a layer of designated bail-in
instruments further supports the aim of making bank bail-out at taxpayers' risk only a rare
exception. Only functions that are essential to the functioning of the society, i.e. the deposit
taking and payment system, would benefit from a government guarantee. As a result, the
separated trading activities will be funded from the market at a price better reflecting the true
riskiness of the operations. This is expected to restrain incentives for excessive growth and
risk taking in the trading entity.
The recommendations will not only have an impact on the size of the financial sector, but
also on what kind of operations there will be. First of all the proposals reduce the distorted
incentives which endangers socially optimal allocation of resources. For example, as the
subsidy of the implicit government guarantee is reduced, competition particularly in the
trading activity is revitalised, which will improve the allocation of funds in the economy.
Moreover, separation restricts banks with insured deposits from engaging in high-risk trading
activities which are not essential to deposit banking. The efforts of the deposit bank are thus
expected to be redirected towards servicing the needs of households and SMEs better.
The interconnectedness within the banking sector and thus the complexity of the financial
sector will be affected too. As intra-group financing and transfers of capital or risks between
the deposit bank and the trading entity will be limited, there will be fewer channels of
contagion. Further, limits on trading activities will reduce the counterparty risks of deposit
banks. There is, however, need for further research on financial networks, focusing on the
effects of structural reform. These issues are notoriously difficult to measure. So we need to
know more about how the complexity of the financial system can be monitored and
effectively reduced.
And, finally, the recommendations will have an impact on how banking business is conducted
in the future. The primary aim is to shift the focus from short to long term, which is more in
line with the interests of the real economy and society. I would also like to emphasise the
importance of eliminating the presumption that profits are private, but downside risks are
public. In the future risk-takers will also have to take into account the potential losses from
their bets.
Efficient market discipline as well as active and timely supervision must help ensure that the
financial sector and banks in particular find a more healthy size and structure. Our
recommendations seek to facilitate this task. Simpler structures will make it easier for both
investors and supervisors to monitor banks. Moreover, the recommendation to improve the
quality, comparability and transparency of risk reporting will further facilitate monitoring of
banks. Our recommendations for separation not only facilitate monitoring by supervisors, but
the additional layer of designated bail-in instruments which we propose should also increase
large creditors' incentives to monitor banks and thereby improve market discipline.
Concluding remarks
As major regulatory reforms are planned after the crisis, it is important to take in account
what research has to say. I have emphasized the increased attention paid to incentives and
risk taking. Before the crisis the consensus view held, with some qualifications, that growth in
finance promotes economic growth. After the crisis, the possibility that the financial sector
can also grow too big has been taken more seriously. Accelerated growth of the financial
sector may indicate a looming crisis. Therefore restrictions may be needed, and we need to
make sure that distorted incentives within the financial sector are minimized. Improving the
quality of finance continues to be a key priority in promoting sustainable economic growth.
Structural reforms of banking should support these aims by helping to weed out distorted
incentives from finance.