HT PAREKH FINANCE COLUMN

september 1, 2012 vol xlviI no 35 EPW Economic & Political Weekly

10
T T Ram Mohan (ttr@iimahd.ernet.in) is with
the Indian Institute of Management,
Ahmedabad.
How Do We Resolve the
Too-Big-to-Fail Problem?
T T Ram Mohan
The Vickers Commission in the
United Kingdom has advocated
ring-fencing of core banking
activities; the Volcker Rule in the
United States prohibits banks
from engaging in certain kinds of
investment activities. Neither will
be easy to implement and neither
is likely to be very effective. To
deal with the risks posed by
systemically important nancial
institutions what is needed is
a multi-pronged approach that
addresses size, concentration
and ownership structure and
far more intrusive regulation
than we have seen in the recent
past. An important element
in this approach must be the
presence of a few large banks in
the public sector.
T
he sub-prime crisis of 2007, the
consequences of which are still
being felt by the world economy,
highlighted glaring deciencies in the
regulation of banks and in the nancial
sector in general. A number of measures
have been taken both at the interna-
tional level (under the auspices of the
Bank for International Settlements (BIS))
and by national regulators by way of tight-
ening bank regulation. Perhaps the most
comprehensive is the Dodd-Frank Act
(2010) passed in the United States (US).
A fundamental problem that remains
unresolved is what is called the too-big-
to-fail problem or the problem posed by
systemically important nancial institu-
tions (SIFIs). Banks that are very big (in
relation to the size of their economies) can-
not be allowed to fail because the failure of
these would cause signicant disruption in
the economy. Knowing this, managers at
these banks can take enormous risks. If
these work out, they will collect big
rewards; if they do not, the government
will rescue them. Given these incentives
for inappropriate behaviour, regulation of
SIFIs poses enormous challenges.
Under Basel 3, some disincentives for
bigness have been created. A higher than
normal requirement of capital is stipulated
for SIFIs. This, however, is far from ade-
quate to prevent failure and the problems
associated with failure remain. Two major
proposals are on the table for dealing with
SIFIs. One is the recommendations of the
Independent Commission on Banking
(2011) in the United Kingdom (UK) (also
known as the Vickers Commission, after its
chairman, John Vickers). Another is the
Volcker Rule which has been built into the
Dodd-Frank Act in the US.
Both, the Vickers Commission and the
Volcker Rule, attempt to tackle the prob-
lem of bigness by addressing the scope
of operations of banks. There could be
several reasons for doing so. One is that
reducing scope could be an indirect way
of reducing size, which is seen as an
issue in systemic risk. The second is that
scope leads to complexity or intercon-
nectedness, which in itself could pose
systemic risk by making risks in a bank
more difcult to manage.
A third reason could be the perception
that investment banking activities are in -
herently riskier and must not be allowed
to jeopardise core banking operations
such as taking deposits and making
loans. If any problem arises on the
investment banking side, it should be
possible to achieve a resolution of assets
in investment banking without, in any
way, impinging on the retail side that
has to do with essential banking serv-
ices. Fourth, implicit government guar-
antees should be available only for core
banking activities and should not extend
to what is derisively referred to as
casino banking.
The Vickers Commission and the Vol-
cker Rule differ in the manner in which
the problem of scope is to be tackled.
Here, we briey review the two propos-
als to see whether they can address the
problem of SIFIs and then go on to con-
sider alternatives.
1 Vickers Commission
The Vickers Commission proposes to
ring-fence core banking activities in a
number of ways. Within the fence, cer-
tain mandated banking activities would
be required: taking deposits from and
making loans to individuals and small
and medium-sized organisations.
Some activities would be prohibited.
These would include trading, purchase
of loans and securities, transactions out-
side the European Economic Area and
with a non-ring-fenced bank, and serv-
ices that require the holding of capital
against market risk and counterparty
risk. Very roughly, a range of investment
banking activities would be outside the
ring fence.
Finally, there would be activities that
would be permitted within the ring
fence. These would include non-prohib-
ited activities, including taking deposits
HT PAREKH FINANCE COLUMN
Economic & Political Weekly EPW september 1, 2012 vol xlviI no 35
11
from customers other than individuals,
small and medium enterprises and lend-
ing to large companies. This specica-
tion of a set of activities is what the com-
mission calls the location of the fence.
Then, there is the height of the fence,
which is meant to ensure the effective-
ness of ring-fencing. This is sought to be
done in a number of ways. The ring-
fenced entity would be a separate legal
entity with its own board of directors and
making disclosures as though it were an
independent listed entity. The relation-
ship of the ring-fenced retail banking
entity with other entities in a wider cor-
porate group should be conducted on a
third-party basis and it should be able to
meet its requirements of capital and
liquidity on its own.
