14 May 2013

iMF Direct: Banking on reform: Can Volcker, Vickers and Liikanen resolve the too-important-to-fail conundrum?

In addition to the G20-led global regulatory reforms such as Basel III, the US and the UK have decided to impose limits directly on the scope of banks' businesses. The EU is contemplating a similar move.

This analysis suggests that structural constraints on banks’ activities, well designed and implemented, can usefully complement traditional tools. As a first best strategy, a targeted approach, where structural measures—such as “living wills”—are tailored to the specific risk profiles of individual banks at a global, group-level would be preferable to an across-the-board approach. However, sufficient confidence in supervisors’ capacity to design and implement the targeted approach, along with strong political support, are key to the ultimate success of structural measures to reduce risks in the financial system. If this confidence is lacking then, as a second best, across-the-board measures, in addition to bank-specific measures, would be appropriate, provided their global benefits are assessed to match or exceed their costs.

The crisis has made many sceptical of the ability of traditional prudential tools, such as risk-based capital requirements, to keep under control the risk transmitted to financial institutions and the system as a whole by trading and certain investment banking activities. The crisis has strengthened the argument for excluding these activities from banks and hence impeding their access to taxpayer-funded backstops enjoyed by deposit-taking financial institutions.

The structural measures to reform banks such as the US Volcker rule, the UK’s Vickers ring-fence, and the EU’s Liikanen proposal, which would create functional separation of businesses, all reflect a deep sense of unease with the risk culture engendered by the assumption of trading and speculative investments by deposit taking banks.

Looking forward, structural constraints on banks can work in tandem with strengthened capital requirements to limit banks’ excessive risk taking. Combining these prudential tools can make a banking group easier to resolve and attenuate the too-important-to-fail problem.

Combining the requirement for higher capital (for the ring-fenced entity) and leverage ratio (for trading activities of the non-ring fenced entity) under each of the Vickers and Liikanen proposals would result in a more robust policy to counter too-important-to-fail.

If successfully implemented, these structural measures would make banks and banking systems safer in the United States, the United Kingdom, and the European Union, which would have a positive effect on global financial stability.

But this analysis also suggests these policies will exert global costs given that they will be imposed on internationally active and systemic financial institutions. This is due to a number of factors:

• First, structural measures will be challenging to implement. How are supervisors consistently and correctly to identify the intent behind bankers’ trades? While difficult in practice, enhanced supervisory collaboration in banks’ home and host countries is critical to the success of the Volcker rule. A broad restriction on banks’ trading activities in these countries could end up inhibiting their ability to make markets and hedge risks, activities that are not restricted under the Volcker rule. This could have adverse implications on liquidity and costs in capital markets.
• Second, as authorities reduce banks’ ability to take excessive risk through structural measures, they must recognise that such risks could migrate to other parts of the financial system, including shadow banking entities. Policymakers may need judiciously to enlarge the regulatory perimeter and enhance the monitoring of shadow banks and their interactions with regulated entities for structural measures to reduce—and not simply redistribute— systemic risk.
• Third, imposing constraints on banks’ activities at a global level, and on group-wide risk management tools, could make banks more resolvable. But this would potentially come at a cost in terms of loss of diversification benefits and efficiencies in risk management. And these costs may be felt globally.

This analysis highlights the need for a global cost-benefit exercise that would encompass the extra-territorial implications of structural measures. The case for introducing these policies at the national or regional level would be strengthened by confirming whether their global benefits match or exceed their global costs, given the potential for the spillover of both benefits and costs to many countries and areas other than the United States, the United Kingdom, and the European Union.

Full information

IMF analysis: Creating a Safer Financial System: Will the Volcker, Vickers, and Liikanen Structural Measures Help?

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