Blog Post

The Liikanen report – is size the elephant in the room?

Yesterday, the High-level Expert Group on reforming the structure of the EU banking sector chaired by the governor of Finland’s central bank Erkki Liikanen, in short the Liikanen report  issued its report. Apart from endorsing other currently discussed points such as common bank supervision and the resolution schemes, one of its main findings is that […]

By: Date: November 9, 2012 European Macroeconomics & Governance Tags & Topics

Yesterday, the High-level Expert Group on reforming the structure of the EU banking sector chaired by the governor of Finland’s central bank Erkki Liikanen, in short the Liikanen report  issued its report. Apart from endorsing other currently discussed points such as common bank supervision and the resolution schemes, one of its main findings is that ‘it is necessary to require legal separation of certain particularly risky financial activities from deposit-taking banks within a banking group’, which fits nicely with the Volcker rule in the US and the Vickers proposal in the UK. The main goals of legal separation are to limit a banking group’s incentives and ability to take excessive risks with insured deposits, to prevent the coverage of losses incurred in the trading entity by the funds of the deposit bank, and to reduce the interconnectedness between banks and the shadow banking system. The proposal argues that this would limit the stake of the taxpayer in the trading parts of banking groups, while making the socially most vital parts of banking groups safer and less connected to trading activities.

Andrew Haldane welcomes the proposal and thinks we should go even further. He argues that asset portfolios of large universal banks are simply too complex for investors to price. Unbundling complex banks activities into simpler parts would allow market discipline to reassess itself and would help solving the too-complex-to-price and too-big-to-fail problems. And too-complex-to-price or too-big-to-fail are indeed real problems. In Europe, the 20 largest banks hold almost around 50% of the total volume of banking assets. Recent work by the OECD suggests that the subsidies that these banks receive in form of implicit or explicit bail-out guarantees form a substantial part of their annual profit.

But there are factors complicating the type of structural regulation proposed, some of which are practical while others are more fundamental.  First, it is difficult to separate useless from useful risky activity. This is also a key issue in the implementation of the Volcker rule proposal – which comprises almost 300 pages. Banks will rightfully argue that some of these complex financial products actually serve a valid economic purpose. For example, derivatives can be used to hedge exposures and investment branches may help customers to tap wholesale funding markets. As a result a possible separation might come with numerous exceptions which make the whole legislation very complex. Apart from undermining simplicity, this will make it easier for markets to find ways to innovate around the structural regulation.

A more fundamental point is that it is not clear that legal separation reduces governments’ incentives to bail-out troubled banks and lowers systemic risk instead of shifting it to other parts of the banking sector. The reasons for saving troubled banks go beyond protecting insured depositors. For example, while ING reported in 2011 a ratio of customer deposits to total assets of roughly 50%, the ratio of insured deposits to total assets will be much lower, as already the level of deposits of ING alone is larger than total insured deposits in the Netherlands. Governments may want to protect such a bank under any circumstances, no matter where the losses originate from because of its sheer size of 960 billion euro (excluding insurance). It is not clear that a legal separation these super-large banks are credible. And the European financial system largely consists of such super-large banks – the 20 largest european banks hold almost 50% of all banking assets. The bottom line? If you want to reduce tax payers’ liabilities, reduce size. Governments can credibly commit to wind down small banks, but not these super-large ones.

From an economists’ point of view the question then becomes, should you prefer structural regulation (i.e. quantity regulation) or price regulation through higher capital requirements or high taxes for big banks. The discussion on whether to use quantity regulation or price regulation to address externalities goes back to a seminal paper in 1974 by Weitzman. He showed that uncertainty about compliance costs causes price and quantity controls to have different welfare implications. Price controls – in the form of taxes – fix the marginal cost of compliance and lead to uncertain levels of compliance, whereas quantity controls – in the form of minimum capital requirements – fix the level of compliance but result in uncertain marginal costs. The relative efficiency of price regulation versus quantity regulation now depends on the relative slopes of the marginal benefit and marginal cost curves. If the marginal cost curve is steeper than the marginal benefit curve, price regulation will be more efficient, whereas if the marginal benefit curve is steeper, quantity regulation will be more efficient. The fact that large banks create substantial systemic risk, while the empirical literature shows for these banks that economies of scale are limited, then suggest that some form of structural regulation may be warranted.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read about event More on this topic

Upcoming Event

Dec
6
19:00

Game Over – The Inside Story of the Greek Crisis -Drawing the broader lessons for Europe

Solvay Brussels School and Bruegel are co-organizing an event at which George Papakonstantinou and André Sapir will discuss the Greek crisis and its social and economical impact over the last 6 years.

