Banking on Reform: Can Volcker, Vickers and Liikanen Resolve the Too-Important-to-Fail Conundrum?
IMF Blog, May 14, 2013
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- Authors: Jose-Vinals, Ceyla Pazarbasioglu
- Published: May 14, 2013
Overview
- Publication: José Viñals, Ceyla Pazarbasioglu — May 14, 2013
- The global regulatory landscape governing banks has changed from its pre-crisis status quo.
- In addition to the Group of Twenty advanced and emerging economies led global regulatory reforms, like Basel III, the United States and the United Kingdom have decided to directly impose limits on the scope of banks' businesses. The European Union is contemplating a similar move.
- Structural constraints on banks’ activities, well designed and implemented, can usefully complement traditional tools.
- As a first best strategy, a targeted approach, where structural measures—such as “living wills”—are tailored to the specific risk profiles of individual banks at a global, group-level would be preferable to an across-the-board approach.
- Sufficient confidence in supervisors’ capacity to design and implement the targeted approach, along with strong political support, are key to the ultimate success of structural measures. If this confidence is lacking then, as a second best, across-the-board measures, in addition to bank-specific measures, would be appropriate, provided their global benefits are assessed to match or exceed their costs.
A tandem tactic to reduce risk
- The crisis has made many skeptical of the ability of traditional prudential tools, such as risk based capital requirements, to keep under control the risk transmitted to financial institutions and the system as a whole by trading and certain investment banking activities.
- The structural measures to reform banks such as the U.S. Volcker rule, the U.K.’s Vickers ring-fence, and the EU’s Liikanen proposal, which would create functional separation of businesses, all reflect a deep sense of unease with the risk culture engendered by the assumption of trading and speculative investments by deposit taking banks.
- Restrictions on proprietary trading or investments in private equity alone would not have prevented major bank failures such as Lehman Brothers. Nor would reorganizing the bank into separate subsidiaries in each host and home country have facilitated its global, group-wide resolution. Legally, Lehman had a subsidiary structure, yet its resolution has been long and costly.
- Structural constraints on banks can work in tandem with strengthened capital requirements to limit banks’ excessive risk taking. Combining these prudential tools can make a banking group easier to resolve and attenuate the too-important-to-fail problem.
- Example: if the investment bank is systemically important, ring-fencing deposits and credit will not necessarily resolve the too-important-to-fail problem; the temptation to bail-out creditors of the non-ring-fenced businesses will still be present. This suggests combining structural measures with higher capital requirements on all the systemically important subsidiaries.
- Combining the requirement for higher capital (for the ring-fenced entity) and leverage ratio (for trading activities of the non-ring fenced entity) under each of the Vickers and Liikanen proposals would result in a more robust policy to counter too-important-to-fail.
- If successfully implemented, these structural measures would make banks and banking systems safer in the United States, the United Kingdom, and the European Union, which would have a positive effect on global financial stability.
Three things to think through
- Structural measures will be challenging to implement. How are supervisors to consistently and correctly identify the intent behind bankers’ trades?
- Enhanced supervisory collaboration in banks’ home and host countries is critical to the success of the Volcker rule.
- A broad restriction on banks’ trading activities in these countries could end up inhibiting their ability to make markets and hedge risks, activities that are not restricted under the Volcker rule. This could have adverse implications on liquidity and costs in capital markets.
- Risk migration: as authorities reduce banks’ ability to take excessive risk through structural measures, such risks could migrate to other parts of the financial system, including shadow banking entities.
- Policymakers may need to judiciously enlarge the regulatory perimeter and enhance the monitoring of shadow banks and their interactions with regulated entities for structural measures to reduce—and not simply redistribute— systemic risk.
- Loss of diversification and efficiency costs: imposing constraints on banks’ activities at a global level, and on group-wide risk management tools, could make banks more resolvable but potentially at a cost in terms of loss of diversification benefits and efficiencies in risk management. These costs may be felt globally.
- Subjecting a global institution to different structural measures in different jurisdictions could exert further pressure on consolidated supervision and cross-border resolution.
- The more resources are taken up policing compliance with multiple rules, the less is available for monitoring risk, which could increase the cumulative costs of these national initiatives.
Policy recommendations and next steps
- Conduct a global cost-benefit exercise that would encompass the extra-territorial implications of structural measures. The case for introducing these policies at the national or regional level would be strengthened by confirming whether their global benefits match or exceed their global costs, given the potential for the spillover of both benefits and costs.
- Develop principles to evaluate the global implications of structural measures. These principles would facilitate corrections by policy makers and thus mitigate adverse implications. They may also be useful for future measures contemplated by other jurisdictions.
- Prioritize enhanced supervisory collaboration between home and host authorities to implement targeted structural measures effectively.
- Consider combining structural separation with higher capital requirements and leverage ratios targeted at systemically important subsidiaries to reduce moral hazard and improve resolvability.
Source: IMF Blog — "Banking on Reform: Can Volcker, Vickers and Liikanen Resolve the Too-Important-to-Fail Conundrum?" (José Viñals, Ceyla Pazarbasioglu, May 14, 2013).
Content in this bundle
- Staff Discussion Note