Back to the future in banking

Philip Molyneux*



Banking systems, particularly those in Europe and the U.S, have been subject to major shocks over the preceding decade, including the turmoil of 2007-8 and, in Europe, the more recent euro sovereign debt crisis. The former led to large losses and the failure and closure of many banks. It also forced the intervention of both central banks and governments in domestic banking systems. The scale of government intervention has been unprecedented, for instance in 2008, the European Union authorised some € 3.5 trillion (28% of EU GDP) of guarantees, after then state support shifted to recapitalization of banks and impaired asset relief. In the U.S the range and level of state intervention was similar, characterised by the Troubled Asset Relief Programme (TARP) and a variety of other measures aimed at supporting a collapsed banking system. The euro sovereign debt crisis highlighted the inextricable link between the safety of the banking system and safety of the sovereign – governments that had used taxpayers money to support the banking system faced their own re-financing problems in the bond markets, and banks were major holders of this debt, so exacerbating the problem.

Post the 2007-8 crises, governments in many countries have been striving to recoup taxpayers’ money used to save their respective banking systems. We now know that the domestic and international regulatory frameworks put in place to protect depositors, investors, and financial systems prior to the recent crises were wholly inadequate. Incentives were misaligned, encouraging individuals and institutions to take on excessive risk without proper regard to the consequences. To be fair, with the onset of the crisis, policy action was fast and effective, and a meltdown in banking and financial systems around the world was at least prevented. A common feature of the banks that went bust was that they were over-reliant on market liquidity (via wholesale funding) rather than more traditional and stable retail and corporate deposits. Banks that engaged in mortgage-backed securities suffered most. Risks were miss-priced by banks, credit rating agencies, and investors.

The extent of state intervention has raised concerns about the current business models pursued by banks in many parts of the world. Large-scale banking rescues have also raised policy concerns about the social and economic costs of ‘Too-Big-To-Fail’ (TBTF) or ‘Too-Systemically-Important-To-Fail’ (TSITF). In some cases, bailed-out banks were not particularly large, nevertheless were of systemic importance (via the connectivity to other institutions within the financial system). An important question for policy makers is whether limits should be placed on bank size, growth or concentration, to minimize moral hazard concerns raised by banks having achieved TBTF/TSITF status, and whether the state should play a bigger direct and indirect role in the banking/financial system.

Governments and their respective regulators did move rapidly to close the gaps and weaknesses in the system for bank regulation and supervision. The passing of the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010, the biggest financial reform in the U.S since the Great Depression, is a good reflection of this trend. Similar reforms have been implemented, albeit somewhat later in the UK[1] and the EU[2]. However, in addition to domestic issues, there is on-going policy discussion as to how to improve coordination of international bank regulation with a focus on improving the responsibilities of home and host countries in the event of large (cross-border) bank failures. Opportunities for regulatory arbitrage across national boundaries are being examined with the objective of eliminating regulatory gaps. There are obvious differences of emphasis and approach among governments, and sometimes coordinated policy action is difficult to achieve. However, a trawl through the timeline of recent post-crisis policy events does suggest a strong correlation between U.S, UK and (to some extent) other European policy action, which is unlikely to be purely coincidental. As banks become more international/global, the need to coordinate policy action also is critical.

The credit crisis exposed weaknesses in the current regime for the regulation of bank capital. Under the risk weighted capital regulation regime of Basel II, the use of backward-looking models for risk assessment created a pro-cyclical (destabilizing) tendency for capital provisioning that seemed to amplify the economic cycle. Past regulation overemphasized capital at the expense of liquidity. In the run-up to the crisis, many banks appear to have been operating with dangerously low liquidity. As has become clear, a liquidity crisis can easily trigger a full-blown capital crisis.

Internationally, the Basel Committee on Banking Supervision has set guidelines for new capital and banking regulations – Basel III – that have to be fully implemented by the end of 2019. Basel III aims to strengthen global capital and liquidity regulations to improve the banking sector's ability to absorb shocks and reduce spillover from the financial sector to the real economy. In addition to the above, the Basel Committee has also set tougher requirements regarding the need for additional capital, liquidity, or other supervisory measures to reduce the TBTF externalities associated with systemically important institutions. Various national governments have sought to introduce capital and liquidity rules substantially tougher than Basel III (such as Sweden and Switzerland). Now there appears to be a regulatory race to the top (investors have a stronger preference for very highly capitalised banks, compared to those that are moderately capitalised) – prior to the 2007-8 crisis there appeared to be more of a regulatory race to the bottom (characterised by shadow banking and securitisation)!

