Sunday, October 21, 2012

Former Fed Chair Volcker Tells UK Parl. Commission that Vickers Proposed Separation of Commercial and Investment Banking within Holding Company Would Break Down

Former Fed Chair Paul Volcker told the UK joint Parliamentary Commission on Banking Standards that the ring-fencing of retail from commercial banking within the same bank holding company would inevitably break down. The exceptions to ring-fencing is where the problems will begin as financial institutions begin to expand the exceptions. Mr. Volcker called for institutional separation of retail banking and proprietary trading and sponsoring hedge funds.

While ring-fencing would be effective to a considerable extent, he allowed, there are holes in the fence, and leakages which are likely to get bigger. That is what happened to the Glass-Steagall Act, he noted. The chipping away at the Glass-Steagall wall of separation between commercial and investment banking began with the creation of subsidiaries and adding more of what was possible for a subsidiary to do in the securities area.

The UK Government has submitted to Parliament landmark legislation to ring-fence retail commercial, deposit-taking banking from investment banking. The bill has been referred for review to the Parliamentary Commission on Banking Standards, which will report on the legislation by December 18, 2012. In the main, the legislation is intended to implement the recommendations of the UK Independent Commission on Banking, the Vickers Commission, which proposed a sweeping structural change under which, within a single organization, the range of ordinary banking operations, such as deposit taking, and lending, would be segregated in a retail bank, which would be overseen by its own independent board of directors and ring-fenced to greatly reduce relations with the rest of the organization.

Mr. Volcker tempered his remarks by noting that ring-fencing will not be totally ineffective and is certainly worth a try. But he believes that the better approach would be to put retail and commercial banking in two separate organizations. In addition, he found common ground among the Volcker Rule, the Vickers Commission and the Dodd-Frank Act in that they all want to create a separation between retail and commercial banking, and between traditional retail banking activities and proprietary trading and sponsoring hedge funds. Put more simply, the common ground is that both the US and the UK are worried about proprietary trading in a financial institution. He also noted that proprietary trading in US commercial banks is diminishing as they approach the implementation of the Volcker Rule.

Mr. Volcker testified that there is a significant difference between traditional bank functions that carry a fiduciary duty to customers and proprietary trading, which does not. Proprietary trading is generally episodic and does not envision a continuing relationship. Mr. Volcker said that proprietary trading should be taken out of the banking organization and be allowed to fail and the protected ring-fenced bank should not engage in proprietary trading. In other words, the government should not protect proprietary trading.

Some members of the committee voiced the belief that a separate and independent board of directors in the proprietary trading subsidiary, as proposed by the Vickers Commission, would ameliorate the problem of blurring the lines between proprietary trading and the ring-fenced retail bank. In Chairman Volcker’s view, a separate independent board of the subsidiary doing proprietary trading may not be enough since the board of the bank holding company will have to take account of what is going on in the subsidiary since that board is responsible for the entire organization. In addition, the ultimate stockholder in the holding company has a stake in both the retail and commercial sides, reasoned the former Fed Chair, and the board has a fiduciary duty to them.
More broadly, trading and retail banking have different cultures and putting two different  cultures into one organization was wrong and created some of the problems leading up to the financial crisis. Moreover, proprietary trading and sponsoring hedge funds have inherent conflicts of interest with other parts of the bank.

Mr. Volcker noted that there is a difference between proprietary trading and market making. In determining the difference, management must control the traders and have metrics to look at, such as volatility and the volume of trading. He said that it would be a ``fool’s errand’’ to look at every transaction, it is better to look at metrics and trends.