Monday, January 24, 2011

UK Commission Considers Volcker-Type Structural Reforms for UK Financial Institutions

The UK should consider ring-fencing the retail banking activities of systemically-important financial institutions from their investment banking activities and require them to be capitalized on a stand-alone basis, said Sir John Vickers, Chair of the Independent Commission on Banking. In remarks at the London School of Business, he said that a variant of this idea would be to require the ring-fenced retail banking activities to be relatively strongly capitalized, while adopting a lighter regulatory policy towards the other activities, thereby focusing on and limiting the need for heightened capital requirements on the key retail services. Chairman Vickers mentioned the Volcker Rule provisions of the Dodd-Frank Act as the type of structural reform that the Commission is considering. Formed by the Government in June of 2010, the Commission will produce an interim report in April and in September will make final recommendations to the Government on reform of the regulation of UK financial institutions.

The remarks of Chairman Vickers may help allay the concerns of Spencer Bachus (R-Ala), Chair of the House Financial Services Committee who, in a letter urging federal financial regulators to interpret the Volcker provisions of the Dodd-Frank Act in a way that does not disadvantage US financial firms in competition with EU firms, said that the Volcker provisions collide with the European universal banking model that the EU is highly unlikely to abandon in the spirit of regulatory harmonization. Given the City of London’s significance as a world financial center, noted Chairman Bachus, the UK’s failure to adopt the Volcker provisions would result in a significant competitive disadvantage for US firms.

Chairman Vickers noted that one of the arguments made in favor of universal banking is that it allows diversification of risks with the result that the probability of bank failure is lower than if retail and investment banking are in some way separated. But he said that diversification by itself is not a good justification for corporate integration insofar as investors can achieve its benefits through portfolio diversification. He also said that it does not follow that retail bank failure is less likely with universal banking.

In this respect universal banking has the advantage that a sufficiently profitable or well-capitalized investment banking operation may be able to cover losses in retail banking. But it has the disadvantage that unsuccessful investment banking may bring down the universal bank, including the retail bank. If the Commission recommends some form of separation similar to the Volcker Rule as a matter of public policy, he continued, there would be the further question of whether it should be required of the financial institutions concerned, or incentivized, for example by appropriately different capital requirements for different business models.

Separately, Chairman Vickers noted that, because normal bankruptcy procedures work so badly for large, complex and interconnected financial institutions, it is imperative to develop credible recovery plans and resolution tools similar to the liquidation regime codified in Title II of Dodd-Frank. Much work is under way in the UK and internationally to tackle this problem. The resolvability of global investment banking operations is a particular challenge, and of heightened importance to the UK given the scale of bank balance sheets relative to GDP.

In the Chair’s view, a credible resolution authority would seem to require some form of separability and. Arguably, there is a case for some form of ex ante separation so that bank operations whose continuous provision is truly critical to the functioning of the economy can clearly be easily and rapidly carved out in the event of calamity. But he added that perhaps the credibility of resolution plans can be ensured otherwise than by forms of separation, and the benefits of creating such options would of course need to be weighed carefully against costs they imposed. There is also the possibility that some form of structural separation of retail and investment banking might enhance the credibility and effectiveness of resolution schemes.

Contingent Capital

The Chair also said that using a contingent capital tool, which converts debt into equity at times of stress, is somewhat problematic. Potential problems with automatic conversion are that the triggering conditions are lagging, or otherwise somewhat arbitrary, indicators of the need for more equity, or else that they are subject to manipulation by speculative market traders. On the other hand, discretionary triggers may run into problems of price uncertainty, regulatory capture by vested interests, and reluctance to activate the trigger when the time comes). The system-wide dynamic effects of conversions at times of emerging systemic stress might also be unpredictable.

These scenarios are compounded by a tax system that encourages both corporate and personal leverage. The corporate tax deductibility of debt interest increases the private cost of equity relative to debt. In the case of financial institutions, therefore, the public desirability of more equity capital meets an opposing force from the tax system.