Erkki Liikanen: On the 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 reforming the structure of the EU banking sector, at the Centre for
European Policy Studies, Brussels, 23 October 2012.
* * *
Changes in banking in the run-up to the crisis
The new landscape
In the years preceding the global financial crisis that started in 2007, the landscape of
banking had gone through major changes. Global financial institutions had grown ever bigger
in size and scope and their organizational complexity had increased, adding to their opacity.
They had become strongly interconnected via increasingly long chains of claims as well as
correlated risk exposures, arising from increasingly similar investment strategies. Their
leverage had strongly increased and the average maturity of their own funding had
shortened.
Driving forces
Behind these trends were forces that intensified competition in banking; technological
development and deregulation. Advances in information technology as well as in investment
theory and practice meant that commercial banks faced increasing competition both on their
liability side and asset side.1
New savings alternatives to bank deposits, such as money market mutual funds, proliferated
and new opportunities for borrowing, in addition to bank loans, emerged. In fact, an entire
shadow banking sector developed, comprising a chain of non-bank institutions which were
able to provide similar financial intermediary services as traditional banks.
In this environment, deregulation was partly a response to this and allowed banks to cope
with the increasing pressure from non-bank competitors.
In the US, the gradual unwinding and the ultimate repeal of the Glass-Steagall Act in the late
1990s made it possible to reunite investment banking and commercial banking which had
been separated since the crisis of the 1930s.2
In Europe, the universal banking model already had a longer history of combining
commercial banking and investment banking under the same roof.
However, there was a trend before the crisis, among the biggest European banking
institutions, to strengthen their focus on investment banking, including trading operations,
and to increase wholesale funding to the point of excess. Part of this trend was driven by the
growing demand by non-financial firms for risk management services.
With more freedom to choose their business models, banks sought for economies of scale
and scope and strived to take advantage of diversification benefits from multiple sources of
income.
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.
This shift in the business model increased traditional banks' connections to the shadow
banking sector and they became part of the long intermediation chains characteristic of
shadow banking.3
The increasing influence of investment banking oriented management culture also spurred
the focus on short-term profits in commercial banking, reinforced by managerial
compensation schemes that were based on short-term performance.
Investment banks in turn transformed themselves from partnerships to public corporations.
This helped them grow but also provided them with incentives to take risks that partners
would not have taken with their own money.
Contributing macroeconomic factors
The expansion of banks' balance sheets in the run-up to the crisis was fuelled by several
macroeconomic factors.
First, global imbalances especially between the leading emerging economies and the United
States developed as globalization continued. Accumulating surpluses in the emerging
economies increased their demand for (seemingly) safe assets.4
Partly as a response to this growing demand, the advanced western financial markets
offered financial innovations that increasingly utilized securitization of previously illiquid
assets such as (subprime) mortgages. In Europe, imbalances started to develop within the
euro area, with many countries experiencing overheating of their property markets.
Another important macroeconomic factor was that, in the aftermath of the slower economic
growth of the early 2000, the monetary policy stance both in the US and Europe was
relatively light.
Finally, the wide-spread consensus of "the great moderation" fostered expectations of
declining macroeconomic risks. This was based on growing evidence that business cycle
fluctuations were getting smaller and inflation rates were getting lower and steadier.
Lack of restraints from regulation, supervision and market discipline
Problems with capital requirements
The Basel capital requirements on banks proved ineffective in restraining the strong growth
in banks' leverage and balance sheet size. Most importantly, the Basel I and II rules required
very little common equity. Much of the eligible capital had poor loss absorbing capacity,
which helped trigger the crisis.
Secondly, 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.5
This was partly spurred by differences in American and European banks' capital
requirements as the EU moved ahead to implement the Basel II reform in full while the US
largely stayed in Basel I and maintained a separate leverage ratio requirement. In effect,
capital requirements on perceived low-risk assets, such as mortgage backed securities, were
lower in Europe than in the US.
The third set of regulatory problems concerned the Basel capital requirements on banks'
trading book positions. The Basel rules allowed banks to lower their capital requirements by
securitizing loans from the banking book and taking corresponding risks onto their trading
books.
