Tuesday, September 20, 2011

FLG Still Doesn't Understand

...the assertions by so many people how a return to Glass-Steagall is like this super-awesome way to save the banking system.

FLG was reading this article, when he came to this sentence:
"You've got to break them up," Adam Strauss says of the big banks. "You've got to bring back Glass-Steagall. And you have to put a cap on the size of the banks."

FLG can see the size of the banks being an issue, but doesn't get the investment versus retail break out. Again, Lehman was NOT a retail bank. It was an investment bank. Yet, it still threatened to bring down the entire financial system.

FLG has written this before and probably will write this again, but he thinks much of this pining for Glass-Steagall is born out of a combination of nostalgia and ignorance. Nostalgia as in longing for the days when finance wasn't so complicated. Ignorance because they don't understand those days are never coming back. Information technology presents far too many opportunities in the financial realm.

But then, as FLG was thinking about this, he remembered a report on the BBC about how the Vickers Commission came back with what basically amounts to just short of a Glass-Steagall implementation in the UK. So, FLG decided to pull up the report and see what they had to say. Given that the UK actually had retail bank runs, it is probably pretty interesting, FLG thought to himself. Here's the relevant passage regarding what they call ring-fencing:

Structural reform: principles

A number of UK banks combine domestic retail services with global wholesale and
investment banking operations. Both sets of activities are economically valuable while both
also entail risks – for example, relating to residential property values in the case of retail
banking. Their unstructured combination does, however, give rise to public policy concerns,
which structural reform proposals – notably forms of separation between retail banking and
wholesale/investment banking – seek to address.

First, structural separation should make it easier and less costly to resolve banks that get into
trouble. By ‘resolution’ is meant an orderly process to determine which activities of a failing
bank are to be continued and how. Depending on the circumstances, different solutions may
be appropriate for different activities. For example, some activities might be wound down,
some sold to other market participants, and others formed into a ‘bridge bank’ under new
management, their shareholders and creditors having been wiped out in whole and/or part.
Orderliness involves averting contagion, avoiding taxpayer liability, and ensuring the
continuous provision of necessary retail banking services – as distinct from entire banks – for
which customers have no ready alternatives. Separation would allow better-targeted policies
towards banks in difficulty, and would minimise the need for support from the taxpayer. One
of the key benefits of separation is that it would make it easier for the authorities to require
creditors of failing retail banks, failing wholesale/investment banks, or both, if necessary, to
bear losses, instead of the taxpayer.

Second, structural separation should help insulate retail banking from external financial
shocks, including by diminishing problems arising from global interconnectedness. This is of
particular significance for the UK in view of the large and complex international exposures
that UK banks now have. Much of the massive run-up in bank leverage before the crisis was in
relation to wholesale/investment banking activities. Separation would guard against the risk
that these activities might de-stabilise the supply of vital retail banking services.
Third, structural separation would help sustain the UK’s position as a pre-eminent
international financial centre while UK banking is made more resilient. The improved stability
that structural reform would bring to the UK economy would be positive for investment both
in financial services and the wider economy. The proposed form of separation also gives
scope for UK retail banking to have safer capital standards than internationally agreed
minima, while UK-based wholesale/investment banking operations (so long as they have
credible resolution plans, including adequate loss-absorbing debt) are regulated according to
international standards. Without separation there would be a dilemma between resilient UK
retail banking and internationally competitive wholesale and investment banking.
Moreover, separation accompanied by appropriate transparency should assist the monitoring
of banking activities by both market participants and the authorities. Among other things it
should allow better targeting of macro-prudential regulation.
Separation has costs however. Banks’ direct operational costs might increase. The economy
would suffer if separation prevented retail deposits from financing household mortgages and
some business investment. Customers needing both retail and investment banking services
might find themselves with less convenient banking arrangements. And although global
wholesale and investment banking poses risks to UK retail banking, there are times when it
might help cushion risks arising within UK retail banking.
In addition, the cost of capital and funding for banks might increase. But insofar as this
resulted from separation curtailing the implicit subsidy caused by the prospect of taxpayer
support in the event of trouble, that would not be a cost to the economy. Rather, it would be
a consequence of risk returning to where it should be – with bank investors, not taxpayers –
and so would reflect the aim of removing government support and risk to the public finances.
For these reasons, the Commission regards structural reform as a key component of reforms
aimed at enhancing the long-run stability of UK banking. This leads to questions about its
design and implementation.

