26 April 2013

BIS: Structural bank regulation initiatives - Approaches and implications

A number of jurisdictions are considering whether to implement regulations that impose restrictions on the scope of banking activity, or have already taken concrete steps towards doing so. These initiatives include the so-called Volcker rule in the United States, the proposals of the Vickers Commission in the United Kingdom, and the European Commission’s Liikanen Report. Draft legislation on structural bank regulation is underway in Germany and France.

The proposals for structural bank regulation break with the conventional wisdom that the banking sector’s efficiency and stability stands only to gain from the increased diversification of banks’ activities. Rather, structural bank regulation sees the combination of commercial banking and certain types of capital market-related activities as a source of systemic risk. The common element of all the proposals is to restrict universal banking by drawing a line somewhere between “commercial” and “investment” banking businesses. Hence, the various initiatives on structural bank regulation aim at changing how banks organise themselves.

Structural bank regulation initiatives are designed to reduce systemic risk in several ways. First, they can shield the institutions carrying out the protected activities from losses incurred elsewhere. Second, they can prevent any subsidies supporting the protected activities (e.g. central bank lending facilities and deposit guarantee schemes) from cutting the cost of risk-taking and inducing moral hazard in other business lines. Third, they can reduce the complexity and possibly the size of banking organisations, making them easier to manage, more transparent to outside stakeholders and easier to resolve.

However, the initiatives also raise some challenges. One risk is that banks may respond to the reforms by shifting activities beyond the perimeter of consolidated regulation. In fact, one reason why the Liikanen Report opts for subsidiarisation rather than full separation is to reduce this risk. Migration would be a concern if these activities proved to be systemic in nature.

Second, structural regulation may, through various channels, affect the international activities of universal banks in particular. For example, disincentives for global banking may be created by initiatives seeking to protect depositors and cut the costs of the official safety net within the home country jurisdiction. Moreover, ring-fencing and subsidiarisation may constrain the allocation of capital and liquidity within a globally operating banking group. Through these channels, structural regulation may contribute to a fragmentation of banking markets along national lines.

A third risk is that structural regulation may create business models that are, in fact, more difficult to supervise and resolve. For example, resolution strategies may be rather complex to design and implement for globally operating banks that have to face increasing heterogeneity in permitted business models at the national level.

Full working paper

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