Reforming the mega banks – two ways to deal with a tsunami

Date published: 25 July 2014
Author: Benoît Lallemand

Benoît Lallemand, co-head of policy analysis at Finance Watch, looks at the case for structural reform of the EU’s largest and most inter-connected banks.

According to the financial lobby, the banking sector has suffered a tsunami of reform. It has faced new rules on capital, liquidity, bank resolution and even a cap on bonuses. If there is any more regulation, we are told, the sector may sink below the waves. If this is true, then the European Commission’s recent proposal on bank structure reform should be blocked or watered down at the earliest opportunity.

Finance Watch does not see it this way. This is not because we want more regulation. We actually want less in quantity, but more in quality. To explain why we think the European Commission’s proposal on bank structure reform is so important, let us return to the image of the tsunami.

Tsunami-Hazard-Zone-web

At the peak of the financial crisis in autumn 2008, a different tsunami, made up of major bank losses, was rolling through the financial system and hitting coastline villages - citizens - in what became the worst financial shock in nearly a century. This shock cost taxpayers €1,600 billion to rescue banks and also resulted in what economists have called ‘the Great Recession’, with public debt and unemployment (of youth in particular) soaring in most European countries. Since the crisis, the number of jobless has increased by two million in Spain alone. In Greece, more than 60% of the young people between 15 and 24 are currently unemployed.

The approach taken by the G20 was to ensure that the next tsunami would not harm coastal villages. For that, they decided to build or strengthen embankments to absorb any future the waves/losses.

There are three such embankments in the regulators’ plan:

  • The first, bank capital, is covered by the Basel III rules (CRD IV/CRR in the EU). A bank’s providers of capital (shareholders) are the first to be “wiped out” by the wave, when the value of their shares is written down to absorb losses. Capital requirements have doubled since the crisis but are still a fraction of the level that many commentators and regulators believe to be necessary. In a nutshell, the embankment is far too small. It also has significant weaknesses, some of which are recognized by the Basel Committee itself (which was responsible for developing the Basel III rules). These include that banks use their own internal risk models to calculate their capital requirements, with major discrepancies in the final outcome, and sometimes lower levels of capital than would have been required with a standardized risk model.
  • The second ‘embankment’ is creditors, who absorb losses after the shareholders have been wiped out. Here, the Bank Recovery and Resolution Directive (BRRD) and the Single Resolution Mechanism (SRM) for countries participating in the Banking Union include ‘bail-in’ provisions that aim to make creditors take their share of losses. The main weakness of this second line of defence is that, currently, too-big-to-fail banks are also very much interconnected, so if creditors of one bank have to take a large loss as the ‘bail-in’ mechanism takes effect, it could spread quickly through the whole system of megabanks. As long as these risks of contagion exist, we think the threat of a “domino effect” makes it unlikely that a significant bail-in of creditors would be implemented in a systemic crisis.
  • The third line of defence is a single resolution fund (SRF) introduced under the Banking Union and based on contributions by banks. It will be up to €55 billion in size within eight years. We only need to compare it with the €1,600 billion that was required from taxpayers following the crisis of 2008 to understand that this fund will be of little use should a major bank – or banks – go under.

These embankments are too small to protect us from a future tsunami. Something else is needed. To extend the metaphor, let us imagine that the source of these tsunamis is a chain of giant underwater volcanos (representing too-big-to-fail megabanks) whose periodic eruptions cause damage far and wide.

Experts (the IMF, ECB, OECD, FSB, academics…) agree that the giant underwater volcanos are still present, are still too big, and are still too close to the coast. And the question is not whether there will there be another eruption, but when. Corporations (including banks) suffer losses or even fail; that’s how our economy works. The question is whether these losses and bankruptcies are bearable. In other words, is the economy able to withstand the next eruptions when they occur? Is there a way to make the eruptions smaller and less devastating?

The missing part of the ‘coastal defences’ is thus a reform that would scale back the giant volcanoes so that future eruptions are rare and, when they occur, are of the smallest size possible. Since megabanks means mega eruptions, the same experts agree that structural reform of too-big-to-fail megabanks would greatly reduce the distorting incentives that stimulated these giant underwater volcanoes to form in the first place. The major incentive comes from the implicit subsidy that provides cheap funding for banks’ trading arms and makes them grow bigger and bigger.

Of course, it is not possible to change the structure of real volcanoes but it should be possible to change the structure of banks. Right?

 

Scenario 1:     The financial lobby kills the proposal

Let us now imagine the following scenario. There will be no reform of the structure of megabanks, they remain too-big-and too-interconnected-to-be-allowed-to-fail, too-complex-to-manage, supervise and resolve. The European Commission’s bank structure proposal is scrapped or drastically watered down.

The main reason is that financial reform is not an intellectual, technical debate, but a power struggle. Six years after the financial crisis, the financial lobby is stronger than ever. It employs more than 1,700 lobbyists in Brussels alone. That’s almost one for every billion euros of public money used to rescue banks after the last crisis! The picture is similar in other key political capitals like Washington and London.

