Abstract
After the 2008 Financial Meltdown, the need to reconsider the separation between commercial banking and other financial risky activities—ring fencing—in order to mitigate systemic risks and to address the too big to fail problems was publicly recognized both in the USA and in Europe. In spite of this widespread demand for structural banking regulation reform, the ring-fencing proposals—the Volcker Rule in the USA Dodd-Frank Act, the Vickers Report in the UK, the Liikanen Report in the European Union—are still in their infancy. How to explain the difficulties in enacting structural banking regulation? This article shows how the path of the banking reforms can be analysed, highlighting the potential role of the public demand for a safe and sound banking system on the one side and the possible influence of the banking lobbies towards soft and light touch rules on the other side. The final outcome is represented by three different stories of how difficult is to reintroduce ring-fencing regulation in the Western countries.
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Notes
The final version of Basel III capital rules was published in June 2011, while revised liquidity rules were issued in January 2013.
Retail banking encompasses the provision of banking services—primarily, deposit taking, payment services and lending—to individuals and small and medium-sized organizations (SMEs). Cf. Independent Commission on Banking, 2011, Glossary.
Proprietary trading activities involve trading in financial products undertaken by a bank on its own account (i.e. unrelated to customer needs).
The principal activities of wholesale and investment banks are the provision of wholesale lending to large companies (wholesale banking), assistance—including underwriting—to corporations in raising equity and debt finance, advice in relation to mergers and acquisitions, market making and acting as counterparty to client trades (investment banking). Investment banks may also engage in proprietary trading but, unlike retail banks and commercial banks, they do not usually take deposits (Cf. Independent Commission on Banking, 2011, Glossary).
For the sake of simplicity, hereinafter all the proposals and reforms aimed to isolate core banking activities will be generally referred to as ‘ring-fencing’ proposals and reforms.
In the strict sense, commercial banking involves the provision of banking services (particularly, deposit taking, payment services and lending) to companies. It is worth noting that banking services provided to SMEs are normally included in retail banking, while banking services for large corporations pertain, to some extent, to wholesale and investment banking (Cf. Independent Commission on Banking, 2011, Glossary). For the sake of simplicity, in this work, the expressions ‘commercial banks’ and ‘commercial banking’ (as opposed to ‘investment banks’ and ‘investment banking’) will relate to banking services provided both to individuals and companies. The expressions ‘retail banks’ and ‘retail banking’ will also be used to indicate, sensu stricto, banking services for retail customers (i.e. individuals and SMEs).
Cf. Whitehead ( 2011, pp. 41–43).
Schwarcz ( 2013, p. 98).
A universal bank may be defined as a bank or banking group that undertakes a combination of retail, commercial, wholesale and investment banking activities.
The adopted political economy view has been introduced and formally developed in Masciandaro (2009).
Specifically, Sects. 16, 20, 21, and 32.
Kelly (1985, p. 41). The Glass bill actually consisted of a comprehensive reform proposal of the whole banking system as, in addition to the divorce between commercial and investment banking, it encompassed provisions regarding, for instance, the structure and powers of the Federal Reserve System, changes in branch banking, and interests on deposits.
Wilmarth Jr (2005, p. 568).
President Hoover and his advisers for long believed that short-term assistance measures, such as temporary support from the Reconstruction Finance Corporation (RFC) or loans through the Federal Reserve banks, were sufficient to secure bank recovery (Kennedy 1973, pp. 53, 74).
Id., p. 204.
The Banking Act of 1933 was actually the result of a compromise, joining together two different legislative projects: bank deposit guarantee was long opposed by Glass and championed by Representative Steagall (Id., pp. 52, 214, 220), who agreed to support the Glass bill after an amendment was added leading to the establishment of the Federal Deposit Insurance Corporation (FDIC). In this sense, Glass was the primary force behind the divorce between commercial and investment banking (Id., p. 223).
Id., p. 204. Eleven days later, the Banking and Currency Committee named a subcommittee, chaired by Glass himself, to consider the bill. By April 7, the subcommittee had a draft which essentially followed the lines of the old Glass bill (Ibid.).
