Banking Standards Joint Committee Contents

5  Challenges to the durability of structural separation


63. Many of the key features of any new framework to give effect to structural separation may not be tested for many years to come. In the interim, a new framework will face number of challenges. This chapter identifies some.

Complexity and financial innovation

64. The first challenge to structural separation lies in the complexity of financial products. This can be illustrated by the example of the development of the rules relating to the implementation of the Volcker rule following the passage of the Dodd-Frank Act. The Volcker rule is based on an ostensibly simple principle, and yet defining what is proprietary trading (which is forbidden for banks) as opposed to other types of (permitted) trading has proved complex. When asked why enactment had required a vast, complex amount of regulation, Paul Volcker replied:

I don't think it does. I think it requires some regulation and that can be complex. Part of this is parody by opponents. How many times have you heard that the proposed rule a year ago was 300 pages long? It was not 300 pages long. It was 35 pages long and 160 pages of questions that lobbyists had raised about how the rule would work. And they said it wouldn't work because it was a 300-page rule. I am cheating a little bit. The rule was 35 pages and had an appendix of 30 or 35 pages laying out the so-called metrics that I was talking about which are probably too complex. I hope that they are getting this better. It comes back to the vexing question of principles against rules. There is no doubt that the American legal system and American habits say, "We want a rule, clear and simple, black and white, so we know when we are obeying the rule". They don't say that they want to know how to get around it, too, but that is part of the deal. With that attitude, 400 bank lobbyists lobbied the agencies on the regulation: "Spell this out exactly or we won't like it" or "How do you tell the precise difference in a proprietary deal?"[100]

65. Paul Volcker went on to suggest that it should be straightforward to require bank directors to distinguish between trading for market-making purposes and proprietary trading.[101] Sir Mervyn King doubted this, suggesting that while "a good banker can tell the difference [...] that is not the issue. The question is whether the regulator or a court can tell the difference between the two and whether it is possible to pull the wool over the eyes of the regulator or to confuse the issue legally."[102]

66. A second challenge derives from the fact that financial products change, sometimes radically, over time. Innovation is characteristic of the financial services industry, and banks have often been at the forefront of that innovation. Households have access to an ever-broader range of savings and borrowing products. The advent of securities markets has broadened the forms of external finance available to firms. A range of insurance products and financial derivatives are now available to enable both financial and non-financial firms to hedge risks that arise in the course of their business so they can provide services to their customers more cheaply. In the years preceding the crisis, asset-backed securities, credit default swaps, interest rate swaps and other derivatives in particular experienced explosive growth. However, this increased the interconnectedness of the financial system, with mixed consequences for its stability.[103]

67. Some new products may not fall neatly on one or other side of the line drawn as part of structural separation. Paul Tucker argued that "we must not jeopardise this regime by trying to define things that it is not actually possible to define, because then the regime will end up in disrepute".[104] The ring-fence may also incentivise the creation of such products. Andrew Bailey warned, "This is an industry that is habitually innovative and habitually wanting to go around regulations or to tunnel under the ring-fence".[105] The Chancellor of the Exchequer drew a lesson from experience and from the prospect of financial innovation:

I would warn against creating a kind of Maginot line in primary legislation that is absolutely right for 2012—absolutely impenetrable to all the weapons that the banks have and that the industry has in 2012—and then find out in 2022, let us say, that the banks and the industry have completely bypassed it.[106]

The influence of banks on politicians and regulators

68. The desire for regulatory clarity might derive in part from experience of the interaction between banks, regulators and politicians over the regulatory framework. Banks have a legitimate interest in the environment in which they operate and seek to change it. The way in which they seek to do so is likely to have more regard to their commercial interests than to the wider public interests in the safety and soundness of the financial system and in the continuity of core services with which regulators are concerned.

69. Speaking of a specific argument which is explored later in this Report, Andrew Bailey drew attention to the danger of a power being "neutralised by the force of lobbying and other pressures that might be set off".[107] He then expanded on this point, saying that he was talking about

the lobbying of politicians and the lobbying of us. There is a very strong lobbying force; it is one of the things that I observe. [...] In the field we operate in—this is, in simple terms, a reflection, if you like, of the concentration of the banking industry in this country—there is a very powerful lobby out there; I read it in the newspapers most days.[108]

70. A similar concern was expressed by Professor Kay. When he gave evidence to the Treasury Select Committee in 2011, shortly after publication of the ICB's report, he said "I would have preferred full separation, but I think 98 per cent of a loaf is pretty good and I am fairly happy with that".[109] He elaborated on this statement when he gave evidence to us:

