BREAKINGVIEWS-Bank firewalls: a guide for the perplexed

Tue Feb 19, 2013 6:28pm IST

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(The authors are Reuters Breakingviews columnists. The opinions expressed are their own.)

By George Hay and Antony Currie

LONDON/NEW YORK, Feb 19 (Reuters Breakingviews) - Regulators in Europe, the United Kingdom and the United States all agree on the need to protect their lenders from the casino-like antics of investment bankers. That’s no great surprise: who wouldn't want to shield regular customers from the billions of pounds of losses caused by rogue traders like Kweku Adoboli of UBS UBSN.VX? But beyond this shared objective, there’s little agreement.

The United States kicked things off in 2010 with proposals to prohibit deposit-taking firms from proprietary trading in what was dubbed the "Volcker Rule" after the former Federal Reserve chairman who created it. In the United Kingdom, a commission headed by Sir John Vickers concluded that retail deposit-taking institutions should be "ring-fenced" from investment-banking arms, which should be legally separated with their own capital and funding. More recently, a European Commission working group chaired by Finnish central bank Governor Erkki Liikanen recommended that Europe's banks should firewall all trading assets, be they prop or market-making.

Why all the different ideas?

It’s partly politics: one of the reasons President Obama embraced the Volcker Rule was to try to deflect criticism after losing his supermajority in the senate. But the main factor is that U.S. and European banks are structured differently.

A Vickers-style firewall between the safe and risky bits of banks would not have cut the mustard in America: its lenders are already carved into legally separate entities with restrictions on intra-group exposures. Yet that didn't prevent investment-banking shenanigans from landing the likes of Citi (C.N) and Bank of America (BAC.N) in hot water.

UK and European universal banks, on the other hand, have historically allowed deposit-taking retail activities and investment banking to co-exist within the same legal entity.

Policymakers in all three regions worry that investment banks get cheaper funding if they're tacked on to an entity that creditors know will be bailed out. But the issue is especially emotive in the United Kingdom, which is home to more than its fair share of big banks. Rescuing them all in a crisis would cripple British taxpayers.

Which plan is most conservative?

Tough one. Vickers is the only one to build a firewall around the supposedly "safe" retail bit. But that's no guarantee of success: witness the $6 billion-odd trading loss the so-called London Whale caused at JPMorgan (JPM.N) when supposedly hedging the bank's excess deposits. And if Barclays’(BARC.L) investment bank collapsed, it’s a fair bet that retail depositors would rush to pull their money out. UK authorities might prefer to use taxpayer money to bail out the trading arm than risk repeating the Lehman debacle.

Both Volcker and Liikanen judge proprietary trading to be “risky” and market-making “safe”. But the losses caused by Adoboli and the Whale were not prop trading. And the main reason U.S. regulators have yet to finalise, let alone implement, the Volcker Rule, is because it has proved exceptionally tricky to define where market-making ends and prop trading begins. In other words, putting only pure prop trading behind a firewall will not remove all the risk from the system.

So what’s the point of firewalls, then?

Global capital and liquidity reforms from the Basel Committee have already made banks safer – and have made prop trading prohibitively expensive. However, banks are still too big to fail. Solving this problem requires global progress on resolution and recovery plans, which enable a failing bank to be safely wound down. Firewalls are a useful first step in this process.

Will there be any nasty side effects?

There could be. Volcker bans prop trading with any U.S. institution, even if the counterparty is outside the United States. This extra-territorial bit of rule-making could effectively extend the rule to non-U.S. banks. Volcker also allows prop trading in American sovereign debt but not in that of any other countries. As currently drafted, this would mean that the likes of Citi or Bank of America Merrill Lynch might withdraw from underwriting primary issuance of Canadian or UK sovereign debt.

Vickers already penalises UK banks: forcing all their market-making and prop trading outside the ring-fence will raise funding costs. But Liikanen could heap further misery on UK lenders. France and Germany, worried about the effect of regulation on economic growth, are likely to adopt a kind of “Liikanen-lite”, whereby they only firewall prop trading. This means a U.S. manufacturer that sells to German consumers might find hedging its dollar/euro currency risk pricier in London, and decide to do so in Paris or Frankfurt instead. Finally, no Asian jurisdiction is currently considering firewalls. That means the region's banks will be less constrained at the same time as their economies are growing faster than those in the West.

How much does any of this matter?

Right now, it’s too early to tell. Crucial details are still up in the air. The size of the Vickers ring-fence will depend on secondary legislation, the European Union has not yet given its official response to Liikanen, and Volcker’s definition of what will count as proprietary trading is still being debated. But even if regulators stick to the current drafts, it’s hard to see firewalls as the game-changer politicians might like to pretend they are. Most of the other critical recent reforms – such as the Basel capital and liquidity rules, and global resolution and recovery schemes – will make global banks more alike. Ultimately, different countries' structural reforms partly reflect the fact that banking systems were different even before the crisis. Regulators will - and probably can afford to - agree to disagree.

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(Editing by Peter Thal Larsen and Sarah Bailey)

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