He mentioned that Title II of the Dodd-Frank Act creates a new regime for the resolution and liquidation of financial companies, banks and non-banks, which pose a systemic financial stability risk. It enables losses to be imposed on creditors in resolution, while also prohibiting state bail-outs. Internationally, in November 2011 the G20 endorsed the Financial Stability Board’s Key Attributes of Effective Resolution Regimes, developed by an international working group. Efforts are underway to align national resolution regimes with these principles. As part of that, in
Europe a draft Directive on recovery and resolution of
financial institutions was published in June 2012.
During the resolution of a financial firm, noted the Executive Director, one way of ensuring continuity of services is by transferring assets and/or liabilities of a failing firm to a third party. But he noted that the only entity with sufficient financial and managerial resource to absorb a large asset or liability portfolio, without ``suffering chronic indigestion,’’ is another large financial institution, citing examples during the crisis of Bear Stearns being swallowed by JP Morgan Chase, Merrill Lynch by Bank of America and Washington Mutual by Citigroup.
According to the senior official, this makes for an uncomfortable evolutionary trajectory, with rising levels of banking concentration and ever-larger too-big-to-fail banks. Levels of banking concentration have risen in many countries since 2007, he noted, precisely because of such ``shot-gun marriages by over-sized partners.’’ In other words, resolving big banks may have helped yesterday’s too-big-to-fail problem, but at the expense of worsening tomorrow’s problems.
One way of lessening that dilemma, he reasoned, and at the same making resolution more credible, is to act on the scale and structure of financial firms directly. Recent regulatory reforms have sought to do just that. In the
United States, the Volcker Rule
prohibits US-operating banks from undertaking proprietary trading and sponsoring
hedge funds and engaging in other types of private equity activity.
the proposals of the Vickers Commission include placing a ring-fence around
retail banking activities, supported by higher levels of capital, and thus
fencing them off from commercial banking. The government’s plan is to enact the
ring-fence through legislation. The EU announced the Liikanen plan in October
2012, which proposes that the investment banking activities of universal banks
be placed in a separate entity from the remainder of the banking group.
Volcker, Vickers and Liikanen seek legal, financial and operational separation of activities, noted the Executive Director, and thus in principle should prevent cross-contamination of retail and investment banking at crisis time. Whether they do so in practice, said the official, depends on loopholes in, or omissions from, the ring-fence.
And each of the existing proposals has open questions on this front. For example, the Volcker Rule separates only a fairly limited range of potentially risky investment bank
activities, in the form of proprietary trading. The Vickers proposals mandate only a limited range of basic banking activities to lie within the ring-fence, namely deposit-taking and overdrafts. And the Liikanen plan allows a wide range of derivative activity to lie outside of the investment banking ring-fence.