Erkki Liikanen: The case for structural reforms of banking after the crisis
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 European Commission,
Brussels, 2 October 2012.
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Changes in banking in the run-up to the crisis
In the years preceding the financial crisis that started in 2007, global financial institutions had
grown ever bigger in size and scope and their organisational complexity had increased. Their
leverage had strongly risen and their average debt maturity had shortened.
Behind these trends were forces that intensified competition in banking, driven by
technological development. An entire shadow banking sector had developed, comprising a
chain of non-bank institutions which were able to provide similar financial intermediary
services as traditional banks.
In this environment, regulatory reforms were partly a response to the changes and allowed
banks to cope with the increasing pressure from non-bank competitors. Banks sought for
economies of scale and scope and strived to take advantage of diversification benefits from
multiple sources of income.
Commercial banking had increasingly moved 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. This shift in
the business model increased traditional banks' connections to the shadow banking sector.
The expansion of banks' balance sheets partly reflected the growing global imbalances,
supported by the accommodative monetary policy stance in the early 2000s.
Regulation, supervision and market discipline failed to counter the developments in the
financial sector. The Basel capital requirements on banks proved ineffective in restraining the
strong growth in banks' leverage and balance sheet size. For example, the Basel rules
effectively allowed banks to lower their capital requirements by means of securitizing loans.
This is an important reason for how and why banks became strongly connected with the
shadow banking sector. The increasing complexity of structures and products, as well as the
financial sector's increasing interconnectedness and 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, but the opposite seems to have happened: the markets rewarded
bank size by charging lower debt margins from the biggest institutions. This suggests that
there was a perception among market participants that the biggest financial institutions
enjoyed an implicit public guarantee; in other words, they had become too big or too
important to fail.
Public reaction to the crisis and the need to rebuild trust
The huge cost of the financial crisis, both in terms of direct public support to banks and lost
economic output has sadly fallen to tax payers, causing an understandable and justified
public outcry.
Trust needs to be rebuilt between banks and the general public, and the role of
internationally co-ordinated regulatory reforms is central in this process. Also in banking not
only gains but also losses must fall on the risk-takers.
Regulatory response to the crisis
The problems in banking, as revealed by the crisis, can be summarized as excessive
risktaking, leverage, complexity, inadequate capital, extensive interconnectedness, and very
limited possibilities to resolve failed banks.
In response to these problems, regulatory reforms have been focused on two crucial areas:
capital adequacy and liquidity requirements, as in Basel III, and recovery and resolution, as
in the Commission's proposal.
These reforms can go a long way toward increasing loss absorbency, reducing incentives to
take excessive risks and increase leverage, and reducing the social costs of bank failures
and the need for implicit public guarantees.
The High-level Expert Group was requested to consider whether there is a need for structural
reforms of the EU banking sector or not and to make any relevant proposals as appropriate,
with the objective of establishing a stable and efficient banking system serving the needs of
citizens, the economy and the internal market.
The proposals of the High-level Expert Group
The Group recommends a set of five measures that augment and complement the set of
regulatory reforms already enacted or proposed by the EU, the Basel Committee and
national governments.
1. Proprietary trading and other high risk trading activities should be assigned to a separate
legal entity if the activities to be separated amount to a significant share of a bank's business
and are above a certain threshold. This would ensure that trading activities beyond the
threshold are carried out on a stand-alone basis and separately from the deposit bank. As a
consequence, deposits, and the explicit and implicit guarantee they carry, would no longer
directly support risky trading activities. The long-standing universal banking model in Europe
would, however, remain untouched, since the separated activities can be carried out in the
same banking group. Hence, banks' ability to provide a wide range of financial services to
their customers would be maintained.
Within the Group, some members expressed a preference for a combination of measures:
imposing a non-risk-weighted capital buffer for trading activities and leaving the separation of
activities conditional on supervisory approval of a recovery and resolution plan, rather than a
mandatory separation of banking activities. Both basic alternatives and their motivation are
presented in the report.
2. Second, effective and realistic recovery and resolution plans must be drawn up and
maintained by the banks, as proposed in the Commission's Bank Recovery and Resolution
Directive. The resolution authority should request a wider separation than the considered
mandatory separation above if this is deemed necessary to ensure resolvability and
operational continuity of critical functions.
3. The use of designated bail-in instruments is strongly supported by the Group. The position
of bail-in instruments within the hierarchy of debt commitments in a bank's balance sheet
must be clear so that investors know the eventual treatment in case of resolution. Banks
should build up a sufficiently large layer of "bail-inable" debt. Such debt (or an equivalent
amount of equity) would increase the overall loss-absorptive capacity, decrease risk-taking
incentives, and improve transparency and the pricing of risk.
4. The Group proposes to apply more robust risk weights in the determination of minimum
capital standards and more consistent treatment of risk in internal models. Once the Basel
Committee has concluded its review of the trading book, the Commission should assess
whether the results would be sufficient to cover the risks of both deposit banks and trading
entities in Europe. Also, the treatment of real estate lending within the capital requirements
framework should be reconsidered, as well as maximum loan-to-value (and/or loan-to-
income) ratios included in the instruments available for micro- and macro-prudential
supervision.
5. Finally, the Group considers that it is necessary to augment existing corporate governance
reforms by specific measures to 1) strengthen boards and management; 2) promote the risk
management function; 3) rein in compensation for bank management and staff; 4) improve
risk disclosure, and 5) strengthen sanctioning powers.