21 January 2014

Bundesbank/Dombret: Cutting the Gordian Knot or splitting hairs - The debate about breaking up the banks

The underlying notion is that there are two different worlds. There is the world of commercial banking, which is populated by conservative and "prudent" bankers who support the real economy and provide a haven for savings. And then there is the world of investment banking that poses a constant risk to financial stability and to taxpayers’ money.

The combination of these two worlds in a universal bank is seen as a source of systemic risk. It is therefore being proposed that they be separated: instead of universal banks there would just be pure commercial and pure investment banks. The general objective when breaking up the banks is to shield those parts that are deemed vital for the real economy from those parts which have little or no connection to the real economy – to shield commercial banking from investment banking. 

But there is more to the argument. One other aspect is the existence of deposit insurance schemes that render deposits risk-free which leads to depositors demanding lower risk premiums. Universal banks can therefore draw on a subsidised source of funds to finance their investment banking activities. It is argued that separating commercial and investment banking would abolish this subsidy, align incentives for investment banks and force them to reduce the size of their business. Another aspect is the existence of implicit government guarantees for certain banks. If a large and interconnected universal bank fails, the whole financial system might be disrupted, as might the real economy. The taxpayer might therefore be forced to step in and save the bank to prevent an even worse outcome.

Proponents of breaking up the banks argue that pure investment banks with no connection to the real economy would be treated differently. They would be excluded from deposit insurance schemes and also from implicit government guarantees. Consequently, if things went wrong, they would not be rescued by the government at the taxpayers’ expense – moral hazard would be reduced. Moreover, banks would become less complex and thereby easier to resolve.

Would it Work?

To me, financial stability cannot be achieved as long as banks are too big, too interconnected or too complex to fail. Finding a solution to this problem would eliminate implicit government guarantees, would align incentives and would increase financial stability. First, we have to make banks safer to reduce the likelihood of failure. Second, if a bank fails, it must be able to do so without disrupting the entire financial system.

It is true that commercial banking would benefit if it had some degree of insulation from the perils of investment banking. But is commercial banking in itself really safer than investment banking? The question of stability ultimately depends on the sustainability of the business model. In addition, breaking up the banks would reduce their potential to diversify. This, in turn, could increase their exposure to individual shocks – they might even become less safe.

And  would breaking up the banks limit the size of investment banks by removing funding subsidies? Well, it certainly would remove at least those subsidies related to deposit insurance. But if deprived of deposits as a source of funding, an increasing number of pure investment banks would have to revert to less stable sources of funding – they would become less safe. 

I am also not fully convinced that breaking up the banks would block the relevant channels of contagion. True, it would block channels of contagion within banks. But wouldn’t they just be replaced by channels of contagion between banks? And what about the problem of shadow banking? I see the danger that breaking up the banks might provide incentives to export more and more risky activities to the realm of non-bank banking. However, the risks could easily be re-imported to the regular banking system. In the end, we would have gained nothing.

Alternatives

It seems unclear whether breaking up the banks would take us all the way to financial stability. It could make banks somewhat easier to resolve – that much is clear. But I doubt that breaking up the banks would make them safe enough; that it would ensure that banks can fail without disrupting the system; and that the proposal of breaking up the banks could be implemented in a suitable manner.

Other things are at least equally important if we want to secure financial stability. To make banks safer, we have to increase capital requirements. To enable banks to fail without disrupting the financial system, we need resolution mechanisms. In my view, these measures are more important and bring us closer to financial stability than just breaking up the banks. And we must be aware that we cannot solve all our problems through regulation. In addition to regulatory reform, there also has to be a change of culture within the world of banking.

Full speech

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