25 March 2010

Paul Goldschmidt: comments on "Building a crisis management framework for the internal market" EC conference

For any substantial progress to be made in dealing efficiently with “crisis management”, two important decisions should be prioritized. First, to negotiate at G20 level a separation of commercial and investment banking activities, and, second, to move speedily ahead at EMU level.

"Building a crisis management framework for the internal market"

(Commentary on the conference held in Brussels on March 19^th)

The European Commission and DG Internal Market are to be congratulated for organising such an impressive gathering on this most challenging, topical and important subject.

Hereunder, I endeavour to draw some conclusions from the exchange of ideas that took place. I hope they will contribute constructively to the debate.

Two main themes dominated the discussions: Complexity and Cross-border related issues. These two matters are, of course, closely interrelated because the more complex the financial institutions, the markets and the products, the greater are the difficulties in reaching a cross-border consensus among authorities charged with regulatory supervision and crisis management.

If progress is to be made it is imperative to proceed by a series of successive choices so as to avoid being trapped by circular arguments or irreconcilable divergences which can only lead to unsatisfactory compromises.

Turning first to complexity, it would appear sensible to debate the merits of the various business models that characterise financial institutions. This involves making a clear choice between “universal banking” as it is now widely practiced, and a partial/total restoration of a separation between “commercial (deposit taking) banking” and “investment banking” along the lines of the Glass-Steagall Act or the Volker Rule. 

The conference clearly showed that complexity increases the “too big to fail” risk because of the unforeseeable consequences resulting from the often opaque “inter-connectedness” of financial markets. This in turn induces a “too big to manage” syndrome leading automatically to a “to big to supervise” situation.

While mandatorily subjecting a greater number of financial instruments, including derivatives, to regulated “clearing and settlement” platforms, will reduce the systemic risk arising from inter-connectedness, such measures do not appear sufficient.

Separating “commercial” and “investment banking” activities would, on the other hand, considerably simplify the regulatory framework applicable to deposit taking institutions and consequently substantially facilitate supervision and enforcement. The aim is, of course, to improve prevention avoiding, to the extent possible, recourse to the “crisis management framework”.

There can be no doubt that by limiting the activities of deposit taking institutions it will be far easier to achieve a consensus on a harmonised EU regulatory framework applicable to commercial banks. It should cover solvency, concentration and liquidity issues as well as standards of professional and ethical qualifications. In exchange for limiting their activities, commercial banks would benefit from the exclusivity of “deposit taking” from the public, guaranteed in turn by a State sponsored insurance scheme. In regard to deposit insurance, attention has been directed essentially to harmonising its application and designing an appropriate financing model. I suggest that Governments should be far more demanding towards the banking system in exchange for granting their guarantee by insisting on more transparency and exchange of information so as to minimise taxpayer’s exposure.

The limitations imposed on commercial banks should facilitate agreement on common supervisory practices and foster greater willingness to consider a more open exchange of information between national regulators. It should also simplify the establishment of an equitable burden sharing mechanism and significantly reduce the risk of having to activate it.

Financially speaking, by reducing drastically the risk profile of commercial banks, lower levels of equity (solvency) should be required to support identical levels of lending, increasing the return on “own funds” commensurately. It is also only fair that the privileged access that commercial banks enjoy to Central Bank funding to support their liquidity requirements should not be captured to finance cheaply high risk activities such as “proprietary trading” or other activities that are vulnerable to market volatility putting depositors and taxpayers at risk.

A first conclusion to be drawn is that excessive complexity of financial business models will lead quasi automatically, by the necessary application of the “principle of precaution”, to excessive regulation. In turn this will engender fragmentation of the regulatory framework undermining the efficiencies of financial markets and their ability to finance the real economy. The industry has a clear choice between either full operational freedom implying heavily constraining regulation or appropriate limitations to its activities and a lesser regulatory burden. It cannot be allowed to have its cake and eat it!

It is therefore particularly important that an agreement be reached at G20 level on the broad lines of business that under the above premise would be confined to “commercial banks” so that they can be encouraged to continue to operate globally. Universal banking flourished in Europe after World War II in parallel with a US market subject to the restrictions of the Glass Stegall Act; this duality was fully compatible with the operation of the Breton Woods system.  Under present circumstances, in a market in which the freedom of capital movements has contributed so enormously to global prosperity, reinstating such a structure is inconceivable without creating severe distortions in competition and opening the way for economically disruptive protectionist measures.