Finally, the ring-fenced entity would
have higher capital requirements than
required under Basel 3. The commission
recommends equity capital of 10% for
ring-fenced banks with risk-weighted
assets of more than 3% of the UK GDP;
total capital would be in the range of
17-20%. For smaller ring-fenced banks, the
capital requirements are lower than these.
Together, these stipulations are inten-
ded to minimise the risks of contagion
from whatever happens outside the ring
fence whether within the larger corpo-
rate group of which the ring-fenced
entity is a part or in the broader nan-
cial system while avoiding the costs
that go with complete separation. The
commission lists the benets:
First, subject to the standalone capital and
liquidity requirements, benets from the
diversication of earnings would be retained
for shareholders and (group level) creditors.
Among other things, capital could be
injected into the UK retail subsidiary by the
rest of the group if it needed support. Sec-
ond, agency arrangements within the group
would allow one-stop relationships for cus-
tomers wanting both retail and investment
banking services. Third, expertise and infor-
mation could be shared across subsidiaries,
which would retain any economies of scope
in this area. Fourth, some operational infra-
structure and branding could continue to
be shared.
There are, however, costs even to the
limited separation proposed. Higher
capital requirements carry a cost. The
investment banking side no longer has
an implicit government guarantee, and
therefore, will face higher funding costs.
The creation of a separate retail subsi-
diary will involve operational costs. As
the commission notes, several analysts
and brokerages have downgraded vari-
ous banks in anticipation of separation
t aking place.
While not attempting a rigorous quan-
tication of the costs, the commission
believes that a plausible range for the
annual pre-tax cost to UK banks of the
proposed reform package is 4bn-7bn,
with at least half of these costs arising
from curtailing the implicit government
guarantee. After taking into account the
implicit cost of government guarantee, the
commission reckons that this translates
into a social cost of 1bn-3bn or around
0.1%-0.2% of GDP. In comparison, the
annual cost of a crisis is around 3% of GDP.
To the extent that the proposed
reforms reduce the probability of a cri-
sis, the commission reckons the social
costs are worthwhile. It is possible, how-
ever, that both private and social costs
are underestimated (in particular, by
not giving due weight to diversication
benets). If that is so, it would raise a
question mark over the cost-benet
c alculation underlying the proposals.
There is also the fundamental issue of
whether the ring fence would indeed be
as effective as thought. First, many prac-
titioners think the fence would be porous
and that banks would nd ways around
it. Second, as Chow and Surti (2011)
point out, ring-fenced banks cannot deal
with non-ring-fenced entities, they have
to rely on entities within their corporate
group for hedging exposures. This could
result in a dangerous level of intra-group
exposure which would defeat the pur-
pose of making it easier to insulate
the ring-fenced entity from the group.
Third, ensuring compliance with regula-
tions on ring-fencing would be difcult.
2 Volcker Rule
The Volcker Rule, which has been incor-
porated in the Dodd-Frank Act on bank-
ing reform passed in the US in the wake
of the sub-prime crisis, attempts to limit
banks exposures to certain investment
banking activities, in particular, what is
called proprietary trading, hedge funds
and private equity. Proprietary trading,
which is banks trading on their own
account, is completely banned. Banks
investment in hedge funds and private
equity should be the lesser of 3% of total
fund assets and 3% of its Tier I equity
capital and even these exposures are sub-
ject to a number of safeguards. US banks
are expected to comply by July 2014.
The rationale for the separation for
investment banking from commercial
banking under the Glass-Steagall Act
arose from the perception of conict of
interest between the two activities. For
instance, a bank that had made a loan to
a company and was keen to recover it
would have an interest in helping the
company raise capital from the markets
to the detriment of investors. Today, the
rationale for separating the activities is
different. It is that some investment
banking activities are inherently riskier
and should not be mixed up with com-
mercial banking.
The perception has arisen following
the collapse of investment banks, such
as Lehman Brothers and Bear Stearns in
the sub-prime crisis. It has been rein-
forced by the large trading loss recently
at JPMorgan Chase and by the Libor
trading scandal. In the minds of the pub-
lic and also policymakers, there is a per-
ception that investment banking has a
roguish character to it.
However, the assumption that risks in
banking arise overwhelmingly on the
investment banking side or even the
trading side (which is one component of
investment banking) is widely ques-
tioned. There is plenty of anecdotal evi-
dence to show that pure commercial
banks are vulnerable. Countrywide Fin-
ancial and Washington Mutual in the US
and Northern Rock in the UK were
among banks that failed.
