Banking StandardsWritten evidence from Professor Rosa M. Lastra, Centre for Commercial Law Studies, Queen Mary, University of London


Financial legislation in this country is changing yet again. The Financial Services Bill was introduced into Parliament in January 2012 and is expected to receive Royal Assent in late 2012 or early 2013. The Bill creates a new regulatory regime that puts the Bank of England at the centre, with responsibility for financial stability and for prudential regulation via the Prudential Regulation Authority, and creates a Financial Conduct Authority—a streamlined FSA—in charge of conduct of business. (Tinkering with design though will not necessarily improve the quality of regulation and supervision; after all it was the failures in the “how” to supervise rather than “who” that contributed to the crisis). Furthermore, the Government is also working to reduce the severity of any such crisis, and to limit the damage it could cause to the wider economy through the Financial Services (Banking Reform) Bill, which was published in draft on 8 October 2012 and which is expected to be introduced into Parliament early next year). This memorandum addresses the three objectives set out in the policy document that accompanies this Draft Bill, presenting my views on effective means of delivering them. This memorandum also responds to some of the specific questions raised by the Parliamentary Commission in its call for evidence.

Making banks better to absorb losses

1. In order to “make banks better to absorb losses”, banks can increase capital (and the benefits a simple leverage ratio are well documented) or increase the loss absorbency of debt (via bail-in and/or other instruments). In a depressed economy, however, it is difficult to raise capital, while at the same time encouraging banks to lend. Pro-cyclical regulation was a cause of the crisis but pro-cyclical capital regulation also contributes to the severity and long lasting nature of the downturn. As a result of the crisis, banks generally distrust each other; the interbank market has not been functioning properly for some time and banks have become “addicted” to central bank liquidity. Concerns about liquidity are always worrisome, since the line between illiquidity and insolvency is a fragile and dynamic one.

2. Bail-in appears to be a logical way to allocate losses amongst the banks’ creditors and shareholders, while keeping access to critical banking functions. Bail-in offers a way for rapid recapitalization and avoids value destruction by keeping an institution as a going concern. The FSB Key Attributes recommend that: “Resolution authorities should have at their disposal a broad range of resolution powers”.1 Bail-in is an important instrument in this toolkit. There are two types of bail in: bail in via write down (partial wind down) of debt and bail in via conversion of debt into equity. The proposed Recovery and Resolution Directive (RRD)2—due to be adopted by the end of 2012—focuses on the latter. The essence of bail in is to keep a streamlined bank (balance sheet restructuring) by allocating losses amongst bank creditors and shareholders as a going concern.

3. Bail-in by definition, however, addresses capital rather than liquidity. Hence, it needs to be complemented with liquidity provision by the central bank. Indeed, the two key challenges when discussing the effectiveness of bail in are: liquidity and credibility (given the stigma likely to be associated with the use of bail-ins).3

4. The “spirit” of the bail-in technique, as well as the spirit of prompt corrective action (PCA) in the USA or the now ubiquitous concept of living wills (recovery and resolution plans) is the same: act early, act promptly, act preventively before losses are potentially inflicted upon taxpayers. (As the old English adage says: an ounce of prevention is worth a pound of cure).

Making it easier and less costly to sort out banks that still get into trouble.

5. In a market economy banks should be allowed to fail. A zero rate of failure is clearly sub-optimal. Like in forest management, where controlled fires have proven to improve the health quality of the forest as a whole, in the banking system, some institutions should be allowed to fail. The business of banking by definition is fragile and vulnerable and banks will continue to get into trouble (100% reserve banking, mutualisation of banking and other narrow banking proposals aim at reducing that fragility by fundamentally changing the business structure, but banking also needs to remain profitable to survive in a market economy). What is essential is that we do not involve taxpayers’ money in the resolution of banks. We need both functional separability and geographic separability to facilitate an orderly resolution.

