ICFR Calendar
Regulatory Calendar

EU Finance Ministers worry about Greece - but also Consider Response to the US "Volcker" Rule

16th February 2010

Comment by Richard Reid

Although the focus of today’s meeting of EU finance ministers will be on dealing with Greece’s budget problem, also on their agenda will be addressing the recent initiative in the US on reforms of the financial sector. President Obama’s backing for the so-called “Volcker” rule threw the evolving international consensus on the regulatory response to the financial crisis into doubt. The Obama proposals which in spirit at least, seemed to point in the direction of a separation between commercial and investment banking were not universally welcomed in Europe. They also highlighted the not infrequent tension between the aims of domestic politics on one side and the G20 agenda of international cooperation on the other.

According to Bloomberg news, EU ministers will express “their concern that the application of the ‘Volcker’ rule in the EU may not be consistent with the current principles of the internal market and universal banking”, and that “Any policy choice should avoid pushing risks to other parts of the financial system.”

Although different jurisdictions have their own approach to the correct regulatory response, there is one strong common underlying theme – finding a way to make banks bear a bigger share of the tax burden involved in either rescuing them or for clearing up after financial failure. The recent G7 meeting in Canada seemed to come down in favour of some kind of levy or fee to establish a stability fund and last week the UK’s Prime Minister Mr Brown indicated that he saw a growing G20 support for such a measure. All of this debate is happening alongside the efforts by the Financial Stability Board in conjunction with the Basel Committee on Banking Supervision (BCBS), to come up with concrete proposals to raise banks capital requirements. Only yesterday at a conference run by the Reserve Bank of India, the FSA’s chief Adair Turner indicated during the Q&A session, that he was in favour of significantly higher capital requirements than he had previously backed. His speech was a wide ranging analysis of the crisis and an assessment of the costs and benefits of financial liberalisation. (see links below)

As we noted a couple of weeks ago there has been an active debate among academics and policy makers for some time about the relative merits of crisis prevention versus containment and resolution. Much of the regulatory response with regards to banking institutions has focused on higher capital requirements. Apart from linking higher capital requirements to the degree to which riskier activities are being undertaken, there has also been discussion over how much by way of capital buffers should be accumulated in the good times. Of course such buffers carry an economic cost in the sense that by holding higher capital than they would otherwise do in “normal” times (which are of course most of the time), this may crimp lending and therefore economic activity. This is a cost that many electorates and governments may feel is no bad thing at present. But would that view hold in the future?

Also, relying solely on this regulatory response does not relieve the agency problem of financing banks, namely that investors will go on charging a premium for supplying large amounts of equity to finance banks in order to compensate for the risks of poor governance and mismanagement.

In the last few months therefore there have been further suggestions for dealing with the issues of bank funding, too-big-to-fail & moral hazard. A leading idea has concentrated on “insurance” in the form of contingent capital that is capital in a form that automatically converts to common equity upon the trigger of a threshold that kicks in before a bank becomes insolvent.  (see for example recent comments by the Bank of England’s Mr King below)

Another idea which has been gaining in popularity but which has been around for a while is that of an insurance “policy”. We highlighted a good paper on this topic earlier this month. In this article (delivered at the Jackson Hole economic symposium in 2008), the authors suggested banks be given the option of a higher capital requirement, or of acquiring an insurance policy that pays in the event of a catastrophe. The authors moot the idea that the insurer (say a sovereign wealth fund) would put a sum into a “fund” say of government securities, and then receive both the premium from the banks and the interest plus the sum at the at the end of the life of the “policy”.  The authors acknowledge that lots of detail would have to be worked out, not the least being how to deal with a single failing institution which is very interconnected. They note though that such a premium is likely to be less burdensome than the higher capital requirement and that this might reduce the banks’ incentive to exploit regulatory arbitrage.
The banking sector itself seems now to be reconciled once more to having to accept more cost sharing. Exactly how this is applied is another question. The more the G20 and the Financial Stability Board can do to show a common approach, the easier it will be to avoid delaying tactics on the part of the financial sector which seeks to exploit indecisive or piecemeal responses on the part of policy makers. 

Join us

Become a member of ICFR