For instance, banks provided short-term loan commitments, which had very low Basel capital
requirements, to off-balance sheet special-purpose investment vehicles (SIVs) which in turn
funded mortgage-backed securities. This is an important example of how and why banks
were strongly connected with the shadow banking sector.
It has been suggested that many of the loan securitizations were motivated by such
regulatory arbitrage rather than credit risk transfer which would aim at a better diversification
of credit risks among banks and other financial institutions and insurance companies.6
The role of overly optimistic agency ratings used to market the securitized assets, and used
as a basis for capital requirements, should not be dismissed either.
Fourth, 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.7
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 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.
Another way for banks to benefit from cheap funding is deposits which are explicitly insured
and whose interest rates are consequently insensitive to banks' risk taking.
To sum up, neither banks' debt holders nor depositors had proper incentives to react to
banks' increasing opacity, leverage and risk-taking.
Lack of a systemic aspect
There was clearly the lack of a sufficient, systemic (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, systemic risks built up in
the form of ever larger, more complex and more leveraged financial institutions.
Three main weaknesses ought to be mentioned.
First, the Basel minimum capital requirements were based on stand-alone risks of a bank.
For instance, the Basel rules entail no direct measure of an asset's exposure to systemic
risk, such as home and real estate loans' exposure to the business cycle.
Second, liquidity risks resulting from short-term money market funding were not part of the
Basel minimum capital requirements. This was a problem because excessive short-term
money market funding increases interconnectedness and thereby systemic risk in the
financial system.
Moreover, if a rapid growth of lending, for example to a booming property market, can only
be financed from the short-term markets, it is often an indication of growing risks on a bank's
asset side.9
Third, the existing supervisory structures focused on risks facing institutions rather than the
financial system as a whole.
Public reaction to the crisis and 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. This has caused an understandable and
justified public outcry.
Trust needs to be rebuilt between banks and the general public, and the coordinative role of
the regulatory reform is central in this process. But management teams and boards of banks
also play a crucial role in rebuilding trust. In order to succeed in this, we must make sure that
also in banking not only gains but also losses, incurred from private risk-taking fall on the
risk-takers.
Our perspective has to be long enough, well beyond the current troubles. But it is also of vital
importance to carefully plan the implementation of reforms in order to ensure the continuation
of smooth provision of lending and other vital banking services in the current challenging
environment.
Regulatory response to the crisis
Summary of problems
The problems in banking, revealed by the crisis, can be summarized as follows.
There has been excessive risk-taking, excessive leverage, excessive complexity and
inadequate capital.
An important form of risk-taking has been the growing maturity mismatch between assets
and liabilities as funding from the market has increasingly shortened. Excessive real estate
lending increased banks' exposure to macroeconomic and hence systematic risks. All these
factors have increased the likelihood of bank failures.
Secondly, there have been extensive interconnectedness and very limited possibilities to
resolve failed banks, including possibilities to shift the burden to banks' creditors. Both these
factors increase the impact of bank failures or, alternatively, the cost to tax payers.
Interconnectedness also increases the risk of bank failure because it increases banks'
opacity which can lead to the loss of investors' trust thereby making banks more prone to
runs.
Thirdly, there have been competitive distortions via explicit and implicit subsidies, which
reduce both internal market efficiency and the level playing field. For instance, the availability
of insured deposits to fund other, more risky, banking activities has skewed incentives and
competition.
Banks' incentives to sound long-run risk management have also weakened.
National measures to implement regulatory reforms and the lack (until recently) of sufficient
EU wide frameworks in supervision and resolution are a concern to the well functioning of the
internal market in the area of banking. Common rules and institutions would also facilitate the
much needed undoing of the bank-sovereign loop.
What has already been done?
In response to the crisis, international and EU wide regulatory reforms have been focused on
two crucial areas, capital adequacy and liquidity requirements (Basel III) and recovery and
resolution (e.g. the Commission's proposal).