There are also worries about how bank business models have evolved. Effective regulation had been limited by a lack of transparency concerning banks’ business models. While the crisis forced banks to provide detailed information on their exposures, information on business models, risk management and valuation practices remained lacking, that is up until the recent stress test environment. Some big banks are rapidly downsizing their investment banking activities (Barclays, Credit Suisse, and UBS) as a consequence. Reform in the market for over-the-counter (OTC) derivatives (predominantly interest rate swaps) and securitised asset markets has involved the set-up of new regulations in both the US and Europe aimed at boosting transparency and pushing much of this activity on more heavily regulated platforms – namely exchanges, trade repositories and so on.

It is against this ever-changing background, that this paper discusses the key contemporary and future role of banks. The paper is setout as follows: Section 2 looks at the role of banks and how they can aid economic advance, whereas Section 3 outlines the unusual structural features of banks highlighting size, complexity and business model issues. Section 4 discusses recent regulatory reforms while Section 5 looks at the role of the government in banking. Section 6 is the conclusion.


1- Role of Banks

Banks play a key role in the economy. They intermediate funds from surplus units (depositors) to borrowers via their asset transformation capabilities. Typically, they take short-term, small denomination; liquid financial assets (deposits) from surplus units (households and firms) and through the intermediation process create longer-term, large denomination and relatively illiquid assets (loans) for borrowers. This activity generates liquidity in the system – depositors can access their funds on demand and borrowers can take out loans when needed. This intermediation activity provides the mechanism for the bulk of small and medium-sized firm’s external financing and therefore, if undertaken efficiently, can aid business investment leading to economic development. Similar arguments can be expounded for consumer finance – particularly in the area of consumer lending and mortgage finance. So banks should facilitate an efficient allocation of resources from surplus to deficit economic units that aids overall investment and consumption. Banks also typically operate the payment mechanism facilitating economic transactions.

Since the late 1970s there has been debate as to what sort of financial system best aids growth – was it one dominated by banks or a system where capital markets were more important. This led to discussion about bank-based and market-based financial systems. In the early years, the general consensus was that former was the preferred type of financial system that best aided growth (mainly because Germany and Japan had bank-based systems and they had performed economically better than the market-based US and UK economies during the 1960s and 1970s). However, this view changed from the mid-to-late 1980s onwards as the political economy of developed economies emphasised pro-market reforms and widespread liberalization, and debate began to focus on the efficacy of financial systems that were more market-based. Anyway, the debate ran its course and the consensus emerged that it did not seem to matter whether an economy had a large banking sector or capital market, what was most important for growth was that there was a sizeable, efficient and competitive financial system overall.

A seminal study by King and Levine (1993)[3] investigated how the features of financial systems in 80 countries, over 1960 to 1989, influenced economic development. They found that growing financial systems (including bank and capital markets) had a positive influence on real GDP per capita (and on the rate of physical capital accumulation). This work spawned an array of (mainly) empirical studies that sought to explain how financial systems drive growth and other features of the development process. The literature finds that financial sector advancement boosts firm productivity and improves the efficiency with which resources are allocated. Companies with better access to finance – either through the banking sector or through financial markets – become more efficient and productive, and it is through this process that economies grow. Other evidence indicates that firms become more innovative and entrepreneurial when the financial system develops – they become more ingenious in formulating business plans in order to raise external finance and this prompts the innovation/entrepreneurial process. External finance can be used by firms to make acquisitions and improve the scale of operations that can also feed through into efficiency and productivity gains. In addition, having a broader based financial system makes the economy less susceptible to financing shocks (if a country has a well-established banking system and stock market, then reduced financing by one part of the system maybe counteracted with increased financing from the other part). There is also evidence that a broader based and well-developed financial system can aid policy formulation. According to an IMF (2012) study, developed financial systems can promote the effectiveness of domestic monetary policy, create a wider base for fiscal policy and can allow for a greater choice of exchange rate regimes.

