Erkki Liikanen: Is a reform of banking structures necessary?
Speech by Mr Erkki Liikanen, Governor of the Bank of Finland and Chairman of the Highlevel
Expert Group on reforming the structure of the EU banking sector, at a meeting with Finance
Watch, Brussels, 20 November 2012.
* * *
Costs of the crisis and the public outcry
The global financial and economic crisis which started in 2007 is by far the worst in the
Western world in the post-war history.
The European Commission estimates that from October 2008 until October 2010, it has cost
13% of the European Union's GDP in the form of public support to the region's banks.1
Moreover, the present value of lost economic output is probably bigger by orders of
magnitude than the direct support.2
The crisis has caused a public outcry which is justified. Regulators are responding to the
pressing need to establish a financial system in which losses, not only gains, fall on the
private risk takers, not on the tax payer.
In order to find appropriate solutions, we need to understand the developments leading up to
the global financial crisis.
Changes in banking in the run-up to the crisis
The new landscape
In the years preceding the global financial crisis, the landscape of banking had gone through
major changes. The banking sector had grown rapidly and global financial institutions had
grown ever bigger in size.
Especially, European banks appear very large when measured in terms of total assets in
relation to the domestic GDP.
Further, the scope and the organizational complexity of global financial institutions had
increased, adding to their opacity.
There was a trend among the biggest banking institutions to strengthen their focus on
investment banking, including trading operations. Part of this trend was driven by the growing
demand by non-financial firms for risk management services. Partly, it was a search for new
revenue streams, higher profitability and economies of scale and scope. The flip side of the
coin was strong incentives for risk taking.
Commercial banking moved increasingly away from customer relationship-based banking
where loans are granted and then held until maturity to the "originate and distribute" model
where granted loans are pooled, then securitized and sold to investors.
As result, banks became strongly interconnected via increasingly long chains of claims as
well as correlated risk exposures, arising from increasingly similar investment strategies. This
shift in the business model increased traditional banks' connections to the shadow banking
sector.3
The increasing influence of investment banking oriented management culture also spurred
the focus on short-term profits in commercial banking, reinforced by short-term performance
based managerial compensation schemes.
There were also dramatic changes in the liability side of banks' balance sheet before the
financial crisis. The leverage of banking institutions had strongly increased and the average
maturity of their own funding had shortened.
Lack of restraints from regulation, market discipline and supervision
Problems with capital requirements
Capital requirements on banks proved ineffective in restraining the strong growth in banks'
leverage and balance sheet size because the Basel I and II rules required very little common
equity.
Further, what was important for the global reach of the financial crisis was that much of the
asset and mortgage backed securities, originating from the US, ended up on European
banks' balance sheets.4
This was partly spurred by differences in American and European banks' capital
requirements.
There were also problems with the Basel capital requirements on banks' trading book
positions. Capital in the range of zero to two percent of trading assets suggests that risks
were not fully covered by existing capital requirements.
In particular, the Basel rules allowed banks to lower their capital requirements by securitizing
loans from the banking book and taking in effect corresponding risks onto their trading books.
It has been suggested that many of the loan securitizations were motivated by such
regulatory arbitrage rather than credit risk transfer.5
The role of overly optimistic rating agency ratings used to market the securitized assets, and
used as a basis for capital requirements, should not be dismissed either.
Finally, many risk-weights used in the Basel framework to determine the effective capital
requirements were simply too low, as was revealed by the crisis.
Lack of market discipline and the too-big-to-fail problem
The increasing complexity of structures and products, and the financial sector's increasing
interconnectedness, along with growing size, led to reduced transparency of bank balance
sheets.
This should logically have rung alarm bells among investors, especially among banks'
uninsured debt holders, at some point. However, the opposite seems to have happened: the
markets rewarded size by charging lower debt margins from the biggest institutions.6
This suggests that there was a perception among market participants that the biggest
financial institutions enjoyed an implicit public guarantee. These institutions could not be
allowed to fail; in other words, they had become too big, too complex or too important to fail.
In a market environment where the price of a bank's own debt funding is insensitive to the
risks the bank takes and decreases with the bank's size, the bank has a strong incentive to
further increase its leverage by taking on even more debt and continue to grow in size.
The implicit subsidies also have important implications for the level-playing field in the
banking sector. Currently, the competitive distortions, manifested in differences in funding
costs between systemically important banks and other banks, are significant. However, our
goal must be that no bank is perceived as too big to fail. As Stephen Cecchetti recently
noted, "there should come a day when the Basel Committee's list of globally systemically
important banks, or G-SIBs, is blank".7
Lack of a systemic aspect
There was clearly also a lack of a sufficient macro-prudential aspect to banking supervision
and regulation prior to the crisis.
The fundamental problem is that banks themselves do not have an incentive to fully
internalize the social cost stemming from their own contribution to system wide risks into their
business decisions.8
In the absence of substitutive regulatory and supervisory measures in the years preceding
the crisis, systemic risks built up in the form of ever larger, more complex and more
leveraged financial institutions.
Regulatory response to the crisis
What has already been done?