In February 1932, President Hoover had entrusted the Senate Banking and Commerce Committee with an investigation on stock exchange market practices. In January 1933, Ferninand Pecora was chosen as the new counsel of the Committee. The hearings, which were conducted by Pecora in a sensational manner, decisively contributed to trigger public outrage, especially towards bank securities affiliates. Pecora Investigation particularly targeted New York’s National City Bank and its securities affiliate, National City Company (for a description of the investigation, Kennedy 1973, pp. 108–128).
Wilmarth Jr ( 2005, p. 568).
Kennedy (1973, pp. 214–220). According to commentators, President Roosevelt, who approved the Glass bill in general terms but opposed deposit insurance, finally recognized that the bill was the best response then available.
Notwithstanding the general prohibition, member banks were: (1) allowed to purchase investment securities (i.e. marketable obligations) for their own account under the limitations and restrictions prescribed by the Comptroller of the Currency; (2) expressly authorized to deal in, underwrite and purchase for their own account eligible securities (i.e. federal, state and local securities) without quantitative limitations; (3) allowed to purchase and sell investment securities on behalf of customers (security brokerage).
The notion of affiliation was defined by Sect. 2(b) of the Act in terms of interlocks or control of the majority of the votes for the election of the directors of the affiliate.
That is, the issue, flotation, underwriting, public sale or distribution of securities. The importance of the expression ‘engaged principally’ was specifically understood in the late 1980 s, when the Federal Reserve Board was required to delimit the scope of permissible activities under Sect. 20 (infra, par. 2.3).
White (1986, pp. 34–35). In the 1920s, many firms shifted their source of finance from bank loans to bond and stock issues. As the demand for loans stagnated, commercial banks responded by modifying their methods of intermediation for corporate clients and thus entered the securities business (Ibid.).
Complementarities between financial services were possible as commercial banks could rely on a network of branches and a large number of depositors, each of whom could invest small sums in the securities business (Id., p. 36).
In 1922, only 10 national banks operated securities affiliates, and another 62 were directly engaged in the securities business. Conversely, by 1929, there were 84 national banks operating securities affiliates and another 151 directly engaged in the securities business. A similar increase was also observed for state banks (Peach 1941, p. 83).
Wilmarth Jr. (2005, pp. 568–569).
Id., pp. 560 and 593.
Cf. Section 4 of the Banking Act of 1956 (‘Interests in nonbanking organizations’).
Leach (2000, p. 683). For this reason, in 1935, Glass unsuccessfully attempted to partially repeal the prohibition on commercial banks underwriting corporate securities established by Sect. 16 of the GSA. Nonetheless, Glass’s proposal was rejected by the Roosevelt Administration (Wilmarth Jr 2005, pp. 590–591): President Roosevelt opposed the change, warning that ‘the old abuses would come back if underwriting were restored in any shape, manner, or form.’.
In the 1970s, commercial banks, which had long played an important role in the brokerage services of non-corporate securities (for instance, treasury securities), began to assist investors also in purchasing and selling corporate securities (Rowen 1979, pp. 310–314). The move into the business of discount brokerage services was facilitated after the deregulation of stock brokerage commission rates in 1975 (White 2010, p. 940).
The involvement of commercial banks in investment banking specifically concerned three areas: investment and advisory activities; plans involving the sale of stock; corporate finance services (Rowen 1979, pp. 310–311).
White (2010, p. 940).
As such, this trend bears some similarities with the one that occurred in the 1920 s, before the stock market crash of 1929 (supra, p. 9).
The development of mortgage securitization was triggered by the creation of the Government National Mortgage Association (Ginnie Mae), whose mandate was to foster housing for low and moderate income families using government guaranteed mortgage-related securities. Throughout the 1970 s and 1980 s, mortgage securitization expanded as the result of the activities of two government-sponsored entities (so-called GSEs), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).
In the 1970s, money market funds developed as the profitability of bank and thrift deposits were limited by regulatory caps on interests (White 2010, pp. 940–941). The money market funds industry continued to grow also in the early 1980 s, although restrictions on bank deposit interests had been removed (Ibid.).
