What can be achieved by structural reform in banking Brussels, December 2, 2014 MPI Collective Goods Martin Hellwig

Structural Reform: Why?  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?