While there appears to be consensus that a more developed financial sector aids economic growth this influence has been found to be non-linear, or to put another way, the most advanced economies and largest companies benefit least. Financial sector development appears to have its biggest impact in the least developed countries and for smaller firms. There are five reasons that have been put forward to explain this phenomenon:

  • Catch-up to best practice – under-developed economies, characterised with many small firms, may be significantly less productive and efficient than economies with more large and medium-sized firms as in advanced economies. They have much further to go in improving firm and economic performance, so developments in the financial sector (such as access to more banking services, and greater access to capital) has a bigger impact on firm investment and growth in less developed economies.
  • Problems with measuring financial sector development – measures of financial sector development, such as bank credit to GDP, banks assets to GDP and stock market capitalization to GDP maybe too crude to pick up the subtleties of financial sector development particularly in the most developed economies. This maybe increasingly an issue with the emergence of the shadow banking sector, namely, financial institutions (hedge funds, private equity firms, investment companies and so on) that undertake banking style activities – like buying and selling securitized assets – but are not regulated like banks and whose activities are not typically recorded or tracked by regulatory organizations. Estimates of the size of the shadow banking industry vary – in the U.S in 2013 the estimated size of the shadow banking industry is about 50% of the official banking sector assets, although prior to the crises of 2008 it was 120% of banking sector assets. Typically measures of financial sector development do not pick shadow banking activity and its subtle effects up – so the role of finance and its impact maybe understated for developed economies.
  • Corporate sector financing has a bigger impact on growth compared to household finance – there is strong evidence to show that the route through which finance impacts growth is through the corporate sector and particularly for small and medium-sized firms. Typically, lending to households – particularly residential mortgage lending – has been the major component of both the level and growth of commercial bank’s credit portfolios in advanced economies. With a preference for retail/household financial services, this has a muted impact on economic growth compared to corporate lending.
  • Developed financial systems employ talented individuals that could be more productive working elsewhere – this suggests that as financial sectors become much more developed, they tend to offer high pay (like in investment banking) to attract the most talented who would be economically more productive if they worked in other industries. Think of all the engineers, physicists, mathematicians and other scientists working in investment banking! The argument goes that after a certain point, more rapid development of the financial system results in the employment of increasingly unproductive staff.
  • Exploitation of safety net subsidies – as banks become larger there is an incentive for them to exploit safety net subsidies (deposit insurance, lender of last resort facilities, TBTF) that provides protection to banks when they get into financial difficulty. This can incentivise risk-taking. Overall, the incentives to grow and take on too much risk are exacerbated by these safety net benefits. Rapid financial sector development and excessive risk-taking is likely to lead to problems that ultimately reduce growth.

It is important to remember that the mechanisms through which financial sector development can aid economic growth also makes economies more susceptible to shocks. More open financial markets have greater capital flows in and out of the country that can exacerbate volatility in domestic capital markets. A fast-growing banking sector can result in excessive risk taking that may feed through into solvency and liquidity problems. All in all, the more developed the financial system then the greater the chance of having a banking or financial sector crisis that has a big adverse impact on the economy. The main features of the finance and growth/development literature are summarised in Table 1.

>> Table 1 Literature on Finance and Development HERE

Therefore, to cut a long story short – banking and financial sector development can promote economic growth, and this impact is more noticeable if one starts from a relatively under-developed economic situation. Thus, there are clear positives. On the downside, the bigger the banking and financial sector and the more advanced the economy, then the less the banking system aids growth and it can create catastrophic problems when things go wrong! As what occurred in the U.S and Europe in 2007-8.


2. Distorted Banking Systems (or Big Banks - Big Problems)

As just mentioned, there can be serious implications when banking and financial systems become big relative to the size of the economies in which they are based. Figure 1 provides a neat snapshot of the globe adjusting the size of countries according to the scale of their financial systems. As you can see – you get a weird picture!

>> Figure 1 World Drawn According To Size of Country Financial Assets HERE

This picture reflecting the scale of countries financial systems is further illustrated if we consider Europe as shown in Figure 2 which shows that the majority of countries have banking system assets more than double the size of their domestic economies, even some of Europe’s largest banks are bigger than their domestic economies as illustrated in Figure 3 and Table 2. Note that although the largest U.S banks are around the same assets size as their European counterparts, the former are (much) smaller relative to the size of their home economy. Therefore, we have mega-sized banks (particularly in Europe) and this means that banking risks are much more likely to be aligned to sovereign risks here.

