Financial Stability Proposals

Proposals that aim to ensure financial stability have been put forward and we briefly comment on them. The most important probably is the Dodd-Frank Act of 2010. The Act contains a number of important constituent elements; the ones relevant to this contribution are as follows. Eliminate proprietary investments (namely to prohibit banks that take insured deposits from running their own trading operations) and also no longer allow ownership of hedge funds by banks; in the final Act this was modified to the banks being allowed to hold proprietary investments of 3 percent of their core capital. Size matters: no financial firm should be allowed to become ‘too big to fail’. End of taxpayer bailouts: the legislation grants government the power to wind down failing institutions, not just banks, if they threaten the financial system. A new ‘orderly liquidation’ authority is equipped with the power to seize a failing ‘systemically important’ institution. Another important aspect of the Dodd-Frank Act is the proposal that the ‘shadow banking’ and the non-bank finan- the interest rate channel but changes in interest rates would be targeting a particular asset class with changing the rate of interest for that particular class.

cial service companies should be properly regulated. It also proposes the introduction of a new Office of Credit Ratings to supervise credit rating agencies. It should be noted that the Dodd-Frank Act has effectively left it to new regulatory bodies to decide further on all these issues.

This Act may not be the Glass-Steagall Act of 1933, but it is the most sweeping and wide-ranging overhaul of the US financial regulations since the 1930s. However, whether this Act would have prevented the ‘Great Recession’ is an interesting question. Our response is on the negative in view of the non-separation of commercial and investment entities, as the experience leading to the international financial crisis of 2007/2008 demonstrated.

Following the US initiative, a UK government-appointed commission on banking was set up in June 2010 to provide a year-long analysis of whether banks should be split up into commercial and investment entities, and whether a version of the Dodd-Frank Act would be appropriate for UK banking. Its final report and recommendations were presented in September 2011. The Vickers Report, as it is now known, recommends ‘ring-fencing’ banks’ retail operations from their investment banking activities, whether conducted by UK or foreign-owned banks. The main problem of ring-fencing is that banks may be encouraged to take greater risk with the activities inside the ring-fencing, such as mortgages, corporate and personal assets. This may be so since such activities would be more likely to be bailed out.

A similar trading ring-fence proposal came from the Committee commissioned by the European Commission and headed by the Governor of the Bank of Finland (and ECB council member), the Central Bank of Finland, Erkki Liikanen. This committee was set up in November 2011 and The Liikanen Report or ‘Report of the European Commission’s High-l evel Expert Group on Bank Structural Reform’ (known as the ‘Liikanen Group’) is a set of recommendations published in October 2012 by a group of experts led by Erkki Liikanen.

The Liikanen Report (2012) suggests ring-fencing but in the case of the European banks it should be the investment banking activities of investment banks’ operations, not of retail activities as in the Vickers Report. In the report’s view, similar to that of the Vickers Report, “The central objectives of the separation are to make banking groups, especially their socially most vital parts (mainly deposit-taking and providing financial services to the non-financial sectors in the economy), safer and less connected to high-risk trading activities and to limit the implicit or explicit stake of taxpayer in the trading parts of banking groups. The Group’s recommendations regarding separation concern businesses which are considered to represent the riskiest parts of trading activities and where risk positions can change most rapidly” (p. i). This report, like the Vickers one, has been criticized on a number of grounds: There is no predefined ‘resolution regime’, which can wind banks down in the case of a disaster scenario. Banks, even ring-fenced ones, may still be bailed out by governments in a crisis. Such a reform could disrupt the flow of corporate funding in that companies may very well turn away from bank loans to capital markets for bond funding; and ring-fencing trading assets, would limit the liquidity of corporate bond trading, thereby making this form of financing more expensive.

Further proposals that intend to deal with the size of financial institutions come from the IMF. These proposals include for the financial institutions more and higher capital requirements, as well as more liquid assets, along with the adoption of legal regimes that provide for the orderly resolution of failing institutions. Strong and effective supervision, along with political support, is an essential part of any serious and lasting reform of the financial sector. A complement to these regulatory reforms is to tax the financial sector. This would discourage excessive size as well as wholesale financing, two serious problems in the ‘great recession’.