Suárez and Kolodny (2010, pp. 14–15), recall that traditional bank customers were attracted by new investment opportunities, as they found higher returns in mutual funds and money market accounts. Similarly, borrowers could obtain loans from other sources, such as bonds and commercial papers, as an alternative to lending from banks (Wilmarth Jr 2002, pp. 231–232).
Suárez and Kolodny (2010, p. 20). A clear example of these contrasting interests concerned revenue bond underwriting: in 1978, the American Bankers Association (ABA) disclosed a program that included amending the GSA in order to allow banks to underwrite revenue bonds. While the banking community argued that the amendment would reduce costs for municipalities in issuing revenue bonds, the securities industry opposed pointing to potential conflicts of interest and concentration of economic power (Rowen 1979, pp. 313–314).
Orders Issued Under Sect. 4 of the Bank Holding Company Act, Citicorp, J.P. Morgan & Co. Incorporated, Bankers Trust New York Corporation, Order Approving Applications to Engage in Limited Underwriting and Dealing in Certain Securities, 73 Fed. Res. Bull. 473, 485 (1987).
Namely, municipal revenue bonds, mortgage-related securities, consumer-receivable-related securities (i.e. obligations secured by or representing an interest in loans or receivables of a type generally made to or due from consumers), and commercial papers.
This interpretation was particularly favourable to commercial banks, especially if one considers the treatment of eligible securities (that is, US government securities and general obligation municipal bonds that both member banks and their affiliates were expressly allowed to deal in under Sect. 16 of the GSA). Indeed, according to the Board, eligible securities were not included in the numerator for the calculation of the relevant 5 % threshold, although they would count in the denominator of the same fraction: as a result, the more bank-eligible securities a Sect. 20 subsidiary underwrote, the more bank-ineligible securities, it was permitted to underwrite (Macey 2000, p. 718). With this regard, it is worth noting that the 1987 Order was not approved by Chairman Paul Volcker and Governor Wayne Angell: in their dissenting statement, Volcker and Angell observed that, as US government securities were actually to be considered ‘securities’ within the meaning of Sect. 20, the Order would enable affiliations between member banks and corporations, which were possibly not only ‘principally engaged’ but also wholly engaged in dealing and underwriting activities.
The Order was issued following the application of five bank holding companies (namely, J.P. Morgan & Co., The Chase Manhattan Corp., Bankers Trust New York Corp., Citicorp, and Securities Pacific Corp). The Board justified its decision considering that bank holding companies were ‘well equipped to provide the proposed new services’ thanks to their existing expertise in securities activities and their broad financial skill. The applicants were also allowed to underwrite and deal in all debt and equity securities.
The Board justified its decision as it was found that, due to market conditions, interest rate changes had reduced the revenue earned by Sect. 20 subsidiaries from holding eligible securities in relation to ineligible revenue, even as the relative proportion of eligible and ineligible securities activities held by subsidiaries had not changed.
Macey (2000, p. 717).
Suárez and Kolodny (2010, p. 16).
Id., p. 719.
Wilmarth Jr (2002, p. 221).
Wilmarth Jr (2014, p. 71). It is no coincidence that the chairmen of Citigroup and Travelers successfully consulted with Federal Reserve Board Chairman Alan Greenspan, Treasury Secretary Robert Rubin, and President Bill Clinton before the announcement of the merger (Id., p. 74).
Id., p. 70.
Id., p. 71.
H.R. 18, ‘Financial Services Competitiveness Act’.
H.R. 10, ‘Financial Services Modernization Act’.
Leach (2000, p. 684).
As a result, the GLBA eliminated altogether the above-mentioned revenue limitations to bank-ineligible securities established for bank affiliates. Conversely, the GLBA did not repeal Sects. 16 and 21 of the GSA: member banks were still prohibited from directly providing a full scale of securities activities, while securities firms were still banned from taking deposits.
As a result of the GLBA, a BHC can apply to become a FHC if specific statutory requirements are met: particularly, all the depository institutions of the BHC are requested to be ‘well capitalized’ and ‘well managed’ and have satisfactory ratings under the Community Reinvestment Act (CRA) of 1977. Section 606 of the Dodd-Frank Act of 2010 added a new standard to these requirements, as it established that also the BHC itself must be well capitalized and well managed.