A rigorous test of the risks posed by
investment banking was done by Chow
and Surti (2011) who examined 79 SIFIs
across Europe, the US and Asia to see if
banks with a high share of income from
trading activities before the crisis were
the ones that experienced distress and
required nancial support. They found
that European and American banks with
high trading income were indeed more
vulnerable but this was not true for
banks in Asia. Thus, the proposition that
HT PAREKH FINANCE COLUMN
september 1, 2012 vol xlviI no 35 EPW Economic & Political Weekly
12
SIFIs with a higher trading income were
more vulnerable received qualied sup-
port from their ndings.
The authors note that Asian banks
may have been less vulnerable because
their economies were more resilient and
also because the banks had lower expo-
sure to sub-prime assets. They raise the
question as to whether the divergence in
results between Asia and the advanced
world suggests that the problem is cycli-
cal rather than structural, meaning that
it arises because Europe and America
are in a different economic phase from
Asia. If that were so, they argue, then
prescribing a structural policy remedy
such as prohibiting banks proprietary
trading altogether may lead to a subopti-
mal outcome.
The Volcker Rule does not outlaw
exposures to hedge funds and private
equity but only sets what one might
regard as a prudential ceiling on these
exposures. Similarly, it permits a num-
ber of exceptions to the ban on proprie-
tary trading. For instance, it allows
investment in a range of eligible securi-
ties (which are specied), transactions
for underwriting, market-making and
hedging. In granting these exceptions,
the Volcker Rule appears to recognise
that outlawing a whole range of invest-
ment banking activities is not the way to
go in making banks safer. It would have
been useful had an attempt been made
to quantify the costs for US banks of fol-
lowing the Volcker Rule as has been
attempted with the Vickers Commission
proposals. To what extent would prots
be dented? We do not know.
For regulators, the challenge will be to
identify or dene in a given situation
whether trading exposures constitute
proprietary trading or whether they qual-
ify as exceptions. Many bankers reckon
this would be an uphill task. JPMorgan
Chase claims that the loss (of around $5 bn)
that it is said to have incurred on its
trading book was, in fact, a hedge, not a
proprietary trade at all. The Volcker Rule
raises another danger that Chow and
Surti point to. Proprietary trading would
migrate to the shadow banking sector
which is not so well-regulated and end up
creating systemic risk through another
part of the nancial system.
A possible answer is to set limits on all
trading assets or income and not just pro-
prietary trading in relation to bank assets
or total bank income, a suggestion made
by Raghuram Rajan (2010). One would
imagine that setting such limits would be
part of risk management at any bank.
However, since banks have shown them-
selves decient in this area, it would make
sense to set regulatory limits on the trad-
ing book as whole, within which each
bank can set its own limits. This may be a
better route to take than focusing on pro-
prietary trading as the Volcker Rule does.
Many in the regulatory community,
academics and even some bankers are
now veering round to the view that the
limited separation envisaged by the
Vickers Commission and the Volcker
Rule is difcult to implement in practice.
They believe that banks can be made
truly safe only by a complete separation.
Sandy Weill, the former chairman of
Citigroup and one of the architects of
todays giant universal banks, recently
created waves in the nancial com-
munity by advocating a return to
the Glass-Steagall Act. Luigi Zingales
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HT PAREKH FINANCE COLUMN
Economic & Political Weekly EPW september 1, 2012 vol xlviI no 35
13
(2012) at the Booth School of Business,
Chicago writes:
The Volcker rule, which prohibits banks
from engaging in proprietary trading but
allows them to put their principal at risk, is
not a good substitute. Proprietary trading is
when a bank invests in stock hoping that its
price will go up. A bank engages in principal
trading when it buys a stock from a client as
a service to that client, who wants to unload
his position quickly. The difference is there-
fore one only of intentions, which are impos-
sible to detect, since any transaction involves
two consenting parties.
The second reason why Glass-Steagall won
me over was its simplicity. The Glass-Steagall
Act was just 37 pages long. The so-called Vol-
cker rule has been transformed into 298 pages
of mumbo jumbo, which will require armies
of lawyers to interpret. The third reason
why I came to support Glass-Steagall was
because I realised it was not simply a coinci-
dence that we witnessed a prospering of secu-
rities markets and the blossoming of new ones
(options and futures markets) while Glass-
Steagall was in place, but since its repeal have
seen a demise of public equity markets and an
explosion of opaque over-the-counter ones.
The argument for a complete separation
along the lines of Glass-Steagall is that
anything else proposed, whether a ring
fence or limits on trading activity, are
simply unenforceable. What the advocates
do not realise is that complete separation
would come at a stiff cost. If the ring fence
proposed by the Vickers Commission
would cost 0.2-0.2% of GDP annually, what
would be the cost of a full separation?
