In the Financial Times yesterday, Martin Wolf provides a stunning statistic: in 2010, U.S. banks in aggregate comprised eighty percent of GDP, while those in the EU ate up 350 percent. And, the U.S. number comes from an industry that, while concentrated, comprises about 7,000 insured depositories – in the EU, there are about six. Okay, a few more, but the point stands. Fundamental structural differences among banking systems make the high ideal of binding, detailed global standards like Basel III a wreck waiting to happen.
Simple though the Wolfe statistic is, it makes more than clear why even the largest U.S. banks are not too big to save even as Dodd-Frank stipulates a robust solution to too big to fail. In the EU, banks threaten their sovereigns nor can they be resolved without the support of the citizenry absent sweeping changes the always contentious Union has yet seriously to contemplate. This is a more than minor difference, since banks without a government backstop need not be punished with rules designed to prevent its use. Mr. Wolf goes on to argue that European banking behemoths urgently need ring-fencing along the U.K. and, now, Liikanen lines. This is, he says, right because ring-fencing helps to limit implicit and explicit government backstops only to what Liikanen describes as the socially-vital – i.e., utility – functions of banking organizations. Since U.S. banks are not TBTF either by structure or, now, law, the EU rationale for ring-fencing does not apply. But, is ring-fencing still warranted here because the merger of commercial with investment bank poses undue prudential risk – as Mr. Volcker argued – or such daunting complexity risk that no other cure suffices?
The Volcker Rule finds proprietary trading and certain investments so vexing that it demurs on ring-fencing and, instead, goes for a flat ban. Importantly, Liikanen decided against this because, I suspect, the experts read the Volcker NPR and were so confused about how to define “proprietary trading” and “market making” that they couldn’t figure out how meaningfully to prohibit it. Ring-fencing works far better than a ban because it directly addresses Mr. Volcker’s risk concerns by putting these hazards in an entity not only isolated from insured deposits – a la Liikanen – but also unprotected by any federal backstop – thanks, Title II.
However, this is only part of the answer. The key to ensuring that ring-fencing works from both a microprudential perspective and the more macro complexity-risk one is to be sure that the fence is secure. Here, Mr. Volcker and the Liikanen Group should take a look at Sections 23A and 23B of the Federal Reserve Act, reading them as revised by Title VI of the Dodd-Frank Act.
What will the experts find? A strict limit on inter-affiliate transactions made considerably more potent by Dodd-Frank. We have yet to see the Fed’s rule’s implementing this change, and it’s often overlooked in the torrent of systemic rules baffling regulators and besieging bankers. It is, though, one of the most important structural rewrites of U.S. banking and one that will go a long way to building ringfences here that would do a lot more to curb risk than flat prohibitions on activities no one knows how to define.