Erkki Liikanen: Too-big-to-fail and a reform of banking structures
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 seminar at the
Bank of Italy, Rome, 27 June 2014.
* * *
Original presentation is on the Bank of Finland's website. Slides
On the regulatory reform
[Slide 4 - Substantial crisis impact on the real economy]
In response to the dramatic events of the crisis, a large number of international and EU wide
regulatory reforms have been launched.1 For example new capital requirements can go a
long way to reduce incentives to take excessive risks across different banking operations.
Above all, they will improve banks' true loss absorbing capacity. These effects reduce the
probability of bank failures.
[Slide 5 - A need to improve banks' true loss absorbing capacity]
[Slide 6 - Focus of current regulatory reforms]
The regulatory initiative, which to date most directly addresses the too-big-to-fail problem
and the assumption that systemically important banks will be bailed-out by the government,
is the recovery and resolution regime. When successfully implemented, the new tools
enable an orderly "failure" of banks. The main tool will be the possibility to "bail-in" bank debt
holders to absorb losses. Substantial social costs can thus be avoided. Moreover, the new
recovery and resolution tools, provided that they are credible, will reduce the implicit
government guarantee and the distortive risk-taking incentives created by public bail-out
expectations and artificially low funding costs.
[Slide 7 - Funding costs are artificially low due to too-big-to-fail expectations]
[Slide 8 - Implicit subsidies remain high]
To match the geographic scope of banks, the new resolution framework has been taken to
the cross-border level. The Single Resolution Mechanism will enable the resolution also
of banks operating across the Banking Union Member States. The importance of the
political agreement on this crucial Banking Union building block cannot be overstated.
[Slide 9 - Many European banks are larger than their home country]
[Slide 10 - The banking sector is particularly large in several European countries]
[Slide 11 - Financial market liberalisation and governance must be complements]
However, I believe that there are still some doubts whether the largest, most complex
and trading intense banks can be orderly resolved without risking the stability of the
financial markets. Hence, pressure on providing public support in a situation like that may still
remain.
We need to alter the incentives for banks to become too-big-to-fail in the first place. By
removing the assumption that these banks will be bailed-out by the government in times of
trouble and thus eliminating the implicit subsidy, the funding costs would more
appropriately reflect the true risk of the bank. This would limit the attractiveness of excessive
risk-taking and bank balance sheet growth.
[Slide 12 - Rapid growth in the EU banking sector]
[Slide 13 - The banking sector in the US is smaller than the euro area banking sector]
Moreover, the banks' focus should be on providing financial services to retail and
corporate customers rather than on trading on own account or with other banks and
financial institutions as primary counterparts.
[Slide 14 - Focus of operations shifted away from customers]
Therefore, while we have gone a long way in reforming the banking regulation, we have not
yet gone all the way. Additional measures are still needed to complement the regulatory
agenda.
Many others have come to the same conclusion. For example IMF's Global Financial
Stability Report from March 2014 includes an assessment of how big the implicit subsidy
for banks seen as too-important-to-fail is..2 The report concludes that the regulatory
reforms already being implemented are not sufficient. Interestingly, estimates of the
implicit subsidy based on changes in CDS spreads and equity returns decline on
announcements related to structural reform. This provides a market based indication that the
structural reforms envisaged would be the right way to go.
[Slide 15 - Extract from IMF's event study on regulatory announcements]
Similarly, the Advisory Scientific Committee of the European Systemic Risk Board, chaired
by professor Marco Pagano, concludes in the very recent report on "overbanking" that the
marginal benefit of additional growth European banking sector is negligible, if not even
negative.3 The report further finds that the attention of many banks has been diverted to
activities other than serving the real economy. The universal bank business model can be
an asset and it can also be is a source of fragility as it contributes more to systemic risk
than other kinds of banks do.
[Slide 16 - Contribution of banks to systemic risk]
According to this important report by ASC additional policy measures are needed to "reduce
excessive private credit creation by banks and mitigate its risks, re-balance the EU's financial
structure away from banks and mitigate the risks from banks' "non-bank" activities". Among
the additional policy measures the report also recommends the implementation of
structural reforms.
The group's proposal for mandatory separation
I take these recent reports as providing important support for our work in the High-level
Expert Group on reforming the structure of the EU banking sector. In October 2012 we
proposed mandatory separation of a deposit bank and a trading entity within the banking
group to complement, not substitute the ongoing regulatory reform. Two avenues as
alternative ways forward were considered in the Group. We came to the conclusion that
structural reform is needed.
[Slide 18 - Two alterative avenues]
The motivation for our decision was the following:
[Slide 19 - Rationale for mandatory separation]
1. We wanted to limit the spill-over of benefits from the deposit guarantee system and
any implicit government guarantees to certain trading activities of banks. 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.
2. We saw the need to simplify the structure of large, complex banks. Reducing
complexity by means of separation facilitates management and implementation of
incentives and it facilitates supervision and monitoring by outside stakeholders
such as shareholders, bank creditors and other market participants, thus
reinforcing market discipline. This will reduce the probability that the bank gets
into trouble in the first place.
3. If a bank would nevertheless get into severe problems, it is easier to impose
recovery and resolution measures if the structure of the bank has been simplified
ex-ante. It is crucial to make credible the resolution also of the largest and most
trading-intense banks in Europe.
