Structural reforms of the regulation of
financial institutions, such as those recommended in the UK by the Vickers Commission, or to be
implemented in the US
via the Volcker Rule, will play an important role in robust regulatory reform,
according to Adair Turner, Chair of the UK Financial Services Authority. He
said that the implementation of the Vickers Commission recommendations will
deliver three important benefits. First, they will increase the array of
resolution options available to the authorities in the event of a crisis,
creating at least the possibility that regulators may choose to rescue the
ring-fenced entity while allowing non ring-fenced entities to fail. That
possibility will in itself reintroduce market discipline into a system characterized
by too-big-to-fail assumptions, he emphasized, which in turn will help
constrain the unnecessary proliferation of complex structuring and trading
activities, reinforcing the impact of higher capital requirements
Second, the implementation of the Vickers
recommendations will give regulators the option, provided the vast majority of
SME lending is conducted within the ring-fence, of applying macro-prudential
policy levers at the ring-fenced level instead of at group level. This
will create a tighter link between macro-prudential levers and the dynamics of
credit supply in the real economy, said the FSA Chair, and increase the
likelihood that regulators could limit the impact of booms and busts in
commercial bank lending. Third, the Vickers recommendations will give
banking groups the opportunity to build institutions very explicitly focused on
the excellent provision of essential banking services to households and SMEs,
which could play a major role in rebuilding customer trust.
The UK government
endorses the recommendations of the Independent Banking Commission, chaired by
Sir John Vickers, that a ring fence be placed around better capitalized banks to
make them safer, and to protect their vital services to the economy if things
go wrong. The Commission is driven by the belief that large scale proprietary trading and large
scale internal hedge funds do not sit easily alongside retail banking. While
the UK
government has not implemented the Volcker Rule per se, in a bow to the Volcker
Rule the Commission recommended ring-fencing a financial institution’s retail
banking activities from investment banking.
The ring-fencing proposal shares a common
motivation and underlying philosophy with the Volcker Rule being implemented
under the Dodd-Frank Act. Similar to a retail ring-fence, the Volcker Rule aims
to curtail government guarantees and the instability they can create by
subsidizing risk taking. Under the Volcker Rule, because deposit-taking banks benefit
from some explicit and implicit government guarantees, they should not be able
to conduct trades or invest in funds purely for the purpose of making money on
their own account. A rubric of both the Volcker Rule and the Vickers Commission
rink fencing proposal is that socializing part of the risk of these activities
while privatizing their benefits encourages excessive risk taking that may
damage the stability of the financial institution.
The Commission’s ring-fencing proposal is
different from the Volcker Rule in that, while proprietary trading and
investments in hedge funds would not be prohibited, these activities would be
outside the ring-fence and so isolated from retail banking where implicit
government guarantees appear strongest.
Chairman Turner cautioned that the
implementation of the Vickers Commission recommendations will not be, standing
alone, sufficient to ensure stability. While complex investment bank
trading activity played a role in the origins of the financial crisis, with the
failure of Lehman’s was a crucial event; so too did over-rapid expansion of
plain lending to commercial real estate companies. Chairman Turner further
cautioned that the isolation of retail and commercial banking within a
ring-fence, as recommended by the Vickers Commission, does not mean that
regulators can be indifferent to the development of risks outside the ring
fence. Such a view would be both wrong and dangerous. But he emphasized that
structural reforms which create either entire banks or units within wider
banking groups more exclusively focused on classic retail and commercial
banking activity will play a vital role.