Banking Regulations: Lessons from Global Reforms

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1 Banking Regulations: Lessons from Global Reforms Gwon, Jae Hyun The recent global financial crisis brought us to revisit banking regulations and structural reforms. The United States and the European Union have advanced new regulations to prevent a taxpayer bailout from risk contagion. Deliberation on the cause of the reforms would help Korea to establish the rules and regulations of its own. Debate over banking activities Banks and other financial firms have been feuding for years. Banks, last year, sought to engage in the wrap accounts business authorized solely for brokers, dealers, fund managers, and investment advisors. Yet the attempt was discouraged by the Financial Services Commission. In the beginning of this year, a high-profile official alluded to abolishing separation between banking and securities trading. Followed was a huge debate over the scope of banking activities. Market recession and falling profitability are pressing hard on banks to expand their horizon onto other financial sectors for business diversification. Banks and other investment companies are on a collision course where they both have a high stake. Korea is not the only country coping with this type of conflict. Going through the global financial crisis, many countries have probed into the cause and drawn up a plan presumably to avert banking crisis. Regulations on banking activities or structural reforms are of main concern. All the details boil down to a simple principle: Core banking activity and high-risk trading cannot get together any further. All opinions expressed in this paper represent the author s personal views and thus should not be interpreted as Korea Capital Market Institute s official position. Ph.D., Research Fellow, Corporate Policy Department, Tel: , gwon@kcmi.re.kr 1

2 Global trend in banking regulations The US has been leading the inquiry into the crisis while devising a new banking regulation. The Volcker Rule was introduced to forbid banking entities 1) from high-risk transactions in order for consumer protection and financial stability. The law, effective in April 2014, contains two main prohibitions. First, banking entities are banned from proprietary trading, that is, engaging as a principal for short-term trading of ineligible securities. 2) Exempted are transactions on behalf of the clients such as underwriting, market making, hedging, and securitization. Second, banking entities are prohibited from investing in or sponsoring hedge funds or private equity funds. Exempted are foreign public funds, joint ventures, and acquisition vehicles. The stability of banking runs through determining regulated activities. The purpose of the Volcker Rule is to protect banking and financial system from high-risk investments that might cause insolvency or systemic risk. The UK is on the same page with the US in diagnosing the underlying causes. The financial crisis was suspected to be amplified because large banks relied heavily on the public safety net while taking excessive risk. Considering its long-standing culture of universal banking, the UK took a slightly different measure, ring-fencing. As opposed to comprehensive limit on banking activities, retail banking is singled out for regulation. According to the separation plan, core banking activities will be ring-fenced as an independent legal entity away from high-risk trades. At the end of 2013, the UK built the legal framework for ring-fencing by enacting the Financial Services (Banking Reform) Act ) Additional legislative procedures will ensue until the Act becomes fully effective in January Banking reform draft secondary legislation published by HM Treasury stipulates that large banks are obliged to transfer their core activities such as deposits from individuals and SMEs to ring-fenced bodies. Ring-fenced bodies are banned from dealing in investments or commodity trading as principal. In addition, they are prohibited from establishing a branch or an affiliate to carry out the prohibited activities outside the European Economic Area and having exposure to financial subsidiaries out of the ring-fenced. The prohibited activities are, however, 1) Banking entities refer to insured depository institutions, their holding companies, foreign banking organizations with US bank subsidiaries and any affiliate of the foregoing. They encompass broader set of companies rather than banks. 2) Bank-eligible securities mean bonds issued by the federal, state, municipal governments, foreign sovereign nations, and international organizations. 3) On December 18, 2013, the UK enacted the Financial Services (Banking Reform) Act 2013 to introduce ring-fencing. 2