>> Figure 2 European Banking Sector Assets/GDP (%) HERE

>> Figure 3 Asset Size of Largest Banks Relative to Domestic GDP (%) HERE

>> Table 2 Europe’s Largest Banks HERE

Banking structures in almost all countries have also become more concentrated with a handful of large banks tending to dominate. According to the World Bank’s Global Financial Development Report (2013)[4] (Fig 3.1, p86) in developed economies the median five-bank assets concentration ratio over 1996 to 2010 stood at around 70%, and it was even higher at 85% for developing economies over the same period. So, banking systems are getting bigger, banks are getting bigger and banking systems are dominated by a handful of players. Size (which is strongly positively correlated with systemic importance) is a major policy concern. In addition to size issues, big banks are also becoming more complex, highlighted by the explosion in the number of subsidiaries they own. According to Avraham et al (2012)[5] the largest U.S bank holding company in 1990 had 1,110 subsidiaries and by the start of 2012 this had increased to nearly 3,500. Goldman Sachs, the fifth biggest U.S bank by assets size in 2011, had 1,114 domestic and 1,670 foreign subsidiaries, and operated in around 60 countries. Since 1990, the number of subsidiaries has grown dramatically for the largest ten US banks, and they operate in many more countries. Their large European counterparts have followed a similar trend. So not only have they become big, they have become more operationally complex – likely too complex! Can such institutions be effectively managed? Is it possible for a smart CEO and Board of Directors to really know what is going on if they are trying to run a business across so many dimensions?

Adding to size and complexity, we can also point to the skewed business model of big banks that emerged in the decade or so up to the 2007-8 crises. The dismantling of Glass-Steagall 1933 by the Gramm-Leach-Bliley Act of 1999 enabled US banks to undertake significantly more securities and investment banking business culminating in the growth of securitisation activity (as well as rapid growth in the shadow banking system). In the EU, member country banks had been allowed to undertake universal banking since the introduction of single market legislation in 1992 (although many, like the German banks) had been practising this for a long time beforehand. Even in Japan, reforms also in 1999 expanded the securities activities of commercial banks. A race began between the world’s largest banks to build global investment banking franchises, as scale seemed to be the key strategy for sustained competitive advantage. So big banks began to dedicate an increasing proportion of their balance sheets to trading and securities related activity to the detriment of traditional lending. See Figure 4. This meant that big banks began to focus less on lending to small and medium-sized business – increasingly viewed as the remit of smaller banks. Lending was regulatory capital costly compared with much securities activity. Moreover, this must have been the case as the big banks internal risk management models and systems were increasingly being used to determine the amount of regulatory capital they were allowed to hold. Basel II sanctioned this – some said it looked like regulatory capture, in the more liberal and competitive environment the big banks were allowed to (if not set) at least cajole the regulators in letting them hold less capital.

>> Figure 4 Distorted Business Models - Assets Available for Trading + Sale / Total Assets (%) HERE

 This move towards a greater emphasis on trading income may help maintain profits, but it is more volatile than revenue from traditional net interest margin sources[6] and there is evidence that cheap liquidity from low-risk traditional banking helped subsidize the more volatile activity. Interestingly there is an extensive literature that highlights agency problems derived from diversification outweigh the benefits from economies of scope[7]. Banks, expanding into trading activities can lose their focus on traditional lending activity and this may encourage managers to be less conservative boosting credit risk. An argument that may well have had resonance during the securitization boom where credit growth expanded rapidly with little monitoring as the risk were sold-on by the banks to investors in the form of mortgage-backed and other asset-backed securities. Brunnermeier et al (2012)[8], find that banks with higher non-interest income (from securities trading, venture capital and investment banking activity) tend to contribute more to systemic risk than those that focus more on traditional commercial banking.

Therefore, during the early 2000s we had big, complex banks, doing more trading, lending less to business, with lower capital (and liquidity) requirements. Increasingly, greater reliance was placed on wholesale funding and securitisation activity to fuel growth. Big banks became increasingly involved in big-ticket commercial loans on investment banking type deals. As Chuck Prince (Citigroup’s CEO) famously told the Financial Times in July 2007 when asked if his bank was still financing leveraged buyouts he said, “As long as the music is playing, you’ve got to get up and dance,” adding, “We’re still dancing.” So far so good, until the crash a year later when Citigroup was bailed out by the US authorities. The music had definitely stopped playing!

Since the 2007-8 crises, there has been much discussion as to what type of bank or business model will yield the safest and most profitable banking system. Liikanen (2012) finds that although different business models (retail v investment banking) were adversely affected by the crisis it seems that the ‘less resilient’ were those that depended more on short-term wholesale funding; excessive leverage; excessive trading/derivative/market activity; poor lending due to aggressive credit growth; and weak corporate governance.