Many of the issues mentioned here above have cross-border implications. It is already apparent in the difficulties that are being encountered in the discussions surrounding the reform of the financial regulatory framework within the EU, derived principally from the proposals contained in the de Larosière Report.

The “intergovernmental” bias of the legislation currently under consideration is fully understandable even if highly regrettable. Indeed, the discussions surrounding the “powers” of the three new financial Regulatory Agencies reveal the determination of the Member States to keep ultimate control over their financial institutions, showing willingness to consider only “reinforced cooperation” as an option to the exclusion of any “mandatory” rules.

This is particularly true in the area of “crisis management” where the coexistence of incompatible legislations in the field of bankruptcy provides for significantly different treatment/rights of shareholders and creditors as well as concerning the possibilities of asset transfers etc. One of the Brussels speakers insisted on “putting the legislative horse before the resolution cart” as a precondition for arriving at any cross border consensus.

In the absence of an EU Directive harmonising these questions, it is understandable -and probably right - that Member States (especially non EMY Members) remain reluctant to the outright transfer to Community bodies of powers that could impinge on their “monetary sovereignty”. Indeed, by giving powers to the EBA (or a lead supervisors located in another jurisdiction) to impose decisions affecting local financial undertakings, there could be instances where severe consequences could ensue affecting the whole economy of the Member State in question, for instance on the exchange rate. One should consider in particular the situation of some of the Eastern Member States where the vast majority of banking assets are under control of third country institutions; in such a situation it is understandable that Members wish to retain the “ring fencing” option as opposed to cross border cooperation.

Short of further harmonisation of the appropriate legislation, one can readily see the embedded limitations of any system built on “voluntary enhanced cooperation” and the temptation, in the event of a crisis, to limit information exchange, precisely at the time it is most needed and when speed is of the essence.

As currently designed, the system submitted to the European Parliament and the Council seems adapted only to a “business as usual” environment, but appears totally inadequate to meet the challenge of dealing with a future crisis.

A much bolder approach is needed to overcome these shortcomings. Recognising the political reality, it is probably wise, nevertheless, to pursue the current legislative initiatives which constitute an unquestionable step forward compared with the existing situation.

However, in parallel, taking full advantage of the new Lisbon Treaty, a determined effort should be undertaken by the 16 Members of EMU to extend their existing “reinforced cooperation” to cover a full “unification” of the Eurozone financial architecture. This would imply adoption of a single Regulatory framework, a single (decentralised) Regulator, as well as harmonised bankruptcy legislation an integrated deposit guarantee scheme and a fully detailed burden sharing agreement. The fact that existing members of EMU have already pooled their “monetary sovereignty” should greatly facilitate achieving consensus on these sensitive issues, which cannot be realistically envisaged among the EU 27 at the present time.

Other Member States would be free to join, from the start, on a voluntary basis (but forced to do so when applying for EMU membership). Composition of the new Community wide bodies (ESRC, ESFS and the three Regulatory Agencies) would be adapted to reflect the fully integrated nature of the representation of EMU participants.

 

Conclusion:

For any substantial progress to be made in dealing efficiently with “crisis management” two important decisions should be considered as priorities:

 

-          Negotiating at G20 level a sensible separation of commercial and investment banking activities.

-          Moving speedily ahead, at EMU level, with the full integration of its financial markets in all of its aspects.

 

The first will substantially contribute to dealing effectively with the thorny questions raised by the complexity of financial markets, products and institutions.

The second attempts to move progressively towards the elimination of “cross border” impediments to implementing effective regulatory/supervisory as well as crisis management frameworks.

Such an agenda would also act as a powerful tool to accelerate the extension of EMU to all 27 Member States which, in turn, would contribute to reinforce considerably the EU’s power and influence in world affairs.

As David Wright so appropriately challenged the discussion panellists in Brussels, the real question is: “Is there sufficient political will to move this important agenda forward?”

 

There are no “easy” solutions. The European citizen, faced with the consequences of the deep financial and economic crisis, largely brought on by the excesses of financial operators, the laxity of Regulators and the indifference of Governments, deserves better than the usual political compromises that, in this instance, will clearly not suffice.

© Paul Goldschmidt