Tuesday, October 30, 2012

UK Central Banker Says Faithful Implementation of Volcker Rule and Vickers Proposals Can Enhance Resolution Authorities

Legislation providing for the orderly resolution of failed financial institutions is an important practical step towards preventing systemic risk and ending too-big-to-fail, as well as lowering the societal costs of the failure of a large interconnected financial firm, noted Andrew Haldane, Executive Director of Stability for the Bank of England. While it is striking how much progress has been made in so short a space of time on so complex an issue, he noted, the practical question is how far this takes us towards removing the too-big-to-fail externality. In recent remarks, he posited that the faithful implementation of both the letter and the spirit of the Volcker Rule in the US and the Vickers Commission ring-fence proposals in the UK will enhance the ability of resolution authorities to succeed in the goal of ending too-big-to-fail.

He mentioned that Title II of the Dodd-Frank Act creates a new regime for the resolution and liquidation of financial companies, banks and non-banks, which pose a systemic financial stability risk.  It enables losses to be imposed on creditors in resolution, while also prohibiting state bail-outs. Internationally, in November 2011 the G20 endorsed the Financial Stability Board’s Key Attributes of Effective Resolution Regimes, developed by an international working group. Efforts are underway to align national resolution regimes with these principles.  As part of that, in Europe a draft Directive on recovery and resolution of financial institutions was published in June 2012.  

During the resolution of a financial firm, noted the Executive Director, one way of ensuring continuity of services is by transferring assets and/or liabilities of a failing firm to a third party.  But he noted that the only entity with sufficient financial and managerial resource to absorb a large asset or liability portfolio, without ``suffering chronic indigestion,’’ is another large financial institution, citing examples during the crisis of Bear Stearns being swallowed by JP Morgan Chase, Merrill Lynch by Bank of America and Washington Mutual by Citigroup.  

According to the senior official, this makes for an uncomfortable evolutionary trajectory, with rising levels of banking concentration and ever-larger too-big-to-fail banks.  Levels of banking concentration have risen in many countries since 2007, he noted, precisely because of such ``shot-gun marriages by over-sized partners.’’  In other words, resolving big banks may have helped yesterday’s too-big-to-fail problem, but at the expense of worsening tomorrow’s problems.

One way of lessening that dilemma, he reasoned, and at the same making resolution more credible, is to act on the scale and structure of financial firms directly. Recent regulatory reforms have sought to do just that. In the United States, the Volcker Rule prohibits US-operating banks from undertaking proprietary trading and sponsoring hedge funds and engaging in other types of private equity activity. 

In the United Kingdom, the proposals of the Vickers Commission include placing a ring-fence around retail banking activities, supported by higher levels of capital, and thus fencing them off from commercial banking. The government’s plan is to enact the ring-fence through legislation. The EU announced the Liikanen plan in October 2012, which proposes that the investment banking activities of universal banks be placed in a separate entity from the remainder of the banking group.

Volcker, Vickers and Liikanen seek legal, financial and operational separation of activities, noted the Executive Director, and thus in principle should prevent cross-contamination of retail and investment banking at crisis time.  Whether they do so in practice, said the official, depends on loopholes in, or omissions from, the ring-fence. 

And each of the existing proposals has open questions on this front. For example, the Volcker Rule separates only a fairly limited range of potentially risky investment bank
activities, in the form of proprietary trading.  The Vickers proposals mandate only a limited range of basic banking activities to lie within the ring-fence, namely deposit-taking and overdrafts.  And the Liikanen plan allows a wide range of derivative activity to lie outside of the investment banking ring-fence.

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