Can banking reforms prevent another financial crisis?

The present crisis has made evident the failure of the three pillars of the Basel II system. Disclosure and risk assessment have been deficient (think for example about the problems with rating agencies), and market discipline has been ineffective because of the blanket insurance offered by ‘too big to fail’ policies. To this a collective moral hazard problem of ‘too many to fail’ may have been added, since when many institutions choose correlated risks, as in the 2007–08 crisis with high direct and indirect exposure to real estate, the central bank and/or the regulator are compelled to bail out failing banks ex post. The incentives to herd are particularly strong for small banks (see Acharya and Yorulmazer 2007, Farhi and Tirole 2012). Furthermore, capital regulation has not taken into account systemic effects (the social cost of failure), and capital requirements have been softened and asset restrictions lifted, likely under the pressure of industry lobbies.1 Supervision has proved ineffective since it allowed a shadow banking system and systemic risk to grow unchecked. In summary, the crisis uncovered massive regulatory failure.

Post-crisis banking regulation

The regulatory response has been to engage in the Basel III process of increasing capital and liquidity requirements and to propose a structural reform of banking. Several initiatives post-crisis have been taken to regulate banking structure: the Independent Commission on Banking (ICB) in the UK (or Vickers Commission), the Dodd–Frank Act in the US, and the Liikanen Commission in the EU. The ICB launched the idea of ring-fencing retail activities from investment banking activities in separately capitalised divisions of a bank holding company. The retail part would be subject to higher capital requirements. This is a compromise to alleviate the gambling problem with public insurance while allowing some scope economies within banking activities (see ICB 2011). This structural measure is currently being implemented and will be effective in January 2019.

In the US the Volcker Rule adopted in Dodd–Frank forbids proprietary trading by banks on their own account but allows it in some permitted activities (market-making, trading in government securities, hedging, and underwriting) and its implementation is still in process. The Dodd–Frank Act was supposed to be the modern version of the Glass–Steagall Act of 1933 (repealed in 1999), which was itself a response to the banking crisis of the early 1930s. According to Glass–Steagall, commercial and investment banking are separated – commercial banks cannot deal with securities and their deposits are insured up to a certain amount, and investment banks cannot take deposits.

The Liikanen Commission (October 2012) took an intermediate route between the proposals of Vickers and Volcker. Vickers pushes most investment banking activities outside the ring-fenced retail division. Volcker separates proprietary trading and hedge and private equity fund investment. In both the Liikanen and Vickers proposals, but not in Dodd–Frank, banks may set up a holding company with banking and trading subsidiaries. According to those proposals, the deposit-taking subsidiary cannot provide market-making services or hedge and private equity fund investment, but other group companies may do so. Liikanen’s proposal also adds a strengthened leverage limit for the trading subsidiary, and Dodd–Frank adds one on designated systemic institutions.2 In January 2014 the European Commission published the Bank Structural Reform proposal, which is partially based on the Liikanen report. It proposes the ban and separation of proprietary trading (but more narrowly defined than in Dodd–Frank) and fosters ring-fencing of wholesale market operations.3

Sources of excessive risk-taking

The sources of potential excessive risk-taking in banking are: limited liability (for shareholders and managers); moral hazard (for managers and investors); explicit and implicit insurance (‘too big to fail’); and excessive competition (eroding banks’ charter value). To this we should add the capacity of modern banking to leverage the insured deposit base in high-risk bets in the marketplace.4 Traditional banks can lose money by making bad loans but, typically, the process is relatively slow. However, the weight of trading in the balance sheet of banks has increased due to the more extensive use of hard information, which erodes traditional relationship banking based on soft information. A bank with access to complex derivative products can bet the whole balance sheet overnight and induce the failure of the institution. Indeed, single traders at Barings (N. Leeson), Société Générale (J. Kerviel), or JP Morgan Chase (the ‘London whale’) have led to huge losses (in the billions of euros) for those institutions.

A framework for understanding regulatory failure and reform

In order to understand both regulatory failure and the rationale of the reform proposals, I propose a framework based on Matutes and Vives (2000).5 The framework considers that the three main frictions in banking are the limited liability charter of banks, imperfect competition (due say to differentiation and/or switching costs among banks), and a social cost of failure of an entity beyond its private cost. Banks compete for deposits and choose the riskiness of their portfolio of loans.

