What can be achieved by structural reform in banking

Brussels, December 2, 2014

MPI Collective Goods

Martin Hellwig

Structural Reform: Why?

Structural measures: size limits, separation: Glass-Steagall/Volcker, Liikanen, EU

legislation, Ring-fencing: Vickers,

Why? To increase the safety of the financial system and to protect taxpayers!!!???

How? I have yet to see a comprehensive analysis

If we eliminate problems in one place, could they emerge elsewhere?

Flawed Nostalgia

Under Glass-Steagall, the US financial system was safe!!! Really???

From the 1930s to ca. 1960, the system was safe: No big risks (interest rates, exchange rates), lack of competition (Regulation Q)

From 1970 on, the system became unsafe: Interest rate risk, Money Market Fund competition

1980s: Insolvency of S&Ls, due to interest rate risk 1990s: Problems of Commercial Banks, due to

specialization and eroding margins... Push into competition with investment banks

Dangerous Illusions

Commercial Banking is risky: Crises of the early 1990s were due to real-estate and SME lending

Credit risk is a much bigger chunk than trading risk (so far)

Depositor protection and the payment system are not the only reasons for systemic concerns

Market making as an infrastructure: Lehman Brothers was a major market maker

Money markets as a major source of funding: The domino effect of Lehman Brothers on Reserve Primary was a major source of chaos in 2008

Lehman Brothers was an investment bank!!!

What matters: Governance

How are funds channeled from final investors to „final“ assets?

Full separation: Investor – MMF – Lehman Brothers – mortgages in warehousing

Full integration: Investor – UBS – UBS Investment Bank – CDOs in own portfolio (as well as MBS in warehousing)

Hybrid system: Investor – Savings Bank – Landesbank – SIV (guaranteed) – CDOs

None of these arrangements has provided good governance.

Issues in Governance

Investor protection: What products are being marketed and how? (Pecora: moral hazard in investment bank access to commercial bank customers; German savings banks as sales agencies for Lehmns?)

Due diligence in investment of „surplus“ funds Professional-investor protection: Is caveat emptor

enough when securities are potentially „toxic“? Are restrictions on activities and investments of

depository institutions sufficient? Regulation: By type of institution in which they can invest; what about products?

What matters: Contagion

Risk sharing inside an institution can reduce system effects; in the crises of the early 1990s, universal banks could use profits from derivatives to compensate for losses in SME lending

Risk sharing inside an institution can support moral hazard, e.g., as investment bankers and traders rely on AAA rating of the parent

Should we think of separation into sub-groups as an arrangement that yields risk sharing without moral hazard? This depends on overall group management and group culture

More on contagion

Separation gives a bigger weight to links by contracts as opposed to internal governance: potentially greater number of domino effects but the domino effects are potentially smaller

With separation, the network of contracts may become more intransparent

What are the effects of separation on firesale contagion, i.e. banks holding things and having to write them down when prices decline?

What matters: Resolution

How should separation be designed so that resolution becomes easier?

Issues: Cross-border resolution Issues: Ring-fencing other systemic activities,

e.g. market makingProposed regulation mentions the need to

coordinate with resolution authorities but does not say much in terms of substance.

What is the standing of intra-group contracts in resolution?