6. Geographic separability has inspired the FSB Key Attributes and the RRD. We need market discipline in regulation, but we also need market discipline in protection. Capitalism relies on the lure of wealth and the discipline imposed by the fear of bankruptcy. Risk is at the essence of finance and, by definition, risk brings return and risk entails failure. Financial institutions may claim to be global when they are alive, but they become national when they are dead. In the aftermath of Lehman Brothers, no one wishes another “chaotic” resolution. The alternative, i.e., a “bail-out” package, is equally unpalatable. There is however, a viable solution between chaos and bail-out and that is an orderly resolution.4 The concept of “living wills” is a very welcome development in this regard.

7. Functional separability has inspired the Volcker rule, the Vickers Report and the Liikanen Report. A return to Glass Steagall, i.e., complete legal separation between commercial banking and investment banking business seems impractical (given the funding structure of modern banks, the interconnectedness, the use of derivatives markets, etc.), though in my opinion it is not impossible. Glass Steagall had three benefits: first, legal clarity and predictability; secondly, it contributed to the depth, volume and diversification of the US financial market, in contrast to the [universal] bank dominated systems in Continental Europe. (I contend that the strength of the US capital markets and securities firms/registered broker dealers was fostered by Glass Steagall) and, thirdly, it established clear expectations amongst depositors and investors about the scope of protection of their deposits and investments, by establishing clear legal lines of separation (lessening the incentives to game the system). The demise of Glass Steagall in 1999 coincided with the increase in excessive risk practices (securitisation and others) that together with other factors contributed to the Great Financial Crisis.

8. The common denominator behind the Liikanen Report, the Volcker rule and the Vickers Report, is to prevent the use of depositors’ money to finance risky trading activities. However, the existence of different proposals is problematic. First, such differences may provide incentives for financial institutions to go “jurisdiction shopping”, opportunities for regulatory arbitrage. While Liikanen proposes the ring-fencing of trading activities, Vickers recommends the ring-fencing of retail activities, and the Volcker rule limits proprietary trading, without ring-fencing. [Of course, in the case of the UK, if Liikanen becomes law, the UK will have to adopt the Liikanen proposals5—as long as it remains in the EU and committed to the obligations of the single market]. Secondly, (and this applies both to Liikanen and to Vickers), whenever a fence or boundary is established, there is an incentive for institutions to place themselves or part of their business inside or outside the boundary depending on what appears to be more advantageous or beneficial for them.6

9. The third and perhaps major concern is that none of the proposals go far enough to address the loss of faith in banking as a respectable business. The competing demands between competition and regulation, the existence of highly protected and oligopolistic banking markets, and more radical proposals such as the mutualisation of the financial industry (as proposed by Lawrence Kotlitkoff) are all issues that should be discussed further, leading then, where appropriate, to adequate structural reforms.

10. Emphasis on capital—important as it is—should not obscure the fact that capital is only one element that contributes to bank’s safety and soundness. The quality of the asset portfolio, the integrity of management, the composition of earnings, risk diversification, adequate liquidity management and incentives are all elements that can make banks safer.

Curbing incentives for excessive risk taking

11. The efforts to address the too-big-to-fail (TBTF) issue have so far focused on the “to fail” part of TBTF. But we also need to address the issue of size (the “too big” of TBTF), which requires adequate competition law and policy. The reasons for saving troubled banks these days go beyond the protection of insured depositors. If we want to reduce taxpayers’ liability, we must also address the issue of size. No institutions should be too big or too complex to fail (as discussed above). If that requires smaller size or simplicity then that should be the solution we should contemplate, regardless of vested interests. The implicit government guarantee must stop. We must simplify banks ex ante. The emphasis should be on prevention.

12. Compensation structures need to align the long term interests of the firm (and its very survival) with the incentives of bankers. This can be done via regulation, via tax incentives or disincentives and via corporate governance. To begin, both gains and losses should be “privatised” (ending “the privatisation of gains—socialisation of losses” that has created so much resentment). Beyond that, this alignment requires a careful examination (and not populist policies of “banker-bashing”) of whether the short term pressures of focusing on current performance and equity prices continue to trigger the sort of incentives that made many traders and investment bankers search for short term profits, often ignoring any medium to long term scenario. The well documented criticism of compensation packages—where salaries of investment bankers are the smallest part of such packages, dwarfed by the bonus payments—is already triggering changes in an industry where people are smart: salaries are already larger and all sort of tax incentives are being considered to address the tax implications of the new compensation packages. But the profitability of the industry will continue to dictate the level of pay packages.