I was probably in a fairly optimistic mood at the time. But certainly I have taken the view that at least half, or more than half, a loaf is better than no bread. A problem that has always concerned me is that even that half loaf would have crumbs knocked off it as a result of lobbying and the passage of time before it actually came into effect. There is certainly nothing that has happened since then that would have alleviated that particular worry.[110]

71. The challenges that result from the banks' approach to the development of public policy are also illuminated by the evolution of the view of banks on the ring-fence. Martin Taylor told us that "when the banks realised that we were going in the ring-fence direction, they all came to see us and said 'why don't you do the Volcker rule instead', because it is much less inconvenient for them".[111] The banks maintained their opposition to ring-fencing when the ICB's proposals were published in interim and final form during 2011. When responding to the ICB's interim report, RBS wrote:

We think that [existing] far-reaching changes, when digested, will eliminate the implicit state support perceived in the past to be extended to banks. Consequently, these reforms should be allowed to bed down before deciding whether to add to them the additional burden of ring-fencing, which in most variants bears a high risk of failing the tests set by the ICB's terms of reference.[112]

Following publication of the ICB's final report, Barclays expressed a similar view in written evidence to the Treasury Select Committee:

We remain un-persuaded that a retail ring-fence offers enhancements to financial stability and believe it has, at best, marginal benefits as a resolution tool over and above reforms already in place, underway, or in development, including the improvement and alignment of resolution plans and powers and improvements to loss absorbency requirements for banks at the global level.[113]

72. When concerns over lobbying were raised with Sir John Vickers, he replied:

I believe that the regulatory institutions and the legislature would be alert and robust enough to resist that [lobbying]. It is a very welcome thing that our proposals, at least in broad terms, have not only the support of the Government but cross-party support. That, too, is helpful in resistance to creep.[114]

73. The Glass-Steagall Act in the USA provides a case study for the erosion of what was initially a clear and concise piece of legislation. Paul Volcker described to us how loopholes in the Glass-Steagall Act relating to the activities of subsidiaries were widened in the six decades between its passage and repeal:

Then you have a subsidiary and you say, "Why can't the subsidiary do it?" Somehow the language is put in there, "Well, if it's not principally engaged, maybe you can do some underwriting." What does principally engaged mean? For 30 years people assumed that meant, "No, you can't do it." Then the banks began getting more serious. "What do you mean? The law says 'principally engaged'. We made up this subsidiary to sell apples and it is principally engaged in the apple market, but we wanted to do some underwriting. That is what the law says." "Oh," we said, in our great wisdom, "with 5 per cent of the activity elsewhere you can do it. That is not principally engaged." But another chairman of the Federal Reserve Board and a few Federal Reserves later, that got to be 25 per cent, 30 per cent or whatever. Through the years a whole lot of additional securities were added to what was possible for a bank and for the subsidiary to own. You could find language in the law that said the regulators had some discretion. There is some justice in those that say by the time Glass-Steagall was abolished it had already been abolished in practice.[115]

He added that the failure of Glass-Steagall was not because full separation was ineffective, but because the separation became less full, saying "the restrictions between the 'commercial bank' and the 'investment bank' in Glass-Steagall broke down over time. I have a little fear that that might happen in Vickers too."[116]

74. Sir Mervyn King also highlighted the difficulties faced by regulators in terms of their relationship with the banks they regulated:

I have been struck in the last five years, learning more about how the regulatory process worked, by how much of it has turned out to be a negotiation between the regulators on the one hand and banks on the other [...] The big principle is that, to be effective, the regulator has to be able to use judgment. That is what we want to get to. But if judgment ends up simply as a negotiation between the regulator and the regulated bank, there is only one winner in that, and that will be a very bad outcome. Clarity is crucial to enable the regulator to exercise judgment within a very well-defined framework, and the regulator needs to be able to tell banks, "This is the capital requirement you will have", as opposed to merely entering into a negotiation.[117]

The next banking crisis

75. To many market participants and others, financial crises can seem to come out of a clear blue sky. The July 2006 Bank of England Financial Stability Review, for example, said the following:

All of the stress scenarios considered are low probability tail events. Far and away the most likely outcome in the near term is that none of the vulnerabilities crystallise. Moreover, even if these vulnerabilities were to crystallise individually, they would be unlikely to erode to any significant extent the capital base of the UK banking system. This provides strong support for the continuing high resilience of the UK financial system. Market estimates of default probabilities for the major UK banks — as proxied by CDS premia — remain very low and are consistent with that encouraging picture.[118]