The large scale banking rescues that followed, both in the U.S and Europe raised serious concerns about the social and economic costs of ‘Too-Big-To-Fail’ (TBTF) or ‘Too Systemically Important to Fail’. An important question for policy makers is whether limits should be placed on bank size, growth or concentration, to minimize the moral hazard concerns raised by banks having achieved TBTF or related status. Many of the regulatory or supervisory frameworks for dealing with problems in the financial system were found to be lacking. National approaches to crisis management and depositor protection in Europe were inadequate and had adverse spillover effects. There was also a lack of co-operation and agreement over arrangements for sharing the burden of fiscal costs arising from the crisis. Governments and their respective regulators moved rapidly to close the gaps and weaknesses in the system for bank regulation and supervision. Effective regulation, however, has been constrained by a lack of transparency concerning banks’ business models. While the crisis forced banks to provide detailed information on their exposures, disclosure of business models, risk management and valuation practices remained limited up until recently when authorities have begun to stress-test big banks – the US Fed finished their most recent tests in March 2014 and the ECB is stressing 128 big EU banks under its so-called Asset Quality Review that reports in Fall 2014. Stress testing has become de rigeur for the global regulatory industry. Likewise, the restoration of confidence in over the counter (OTC) markets for securitized assets and credit derivatives has result in regulations (not yet fully implemented) aimed at increasing transparency, reducing complexity and improving oversight. The following section highlights major recent reforms.


3. Regulatory Reform – On, and on, and on…

Big banks focused too heavily on high-risk non-interest revenue generation - particularly through securities trading and investment banking activity – creating unsustainable business models. As such, this led to a series of proposals and legislation aimed at reducing bank risk and minimising the likelihood of taxpayer financed bank bailouts. These include: the passing of the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010 (the biggest financial reform in the U.S since the Great Depression); implementation of the September 2011 Independent Commission on Banking (known as the Vickers Commission after its Chair Sir John Vickers) into the UK’s Banking Act; and recommendations made by October 2012 EU High-level Expert Group on Reforming the Structure of the EU Banking Sector chaired by Erkki Liikanen (otherwise known as the Liikanen Report). In general, the proposals are similar although differ in detail. In the UK, the Vickers Commission proposes to ring-fence retail and various investment banking activities; recommendations of the U.S Dodd Frank Act of 2010 to not allow banks to undertake proprietary trading and limit their hedge fund and private equity activity; and the EU proposal aims to legally separate various ‘risky financial activities from deposit-taking banks within a banking group[9].

However, the reform process is still ongoing in the US with full implementation of Dodd-Frank yet to occur, the recommendations made by Liikanen (plus the EC’s Recovery and Resolution Directive) to yet to be introduced, and recommendation of Vickers yet to be fully incorporated into UK law. Clearly, the legislation at different stages of development and has varying features. The U.S rules stem from a long-standing legal regime and the provisions in Dodd-Frank, are unlikely to be amended. In contrast, the UK White Paper stemming from Vickers lacked details and this has left room for substantial arbitrage especially concerning defining what parts of the business specifically need to be ring-fenced. And it could be argued that the Liikanen Report is even more limited as it is simply advice from a high-level expert group to an EU Commissioner – so far, it’s clear that the tougher recommendations are being watered down.

It is interesting, however, to compare the main recommendations of the Vickers report with Liikanen. The former’s brief was to consider structural and related non-structural reforms to the UK banking sector to promote financial stability and competition. On September 12th, 2011, the Commission published its Final Report that sets out views on reforms stating that:

  • Retail banking activity is to be ring-fenced from wholesale and investment banking.
  • Different arms of the same bank should have separate legal entities with their own boards of directors
  • Systemically important banks and large UK retail banking operations should have a minimum 10% equity to assets ratio; 
  • Contingent capital and debt should be available to improve loss absorbency in the future;
  • Risk management should become a self-contained, less complex business for retail banking, but remain complex for wholesale/investment banking.

The cost of these reforms to the UK economy are estimated to range between £1billion and £3billion per annum, which compares favourably with the estimated annual cost (of £40billion) of lost output that typically follows a financial crises. If adopted the proposed reforms aim to be fully implemented by 2019.

Key recommendations of the EU’s Liikanen Report are:

  • Proprietary trading and other significant trading activities should be assigned to a separate legal entity if the activities to be separated amount to a significant share of a bank’s business.
  • Banks need to draw up and maintain effective and realistic recovery and resolution plans as proposed by the Recovery and Resolution Directive. The resolution authority should request wider separation than considered mandatory above if deemed necessary.
  • Banks should build up a sufficiently large layer of bail-inable debt and such debt should be held outside the banking system.
  • There should be application of more robust risk weights in the determination of minimum capital standards and more consistent treatment of risk in internal models.
  • There should be an augmentation of existing corporate governance reforms by specific measures to i) strengthen boards and management; ii) promote the risk management function; iii) rein in compensation for bank management and staff; iv) improve risk disclosure and v) strengthen sanctioning powers.

