The Liikanen report – is size the elephant in the room?

Yesterday, the High-level Expert Group on reforming the structure of the EU banking sector chaired by the governor of Finland’s central bank Erkki Liikanen, in short the Liikanen report  issued its report. Apart from endorsing other currently discussed points such as common bank supervision and the resolution schemes, one of its main findings is that ‘it is necessary to require legal separation of certain particularly risky financial activities from deposit-taking banks within a banking group’, which fits nicely with the Volcker rule in the US and the Vickers proposal in the UK. The main goals of legal separation are to limit a banking group’s incentives and ability to take excessive risks with insured deposits, to prevent the coverage of losses incurred in the trading entity by the funds of the deposit bank, and to reduce the interconnectedness between banks and the shadow banking system. The proposal argues that this would limit the stake of the taxpayer in the trading parts of banking groups, while making the socially most vital parts of banking groups safer and less connected to trading activities.

Andrew Haldane welcomes the proposal and thinks we should go even further. He argues that asset portfolios of large universal banks are simply too complex for investors to price. Unbundling complex banks activities into simpler parts would allow market discipline to reassess itself and would help solving the too-complex-to-price and too-big-to-fail problems. And too-complex-to-price or too-big-to-fail are indeed real problems. In Europe, the 20 largest banks hold almost around 50% of the total volume of banking assets. Recent work by the OECD suggests that the subsidies that these banks receive in form of implicit or explicit bail-out guarantees form a substantial part of their annual profit.

But there are factors complicating the type of structural regulation proposed, some of which are practical while others are more fundamental.  First, it is difficult to separate useless from useful risky activity. This is also a key issue in the implementation of the Volcker rule proposal – which comprises almost 300 pages. Banks will rightfully argue that some of these complex financial products actually serve a valid economic purpose. For example, derivatives can be used to hedge exposures and investment branches may help customers to tap wholesale funding markets. As a result a possible separation might come with numerous exceptions which make the whole legislation very complex. Apart from undermining simplicity, this will make it easier for markets to find ways to innovate around the structural regulation.

A more fundamental point is that it is not clear that legal separation reduces governments’ incentives to bail-out troubled banks and lowers systemic risk instead of shifting it to other parts of the banking sector. The reasons for saving troubled banks go beyond protecting insured depositors. For example, while ING reported in 2011 a ratio of customer deposits to total assets of roughly 50%, the ratio of insured deposits to total assets will be much lower, as already the level of deposits of ING alone is larger than total insured deposits in the Netherlands. Governments may want to protect such a bank under any circumstances, no matter where the losses originate from because of its sheer size of 960 billion euro (excluding insurance). It is not clear that a legal separation these super-large banks are credible. And the European financial system largely consists of such super-large banks – the 20 largest european banks hold almost 50% of all banking assets. The bottom line? If you want to reduce tax payers’ liabilities, reduce size. Governments can credibly commit to wind down small banks, but not these super-large ones.

From an economists’ point of view the question then becomes, should you prefer structural regulation (i.e. quantity regulation) or price regulation through higher capital requirements or high taxes for big banks. The discussion on whether to use quantity regulation or price regulation to address externalities goes back to a seminal paper in 1974 by Weitzman. He showed that uncertainty about compliance costs causes price and quantity controls to have different welfare implications. Price controls – in the form of taxes – fix the marginal cost of compliance and lead to uncertain levels of compliance, whereas quantity controls – in the form of minimum capital requirements – fix the level of compliance but result in uncertain marginal costs. The relative efficiency of price regulation versus quantity regulation now depends on the relative slopes of the marginal benefit and marginal cost curves. If the marginal cost curve is steeper than the marginal benefit curve, price regulation will be more efficient, whereas if the marginal benefit curve is steeper, quantity regulation will be more efficient. The fact that large banks create substantial systemic risk, while the empirical literature shows for these banks that economies of scale are limited, then suggest that some form of structural regulation may be warranted.