13. Changes in corporate structure and corporate governance are needed. Whether the public limited company, société anonyme, should continue to be the corporate form of banks should be discussed further. Mutualisation of the financial industry as proposed by Kolitkoff7 appears as a radical solution. But clearly focusing on the interests of shareholders and managers ignores the interests of many other stakeholders that are crucial for a healthy banking business: depositors and other creditors, taxpayers, pensioners etc. The problem is the level of protection afforded to banks. The public interest in banking is not aligned with the private interests of managers and shareholders.

Other issues (re accountability, ethics and the European dimension)

14. At a time of rapid change in the EU and Eurozone, national legislative proposals that are not aligned with European legislative initiatives are likely to be short-lived. Hence, Britain must fully “engage” in the current negotiation of the Capital Requirements Directive (CRIV), the RRD and the changes to deposit guarantee scheme that are to be adopted by the end of 2012. For example, depositor preference (a good idea in my opinion and a recommendation of the FSB’s Key Attributes) is not compatible with the current RRD. Britain must also engage in the banking union proposals, which will grant very significant supervisory powers to the European Central Bank and may end up rendering the European Banking Authority irrelevant. Furthermore, the interaction between the European System Risk Board, the ECB and the Bank of England ought to be debated and clarified.

15. We need ethics in banking and finance. The banking culture must change. There are a number of concepts—credibility, confidence, fairness—that should permeate through different layers of regulation and influence the behaviour of bankers and financiers. Regulation should be designed in good times, when rapid credit expansion and exuberant optimism cloud the sound exercise of judgment in risk management, rather than in bad times, in response to a crisis. We must also remember that markets are part of the solution since it is well functioning markets that generate growth.8

16. My last comment relates to accountability (who exams the examiners?), more specifically concerns about the accountability of both the Bank of England and the ECB, given their hugely expanded mandate. Article 17 of the proposed ECB Regulation (of 12 September 2012) simply requires: “The ECB shall be accountable to the European Parliament and to the Council for the implementation of this Regulation in accordance with this Chapter”. Is that enough? The answer, in my opinion, is No. With power comes responsibility; Lord Acton’s dictum remains true.

26 October 2012

1, 3.2

2 See also As regards the bail-in tool, see memo by Lastra in The House of Lords European Union Committee - EU Economic and Financial Affairs Sub-Committee (Sub-Committee A) chaired by Lord Harrison - is conducting an inquiry into the reform of the EU banking sector, which offers interesting insights and addresses some of the issues – e.g., bail in, ring-fence and accountability – that the Parliamentary Commission on Banking Standards is examining. I submitted written evidence to this Sub-Committee A and was invited to give oral evidence on 9 October 2012.

3 See IMF staff paper ‘From Bail-out to Bail-in: Mandatory Debt Restructuring of Systemic Financial Institutions’ at published on 24 April 2012. The paper cautions about the fact that if the use of bail-in is perceived by the market as a sign of the concerned institution’s impending insolvency, it could trigger a run by short-term creditors and aggravate the institution’s liquidity problem.

4 See generally Lastra, Cross Border Bank Insolvency (OUP, 2011).

5 Liikanen endorses the loss absorbency of debt via bail in instruments, in line with the proposed Resolution and Recovery Directive. This is of course a very positive aspect of the report, which requires that the subsidiary with the ring-fenced risky trading activities develop a recovery plan. After all, it was the failure of an investment bank (Lehman Brothers) that triggered the great financial crisis.

6 See generally Lastra and Charles Goodhart, “Border Problems”, Journal of International Economic Law, Vol. 13, No. 3, September 2010, pp. 705-718.

7 Laurence J. Kotlikoff (Wiley, 2010), Jimmy Stewart is Dead. Ending the World’s Ongoing Financial Plague with Limited Purpose Banking.

8 See generally Lastra

Prepared 2nd January 2013