If you compare the Vickers, Liikanen and Dodd Frank proposals one can see that all recommend either legal separation or ring-fencing the deposit bank from the investment bank or trading arm with slight variation in detail. All insured banks have to separate deposit and investment banking activity in the US; Liikanen recommends separation only if the activities form a major share of banks activities or pose a systemic stability threat; and the White Paper following Vickers says that ring-fencing should occur only for banks with retail deposits greater than £25 billion. Trading and investment banking activity can be undertaken by a company in the same corporate group as the deposit bank – so long as it does not pose resolution problems (in the case of Vickers and Liikanen), although under the Volcker rule this prohibits propriety trading in any group that contains a deposit bank (and the parent of the bank must be a financial holding company if it is to conduct any investment banking / trading). Deposit banks are also prohibited from an array of securities activities – in the U.S for instance, deposit-taking banks are precluded from investing in most securities and entirely from securities dealing (including market-making) and underwriting. Under Dodd Frank they will also have to move out some derivatives and credit default swap (CDS) activities that are currently done in the deposit-taking bank. In the UK legislation there is a long list of proposed prohibited securities activities (including propriety trading, securities lending, trading, origination, securitisation originated outside the ring-fence and so on) – but these can be conducted if they are regarded as ‘ancillary’ to the main business; Liikanen refers to similar things as well as prohibition of deposit bank’s credit exposure to hedge funds and investments in private equity. The legislation is tougher and more restrictive in the U.S on the (legal) relationships between deposit banks and investment banks in the same corporate entity, and go far beyond large intra group exposure rules (this is because of big U.S corporate finance interest in conflicts and problems that can be caused by things like tunnelling). In contrast Liikanen and Vickers are somewhat vague on these issues – the UK have some tentative proposals relating to reducing intra group guarantees – but it still remains rather unclear. Liikanen asked the BIS and EC to look at this in more detail. The UK and EC proposals (the latter linked to other legislation) both propose detailed bank resolution regimes, whereas Dodd Frank asks banks themselves to develop their own resolution plans (living wills). Also the UK and EC legislation propose the use of bail-in debt whereas this is not the case in the U.S (although Dodd Frank may encourage the Fed to ask the biggest banks –systemically important financial institutions, SIFIs) to hold more contingent capital. On capital requirements the EC (and therefore UK) banks are subject to the Capital Requirements Directive 4 (CRD IV) and Capital Requirements Regulation (of 2011). Liikanen has recommended that more capital should be held against trading book exposures and real estate lending; and the UK White Paper suggests more tier 1 capital needs to be held by systemically important banks, US also has buffers for these.

The problem for banks is that although the broad features of the aforementioned legislation / reform proposals are similar they differ in the detail. There is also not much legal clarity on many of the issues which can stifle developments in the sector and this has even lead to some big banks saying they may have to create 3 separate legal entities (or silos / divisions) to deal with different rules and restrictions going forward. In reality reform has taken place so far although most progress has been unilateral (U.S, UK) – prospects for effective reform at the EU level is slower moving because of the Banking Union and the challenges posed associated with setting up an effective pan-European resolution regime – although a lot is expected to be done by the time Basel III comes into force in 2019.

Before moving on to talk about the role of the state it would be remiss not to briefly mention Europe’s attempt to decouple banking sector and sovereign risk by introducing the European Banking Union (EBU). This was announced in June 2012 when the European Council (2012)[10] outlined proposals to create an EBU, the aim being to help resolve problems in Europe’s financial system as well as to create a more resilient financial system. The proposals had three key elements. First, the responsibility for bank supervision should be at the European level, and common mechanisms should be put in place to second, resolve banks and, thirdly to guarantee customer deposits. The evolution of the European banking union has evolved swiftly and comprises three main pillars:

  • A Single Supervisory Mechanism (SSM);
  • A European resolution scheme;
  • A European deposit insurance scheme.

The first step involves establishing a Single Supervisory System (SSM) with both a European and national dimension. The European level would be given supervisory authority and pre-emptive intervention powers that apply to all banks. Part of the process of moving towards a SSM involves the adoption of new rules on capital regulation (the Capital Requirements Regulation) as well as the fourth Capital Requirements Directive (CRD4). The objective here is to implement a single harmonised supervisory rulebook based on Basel 3, rather than on divergent national arrangements. A major concern of the UK authorities who (along with Sweden) have said they will not participate in the SSM relates to the potential for differential treatment for euro and non-euro member countries. The arrangements are primarily being put in place to protect the 11-euro members banking systems, and the remaining 17 non-euro members are being asked whether they will enter into ‘close cooperation arrangements’ to participate in the SSM.

