Banking StandardsWritten evidence from Paul Volcker
(a) History, culture, and social value of innovations in banking
1. The internal culture of the dominant international banks has changed radically in recent decades. That change is related to the increased emphasis on trading activity, highly complex financial engineering, and the related spread of aggressive compensation practices. In practice, the traditional commercial banking emphasis on “customer” relationships, with the implication of fiduciary responsibility, has given way to impersonal “counter-party” transactions, with the implication of caveat emptor.
2. While richly rewarded, the economic and social value of much of the trading and innovative financial engineering is questionable, and in fact has contributed to volatility and risk.
(b) The need for structural reform
1. Traditional commercial banks provided essential public services: safe depositary; lending to businesses (particularly small and medium-sized business); a reliable and efficient payments system, and home buyers. Recognizing that role, banks have long been supported by central bank liquidity facilities, various forms of deposit insurance, and emergency assistance. These protective facilities in effect reduce perceived risks to creditors and lower bank financing costs, constituting a significant public subsidy. The sense that creditors, and even stockholders, of the large publicly-protected commercial banks will be protected in time of crisis may encourage excessive risk taking.
2. The recent and continuing crisis has led to intense and useful efforts to raise bank capital and liquidity standards internationally. Experience suggests that, however important capital standards may be, regulated institutions, market developments, and political pressures may reduce the effectiveness of risk-based standards over time, particularly as they are (and must be) subject to supervisory judgment rather than imposed by explicit and rigid statutory language.
(c) These considerations point to the importance of structural reform of banks
1. Risk-based capital standards need to be supplemented by a clear restriction on leverage of the entire banking organization (including off-balance sheet liabilities).
2. More speculative, proprietary actions of banking organizations need to be prohibited (as in the “Volcker Rule”), or walled off from the socially and economically essential activities of commercial banking organizations (as in the Vickers and Liikanen proposals).
3. Whichever broad approach is adopted, questions of practical implementation will arise. “Borderline” issues will be intensely lobbied. Strong statutory language will be necessary to assure regulatory authority and to support supervisory judgment.
4. There is a critical need for adequate “resolution authority” to deal with large (“systemically important”) failing financial institutions. Superseding existing bankruptcy procedures, prompt government intervention and financial and interim financial support will be needed to maintain market continuity, while forcing management change and stockholder loss and placing unsecured creditors at risk. Contingency planning in preparing so-called “living wills” is common ground internationally. Specific approaches will need to be coordinated internationally, particularly with the US and the UK in the lead.
(d) Vickers, Liikanen, Volcker—and the ghost of Glass-Steagall
1. These reform proposals call for a particular form of structural change to help deal with critically important cultural issues as well as specific risks.
2. They have in common a statutory separation of certain trading activities from the core banking functions.
In the case of Vickers and Liikanen, all trading activities (proprietary and “market-making”) and certain lending activities related to “wholesale” and investment banking functions, would be confined to a separate subsidiary of a banking organization. Transactions with an “independent” commercial bank subsidiary strictly would be limited, inevitably with certain exceptions.
This approach appears close to the former Glass-Steagall restrictions in the U.S. The fact that those restrictions broke down over time in the face of financial innovations and complacency may provide a cautionary lesson.
In the case of Volcker, the restriction is confined to proprietary trading and sponsorship of equity and hedge funds (apart from limited, defined exceptions). Complete legal and organizational separation of those activities from the commercial banking organizations is required. Underwriting, prime brokerage, securitization, lending to all businesses (as well as other widely practiced functions such as investment management) would remain with the commercial banking organization. In essence, the distinction (now embodied in law) in Dodd/Frank legislation is between customer-related business and strictly proprietary or speculative trading.
3. Each of these approaches requires careful regulatory definitions and supervisory oversight to maintain the separation of functions. In practice, identifying the precise line between market-making and proprietary trading has been questioned. Based on the American experience, the concept that different subsidiaries of a single commercial banking organization can maintain total independence either in practice or in public perception is difficult to sustain.
(e) Other areas of “unfinished reform”
Money market mutual funds—particularly important in the US.
The nature of bank capital, including the usefulness of contingent debt instruments.
Credit rating agencies.
Common accounting standards.
17 October 2012