Different possible banking regimes, the incentives for risk-taking, and the appropriate regulation in a context with low charter values and a high social cost of failure are depicted in Table 1. With limited liability, banks will assume excessive risks on the asset side, unless the risk position is observable and market discipline becomes effective. Disclosure requirements help to uncover the bank’s risk position (or, more realistically, ensure a better assessment). This is represented by the banking regime in the first row of the table, where the incentives to take risk are absent on the asset side and moderate on the liability side. If the asset risk position of the bank is not observable (second row of the table), then incentives to assume more risk increase considerably on the liability side and are maximal on the asset side. Those incentives become maximal on both sides of the balance sheet with risk-insensitive insurance (third row in the table), since it destroys investors’ monitoring incentives. Properly priced risk-based deposit insurance (bottom row in the table) moderates risk-taking incentives and compensates for the bank’s limited liability charter, but banks may still take too much risk in the presence of a large non-internalised social cost of failure. In the top and bottom rows, an instrument such as capital requirements may effectively control risk-taking, because the incentives to assume risk on the asset side are disciplined by the market, but in the middle rows asset restrictions need to complement capital requirements. Asset restrictions basically mean that the amount of risk that the bank can take on the asset side is bounded.

Table 1. Possible banking regimes, the incentives to take risk on the liability and asset sides, and the necessary regulatory instruments, when charter values are low and the social cost of failure is high

The introduction of competition in banking in the 1980s was accompanied by checking risk-taking with capital requirements, allowing banks to rely on their own internal models to assess and control risk, and including disclosure requirements for financial institutions in order to increase transparency and foster market discipline. A flexible view of capital requirements, supervision, and market discipline were the three pillars of the Basel II framework. The rationale of this framework was to provide more risk-sensitivity to capital requirements. Advanced economies tried to move towards the top and the bottom rows of the table. Supervisors would assess how well banks were matching their capital to the risks assumed (substituting risk-based deposit insurance by risk-sensitive capital requirements) and banks would disclose information on their capital structures, accounting practices, and risk exposures. Risk-sensitive capital requirements and internal capital models proved ineffective because of their complexity and possibilities of being gamed.6 This regulatory strategy failed.

Evaluating the reform proposals

Will the present structural banking reform proposals be effective? The assessment of these proposals is complex since they are bound to have mixed effects. They will tend to lower the complexity of banking institutions and improve resolvability, as well as reducing the scope for conflicts of interest and interdependencies within groups and with financial markets. They may be important in increasing the credibility of resolution procedures. At the same time some versions of the proposed reforms may increase the burden on the supervisor and increase the danger of misidentifying prohibited or permitted activities, and limit scope and diversification economies. And the risk of migration of risky activities to the shadow banking system or other jurisdictions where regulation is lax is always present. The outcome may be that the investment bank part may need to be rescued if it becomes systemic. A proposal to counteract such incentives is to construct a ‘wired’ ring-fence such that if the boundary fails strict separation of activities would be imposed (and this is contemplated in the UK proposal).

The present regulatory reform is aiming at pricing risk, be it by the market with disclosure and market discipline (e.g. bail-in of subordinated and even senior debt in cases of trouble) or by the regulator (with risk-based insurance), and at the same time limiting activities of banks as in the structural banking reform proposals. Pricing risk corresponds to moving towards the top and/or the bottom rows of the table, where, paradoxically, activity restrictions are not needed. Put another way, imposing mechanisms to price risk correctly should make activity restrictions redundant.

However, it may be argued that there is a complementarity between the two types of measures, since separation of activities may make banking groups more easily resolvable (reducing the social cost of failure) and therefore lower the cost of imposing market discipline. Indeed, important efforts are being made in order to improve resolution mechanisms so that it is credible to impose market discipline and commit to bail-in procedures when a bank fails, but most likely a relevant residual cost of liquidation will exist.

Furthermore, scrapping deposit and creditor insurance (explicit or implicit, as in ‘too big to fail’ policies) may increase fragility by aggravating coordination failure and/or increase information-based runs when coupled with more disclosure. That is, even maintaining a certain level of deposit insurance for retail deposits, runs may occur for uninsured debt if credible bail-in procedures are in place. Activity restrictions are justified then if insurance has to be provided and cannot be fully priced. This means that to a certain extent flat insurance mechanisms and ‘too big to fail’ policies stay in place. This is what the regulatory reform process seems to have implicitly concluded by proposing both mechanisms to price risk and a certain degree of separation of activities.

Will this ‘carpet bombing’ strategy be enough to deter, or at least alleviate substantially, financial crises? We will know the answer when the next crisis strikes.

This article is published in collaboration with VoxEU. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Xavier Vives is a Professor of Economics and Finance and academic director of the Public-Private Sector Research Center at IESE Business School; CEPR Research Fellow.

Image: The Thames flood barrier is seen in front of London’s financial district of Canary Wharf at dawn. REUTERS/Russell Boyce