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13 June 2013

Bank of Finland/Liikanen: Banking after the regulatory reforms – Business as usual?


Liikanen looked at research findings and the rapid growth in the EU banking sector. He then elaborated on the HLEG proposals and the rationale behind the HLEG's proposal for mandatory separation, and gave a comparison with other suggested structural reform.

Comparison of suggested structural reforms

The Volcker rule is the most narrow, but also most radical in that it targets mainly proprietary trading, and 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 in the form of subsidiarisation 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.

The EU High-level group wants to separate not only proprietary trading in the narrow sense, but also market making. So, avoiding the difficult segregation of proprietary trading and market making is one way 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.

The treatment of market making in structural regulation has become a point of some controversy. In addition to the problem of circumvention, the debate concerns a question of principle: is there some market failure in the supply of liquidity through market making, which justifies use of insured deposits to fund the market making inventory? It is not at all obvious that there is.

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.

About half a year ago the French and German governments published national proposals for structural reform in the banking sectors of those countries. These initiatives can be seen as adaptations of our proposal as they apply the same “subsidiarisation” model. The activities to be separated are somewhat narrower as proprietary trading would 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.

During last spring, structural reforms were put on the agenda of the international regulatory community. The issue has been discussed both at the Bank for International Settlements and at the International Monetary Fund.16  Simultaneously, the European Commission has worked on an impact assessment and recently launched a consultation where two alternative scenarios for structural reform in EU are to be assessed by the banks; one scenario is close to our proposal while the other is somewhat broader both in terms of its scope and the depth of the gorge between the entities to be separated.

How the HLEG proposals address the malign diagnosis of the size and structure of the banking sector

Subsidiarisation of trading facilitates resolution by making bail-in rather than bail-out a more 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. First of all the proposals reduce the distorted incentives which endangers socially optimal allocation of resources. For example, as the subsidy of the implicit government guarantee is reduced, competition particularly in the trading activity is revitalised, which will improve the allocation of funds in the economy. Moreover, 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 better.

The interconnectedness within the banking sector and thus the complexity of the financial sector will be affected too. As intra-group financing and transfers of capital or risks between the deposit bank and the trading entity will be limited, there will be fewer channels of contagion. Further, limits on trading activities will reduce the counterparty risks of deposit banks. There is, however, need for further research on financial networks, focusing on the effects of structural reform. These issues are notoriously difficult to measure. So we need to know more about how the complexity of the financial system can be monitored and effectively reduced.

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. I would also like to emphasise the importance of eliminating the presumption that profits are private, but downside risks are public. In the future risk-takers will also have to take into account the potential losses from their bets.

Efficient market discipline as well as active and timely supervision must help ensure that the financial sector and banks in particular find a more healthy size and structure. Our recommendations seek to facilitate this 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 for separation not only facilitate monitoring by supervisors, but the additional layer of designated bail-in instruments which we propose should also increase large creditors’ incentives to monitor banks and thereby improve 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. I have emphasised the increased attention paid to incentives and risk taking. 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 minimised. Improving the quality of finance continues to be a key priority in promoting sustainable economic growth. Structural reforms of banking should support these aims by helping to weed out distorted incentives from finance.

Full speech



© Suomen Pankki - Finlands Bank


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