In this scenario, the lobbyists for these megabanks will argue that reforming their structure would impede the ability of Europe’s economy to recover from recession – never minding that it was these very banks that put us in that recession! They will tell you that structural reform – breaking up the too-big-to-fail banks – would cause business lending to fall, would lead to job losses, and would reduce EU banks’ competitiveness vis-à-vis large US banks.

They will insist that their main mission is to support the economy and society, despite the fact that more than half of their assets have no connection to the real economy (only 12% of EU bank balance sheets represent lending to non-financial corporations and 16% lending to households, see Liikanen report, table A1.3).

Small and medium-sized banks, including those with alternative business models, will side with their bigger sisters, convinced by them and the trade bodies they share that structural reform is bad for the whole sector.

Policymakers will succumb to what Simon Johnson, ex-IMF, now Massachusetts Institute of Technology (MIT), calls ‘the fear factor’: they are so afraid that their economies might go into recession (already facing sluggish or at best tepid growth) that they surrender to the financial lobby’s claims that regulations will damage banks’ ability to fulfil their basic functions, especially their capacity to lend to the real economy. Despite the wealth of evidence showing that this argument does not hold, policymakers will fall victim to this fear and lack the courage to impose reforms.

Another human factor is at play: we mostly dislike change and sometimes find it easier to buckle down and tolerate a bad situation knowing it will become someone else’s problem in the future, rather than to stand up for change.

In this scenario, there will be no reform as some of the largest EU member states will aggressively defend their national champion banks and act as the mouthpiece for the banking sector, opposing reform. The April 2014 ECOFIN meeting between the European finance ministers sent a pretty clear message in this regard – making it difficult to distinguish between the arguments of the banking lobby and some of Europe’s finance ministries.

There will be no reform because corporations, trade unions and consumers, influenced by the ‘fear factor’ just mentioned, will not actively support the proposal – even though they are the first to suffer from the current situation. There will be no reform because civil society will shy away from a technically complex topic, failing to engage the broad audience needed to ensure that elected officials drive through real change.

I am afraid this scenario is unfolding before our eyes as we speak. And at the end are the major losses that will echo the tsunamis we experienced only a few years ago.

 

Scenario 2:     Public interest prevails: banks are separated!

There is another scenario. In this one, the European Commission’s proposal on bank structure will be strengthened and adopted. The structure of megabanks will be reformed to separate investment banking (including market making) from deposit taking, and society will benefit from less financial risk and more productive economies.

At the heart of banks’ opposition to structural reform is their (understandable) desire to hang on to the valuable implicit subsidy that banks receive from being too-big or too-interconnected-to-fail. This is estimated in the European Commission’s Impact Assessment to be worth between €59 billion and €96 billion a year in cheaper funding for large EU banks (between one-third and one-half of the banks’ profits), and by the IMF at between €90 billion and €300 billion a year.

That’s quite a powerful motivation to resist change but, in this scenario, there will nevertheless be structural reform of banks because public interest will prevail over the interests of the financial sector.

Policymakers will abandon their belief, held over the last 25 years of deregulation, that whatever is good for the financial sector is automatically good for the economy and society. They know that reducing the size of this implicit subsidy will also remove a big distortion from our market economy, which would become healthier and more productive as a result. Politicians will overcome their fear of change and confront the special interest lobbying of banks.

Co-operative banks and savings banks, which are mostly outside the European Commission’s reform proposal, will see how structural reform of their bigger sisters could make them more competitive and will stand behind the proposal. Small and medium-sized banks will speak out against too-big-to-fail banking in the hope of restoring a level playing field, calling for fair competition, a more balanced banking landscape and lower barriers to entry.

Large corporations will celebrate the end of conflicts of interest inside the banks that serve them, and small and medium-sized enterprises will welcome an increase in lending as banks’ deposit funding is no longer diverted to support investment banking. Non-bank business lobbies will back smaller banks, knowing that an outsize financial sector has only increased the cost of financial services over the years, instead of reducing it.

Unions will support the proposal because it will help to create sustainable, high-quality jobs. They know that growth and employment are negatively affected by excessive development of the financial system – a threshold that has been reached in all developed countries.

Investors will support more diversity in the banking sector as it will enable them to spread their risk and choose between higher and lower risk banks in which to invest. They do not want unsustainably high returns on bank equity followed by big losses in a crash, or banks that starve the real economy in which they invest. So they will exert pressure on the too-big-to-fail banks that they have invested in to demerge and break themselves up into more manageable entities.

Civil society will make its voice heard, making the connection between financial reform and the many relevant, urgent causes that people care about (fighting climate change, reducing inequalities, creating a sustainable and inclusive economy, etc.). To address all these causes, we need sustainable and stable financing. Supervisors will welcome clear, simple, supervisable bank structures that are subject to market discipline.

In this scenario, there will be a separation because banks, businesses, investors, unions, consumers, civil society and supervisors will all profit from a banking system that is capable of serving society better.

Conclusion

I don’t need to tell you which scenario we prefer. Unfortunately however it is not going to happen unless everyone plays their part. Let’s act together to Change Finance and ensure that public interest prevails.

 

Further reading:

 

Image:

Add comment