Banking The Role of Structural Separation Systemic Risk and Financial Regulation Bonn 2015, Lecture 9 MPI Collective Goods Martin Hellwig

The good old time in Banking  Banking crises in the Great Depression – runs, closures and depression  Reform after the Depression: Deposit Insurance and the Glass-Steagall Act in the US  Banking regulation in Europe  Much regulation was dismantled between 1975 and 2000  Should be return to the good old time?

US under Glass-Steagall  Separation of depositary institutions and investment banking  Depository institutions  Commercial banks: demand deposits, commercial loans  Savings institutions: saving deposits, housing loans  Investment banks and brokerage houses  Advice to corporations, IPOs  Trading (speculation)

US under Glass-Steagall, ctd.  McFadden Act: prohibition of interstate banking  Regulation Q: Restrictions on interest rates on deposits  The model of banking

Europe in the stable era  Regulation of interest rates  Rules for lending, quantitative restrictions, specification of customers, privileges to sovereigns  Restrictions on international capital movements  Particularly strong in the southern periphery and the Scandinavian countries  Germany and Switzerland: Mainly cartelization

What changed? Ca in the US! 1980 – 1995 in Europe!  US: High inflation, high nominal interest rates  Introduction of money market funds  Competition for Deposits  Deposit like funding for brokerage houses  1973: End of Bretton Woods, oil price shock  Restrictions on capital movements ended  Recycling of petro dollars

What changed, ca  IT Revolution:  Communication revolution affects competition (e.g. Pagano Roell 1990 on stock markets)  Information processing revolution provides a basis for risk management  Derivatives and risk management  Black-Scholes-Merton 1973  A new line of business  Provides an entry for commercial banks into competition with investment banks

Erosion of Glass-Steagall  Ca. 1980: Depositors run away from S&Ls and to money market funds  Deregulation, but S&Ls are insolvent .... But not closed, gambling for resurrection .... Closed and restructured in 1990s  Mortgage securitization follows

Erosion of Glass-Steagall  Commercial banks also squeezed, move into areas where they compete with investment banks, beginning with derivatives  1999 final dismantling of Glass-Steagall  Comment on derivatives: Inherently unstable: „Natural monopoly“ – high fixed cost (inventing the contract and hedge strategy), low (zero) marginal cost (implementing the contract and strategy) – imitation destroys rents so new contracts and strategies have to be found. „Runious competition“?

Erosion of Glass-Steagall  In competition, commercial banks have funding advantage over investment banks: insured deposits and access to the Fed  Investment banks move into a new line of business, subprime mortgage securitization  In the crisis, investment banks disappear or become bank holding companies

The European side  1980s marked by deregulation of asset allocation rules and interest rates  No longer viable  Preparation for competition in the EU internal market, ... Dismantling of restrictions on capital movements play an important role  The shift towards globalization and investment banking, example UBS

The following slides on structural reform are taken from my testimony at the European Parliament hearing on the European Commission‘s proposals for structural reform along the lines of the Volcker rule requiring a separation of deposit taking and proprietary trading, albeit possibly in separate subdiaries under the same holding.

The Structural Reform Agenda  Structural measures:  size limits,  separation: Glass-Steagall/Volcker, Liikanen, EU legislation,  Ring-fencing: Vickers,  Why? To increase the safety of the financial system and to protect taxpayers!!!???  How? I have yet to see a comprehensive analysis  If we eliminate problems in one place, could they emerge elsewhere?

Flawed Nostalgia  Under Glass-Steagall, the US financial system was safe!!! Really???  From the 1930s to ca. 1960, the system was safe: No big risks (interest rates, exchange rates), lack of competition (Regulation Q)  From 1970 on, the system became unsafe: Interest rate risk, Money Market Fund competition  1980s: Insolvency of S&Ls, due to interest rate risk  1990s: Problems of Commercial Banks, due to specialization and eroding margins... Push into competition with investment banks

Dangerous Illusions  Commercial Banking is risky: Crises of the early 1990s were due to real-estate and SME lending  Credit risk is a much bigger chunk than trading risk (so far)  Depositor protection and the payment system are not the only reasons for systemic concerns  Market making as an infrastructure: Lehman Brothers was a major market maker  Money markets as a major source of funding: The domino effect of Lehman Brothers on Reserve Primary was a major source of chaos in 2008  Lehman Brothers was an investment bank!!!

What matters: Governance  How are funds channeled from final investors to „final“ assets?  Full separation: Investor – MMF – Lehman Brothers – mortgages in warehousing  Full integration: Investor – UBS – UBS Investment Bank – CDOs in own portfolio (as well as MBS in warehousing)  Hybrid system: Investor – Savings Bank – Landesbank – SIV (guaranteed) – CDOs None of these arrangements has provided good governance.

Issues in Governance  Investor protection: What products are being marketed and how? (Pecora: moral hazard in investment bank access to commercial bank customers; German savings banks as sales agencies for Lehmns?)  Due diligence in investment of „surplus“ funds  Professional-investor protection: Is caveat emptor enough when securities are potentially „toxic“?  Are restrictions on activities and investments of depository institutions sufficient? Regulation: By type of institution in which they can invest; what about products?

What matters: Contagion  Risk sharing inside an institution can reduce system effects; in the crises of the early 1990s, universal banks could use profits from derivatives to compensate for losses in SME lending  Risk sharing inside an institution can support moral hazard, e.g., as investment bankers and traders rely on AAA rating of the parent  Should we think of separation into sub-groups as an arrangement that yields risk sharing without moral hazard? This depends on overall group management and group culture

More on contagion  Separation gives a bigger weight to links by contracts as opposed to internal governance: potentially greater number of domino effects but the domino effects are potentially smaller  With separation, the network of contracts may become more intransparent  What are the effects of separation on firesale contagion, i.e. banks holding things and having to write them down when prices decline?

What matters: Resolution  How should separation be designed so that resolution becomes easier?  Issues: Cross-border resolution  Issues: Ring-fencing other systemic activities, e.g. market making Proposed regulation mentions the need to coordinate with resolution authorities but does not say much in terms of substance. What is the standing of intra-group contracts in resolution?