4. 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.
5. We emphasised the need to reduce the mixing of two very different
management cultures in 1) the customer-based retail and commercial banking and
2) the transaction-based trading activities. The aim was to shift the focus from
short-term to long-term, which is more in line with the interests of the real
economy and society at large. We also wanted to address the pre-crisis
presumption that profits are private, but downside risks are public.
The choice of where to draw the line between the deposit bank and the trading entity
was made so as to enable banks to service the real economy in the best way possible,
while separating the activity that we thought should not enjoy the benefit of the implicit
government guarantee.
Because the difference between proprietary trading and market making is hard to
distinguish, we in the Group proposed to keep them together in the separated trading
entity. It is better to err on being too prudential than supporting potentially risky activities with
insured deposits.
[Slide 20 - Comparison of structural reforms]
We also suggested that exposures to shadow banking entities such as hedge funds ought
to be separated from deposit-taking and lending activities.
Finally, we wanted to preserve the universal banking model at group level and keep the
trading activity within the bank supervisory umbrella. This would also reduce the risk of
migration of activities to the shadow banking system. Having the deposit bank and trading
entity under one roof would also allow "one-stop banking" to continue where it is to the
benefit of customers.
[Slide 21 - "One-stop shopping" still possible in the proposal for structural reform]
On Commission's proposal
On January 29th 2014 the European Commission presented its proposal for a Regulation
on structural measures improving the resilience of EU credit institutions.4
[Slide 23 - From idea to proposal on Regulation on structural measures in two years]
The Commission proposal has the same objectives as the Group's recommendations.
[Slide 24 - The objectives of Commission's proposal for structural reform]
The set of activities which the proposal would affect are also similar. The proposal obliges
the competent authority to review trading activities and empowers the competent
authority to require separation of market-making, risky securitisation and complex
derivatives when specific conditions prevail.
[Slide 25 - The Regulation takes elements from structural reforms previously proposed]
[Slide 26 - Banking groups are to be structured in two sub-groups]
The Commission proposal leaves an important role for the future judgment of the
competent authorities, which in most cases would be the European Central Bank, the EBA
and the Commission itself in detailing the separation process and metrics to be used. Here
transparency, predictability and public accountability are crucial. Moreover, the
elements of discretion need to be implemented so that the objectives of the Regulation are
achieved without compromising the level playing field in banking and the integrity of the
internal market. Provided that this is achieved, I do believe that the proposed Regulation
could bring about needed structural changes as envisaged by our Group.
In some respects, the proposed Regulation does also differ from the Group's
recommendations. The Commission's proposal includes an outright ban on organised
proprietary trading instead of requiring it to be assigned to a separate and separately
capitalised legal entity. Even though the definition of proprietary trading is rather narrow, the
Commission proposal resembles the structural reform implemented in the United
States. This would allow for regulatory convergence at the international level. International
consensus on the key features of structural reform is warranted in order to prevent regulatory
arbitrage. Thus, I warmly welcome international coordination of structural reform proposals
tasked to the Financial Stability Board.
The Commission proposal would cover the largest and most trading-intense banks in
Europe. These are the banks that have benefitted the most from the implicit government
guarantee and where there still are doubts whether they could be resolved in an ordinary
fashion. It is thus natural that the structural reform is targeted at them.
[Slide 27 - G-SIBs and banks exceeding limits on trading activity would be affected]
Moreover, competent authorities or Member States may decide to impose similar measures
also on smaller banks, or exempt some qualifying banks from the requirement if these
banks can demonstrate that they do not compromise the objectives of the Regulation or
threaten financial stability.
In implementation of the Regulation, the Commission could grant individual credit
institutions derogations from application of the Regulation if national primary law in their
home country is already adopted and considered at least as stringent as the Regulation
itself.
The elements of discretion entrust the competent authorities, the EBA and the Commission
with a significant responsibility for ensuring that the objectives of the Regulation are
achieved without compromising the level playing field in banking and the integrity of the
internal market. It is important that the Regulation is implemented in a coherent manner
throughout the EU.
To conclude
I welcome the Commission's proposal and supporting impact assessment. They give a
profound base for fruitful discussions on the intriguing topic of structural reform. It deserves
a fair debate and parliamentary discussion. I am happy that the negotiations have already
started in the Council working group and are scheduled to continue throughout the summer.
But naturally the pace will pick up only in the autumn, when the new Commissioner and
Commission have been selected and the new Parliament starts its work.
The proposed Regulation would give the authorities powers to implement a structural
reform that would prevent depositor protection from becoming an incentive for banks to
engage in excessive risk-taking.
Together with the EU framework for bank recovery and resolution and the Single
Resolution Mechanism, the proposed Regulation would reduce the pervasive
too-big-tofail and too-complex-to-fail problems also among the largest and most trading-intense
banks in Europe. Moreover, 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.
If consistently implemented, structural reform would improve market discipline and redirect
the European banking sector towards better serving the real economy.
[Slide 29 - Measures are needed to improve market discipline]
We need to take the necessary actions to achieve financial sector stability while ensuring
economic sustainable growth and prosperity in the EU.
[Slide 30 - On the role of banking]
Thank you!