Macey (2000, pp. 715–719). Other factors that contributed to the repeal of the GSA in 1999 were: (a) the increasing importance of academic literature, providing empirical evidence against the need for such restrictions (Cf. White 1986; Kroszner and Rajan 1994); (b) technological development which fostered cost reduction, thus raising the profitability of cross-selling banking, securities and insurance products (Barth et al. 2000).
As mentioned, Paul Volcker was the former chairman of the Federal Reserve Board. Bill Donaldson was previously the head of the Securities and Exchange Commission (SEC).
The President’s Economic Recovery Advisory Board (PERAB) was a panel of non-governmental experts, chaired by Paul Volcker, which was created on 6 February 2009 by President Obama to ensure independent analysis and advice in view of the implementation of his plans for economic recovery and enhanced competitiveness.
Specifically, Sect. 619 of the Dodd-Frank Act amended the BHCA of 1956 by adding a new Sect. 13.
For the purpose of the new Sect. 13, the term ‘banking entity’ means any insured deposit institution, any company controlling insured banks, and their affiliates or subsidiaries.
Proprietary trading as referred to by new Sect. 13 means own account trading with regard to any transaction ‘to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative, or contract, or any other security or financial instrument that the appropriate Federal banking agencies, the Securities and Exchange Commission, and the Commodity Futures Trading Commission may, by rule as provided in subsection (b)(2), determine’. On 10 December 2013, the interagency final rules implementing Sect. 619 were finally issued, providing key definitions and identifying specific characteristics of prohibited and permitted activities and investments as provided by the Dodd-Frank Act. These rules have become effective on 1 April 2014.
That is, acquiring or retaining any equity, partnership or other ownership interest in or sponsoring a hedge fund or a private equity fund.
In the ICB Report, the word ‘bank’ is used with a broad meaning, encompassing all types of deposit takers.
According to the ICB, a proposal based on a set of principles, as such not specified in terms of the products in existence at the time of reform, would help keep pace with financial innovation.
Incidentally, ancillary services would encompass the activities that are necessary to the effective provision of non-prohibited services (for instance, hedging activities): ring-fenced entities might perform ancillary activities on condition that they do not become standalone businesses.
The ICB identified mandated services on the basis of two criteria: (1) even a temporary interruption to the provision of the service, resulting from the failure of a bank, would have a significant economic costs, and (2) customers would be not well equipped to plan for such an interruption.
Prohibited services were thus identified considering whether they would make it harder and/or more costly to resolve ring-fenced banks, increase the exposure to global financial markets, involve the ring-fenced bank taking risks and be not integral to the provision of payment services or to the direct intermediation between savers and borrowers within the non-financial sector, or in any other way threaten the purpose of the ring fence.
For example, the ICB considered that many large companies do not multi-bank: hence, corporate customers of a ring-fence bank would suffer significantly from disruption to their deposit services. A similar reasoning would apply to growing businesses—that is, SMEs that would otherwise be forced outside the fence as they become large companies.
The ICB considered that, without such a ban, otherwise prohibited services would be founded by means of loans made by ring-fenced banks to financial organizations. Accordingly, ring-fenced banks would be permitted to provide only payment services to non-ring-fenced banks or financial institutions, on condition that this would not represent a form of lending.
Likewise, ring-fenced banks would be permitted to offer some products so as to help their clients to manage risk, on condition that this does not give rise to market risk exposures for the bank itself.
Accordingly, a ring-fenced body is defined as a UK institution, which carries out one or more ‘core activities’.
In specified circumstances, the Treasury may anyhow allow ring-fenced bodies to deal in investments as principal if this would not be likely to result in any significant adverse effect on the continuity of the provision of core services.
Cf. the Financial Services and Markets Act 2000 (Ring-fenced Bodies and Core Activities) Order 2014. Particularly, the Order provides a de minimis exemption from the definition of ring-fenced body for banks, which hold less than £25 billion core deposits.
