Wednesday, September 19, 2012

Splitting up major banks is a complex solution to a simple problem

Der Spiegel carried an interesting article on how the EU is considering how to use a combination of the Volcker Rule and the Vickers' ring-fence to effectively split up the major banks so that they do not have to be bailed out at taxpayer expense in the future.

The focus on splitting up the major banks is a misplaced as it leads to adoption of a very complicated solution that is heavily dependent on the regulators.

Instead, the focus should be on how to prevent policymakers and financial regulators from ever bailing out a bank in the first place.

Regular readers know that prevention can be easily achieved under the FDR Framework.

Under the FDR Framework, governments are responsible for ensuring that market participants, including other banks, have access to all the useful, relevant information about any bank in an appropriate, timely manner.

Fulfilling this responsibility means that governments must require banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Under the FDR Framework, all market participants, including banks, are responsible for all gains and losses on their exposures.  As a result, all market participants have an incentive to independently assess the risk of each bank and adjust their exposure to reflect each bank's risk.  Simply put, market participants have an incentive to be sure they do not have a greater exposure than they can afford to lose.

The FDR Framework eliminates the need for bailouts as the collapse of one bank will not bring down the financial system.  As a result, there is no need for policymakers and financial regulators to interfere.

The European Commissioner for Internal Market and Services, Michel Barnier, a former French cabinet minister with snow-white hair, is the most feared of the Brussels commissioners in European financial centers. He is already responsible for more than 30 EU regulations decreeing how banks and other financial market players are to do business in the future.
All 30 EU regulations substitute complicated rules and regulatory supervision for transparency and market discipline.
Nevertheless, Barnier has shied away from a structural reform that would affect Europe's major lenders. 
He is part of the power elite in Paris, which has close ties to large French banks like BNP Paribas and Société Générale. Only after extensive plans for the restructuring of major banks were discussed in the United States and Britain did he ask Erkki Liikanen, the governor of Finland's central bank, to assemble a commission to investigate structural reforms that could lead to the splitting up of major banks. 
Liikanen has put together a group consisting of economists, bankers and industry representatives....
Is there a problem when the commission to investigate structural reforms is comprised of the membership from the Financial, Regulatory and Academic Complex (FRAC)?

FRAC has an incentive to proposed complicated rules.  It insures continuation of the status quo.
The 11 experts have been instructed to pay particular attention to reforms in the United States and Britain. In the United States, the so-called Volcker rule largely prohibits banks from engaging in risky trading activity for their own accounts. The Vickers Commission in London has put forward proposals aimed at separating capital market transactions from banking activities that are vital to the functioning of the economy and the financial system, namely the lending and deposit business.
Regular readers know that enforcement of the Volcker Rule requires ultra transparency and not the 298 pages that the regulators are currently drafting.
In Europe, breaking up the banks was long seen as more of a subject for armchair economists than a real prospect. But in recent weeks, even corporate leaders like Nikolaus von Bomhard, head of the insurance giant Munich Re, and Klaus Engel, CEO of chemical manufacturer Evonik Industries, have conceded that they would like to see a separation between high-risk investment banking and other bank operations. 
Despite numerous reforms in the financial sector, there is one problem regulators have yet to solve: Many banks are so big that no country can afford to allow them to fail. 
Requiring banks to provide ultra transparency is the simple solution to this problem.  With an ability to assess the risk of each bank, markets can exert discipline on the banks to reduce their risk.
This is why the government bailed out a number of financial companies starting in 2008, a move that allowed major banks like Deutsche Bank to grow even larger. 
"Taking a more-of-the-same approach in the treatment of major banks is not an option", warns Daniel Zimmer, head of the German Monopolies Commission. "First of all, in contrast to 2008, many countries no longer have the resources to bail out banks. Second, taxpayers are no longer willing to foot the bill for the financial industry's mistakes." 
Taxpayers never should have footed the bill in the first place as banks are designed to absorb significant amounts of losses and continue operating.

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