What banks actually do

As the financial storm recedes the full cost of the damage is being assessed. According to Financial Market Trends, from the start of the crisis to October 2009 governments and central banks in the US and Europe had provided over $11 trillion in support to banks and other financial firms, made up of capital injections, asset purchases, debt guarantees and facilities, and so on. This total does not take account of other wider social and economic costs incurred by way of losses in business, jobs and other fallout from the crisis. Still, as a Dow Jones journalist pointed out in seeing the figures, it amounts to a contribution of over $1,600 for every person on the planet. The question is: are policymakers doing enough to tackle the root of the problem and prevent the worst crisis in 50 years from happening again?

The authors of one paper in Financial Market Trends would like to see more attention being paid to underlying structures. Indeed, the OECD has argued for structural separation of commercial and investment banking functions for 18 months, in numerous publications including the material submitted by the secretary-general to the London G20 summit. Previous papers and books have set out the best legal structure to achieve separation. This latest piece explains why separation is an essential complement to a leverage ratio in the case of large (too-big-to-fail) conglomerates. Since its publication, the Obama administration has come out with a similar idea–for structural separation–referred to as the Volcker plan. The political ground is shifting in the direction of the separation approach, though for the OECD authors, more governments need to act.

“The world outside of policy making is waiting for a fundamental reassessment of what banks are supposed to do and how they compete with each other. It is the ‘elephant in the room’ on which some policy makers have not yet had the time or inclination to focus.”

They cite a well-respected fund manager, writing in a quarterly letter to clients, who was worried that “by working to mitigate the pain of the next catastrophe, we allow ourselves to downplay the real causes of the disaster and thereby invite another one.”

Is there a solution? Is there a better way to prevent volatile investment banking functions from affecting the future stability of the commercial banking and financial intermediation environment that underpin economic activity?

The authors believe there is, via rules on leverage and on the structures of large conglomerates. They point to examples such as Santander, a bank that fully participates in commercial banking and the structuring of products, but in a well-balanced and risk-controlled way. By looking at banking structures and how banks compete, both in the too-big-to-fail category of banks and financial firms on the one hand, and in the hundreds of small regional banks focused on mortgages that have failed and are being merged or closed on the other, the authors describe how the “equity culture” in banking dominated the “credit culture” in what firms actually do.

They assess in detail a range of possible reforms in accounting, corporate governance, and capital adequacy rules, though none of these get to the heart of what banks actually do and so would probably not be enough to prevent a crisis from recurring. The authors recommend combining a leverage ratio to reduce risk at group level with new non-operating holding company structures to reduce contagion. Such a structure allows separation as far as prudential risk and the use of capital are concerned while still permitting synergies and economies of scale. Basically, the non-operating parent could raise capital on the stock exchange and invest it transparently. Its banking subsidiaries would be separate legal entities with their own governance and would pay dividends through the parent to shareholders out of profits. Contagion is reduced in part because the non-operating parent would have no legal basis to shift capital between affiliates in a crisis.

In short, because revising ownership structures deals with root problems, it would steady the ship and confi dence would return as a result. With fiscal policy stretched and joblessness rising, most taxpayers would probably support that.

Blundell-Wignall, Adrian, Gert Wehinger and Patrick Slovik (2009), “The Elephant in the Room: The Need to Deal with What Banks Do”, in Financial Market Trends, October.

Hannon, Paul (2009), “OECD: Global Government Support For Financial System $11.4 Trillion”, on Dow Jones Newswires, 13 January.

Economic data


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