The second pillar, a European resolution scheme is to be mainly funded by banks and could provide assistance/support in the application of measures to banks overseen by European supervision. The key objective is to provide a mechanism for the orderly shutdown of non-viable banks, so protecting taxpayer bailouts. Features of the proposed resolution scheme are incorporated in the 2012 Recovery and Resolution Directive that (among other things): applies to all credit institutions and most investment firms, including financial groups; requires firms to have ‘living wills’; it will provide for supervisory early intervention powers; specify minimum harmonised resolution tools (including the power to sell businesses to third-parties, to transfer a business to a state-owned bridge institution or bad assets to a publicly owned asset management firm; bail-in debt where debt converts to equity – institutions would be required to hold a minimum amount of ‘bail-enable’ liabilities by January 2018); national member states would have to set-up pre-funded resolution funds; national deposit guarantee schemes would be configured for resolution funding purposes.

Many commentators are sceptical as to whether the EU can establish a credible and effective bank resolution regime. Notwithstanding concerns about different treatment for euro and non-euro members, it is argued that European policymakers and investors have virtually no experience of orderly bank resolution as most bank failures in the past have been dealt with via nationalisation or taxpayer capital injections. Banking systems in Europe are highly concentrated, and even in the U.S, where most of the lessons for bank resolution come from (Prompt Corrective Action and so on) have never ‘orderly resolved’ a major bank – resolution and recovery procedures seem to work for small non-systemic banks, there is no evidence that such actions can be done effectively for big bank failures. Also, insolvency frameworks are fragmented along national lines which suggest also a major reform of such laws if a single resolution scheme in Europe is to be introduced. In principal, an effective resolution regime should reduce banking sector stability and the cost to taxpayers associated with bank rescues, in practice, however, there is little evidence that orderly resolution can be done for major bank failure – sceptics need only point to the failure of the U.S prompt corrective action (PCA) scheme in September 2008 to highlight such limitations.

Finally, the third pillar of the banking union is to establish a European deposit insurance scheme, along with the resolution fund, under a common resolution authority. The argument goes that bank deposits must be seen as just as safe in every EU / or Euro member country, because if capital is mobile, in the event of banking problems deposits will flee to safe havens. This proposal, however, is also controversial as it implies a form of debt mutualisation within the EU or Eurozone whereby deposit protection, say, funded by a member with an orderly banking system would be used to protect depositors in a country with a failing banking system. Despite criticisms, plans for the set-up of the European Banking Union are moving ahead rapidly and by mid-2014 half the measures had been put in place – full union is hoped to commence during 2015 or early 2016.

So, a lot is happening on bank reform, but a whole new parallel array of regulations are being implemented globally to deal with creating more transparency and regulatory oversight in the OTC derivatives markets (dominated by interest rate swaps), to gauge the role of credit rating agencies, to provide more coverage of shadow banking (nearly 30% larger than the conventional US banking system in 2007 – now around 50% the size) and so on. Compliance to the ever changing regulatory environment has become an operational headache and significant cost for the banking and financial sector. Then there is the LIBOR scandal that has already cost big banks around $4 billion in legal settlements to the U.S Department of Justice, EU and UK’s Financial Conduct Authority – and just when it looked like it was over we now have a FX rate rigging scandal being investigated (and there are similar investigation into price rigging an array of other financial and commodity benchmarks) – but we have not got time to go into these! The regulatory saga runs on and on and on.


4.Role of the State

Governments have long been involved directly or indirectly in banking and financial systems. If one looks back even to the early 1980s some of the largest European countries had banking systems dominated by state-owned commercial (particularly in France and Italy where the majority of both of these banking systems were under state control up until the late 1980s). The UK had a state bank (Girobank) that operated through the Post Office (this was sold to a building society in the 1980s), and in Germany the regional Landesbanken and more localised sparkasse (savings banks) all of which have public guarantees, played a major banking role (in fact this is still the case for the local sparkasse in Germany). Even nowadays in the U.S where there is widespread suspicion of the role of the state they have a mortgage finance industry propped up by government sponsored enterprises (GSE’s) – like Freddie Mac, Fannie Mae and so on - that account for over 50% of the residential mortgage market. (The big GSEs – like Citigroup – had to be bailed out by the state in September 2008 too). In many emerging markets also, some of the largest banks are owned by the state, for instance in Brazil government owned banks have increased their assets market share from around 10% in 2001 to some 15% by 2011[11]. And since the crisis and subsequent bank bailouts many European countries have seen an increase in government ownership – even in the UK where the Royal Bank of Scotland is 82% owned by the state (and Lloyds about 26%). All said and done, however, the role of the state has declined in most regions of the world since its peak in the 1970s as shown in Figure 5 – although increases can be seen in Europe and Central Asia between 2002 and 2009 (this is mainly because of government bailouts over failed banks in the 2007-8 crises). Countries in the Middle East, North Africa and South Asia still have significant government ownership of their banking systems.