The IMF (2010a) bank tax proposals, for the G20 finance ministers, are relevant in this context and rely heavily on the need for a global approach. They are designed to ensure that financial institutions bear the direct costs of future failures or crises. In this way, future bailouts would be funded by the banks paying the costs of financial and economic rescue packages. These tax plans comprise of: (i) a financial stability tax, in the IMF language a ‘Financial Stability Contribution’ (FSC) tax, which would require banks and other financial institutions to pay a bank levy, initially at a flat rate. This would be later adjusted to reflect risk so that financial sector activities that pose a greater risk would pay a higher rate. This type of tax is designed to fund future government support, and thereby avoid ‘moral hazard’ problems. At a later stage, (ii) a financial activity tax (FAT) is proposed, which is a tax on the sum total of profits and remunerations paid by financial institutions (see, also, Sawyer 2015). The sum would be a kind of Value-Added Tax (VAT), a tax from which financial institutions are currently exempt. So that imposing such a tax could make the tax treatment of the financial sector similar to other sectors. This would deter the financial sector from being too large on purely tax reasons. It would also contain the tendency of the financial sector for excessive risk-taking. Further proposals (IMF 2010b) include higher capital requirements and liquid assets; also the adoption of legal regimes that would provide for the orderly resolution of failing institutions.

It might be, though, that neither ‘too big to fail’ nor taxing the financial institutions should be considered in isolation. They are both necessary and should be treated as such, along with relevant international agreements. In this sense IMF suggest that global financial stability would help in that the reforms should be “nationally relevant and internationally consistent” (IMF 2010b, p. 26). Not likely, though, in view of disagreements among the G20 members.

Objections to this proposal have been raised by the central banks of mainly Australia, Brazil, Canada and Japan, the least affected countries by the ‘great recession’. They argued that taxing banks would reduce in effect their capital thereby making them more, not less, vulnerable to financial crises. Banks have argued that taxing liabilities and transactions to stave off future financial crises carry their own problems. Most important of which is that taxes would not reduce risk in the system; on the contrary, it might increase risk by implicitly building in insurance for bank’s risky behaviour. Another objection is that under such plans the financial sector would not be able to provide the products and services demanded by their customers. Such rules might create a new credit crunch if introduced without full consideration of these possibilities. Requiring banks to hold more capital could actually result in banks providing less lending than otherwise. Banks have, thus, resisted reform, on weak grounds in effect, but with powerful lobbying. And yet substantial and far-reaching reforms are absolutely necessary to avoid another similar crisis.

The 27 member countries of the International Basel Committee on Banking Supervision of the Bank for International Settlements with the Group of Central Bank Governors and Heads of Supervision at their meeting on 12 September 2010 reached an agreement on regulatory issues. Further discussion took place at the first 2011 G20 meeting in Paris (see, for example, BIS 2011). The so-called ‘Basel III Package’ was concerned with bank capital and liquidity standards. The new ruling, phased in from January 2013 with full implementation to be achieved by January 2019, has only dealt with bank capital.

It requires banks to hold equity at 9.5 percent of their Risk-Weighted Assets (RWA); and liquidity standards include a liquidity coverage ratio, which requires banks to meet a 3 percent leverage ratio. The timetable is a victory for the banks, which gives them longer to earn profits to offset against losses accumulated during the ‘Great Recession’ and in the process tax advantages emerge. The new capital ratios are lower than they might have been and also they are not to be fully implemented until 2019. This long phase-in period seems to have been a concession to small banks, especially in Germany. These are the banks that would struggle with the new rules presumably because of undercapitalization. Another problem is that unlike the US Dodd-Frank Act, which provided relevant regulations in the case of banks migrating to the ‘shadow banking’ sector and to the lightly supervised non-bank financial services companies, Basel III does not contain such provision. A further problem concerns the definition of the capital ratio, which is defined in relation to RWA, not to total assets. An implication of this is that toxic leverage is highly probable, when the RWA is a small proportion of total assets; the exposure of the banking sector to risk would be very high under such eventuality.

The IMF in its 2012 Global Financial Stability Report (IMF 2012), argues that Basel III rules would exacerbate the ‘too-big-to-fail’ problem. It is suggested that “Big banking groups with advantages of scale may be better able to absorb the costs of the regulations; as a result, they may become even more prominent in certain markets, making these markets more concentrated”. The IMF (op. cit.) is particularly concerned that banks with large shares of their activity in fixed income, currency and commodity markets would become even more dominant. The IMF also cautions that Basel III rules raise the incentive to develop new products to circumvent the framework. There is also a ‘high chance’ that the framework would push riskier activity into less regulated parts of the financial system. Clearly, then, Basel III has failed to correct the mechanism through which the main cause of the ‘great recession’ emerged.

Radical measures to increase stability and competition in the financial sector have been bypassed. Under such circumstances it should not be surprising for another similar crisis to take place. All in all, and given the key role of Basel III in the global regulatory system, it would appear that financial stability remains unresolved and elusive. What is required is a complete institutional separation of retail banking from investment banking.

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