In response to the crisis, a number of international and EU wide regulatory reforms have
been launched. Two reform areas have been particularly relevant to the work of the
High-level Expert Group; capital adequacy and liquidity requirements (Basel III as
implemented in the EU through the CRD IV/CRR) and recovery and resolution (as in the
Commission's proposal).
If effective, the new and still evolving capital adequacy requirements can go a long way to
reduce incentives to take excessive risks across different banking operations and the use of
excessive leverage.
Most obviously, higher capital requirements provide for more loss absorbency. Liquidity
requirements can also reduce banks' interconnectedness by restricting the use of short-term
market funding. They will also be helpful in reducing excessive leverage and building liquidity
buffers.
The new capital requirement framework also reduces complexity and interconnectedness by
blocking opportunities for regulatory arbitrage which previously was possible via complex
securitisation structures.
Recovery and resolution regimes aim to create a framework which did not exist at EU level
prior to the crisis. If successfully implemented, the new tools such as the recovery and
resolution plans can greatly reduce the social costs of bank failures and thus reduce the
implicit public guarantee. This means that recovery and resolution tools can reduce the
distortive risk-taking incentives created by public bail out expectations.
Moreover, a number of initiatives9 have been launched with the aim of reducing contagion
and complexity in the financial market. In order to improve transparency, accounting
standards are in the process of being reviewed. Banks are urged to improve risk
management and corporate governance practices and new macro-prudential tools are given
to international and national authorities to better tackle asset price bubbles and procyclicality
in lending.
Proposals of the High-level Expert Group
The High-level Expert Group on reforming the structure of the EU banking sector evaluated
the current regulatory reforms and came to the conclusion that they take us a long way, but
not all the way, in ensuring financial system stability and strengthening banks' ability to
provide socially vital financial services.
Let us first consider capital requirements. When capital requirements are truly risk-based,
they will contain the excessive risk-taking incentives which result from banks' access to
insured deposits. However, where risk profiles can change rapidly and where risks are
difficult to measure with precision, risk-based capital requirements may not provide sufficient
protection against excessive risk-taking. Asset and activity restrictions provide a more robust
measure to limit risk-taking in these circumstances.10
Second, the High-level Expert Group came to the conclusion that many banks are still too
complex for the proposed recovery and resolution regime to be truly credible and time
consistent.
Hence, the High-level Expert Group concluded that there is a need for structural measures to
complement the current regulatory reform. More specifically, the High-level Expert Group
proposes a mandatory separation of certain trading related activities according to the
following three principles.
First, if the share of proprietary trading, market making and certain other securities-related
businesses in the balance sheet exceeds a given threshold, banking groups must organize
these businesses to a separate legal entity ("trading entity").
The other businesses that must be separated are loans, loan commitments, or other
exposures to hedge funds (including prime brokerage), SIVs and other such entities of
comparable nature. Private equity investments must also be separated.
The client-driven trading positions against which the bank has hedged itself do not have to
be separated. Also, securities underwriting does not have to be separated but it is important
that risks in non-transitory positions possibly arising from underwriting are carefully
monitored by supervisors.
Second, the trading entity must be separately capitalized and must not be funded by insured
deposits.
And third, the deposit-taking part of the banking group ("deposit bank") is not allowed under
any circumstances to support the trading entity either directly or indirectly by making
transfers or commitments to the extent that its capital adequacy including capital buffer
requirements would be endangered or that the general limits on large exposures would be
violated.
All other banking businesses are allowed to the deposit bank unless firm-specific recovery
and resolution plans require otherwise. Similarly, the trading entity can engage in all banking
activities which are not specifically mandated to the deposit bank. For instance, the trading
entity is allowed to make loans and loan commitments to its customers.
Only the deposit bank is allowed to provide retail payment services.
An important objective of the mandatory separation, proposed by the Group, is simplicity and
avoiding ambiguity. These facilitate implementation at the EU level.
Furthermore, banking activities which naturally belong together should be conducted within
the same legal entity.
To promote these aims the proposed mandatory separation includes both proprietary trading
and market making. Differentiating these from one another would be difficult11 and, if placed
in different legal entities within the same banking group, some natural synergies might be
lost.
By avoiding the decoupling of proprietary trading and market making, the proposal differs
from the Volcker Rule in the United States. However, the proposed mandatory separation in
the EU can take place within a banking group whereas the Volcker Rule prohibits proprietary
trading from the entire banking group.
When comparing the proposal of the High-level Expert Group and the proposal presented by
the UK's Independent Commission on Banking (ICB) last autumn, one can say that the
proposals started from different directions, but their results are qualitatively similar. Both
proposals seek to prevent the use of guaranteed deposits to risky investment. However, the
approach taken by ICB started from the narrow banking philosophy and sought to restrict the
use of those funds. The High-level Expert Group on the other hand focused on the most
volatile parts of banking business and sought to cordon off those.
The main practical difference in the position of the ring-fence is that the High-level Expert
Group proposal allows securities underwriting by the deposit bank, whereas the ICB proposal
forces it out of the ring-fenced deposit bank. The solution of the High-level Expert Group is
based on the view that underwriting is actually closely connected with corporate finance and
prohibiting it would hurt the universal banking model. Note that if a bank would feel that
synergies so require, there would be no prohibition for conducting underwriting business
within the trading entity to which the market-making operations have to be transferred.