There was an economic logic underly-
ing the move towards universal banks or
for banks to get into just investment bank-
ing. With deregulation and intermedia-
tion, banks margins tend to get squeezed
as borrowers and depositors both head for
the capital market. Providing investment
banking services, banks felt, was a way of
retaining customers. It is not clear that
banks can spin off the entire set of invest-
ment banking acti vities and still remain
competitive or even viable.
There are also benets to be had
through diversication of revenue stre-
ams. Can anybody seriously contend, for
instance, that the erstwhile ICICI (with its
focus on development banking) had a
superior business model to todays ICICI
Bank? At the very least, the cost of reversing
the trend towards integration of banking
and investment banking must be computed.
There is a cost not just to banks but to cus-
tomers who may favour a single window
for all their needs. It is like decreeing that
we should banish supermarkets and settle
only for the corner retail store. The costs
of total separation have to be weig hed
against the reduction in systemic risk that
might be achieved by such separation.
Fundamental Issue
The costs apart, the fundamental prob-
lem with both the Vickers Commission
proposals and the Volcker Rule is that it
is not clear that scope is the dominant
source of systemic risk. Are full-scope
banks riskier than focused commercial
or investment banks? We lack the evi-
dence to say so. Paul Volcker seems to
acknowledge as much:
I think Dodd-Frank was close to as good as
we could get, but its nowhere near what we
need, Volcker said in an interview with
Charlie Rose at a Manhattan event spon-
sored by Syracuse University.
Volcker said the problems surrounding
banks that are too systemically signicant to
be allowed to fail have not yet been convinc-
ingly settled, despite being the heart of the
reform question (Hufngton Post, 20 Sep-
tember 2011).
It is more plausible that the problem of
SIFIs is posed, not by scope, but by big-
ness. Beyond a certain size, banks
become difcult to manage; they also
pose systemic risks because of the dif-
culty in resolving them when they fail.
There may be greater merit, therefore,
in addressing size and concentration in
banking than scope. The size of a banks
assets in relation to GDP and the share of
the top ve or six banks in total banking
assets may be more appropriate para-
meters to monitor. Large banks may need
to be broken up, not by limiting the
scope, but by selling off assets across the
entire spectrum. Given the sizes of some
of the large banks and the state of nan-
cial markets, whether this is feasible at all
in todays context is a different matter.
We also need to address ownership
structure in banking, an idea that is almost
totally missing in the present debate. The
scandals that have made headlines in
recent months the rigging of Libor,
money-laundering, non-compliance with
sanctions, etc have prompted calls for a
sweeping change in culture at banks.
There is more than an element of
delusion to these calls. No major cultural
change is possible under the incentives
that go with private ownership. What we
need in banking is an alternative model
in the form of public ownership. It is nec-
essary to have at least a few large banks
under public ownership. Then, share-
holders, customers and employees, all
have a choice. They can go with the go-
getting culture of private banks or the
risk-averse culture of government-
owned banks. The culture in the system
as a whole changes, with conservatism
in the public sector offsetting a greater
appetite for risk in the private sector.
Can government-owned banks perform
in the face of competition from private
banks? We have tentative answers from
the Indian experience. Size confers an
advantage as does access to government
business, managerial costs are lower,
there is greater depositor condence, and
listing on stock exchanges makes for bet-
ter focus on commercial performance. A
track record of stability in earnings in
itself can help improve market ratings.
Government ownership must be sup-
ported by more intrusive regulation and
supervision than has happened in the
recent past in the west. This must
include norms for the composition of
boards, approval of independent direc-
tors, and approval of top management at
banks. Norms for risk management must
go well beyond those prescribed by the
BIS risk management cannot be left
entirely to banks or to market discipline.
To sum up, everybody understands
that the problem of SIFIs cannot be tack-
led by increasing capital requirements
alone. Perhaps, the time has come to rec-
ognise that limiting the scope of banks is
not the answer either. We need a multi-
pronged approach that addresses size
and concentration, the ownership struc-
ture and entails far more intrusive regula-
tion than we have seen in the recent past.
References
Chow, Julian and Jay Surti (2011): Making Banks
Safer: Can Volcker and Vickers Do It?, IMF
Working Paper, November.
Dodd-Frank Act (2010): http://www.sec.gov/
about/laws/wallstreetreform-cpa.pdf
Independent Commission on Banking, UK (2011):
Final Report, September.
Raghuram, Rajan (2010): Fault Lines, Harper Col-
lins, India, p 173.
Zingales, Luigi (2012): Financial Times, 10 June.