Structural reform: practical recommendations
How should the line be drawn between retail banking and wholesale/investment banking?
Should separation be total, so as to ban them from being in the same corporate group? If not,
what inter-relationships should be allowed, and how should they be governed and

The Commission’s analysis of the costs and benefits of alternative structural reform options
has concluded that the best policy approach is to require retail ring-fencing of UK banks, not total separation. The objective of such a ring-fence would be to isolate those banking
activities where continuous provision of service is vital to the economy and to a bank’s
customers. This would be in order to ensure, first, that such provision could not be threatened
by activities that are incidental to it and, second, that such provision could be maintained in
the event of the bank’s failure without government solvency support. This would require
banks’ UK retail activities to be carried out in separate subsidiaries. The UK retail subsidiaries
would be legally, economically and operationally separate from the rest of the banking
groups to which they belonged. They would have distinct governance arrangements, and
should have different cultures. The Commission believes that ring-fencing would achieve the
principal stability benefits of full separation but at lower cost to the economy.
Scope of ring-fence

Which activities should be required to be within the retail ring-fence? The aim of isolating
banking services whose continuous provision is imperative and for which customers have no
ready alternative implies that the taking of deposits from, and provision of overdrafts to,
ordinary individuals and small and medium-sized enterprises (SMEs) should be required to be
within the ring-fence.

The aims of insulating UK retail banking from external shocks and of diminishing problems
(including for resolvability) of financial interconnectedness imply that a wide range of
services should not be permitted in the ring-fence. Services should not be provided from
within the ring-fence if they are not integral to the provision of payments services to
customers in the European Economic Area1 (EEA) or to intermediation between savers and
borrowers within the EEA non-financial sector, or if they directly increase the exposure of the
ring-fenced bank to global financial markets, or if they would significantly complicate its
resolution or otherwise threaten its objective. So the following activities should not be carried
on inside the ring-fence: services to non-EEA customers, services (other than payments
services) resulting in exposure to financial customers, ‘trading book’ activities, services
relating to secondary markets activity (including the purchases of loans or securities), and
derivatives trading (except as necessary for the retail bank prudently to manage its own risk).
Subject to limits on wholesale funding of retail operations, other banking services – including
taking deposits from customers other than individuals and SMEs and lending to large
companies outside the financial sector – should be permitted (but not required) within the

The margin of flexibility in relation to large corporate banking is desirable. Rigidity would
increase the costs of transition from banks’ existing business models to the future regime.
And it would risk an asset/liability mismatch problem if, for example, retail deposits were
prevented from backing lending to large companies. Mismatch could give rise to economic
distortion and even to de-stabilising asset price bubbles.

The Commission’s view, in sum, is that domestic retail banking services should be inside the
ring-fence, global wholesale/investment banking should be outside, and the provision of
straightforward banking services to large domestic non-financial companies can be in or out.

The aggregate balance sheet of UK banks is currently over £6 trillion – more than four times
annual GDP. On the criteria above, between one sixth and one third of this would be within
the retail ring-fence.

Again, FLG thinks the permitting of derivatives trading "except as necessary for the retail bank prudently to manage its own risk" is a big hole in the ring fence, but an important one. 

>Look, as FLG has said before, much of the debate surrounding financial regulation consists of political hobbyhorses.  The issue is leverage.  If the UK wants to have its investment banks commit to Basel III leverage limits and capital requirements, but require even more conservative leverage ratios for their domestic retail banks then more power to them.  FLG just isn't sure what it buys the UK.  

Are people, upon hearing Bank A is in trouble, going to sit back and say, well, you know, Bank A is in trouble, but it's only Bank A's investment banking subsidiary, not it's retail banking subsidiary, no need to get my money out?   Doesn't seem like it would stop runs.  Although, FLG guesses the underlying solvency would be pretty secure if regulated properly, so then it's merely a matter of providing liquidity during the crisis.

Let's say that the retail sector is actually safe, leaving the problems of misperceptions among the public causing runs anyway aside.  FLG has written it before and will write it again, Bear and Lehman were investment, not retail banks, and they threatened to bring down the whole system.  So, it's not like the problem of moral hazard or risk to financial system, economy, or  taxpayer goes away because retail banks are safe.

All told, FLG thinks this proposal helps to the extent that it limits the amount of leverage in the banking system and allows some prepositioning for unwinding of failing banks.  What he worries about is the perception that this type of regulation therefore solves the problems of systematic risk in the banking system, because it does not.  

FLG doesn't see how the UK could allow, let's say, Barclays investment banking division to fail even if the retail bank division has adequate reserves.  He thinks there'd still be a run on the retail side and the counter-party problems would be huge for other investment banks.

There's just no way to go back to whatever it is people think we'd be going back to if there were separate investment and retail banks.   Financial products and services are just too intertwined today.  Heck, let's remember that AIG was not even a bank, but an insurance company.  Yet, the counterparty problems its failure created in the banking system were mind-boggling.

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