Another difference which stems from the different starting points is that, in the ICB proposal,
higher capital requirements are recommended for the ring-fenced deposit banks. As will be
discussed shortly, the High-level Expert Group was more concerned of strengthening the
capitalisation of the trading entity.
To sum up the rationale for separation as a regulatory measure, I would emphasize the
following four points.
First, as already discussed above, separation is a way of prohibiting banks with insured
deposits from engaging in activities whose risks are potentially high and difficult to measure
precisely, and which are not essential to deposit banking. Essentially, prohibition of such
activities is a way to complement capital requirements in limiting moral hazard which may
arise from deposit insurance.
Second, separation of activities is the most direct instrument for tackling banks' complexity
and interconnectedness. As banks become simpler in structure, recovery and resolution will
also be easier.
The High-level Expert Group emphasised the importance of the recovery and resolution
plans and noted that more intrusive separation might be needed to make the plans truly
credible (Proposal 2).
Third, simpler structures can make it easier for the management and board to understand
and manage and for outsiders to monitor and supervise banking institutions. This can
enhance the effectiveness of both market discipline and financial supervision.
To facilitate the monitoring of banks further, the High-level Expert Group emphasised the
need for greater transparency. In particular, the High-level Expert Group suggested that the
quality, comparability and transparency of risk disclosures should be improved by requiring
detailed financial reporting for each legal entity and main business lines (Proposal 5). This
suggestion is in line with the suggestions presented by the Financial Stability Board's
Enhanced Disclosure Task Force in the end of October.12
The High-level Expert Group wished to further strengthen the incentives for outsiders to
monitor banks by strongly promoting the use of bail-in instruments. These would ensure that
also creditors are made responsible for losses (Proposal 3).
Fourth, separating deposit banking and trading entities can also reduce the mixing of the two
different management cultures. As Andy Haldane has described, resources were diverted
away from retail banking towards investment banking before the crisis and at the same time
the culture of investment banking infiltrated retail banking resulting in short-termism and
harmful cross-selling.13
To support the separation of the sub-cultures of retail and investment banking, the High-level
Expert Group strongly promotes the strengthening of capabilities of boards and management
to run large complex banks and use of remuneration schemes that create long-term, rather
than short-term incentives (Proposal 5). I agree with Wayne Byres who notes that "ensuring
that incentives are working in the right direction in the diverse and complex organisations
such as today's banks is easier said than done".14 However, separation of deposit banking
and trading entities, by making organizations simpler, can help in building the right
incentives.
To ensure that both the deposit bank and trading entity are sufficiently capitalised (Proposal
4), the High-level Expert Group found that there is a need to address a number of issues
related to how the capital requirements on trading assets and real estate related instruments
are defined. In particular it is important that make sure that the capital requirements on
trading assets are adequate to stabilise the trading entities on a stand-alone basis.
To this end the High-level Expert Group expressed its support for the Basel Committee's
trading book review. It should be carefully assessed by the Commission once completed.
Similar capital requirements review should also be carried out by the Commission on real
estate related lending as risks in these instruments were central in the crisis.
The ultimate goal of the five proposals of the High-level Expert Group is to ensure financial
system stability while ensuring banks' role in financing the European economy. Or as stated
in the mandate "to establish a safe and efficient banking system, serving the needs of
citizens, the EU economy and the internal market". As this list shows, the High-level Expert
Group did not see structural separation as a "silver bullet" for stability and security. It is not
sufficient alone, but it is a necessary component of a balanced set of banking reforms.
The role of banks in financing the European economy
To conclude, I would like to emphasise the importance of redirecting the banking sector
towards strengthening its important role in the society by means of regulatory reform. The
financial crisis reminded us that financial stability is a prerequisite for stable economic
growth.
Banks have a pivotal role in providing financing to households and firms. It is particularly so
in Europe where the banks' role in corporate finance has traditionally been large. The banks'
role in corporate finance is central especially for small and medium sized enterprises
(SMEs). The continuous and smooth supply of banking services to SMEs is also essential to
large corporations because SMEs are often subcontractors to them.
It is of utmost importance that regulatory reforms as a whole support and strengthen the
banking sector's ability to continue to provide these socially vital financial services efficiently
and in a stable manner.
Along these lines, the High-level Expert Group recognised the value of universal banks as
suppliers of a comprehensive service to their customers and their important role in financing
the European economy. As a result, complete separation similar to the former Glass-Steagall
Act in the US was not required. As the deposit bank and the trading entity are allowed to
co-exist within a holding company structure, the banking group could still market all of the
services, from its different constituent units.
Concluding remarks
The reputation of banks and the public trust that they rely on has been severely dented
during the latest financial crisis. This has hurt not only banks themselves but also the
economies and societies of Europe and the whole Western world.
Trust and public acceptance must now be restored, and the proposals which the High-level
Expert Group has submitted for the consideration of the EU Commission will contribute to
this end. Achieving this important aim will benefit the banking industry and our societies at
large.
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