Cf. the Financial Services and Markets Act 2000 (Excluded Activities and Prohibitions) Order 2014. The Order defines the circumstances in which ring-fenced bodies will be able to deal with investments as principal by providing for some exceptions (specifically, management by the ring-fenced body of its own risks or of its liquid assets or the provision of derivatives to its clients). The Order also imposes prohibitions on ring-fenced bodies, limiting the use of services provided through an inter-bank payment system, restricting the exposures to financial institutions and ensuring that a ring-fenced body may not have a subsidiary or branch in any country outside the EEA.The Order also identifies an additional excluded activity (i.e. commodities trading).
The BRA identifies four relevant conditions (from A to D) for the application of these powers. Condition D is the most general one, as it establishes that the regulator may exercise group restructuring powers if the conduct of the ring-fenced bank or another group member conduct is having or is likely to have an adverse effect on regulatory objectives. The other three conditions recall the purposes of the aforementioned ‘group ring-fencing rules’: (A) the carrying on of core activities by the ring-fenced bank is being adversely affected by the conduct of other group members; (B) the ring-fenced bank is unable to take decisions independently or depends on resources provided by another group member, which would cease to be available in the event of the insolvency of the other member; (C) in the event of the insolvency of one or more of other group members, the ring-fenced bank would be unable to carry on the core activities. Separation is achieved by requiring the divestment of specified property (including shareholdings in the ring-fenced body, or any other member of the group) or applying to the court for approval of a ring-fencing transfer scheme relating to the transfer of the whole or part of the business to an outside person.
The other four recommendations concerned recovery and resolution plans (RPPs), bail-in instruments, risk weights and the treatment of risk in internal models and specific measures of corporate governance.
According to the Liikanen Report, the proposed separation would concern both proprietary trading and market making, thus avoiding the ‘ambiguity’ of defining separately the two activities. From this point of view, the EU proposal marked a difference with the Volcker Rule, which allows bank entities to engage also in market making.
The Liikanen Report suggested that the proposed separation should be mandatory only if the activities to be separated amounted to a significant share of a bank’s business or if the volume of these activities could be considered significant from the viewpoint of financial stability. In any case, the smallest banks would be considered to be fully excluded from the separation requirement.
89 responses to the consultation were received. The largest number of responses came from banks (38), followed by other financial institutions, retail customers, corporate customers and public authorities.
Proposal for a Regulation of the European Parliament and of the Council on structural measures improving the resilience of EU credit institutions, COM (2014) 43 final.
Carr et al. (2014, p. 1).
Art. 3 of the proposed Regulation. The relevant thresholds are: a) the bank's total assets exceed €30 billion; and b) the bank's total trading assets and liabilities exceed €70 billion or 10 % of their total assets.
Carr et al. (2014, p. 4).
Art. 6(1).
Art. 5(4). Some significant exceptions are established, as the general prohibition does not refer to (i) buying and selling money market instruments for the purpose of cash management; (ii) trading in Union government bonds (art. 6(2)).
An exemption is provided for unleveraged and closed-ended AIFs, European Venture Capital Funds (EuVECA), European Social Entrepreneurship Funds (EuSEF) and European Long Term Investment Funds (ELTIF), considering their importance in financing the real economy.
Art. 9(1).
Explanation Memorandum to the proposed Regulation, par. 3.3.4.2.
Art. 8. In any case, Union sovereign bonds are exempted from the obligation to review and power to separate.
Art. 9, which also entrusts the European Banking Authority (EBA) with developing a binding implementing technical standard to be adopted by the Commission to ensure that these metrics are consistently measured and applied.
The EBA shall be consulted prior to adopting any decision and notified the final measures. Decisions requiring a bank not to carry out relevant trading activities will be subject to review by the competent authority every 5 years.
Art. 18. The trading entity is obviously prohibited from providing payment services and taking deposits eligible for deposit insurance (Art. 20).
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The authors gratefully acknowledge financial support from the Baffi Centre of the Bocconi University.
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Masciandaro, D., Suardi, M. Public interest and lobbies in reforming banking regulation: three tales of ring fencing. Int Rev Econ 61, 305–328 (2014). https://doi.org/10.1007/s12232-014-0217-5
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DOI: https://doi.org/10.1007/s12232-014-0217-5