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Home > Capital Markets Viewpoints > Reforming the mega banks – or “what happened after the tsunami”

Capital Markets Viewpoints

Reforming the mega banks – or “what happened after the tsunami”

by Benoît Lallemand

Where did the tsunami come from?

According to the financial lobby, the banking sector has suffered a tsunami of reform. It has faced new rules on capital, liquidity, bank resolution and even a cap on bonuses. If there is any more regulation, we are told, the sector may sink below the waves. If this is true, then the European Commission’s recent proposal on bank structure reform should be blocked or watered down.1

Finance Watch does not see it this way. This is not because we want more regulation. We actually want less in quantity, but more in quality. To explain why we think the European Commission’s proposal on bank structure reform is so important, let us return to the image of the tsunami.

At the peak of the financial crisis in autumn 2008, a different tsunami, made up of major bank losses, was rolling through the financial system and hitting coastline villages (representing citizens) in what became the worst financial shock in nearly a century. This shock cost taxpayers €1,600 billion and resulted in what economists have called ‘the Great Recession’, with public debt and unemployment (of youth in particular) soaring all over Europe. Since the crisis, the number of jobless has increased by two million in Spain alone.

The approach taken by the G20 was to ensure that the next tsunami would not harm coastal villages. For that, they decided to build or strengthen embankments to absorb any future the waves/losses.

There are three such embankments in the regulators’ plan:

The first, bank capital, is covered by the Basel III rules (CRD IV in the EU). A bank’s providers of capital are the first to be “wiped out” by the wave, when the value of their shares is written down to absorb losses. Capital requirements have doubled since the crisis but are still a fraction of the level that many commentators and regulators believe to be necessary. The embankment also has major weaknesses, some of which are recognized by the Basel Committee itself. These include that banks use their own internal risk models to calculate their capital requirements, with major discrepancies in the final outcome.

The second ‘embankment’ is creditors, who absorb losses after the shareholders have been wiped out. Here, the EU’s Banking Union (Bank Recovery and Resolution Directive) includes ‘bail-in’ provisions that aim to make creditors take their share of losses. The main weakness of this second line of defence is that, currently, too-big-to-fail banks are also very much interconnected, so if creditors of one bank have to take a large loss, it could spread quickly through the whole system of megabanks. As long as this remains the case, we think the risk of a “domino effect” makes it unlikely that a significant bail-in would be implemented in a systemic crisis.

The third line of defence is a single resolution fund introduced under the Banking Union and based on contributions by banks. It will be up to €55 billion in size within ten years. We only need to compare it with the €1,600 billion that was required from taxpayers following the crisis of 2008 to understand that this fund will be of little use should a major bank – or banks – go under.

These embankments are too small to protect us from a future tsunami. Something more is needed. To extend the metaphor, let us imagine that the source of these tsunamis is a chain of giant underwater volcanos (representing too-big-to-fail megabanks) whose periodic eruptions cause damage far and wide.

Experts (the IMF, ECB, OECD, FSB, academics…) agree that the giant underwater volcanos are still there, are still too big, and are still too close to the coasts. And the question is not whether there will there be another eruption, but when. Corporations fail and banks make losses; that’s the economy.

So the missing part of the ‘coastal defences’ is working to scale back the giant volcanos and make them safer. The same experts agree that structural reform of too-big-to-fail banks would greatly reduce the distorting incentives that stimulated these giant underwater volcanos to form in the first place (the implicit subsidy that provides cheap funding for banks’ trading arms).

Of course, it is not possible to change the structure of real volcanos but it should be possible to change the structure of banks. Right?

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