Speakers: André Sapir, Guntram B. Wolff and George Papakonstantinou Topic: European Macroeconomics & Governance Location: Avenue Franklin Roosevelt 42 Brussels, 1050, Ixelles
Read about event More on this topic

Upcoming Event

Dec
7
12:30

Transition for all: equal opportunities in an unequal world

How inclusive is growth in transition countries? Post-communist countries are becoming more prosperous but many people are being left behind, risking setbacks in political and economic development.

Speakers: Heather Grabbe, Zsolt Darvas, Katarina Mathernova, Sergei Guriev and Jonathan Charles Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author

Blog Post

Pia Hüttl

Macroeconomics in the crossfire (again)

What’s at stake: After a first go at macroeconomics and its flaws a year ago, Paul Romer kicked off the debate again with a recent essay on how macroeconomics has gone backwards. The way that this debate, along with the debate of the role of economics in general, feeds into today's election woes, has also attracted attention in the blogosphere.

By: Pia Hüttl Topic: European Macroeconomics & Governance Date: December 5, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

Financial implications of the Italian referendum

On Sunday, Italy will held a constitutional referendum whose implications for the political stability of the country are uncertain. Right after the referendum, Italy’s oldest and most troubled bank - Monte dei Paschi di Siena - is expected to complete a very important and sizable capital raise. Here we look at the situation and implications of this critical juncture.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: December 2, 2016
Read about event More on this topic

Past Event

Past Event

Labour mobility after Brexit

What will Brexit mean for the free movement of workers between the UK and the EU?

Speakers: Lindsey Barras, Zsolt Darvas, Jonathan Portes and Klaus F. Zimmermann Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: December 2, 2016
Read article Download PDF More on this topic

Policy Contribution

pc-20-16_page_01

What impact does the ECB’s quantitative easing policy have on bank profitability?

This Policy Contribution shows that the effect of the ECB’s QE programme on bank profitability has not yet had a dramatically negative effect on bank operations.

By: Maria Demertzis and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: November 30, 2016
Read article

Blog Post

Giuseppe Porcaro
hsbeziyq

Tweeting the Italian referendum: the hashtag war

We are monitoring an aggregate of twitter hashtags in the run up to the Italian Constitutional referendum of 4 December 2016.

By: Giuseppe Porcaro, Henrik Müller and Gerret von Nordheim Topic: European Macroeconomics & Governance Date: November 29, 2016
Read article More on this topic More by this author

Blog Post

Silvia Merler

The Italian referendum

What’s at stake: on 4 December, Italy will hold a referendum on a proposed constitutional reform approved by Parliament in April. The reform, which was designed in tandem with a new electoral law, aims to overcome Italy’s “perfect bicameralism” by changing the structure and role of the Italian Senate. It also changes the distribution of competences between the state and regions. After the shocks of Brexit and the US election, polls are now drifting towards a defeat of the government’s position in Italy.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: November 28, 2016
Read about event More on this topic

Upcoming Event

Jan
9
09:30

Can migration work for all in Europe?

On 9 January Bruegel together with the IMF is organizing a conference on migration and whether it can work for all in Europe.

Speakers: Jorg Decressin, Gianpiero Dalla Zuanna, David Lipton, Alessandra Venturini and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author

Blog Post

Zsolt Darvas

Income inequality has been falling in the EU

The properly measured EU-wide Gini coefficient of disposable income inequality shows that inequality in the EU as whole declined in 1994-2008, after which it remained broadly stable. However, within the EU, there are large differences in income inequality which require policy action.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: November 23, 2016
Read article More on this topic

Blog Post

Pia Hüttl
Silvia Merler

An update: Sovereign bond holdings in the euro area – the impact of QE

Since the ECB’s announcement of its QE programme in January 2015, national central banks have been buying government and national agency bonds. In this post we look at the effect of QE on sectoral holdings of government bonds, based on our recently updated dataset.

By: Pia Hüttl and Silvia Merler Topic: European Macroeconomics & Governance Date: November 22, 2016
Read about event More on this topic

Past Event

Past Event

Vision Europe Summit 2016

The 2016 Vision Europe Summit is titled "Redesigning European Migration and Refugee Policy" and will be held in Lisbon on 21-22 November 2016.

Topic: European Macroeconomics & Governance Location: Lisbon Date: November 21, 2016
Load more posts