ET BureauSome three years after the sub-prime crisis erupted, the US Senate passed a bill on banking reform last week. The Senate bill has to be reconciled with the one passed earlier by the House of Representatives . The news made the headlines last week.
You have to wonder what the hoopla is all about. The measures that are likely to go through hardly qualify as big reforms or even as reforms. Some of the most important issues will remain unaddressed. It does seem a case of a mountain of labour producing a mouse.
The US already suffers from a profusion of bank regulators. The Senate bill would create two new agencies. One is a Consumer Financial Protection Bureau that would be inside the Fed but independent of it, whatever that means. Another is the Financial Oversight Council of Regulators, chaired by the treasury secretary that would identify systemic risks and market bubbles. These are attractive sounding names but they promise to make the regulatory structure even murkier.
Derivative trades are to be moved to exchanges . This is desirable but there are still many exemptions provided in the bill. A more controversial proposal is to get banks to spin off their derivatives dealing operations . This is opposed by the US administration as well as the banks themselves and may not go through.
The idea of getting banks out of risky businesses seems to go down well the public. So, everybody is gung-ho about the ‘Volcker rule’ that would get banks out of proprietary trading , private equity and hedge funds. A moment’s reflection should tell us that diversification of revenue streams helps lower risk.
Take, for instance, trading in government securities. When interest rates decline, banks’ margins on loans can fall because bank deposits tend to be of shorter duration than loans. But the value of government securities rises when interest rates decline. Gains on this account can help cushion bank profits. In India, we have seen over the years how treasury profits can help smooth out earnings.
We need banks to set prudential limits on risky business, not to exit them. In India, we don’t expect banks to exit real estate or commodities because they are risky. We impose exposure limits. Exiting risky businesses is a blunt tool for managing risk.
Fortunately, it appears that, whatever the legislation proposed by Congress, the details of the ‘Volcker rule’ will be left to the Fed. If the US alone were to impose a ‘Volcker rule’ , it would disadvantage American banks. The Fed knows this very well.
The last important piece in the Senate bill is a resolution authority that can seize and wind up a large financial institution that faces failure. In a crisis, this is almost impossible to do especially if creditors have to face losses. The failure of Lehman in the present crisis showed how dire the consequences could be. The Senate bill provides for creditors to be taken care of but would recoup payments made by the government from the industry. In other words, the survivors would have to pay for the misdeeds of the failures. This sounds ridiculous.
Whatever legislation emerges finally from Congress will have a limited impact on banking in the US as well as on banking globally. For two reasons. One, the details of most of the proposals mentioned above and also the key proposal on higher capital for banks will have to be decided by US regulators . The legislation merely provides broad direction to the regulators.
Secondly, unilateral US action on capital requirements can at best only go so far —- maybe, set a requirement slightly higher than the present one. For any imposition of higher capital requirements for banks to be effective, we need global agreement under the auspices of the Bank for International Settlements. Any country that races ahead of others in setting high capital requirements for banks in its country risks driving banking activity elsewhere.
When eventually all regulators agree on higher capital requirements, does that diminish the probability of the next crisis? Not at all. We will still be grappling with one problem, banks that are too big to fail. Neither higher capital nor the outlawing of socalled risky activities nor any resolution authority can address this problem.
And the problem has, if anything, worsened after the present crisis. The survivors have become bigger and dominate banking more than before, the industry has become even more concentrated. The incentives for management at these banks to make reckless gambles remain intact. But politicians lack the appetite to do what it takes, which is to limit size in banking.
They think the problem will somehow go away by limiting the scope of banking activities . As I have pointed out above, scope in banking actually has the potential to diminish risk, so this is actually getting hold of the wrong end of the animal. Policymakers must take the bull by its horns and that means tackling the problem of size. Alas, that may require a bigger crisis than the present one.
You have to wonder what the hoopla is all about. The measures that are likely to go through hardly qualify as big reforms or even as reforms. Some of the most important issues will remain unaddressed. It does seem a case of a mountain of labour producing a mouse.
The US already suffers from a profusion of bank regulators. The Senate bill would create two new agencies. One is a Consumer Financial Protection Bureau that would be inside the Fed but independent of it, whatever that means. Another is the Financial Oversight Council of Regulators, chaired by the treasury secretary that would identify systemic risks and market bubbles. These are attractive sounding names but they promise to make the regulatory structure even murkier.
Derivative trades are to be moved to exchanges . This is desirable but there are still many exemptions provided in the bill. A more controversial proposal is to get banks to spin off their derivatives dealing operations . This is opposed by the US administration as well as the banks themselves and may not go through.
The idea of getting banks out of risky businesses seems to go down well the public. So, everybody is gung-ho about the ‘Volcker rule’ that would get banks out of proprietary trading , private equity and hedge funds. A moment’s reflection should tell us that diversification of revenue streams helps lower risk.
Take, for instance, trading in government securities. When interest rates decline, banks’ margins on loans can fall because bank deposits tend to be of shorter duration than loans. But the value of government securities rises when interest rates decline. Gains on this account can help cushion bank profits. In India, we have seen over the years how treasury profits can help smooth out earnings.
We need banks to set prudential limits on risky business, not to exit them. In India, we don’t expect banks to exit real estate or commodities because they are risky. We impose exposure limits. Exiting risky businesses is a blunt tool for managing risk.
Fortunately, it appears that, whatever the legislation proposed by Congress, the details of the ‘Volcker rule’ will be left to the Fed. If the US alone were to impose a ‘Volcker rule’ , it would disadvantage American banks. The Fed knows this very well.
The last important piece in the Senate bill is a resolution authority that can seize and wind up a large financial institution that faces failure. In a crisis, this is almost impossible to do especially if creditors have to face losses. The failure of Lehman in the present crisis showed how dire the consequences could be. The Senate bill provides for creditors to be taken care of but would recoup payments made by the government from the industry. In other words, the survivors would have to pay for the misdeeds of the failures. This sounds ridiculous.
Whatever legislation emerges finally from Congress will have a limited impact on banking in the US as well as on banking globally. For two reasons. One, the details of most of the proposals mentioned above and also the key proposal on higher capital for banks will have to be decided by US regulators . The legislation merely provides broad direction to the regulators.
Secondly, unilateral US action on capital requirements can at best only go so far —- maybe, set a requirement slightly higher than the present one. For any imposition of higher capital requirements for banks to be effective, we need global agreement under the auspices of the Bank for International Settlements. Any country that races ahead of others in setting high capital requirements for banks in its country risks driving banking activity elsewhere.
When eventually all regulators agree on higher capital requirements, does that diminish the probability of the next crisis? Not at all. We will still be grappling with one problem, banks that are too big to fail. Neither higher capital nor the outlawing of socalled risky activities nor any resolution authority can address this problem.
And the problem has, if anything, worsened after the present crisis. The survivors have become bigger and dominate banking more than before, the industry has become even more concentrated. The incentives for management at these banks to make reckless gambles remain intact. But politicians lack the appetite to do what it takes, which is to limit size in banking.
They think the problem will somehow go away by limiting the scope of banking activities . As I have pointed out above, scope in banking actually has the potential to diminish risk, so this is actually getting hold of the wrong end of the animal. Policymakers must take the bull by its horns and that means tackling the problem of size. Alas, that may require a bigger crisis than the present one.
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