3 allowed outside the ring-fenced. Exemptions are simple derivatives for liquidity management, securitization of own assets, and debt-equity swaps. Ring-fencing is designed for banks to sustain their core activities even during a crisis. It is to minimize the shock to the real economy while improving the resilience of banking without taxpayers bailout burden. Except that the reform mandates a structural separation, the objective goes with the spirit of the Volcker Rule that is to prevent banks from risk taking and risk contagion. At the same time, Europe also has looked into the crisis and set up a rule. In October 2012, the European Commission (EC) released the Liikanen Report, which recommended the separation of speculative trading out of banks. While the UK rings a fence around core retail banking, the EC wants to fence high-risk trading. France 4) and Germany 5) legislated laws to separate high-risk trading from large banks. They differ in the details such as the scope of regulated banks, the definition of high-risk trading, and exemptions. As legislations kick in at individual countries, the EC published a new proposal 6) for legislation at the beginning of 2014 concerning about regulatory discrepancies among countries in the region. The proposal is a hybrid mix of the US Volcker Rule and European nations ringfencing. First, it bans large banks or systemically important financial institutions from engaging in proprietary trading and investing in alternative investment funds. Proprietary trading is defined narrower than the US version, therefore trading activities for hedging, underwriting, market making, and securitization are exempt from the ban. Second, banks subject to the regulation should separate its trading arms if the risk and the complexity of its trading activities are determined to exceed certain thresholds. For now, proper metrics about complexity and riskiness have not been ready yet. The proposal is giving a rough idea of what constitutes the trading activities for separation, for instances, market making activities, complex securitization, and derivatives trading. 4) On July 26, 2013, France enacted LOI n du 26 juillet 2013 de séparation et de régulation des activités bancaires (Law no of 26 July 2013 on the separation and regulation of banking activities). 5) On August 7, 2013, Germany enacted Gesetz zur Abschirmung von Risiken und zur Planung der Sanierung und Abwicklung von Kreditinstituten und Finanzgruppen (Law concerning Separation of Risks and Restructuring and Winding-Up of Credit Institutions and Financial Groups). 6) European Commission, January 19, 2014, Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on structural measures improving the resilience of EU credit institutions. 3

4 Principle of banking regulation Global regulatory trends give us a hint about economic theories on banking regulation. Limiting moral hazard and adverse selection penetrates the recently introduced banking regulations. Against explicit deposit insurance and implicit bailouts, depositors have no reason to monitor the soundness of banks. Knowing this, banks would expand to high-risk, high-return businesses ( moral hazard ). High-risk trading intends to join the bank under the safety net ( adverse selection ). It makes a profit at good times but loses nothing at bad times due to bailouts. Provided that a public safety net is indispensable for protecting banks and controlling systemic risk, additional regulations should be placed on banking activities. This is why the Volcker Rule and ring-fencing came up as the remedies for crisis. Passing through the Asian financial crisis in 1997, Korea had carried out government bailouts. For three years immediately after the crisis, the government had spent 31.2% of its GDP on restructuring the financial industry. It is way much high compared to 4.5%, 8.8%, 1.8%, and 1.0% of US, UK, Germany, and France during the recent financial crisis. 7) Pertaining to cumulative amounts of bailouts, Korea spent KRW 86.9 trillion on banks out of KRW trillion for total (Public Fund I from November 1997 to June 2013), and additional KRW 1.2 trillion out of KRW 6.2 trillion during a recent crisis (Public Fund II from June 2009 to June 2013). 8) Statistics show that bailing banks out is a burden on taxpayers by any means. Admittedly, as long as this public protection is all in place for a crisis, it is unavoidable to regulate banks high-risk trading activities. The reforms might not fit Korea though. Compared to the US and Europe, Korean banks hardly run proprietary trading. Hedge funds and private equity funds are not active that banks involvement in those funds is of little concern. Korea s market environments are different from developed countries, but, be that as it may, the principle on banking regulation is more than needed, for the scope of banking is controversially questioned. 9) No matter what delineates banking scope, the stability of their inherent services deposit takings, loans, and foreign exchange services - must be left unaffected since they have a significant impact on the real economy. If the regulator allows banks to engage in some securities trading, financial holding companies could be utilized. Securities transactions need to stay in a trading arm of the same 7) Laeven, L., Valencia, F., 2013, Systemic Banking Crises Database, IMF Economic Review, 61(2), ) Public Fund Oversight Committee of the Financial Services Commission, 2013, Public Fund White Paper. 9) The Financial Services Commission pointed out the need to establish the principle on whether banks are allowed to enter the grey area between securities firms and banks (Attachment 2, Plans for Financial Regulatory Reform, Press Release on March 13, 2014). 4

5 financial holding company rather than in-house division. Lumping similar services together in the same legal entity will make resolution procedures much easier. The problem in Korea is that financial holding company does not act as a single entity sharing the same economic interest. 10) To address this, the synergy among entities within a business group should be enhanced, and, at the same time, efficient resolution schemes should be ready for default. Regulation is a type of government intervention to correct market failures. The government places a protection to control systemic risk, which necessitates additional regulations to prevent banks moral hazard. Ironically an essential regulation begets another regulation. Despite the controversy, it is obvious that the profitability cannot be grounds for banking regulation. 10) Bosung Shin, 2013, Growth of Financial Holding Companies and Synergy Creation, Korea Capital Market Institute, Capital Market Opinion,