If effective, the new and still evolving capital adequacy requirements of Basel III can go a
long way to reducing incentives to take excessive risks and the use of excessive leverage.
Most obviously, Basel III addresses the issue of inadequate capital. Basel III 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.
Basel III also reduces complexity and interconnectedness by blocking opportunities for
regulatory arbitrage which under Basel II was possible via complex securitisation structures.
Recovery and resolution regimes for systemically important financial institutions aim at
creating a framework which did not exist at EU level prior to the crisis. If successful, such
plans can greatly reduce the social costs of bank failures and reduce the need for the implicit
public guarantees. This means that recovery and resolution plans can reduce the distortive
risk-taking incentives created by public bail out expectations.
Moreover, a number of initiatives 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 will be given to international
procyclicality
and national authorities to better tackle asset price bubbles and in lending.
Proposals of the High-level Expert Group
The High-level Expert Group on reforming the structure of the EU banking sector has
presented a structural proposal to be implemented at the EU level.
In the process of reaching the final outcome, the Group considered two avenues as a
possible way forward.
In the first avenue, additional, non-risk-weighted capital requirements on trading activities
and banks' credible recovery and resolution plans, subject to supervisory approval, were the
main instruments.
Such measures would be in line with the ideas of academic researchers who have suggested
that a review of capital requirements is the best way to tackle risks in trading 10and who have
emphasized the need to develop bank resolution and recovery mechanisms.11
However, if the bank were not able to prove that its required recovery and resolution plan
was credible, separation of certain banking activities could be imposed.
In the second avenue, separation of retail and investment banking would be imposed.
Separation would be consistent with research which emphasizes that capital requirements
are not sufficient to limit excessive risk-taking incentives induced by deposit insurance if risks
are difficult to measure and risk profiles can be changed rapidly.12
Sufficiently wide separation of investment banking activities would also avoid definitional
problems which arise, for example, when the dividing line is pursued between proprietary
trading and market making.13
Eventually, the Group converged to the following five proposals to be implemented at the EU
level.
1. Proposal for mandatory separation
The 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").
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.
The threshold above which separation is required must be low enough so that the volume of
activities below the threshold can be considered insignificant from the viewpoint of financial
stability.
The other businesses that must be separated are loans, loan commitments, or unsecured
credit 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 long-term positions possibly arising from underwriting are carefully monitored by
supervisors.
All other banking businesses are allowed to the deposit bank unless firm-specific recovery
and resolution plans require otherwise.
Only the deposit bank is allowed to provide retail payment services.
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.
The rationale for separation as a regulatory measure can be summarized in the following four
points.
First, 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.
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
be easier.
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 market discipline and financial supervision.
Fourth, separating deposit banking and trading entities can also reduce the mixing of the two
different management cultures.
The separation of activities is complementary to, rather than a substitute for, other areas of
bank regulations.
The disadvantage of separating banking activities may be that the benefits of scale and
scope and diversification of revenue streams are reduced. However, evidence on the
economies of scale and scope in banking as well as the benefits from diversification seems
to be mixed.
Most importantly, when separation is allowed to be carried out within the banking group, the
banks' ability to efficiently provide a wide range of financial services to their customers is
maintained.
2. Additional separation conditional on the recovery and resolution plan
A credible recovery and resolution plan implies that the bank stakeholders bear the costs of a
possible bank failure and that there is no significant harm to the real economy, even in a
crisis situation when many banks are in trouble at the same time. This would imply that no
tax payer money is under threat of being used in a bail out.
Therefore it is essential to strive for good recovery and resolution plans. A solid plan will also
enhance the bank's own risk management and potentially increase transparency of the bank
to outsiders.
The European Commission's plan that banks need to draw up and maintain effective and
realistic recovery and resolution plans (RRP) is of utmost importance. Banks should be able
to demonstrate the ability to isolate retail banking activities from trading activities and to wind
down significant trading risk positions in a crisis situation, in a manner that does not
jeopardize the bank's financial health nor does significantly contribute to systemic risk.
