Thursday, July 26, 2012

UK FSA Chair Sees Benefits from Ring-Fencing Commercial and Investment Banking Similar to Volcker Rule

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.