Erkki Liikanen: On the structural reform
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 Securities Industry and
Financial Markets Association (SIFMA), New York, 19 April 2013.
* * *
Clearly detailed accompanying slides can be found at the end of the speech. Original charts are on the Bank of
Finland's website
Research findings
Before the financial crisis, the consensus view from the finance and growth research was at
that time 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.
[Slide 2: Rapid growth in the EU banking sector]
Let me start with the benign appraisal of the expanding financial sector and the emergence
of increasingly large banks that prevailed before the crisis. I will then consider the more
malign diagnosis that has emerged after the crisis.
The predominant view 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 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 cross-border to internationally active clients.
It is also possible that returns to scale in the largest banks stem from leveraging the superior
skills of high-performing teams of bankers. This argument offered an explanation to the
conspicuous compensation levels observed before the crisis. Because in the banking
industry such teams are relatively mobile and hence their bargaining power is strong, much
of the returns may accrue to bankers in the form of high compensation, rather than to banks'
owners.3
Nonetheless, the question was raised later, whether the productivity of the top human
resources in banking had been so much higher than in other industries as the increase in
bankers' compensation over the years suggested.
The events of the financial crisis have led 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 contribute to economic growth
but only up to a point.4 Too large a 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.
Too large and a very well paid financial sector may also deprive other sectors of some of the
most productive human resources.
What makes the financial sector grow too big?
Researchers have suggested reasons ranging from banks' failure to internalize systemic
risks that stem from growth in leverage and ballooning balance sheets to rent-extraction in
opaque OTC markets.5
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.6
Recent research at the Bank of England suggests that the increasing returns to scale in
banking, beyond a certain size range, may largely result from the cheaper funding costs of
the presumed too-big-to-fail banks.7 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.8
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 strengthen their
focus on investment banking, including trading operations.
[Slide 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.9
The relative importance of customer loans fell over time and the importance of interbank
lending grew. Moreover the customer loan business 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 are pooled, then securitized and sold 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.
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. 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 contagion channels.10
[Slide 4: Increased leverage as illustrated by shifts in funding structures]
Another risk of a more systemic nature is that diversification along similar lines can make
financial institutions more similar to one another by exposing them to the same risks.11
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.12
Some potential benefits of diversification may also have been lost as implementing a
diversification strategy is a big managerial challenge.13 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
structure and size in order to redirect banking activities to support the society and real sector
in the best way possible.
The key is to remove any perverse incentives, which could lead to an excessive growth of
the financial sector. For example, the inevitable safety nets needed to protect depositors
must not lead to moral hazard which would undermine the stability of the financial system
and entire economies.
How the HLEG proposals address the identified challenges in the size, structure and
conduct of the business of banks
In the High-level Expert Group on reforming the structure of the EU banking sector,
nominated by Commissioner Barnier about a year ago, 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.
[Slide 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 on 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.
[Slide 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, any significant trading activities would be required to be separated
from retail deposit banking. The separation proposal (or subsidiarisation as it has been
labelled in the international discussion) 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.
Further, a sufficiently wide separation of trading activities would avoid definitional problems
which arise, for example, if the dividing line had to be drawn between proprietary trading and
market making.
After a long discussion, where both avenues were supported, the group decided to propose
mandatory separation.
[Slide 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 effects of the deposit guarantee system
and any implicit government guarantees to the trading activities of banks. The deposit bank
and trading entity are to stand on their own merits also in terms of capitalisation and funding,
even though they could operate within the same banking group. Without separation, the
explicit and implicit guarantees would distort the market mechanism and spur the deposit
banks to unhealthy expansion in their trading activities.
[Slide 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.
Third, we further 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 trust in 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 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 allowed 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 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.
[Slide 9: Comparison of suggested structural reforms]
The Volcker rule is the most narrow, but also most radical in that it targets mainly proprietary
trading, but 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 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.
By avoiding the challenging segregation of proprietary trading and market making, 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.
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.
Earlier this year also the French and German governments published proposals for structural
reform in the banking sector. These national level initiatives can be seen as adoptions of our
proposal as they apply the same "subsidiarisation" model. The activities to be separated are
somewhat narrower as proprietary trading ought 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. Hence, the French and German proposals can be
seen as an intermediate position between our proposal and separating only proprietary
trading in the narrow sense.
Continuing with a few words on the rest of our proposals.
[Slide 10: The five proposals of the High-level Expert Group]
Our analysis of capital requirements also found its way to our final recommendation. 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 the European Banking Authority (EBA).
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 is outlined by the Commission in the proposed Bank Recovery and
Resolution Directive plays a key role in ensuring 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.
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.
How the HLEG proposals address the challenges of the financial sector discussed in
the beginning
Subsidiarisation of trading facilitates resolution, thus making bail-in rather than bail-out a
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. For example, 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.
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.
Efficient market discipline as well as active and timely supervision will ensure that the
financial sector and banks find their way to a more healthy size and structure. Our
recommendations will also facilitate their 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 not only facilitate monitoring, but the additional layer of
designated bail-in instruments will increase also creditors' incentives to monitor banks and
thereby improves 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. 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 economic growth. Structural reforms of banking can support these aims by
helping to weed out distorted incentives from finance.
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