A credible recovery and resolution plan is a challenging goal to achieve, so the criteria on
passing the credibility "test" must be set high. The European Banking Authority (EBA) plays a
central role as a standard setter in ensuring that the RRPs and their supervisory
assessments are applied uniformly across the Member States.
The Group suggests that if a bank's recovery and resolution plan, assessed by the
supervisor, is not acceptable, a more comprehensive separation of activities can be required
than under the proposed mandatory separation. For example, a wider separation might have
to cover all trading related assets.
3. Facilitating the use of bail-in instruments
The Group strongly promotes the proposal to use bail-in instruments to further increase the
loss absorbing capability of banks.
In order to limit interconnectedness within the banking system, it is preferable that the bail-in
instruments should not be held by investors within the banking sector.
In order to create a liquid market for the bail-in instruments, it would be essential to carefully
define their contractual properties in order to reduce uncertainty and ambiguity and hence
facilitate their efficient market pricing.
Therefore the Group is of the opinion that the bail-in instruments should be applied only to
particular debt instruments and to make sure that investors know the eventual treatment of
the respective instruments in a crisis situation.
4. A review of capital requirements on trading assets and real estate related
instruments
The measurement of risks inherent in trading assets is prone to a significant "model risk"; the
risk that the model itself, used in the risk measurement is inaccurate.
The severity of model risk stems largely from the presence of "tail risks" in trading assets.
These are risks which cause catastrophic losses but which materialize with a very low
probability. Moreover, tail risks are intertwined with severe liquidity shortages which
materialize in systemic crises. Hence, almost by definition, tail risks are difficult to model and
measure.
Separation of the riskiest trading activities from deposit banking is a key to limiting the impact
of these risks.
Other measures available are robust capital requirements which do not heavily rely on
models, and limits on risk concentrations and counterparty exposures. In this respect, the
Group acknowledges the important work in reviewing the trading book capital requirements
conducted by the Basel Committee on Banking Supervision.
The Group recommends that the Commission should carry out an evaluation of whether the
resultant amendments, in terms of robust capital requirements and limits on risk
concentrations and counterparty exposures, would be sufficient at the EU level.
The Group recommends that the Commission should also evaluate the sufficiency of the
current capital requirements on real estate related lending which has been the major source
of losses in many financial crises, including the most recent one.
5. Need to reinforce corporate governance reforms
Finally, the Group strongly promotes the strengthening of corporate governance and control
of banks. In particular 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.
Comparison with other proposals
An important objective of the mandatory separation, proposed by the Group, is simplicity and
unambiguity. 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 as differentiating these from one another would be challenging14 and, if
placed in different legal entities within the same banking group, some natural synergies might
be lost.
In this respect, the proposal makes deposit banks somewhat narrower than the definition
under the Volcker Rule in the United States. However, an important difference is that 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.
Further, all corporate loans are allowed in deposit banks because differentiating among loans
according to the customer size would be equally challenging at the EU level and important
scale economies in corporate lending might be lost.
This suggests that, as regards corporate lending, deposit banks would be somewhat broader
than under the UK's Independent Commission on Banking (ICB) proposal.
Conclusions
Remaining concerns
Many observers have noted that major systemic risks can remain in the various parts of the
banking system, even if these are separated from one another.15 This is a valid concern even
though separation by definition reduces interconnectedness as a key source of systemic risk.
The possibility to further review capital requirements and limits on risk concentrations and
counterparty exposures in trading activities, as discussed in the other recommendations, are
the means to further containing systemic risks.
It is also important that the development of capital surcharges for systemically important
institutions as well as macro-prudential tools such as caps on loan to value ratios (LTVs) is
continued.
An obvious danger lies in the possibility that structural measures, together with higher capital
and liquidity requirements, may drive an increasing part of banking to the shadow banking
sector.
If this implies that market expectations of implicit public guarantees shift to the less regulated
shadow banking sector, then the fundamental problem has not been solved. This is a matter
that needs further consideration and needs to be constantly monitored. Proactive measures
may need to be taken.
The role of banks in financing the European economy
Banks play an important role in the society.
Banks have a pivotal role in providing finance 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.
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.