The IMF expressed a similar view in its 2006 Global Financial Stability Review:

There is growing recognition that the dispersion of credit risk by banks [...] has helped to make the banking and overall financial system more resilient [...] The improved resilience may be seen in fewer bank failures and more consistent credit provision. Consequently, the commercial banks, a core segment of the financial system, may be less vulnerable today to credit or economic shocks.[119]

Referring to similar developments in risk transfer mechanisms, Tim Geithner said in

February 2006:

These developments provide substantial benefits to the financial system. Financial institutions are able to measure and manage risk much more effectively. Risks are spread more widely, across a more diverse group of financial intermediaries, within and across countries. These changes have contributed to a substantial improvement in the financial strength of the core financial intermediaries and in the overall flexibility and resilience of the financial system in the United States. And these improvements in the stability of the system and efficiency of the process of financial intermediation have probably contributed to the acceleration in productivity growth in the United States and in the increased stability in growth outcomes experienced over the past two decades.[120]

76. Major financial crises are infrequent, but recurring events. Their infrequency creates an added challenge in designing frameworks for such events due to loss of collective memory. As Lord Turner said:

How do we guard against it in future? Well, in part, the generation of us who lived through October 2008, we may be reasonably safe against the re-emergence of this delusion. The classic problem for human institutions and for the design of our regulatory structures and our policy is how do we design against it in 25 years' time, when the generation of those who were there in October 2008 are in retirement and we have another: "This time it's different. This time we're cleverer than the previous generation." That is the institutional challenge, and we have got to try and embed the intellectual challenge, the counter point of view—but also try and embed through what we do on structure things which are resilient to changes in intellectual fashion.[121]

77. Major financial crises are also not identical to one another. The ICB Interim Report noted, "Reforms to financial regulation must not aim solely at addressing past crises," adding "The goal must be to improve the resilience of the banking system to shocks regardless of the form they take".[122]

78. The characteristics of financial crises and the nexus between banks, politicians and regulators together pose fundamental challenges for the design and implementation of structural separation. Any framework will need to be sufficiently robust and durable to withstand the pro-cyclical pressures in a future banking cycle. Those pressures will include the siren voices of those who contend that structural separation as implemented represents a barrier to financial innovation and growth. Politicians need to face up to the possibility that they may prefer those siren voices to the precautionary approach of regulators, particularly if, once again, it appears that banks are performing alchemy. In the chapters that follow, we consider the approach needed best to ensure that structural separation is able to withstand these challenges.

100   Q 86 Back

101   Q 68 Back

102   Q 1149 Back

103   Bank of England, Financial innovation: what have we learnt?, Bank of England Quarterly Bulletin 2008 Q3, p 330; Beck, Tao Chen, Chen Lin, and Frank M Song, "Financial Innovation: The Bright and the Dark Sides", HKIMR Working Paper 05/2012, January 2012 Back

104   Q 1201 Back

105   Q 948 Back

106   Q 1053 Back

107   Q 949 Back

108   Q 951 Back

109   Evidence taken before the Treasury Committee, 18 October 2011, HC 1534-ii, Q190 Back

110   Q 292 Back

111   Q 390 Back

112   RBS Group response to ICB Interim Report of 11 April 2011, Back

113   Treasury Committee, Independent Commission on Banking Final Report October 2011, Oral and Written Evidence, HC (2010-2012) 1534, Ev 130 Back

114   Q 778 Back

115   Q 74 Back

116   Q 92 Back

117   Qq 1144-5 Back

118   Bank of England, Financial Stability Report, Issue No.2, July 206, p 10-11 Back

119   IMF April 2006 GSFR, Chapter 2. It should be noted that the IMF did go on to say: 'At the same time, the transition from bank-dominated to more market-based financial systems presents new challenges and vulnerabilities. These new vulnerabilities need to be understood and considered in order to form a balanced assessment of the influence of credit derivative markets.' Back

120   Tim Geithner speech to the Global Association of Risk Professionals, 28 February 2006. It should be noted that Tim Geithner did go on to say: 'These generally favorable judgments require some qualification, however. These changes appear to have made the financial system able to absorb more easily a broader array of shocks, but they have not eliminated risk. They have not ended the tendency of markets to occasional periods of mania and panic. They have not eliminated the possibility of failure of a major financial intermediary. And they cannot fully insulate the broader financial system from the effects of such a failure.' Back

121   Q 1011 Back

122   Independent Commission on Banking, Interim Report, April 21011, p 20 Back

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© Parliamentary copyright 2012
Prepared 21 December 2012