>> Figure 5 Assets Share of Government Banks / Financial System (%) HERE

Widespread liberalisation and privatisation of many state-owned banks, and the general move to a neo-liberal view that regards state ownership as problematic, however, has resulted in a big fall in government ownership of banking sector assets. It is now timely to reappraise the situation. Recent disasters reminded us that the private sector business model that evolved in banking was not fit for purpose. So the policy re-action has been to heavily re-regulate asking banks to hold more capital, liquidity and generally cutting out the more risky types of their business as well as limit executive pay and change other governance features. But maybe there is an important role that state banks can perform? Large state owned commercial banks can be used to provide a mechanism for support during times of banking sector crisis, can coerce and discipline the behaviour of large privately owned banks, can act as conduit to provide finance (to small firms and other strategic areas) when needed, and they can also help guide market pricing. A strong case can be made for maintaining a major state bank in every banking system. Regulators could use their influence to cajole private banks, or alternatively they could do more to regulate the whole system like public utilities so bank pricing and profitability could be restricted. This should lead to a reduction in excessive risk-taking. Give public recognition that the private sector and market solutions are not the best for big banks (operating in Europe and the U.S at least) there is a case for a greater role of the state in banking systems given that a public/private sector mix appears more optimal.

>> Figure 5 Assets Share of Government Banks / Financial System (%) HERE


5. Conclusions

Global banking systems are in a state of flux being subject to major structural and regulatory reform. In particular, advanced economy systems in Europe and the U.S have been hit by major collapses over 2007 and 2008, and the euro sovereign debt crisis has forced the creation of a new environment for resolving troubled institutions. Banks everywhere have to hold more capital, liquidity, reduce their exposures to risky business and revise their governance structures. There now appears to be race to the top to have safer banks and banking systems – this will constrain their ability to extend credit although it is not crystal clear as how this will play out. We know that finance has less of an impact on economic development the bigger and more advanced the economy – so as most of the new regulations impacts the largest banks in advanced economies it may not have a major adverse influence on growth. However, this begs the question as to what big banks do to benefit the economy overall. Banking systems in advanced economies have evolved into distorted structures, too big, complex with dis-functional business models. They still pose a systemic threat through their size, complexity and the interlocking networks they have with links to other big financial institutions and their shadow banking counterparts. And they still benefit from safety net subsidies that engender moral hazard problems.

Regulatory reform has sought to make banking systems safer and to reduce the likelihood of future taxpayer bailouts. But the issue of size, complexity and skewed business models focusing on trading at the expense of traditional intermediation have not been fully addressed. We still have banks bigger than domestic economies, financial systems much larger than the countries in which they operate and the status quo has barely altered. Given that TBTF/TSITF problems still prevail, maybe more constraints on banking should be considered. Perhaps their returns and pricing should be more heavily regulated by the authorities? There is a case to regard big banks as public utilities and regulate them accordingly. Also the role of government in the banking system should be considered, maintaining a robust state bank (or banks) can provide the economy certain benefits helping to coerce private sector institutions, direct resources to policy important areas and providing support in times of crises. Clearly, the move over the last few decades towards a liberal market based environment has not been optimal – such an environment caused a financial crash last seen in the Great Depression in the U.S. What was the response to the Great Depression crash – well commercial banks were constrained from being universal (Glass Steagall Act of 1933), deposit insurance was introduced (also in 1933), branching restriction, merger controls and a wide array of business activities were proscribed. It took between 50 to 60 years before these constraints were gradually removed. This provides a salutary lesson – reforms being proposed in the U.S and Europe are not as draconian as the aforementioned (which maybe a worry) but at least banks are being somewhat constrained. Throw in the heightened role of the state in many systems and it seems sensible to suggest that a public/private mix for banks may provide a better solution than the liberal privately focused model that has been shown to have serious flaws.





* Dr Philip Molyneux is a Professor of Banking and Finance and Dean of the College of Business, Law, Education and Social Science at Bangor University, Bangor, North Wales, U.K. He presented this paper in the Islamic Ethics and Economy Seminar which was held on 10-12- June 2014 in Doha, Qatar.



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