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

Sep
29
08:30

Inclusive growth in the European Union

Why is inclusive growth important and how do the EU’s social problems differ from social problems in other parts of the world?

Speakers: Brando Benifei, Monica Brezzi, Bea Cantillon, Zsolt Darvas, Jana Hainsworth, Stefaan Hermans, Barbara Kauffmann, Dalia Marin, Tim Murphy, André Sapir, Reinhilde Veugelers, Luca Visentini and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic

Blog Post

André Sapir
Guntram B. Wolff

The Continental Partnership proposal: a reply to five main criticisms

The proposal for a Continental Partnership (CP) has received a great deal of attention. Two of the authors, André Sapir and Guntram Wolff, clarify some misunderstandings and respond to five key criticisms. They argue that the CP does not offer a way for EU members to restrict freedom of movement, nor is there a great risk of “political contagion”. Indeed, a CP arrangement could be the best route for the remaining EU members to maintain strong economic and security cooperation with the UK, while defending themselves against dumping and vetoes.

By: André Sapir and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: September 27, 2016
Read about event More on this topic

Upcoming Event

Oct
4
12:30

Potential impediments to long-term investment

How can we encourage long-term investment in Europe? Many factors hinder long-term investment but are there risks involved in reviewing existing regulation?

Speakers: Sophie Barbier, Grégory Claeys, Miguel Gil Tertre, Edoardo Reviglio and Sandra Rigot Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article Download PDF More on this topic More by this author

Policy Contribution

pc15_16

Low long-term rates: bond bubble or symptom of secular stagnation?

Yields on European sovereign bonds have reached historically low levels in 2016. This secular decline in long-term sovereign yields is not limited to the euro area. Why are interest rates currently so low? Are low long-term trates justified by fundamental factors or is it an artificial phenomenon?

By: Grégory Claeys Topic: European Macroeconomics & Governance Date: September 26, 2016
Read about event More on this topic

Upcoming Event

Oct
10
12:30

Financial Times/Bruegel European Forum: Where now for the UK and the EU after the vote for Brexit?

Three months after the results of the UK referendum there is still a lot of uncertainty about the future. The Financial Times and Bruegel bring together a panel to discuss the most crucial questions.

Speakers: Lionel Barber, James Blitz, Maria Demertzis, Sylvie Goulard and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Oct
13
08:30

The Euro and the battle of ideas

Why is the Euro in trouble? Are philosophical differences between the founding countries to blame and can those differences be reconciled?

Speakers: Markus K. Brunnermeier, Marco Buti, Maria Demertzis and Harold James Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article Download PDF More by this author

Parliamentary Testimony

written-evidence-house-of-lords-12-9House of Lords

The future of financial services in the UK following the Brexit vote

UK House of Lords EU Sub-Committee on Financial Affairs' call for evidence on the future of Financial Services in the UK following the vote to leave the European Union.

By: Dirk Schoenmaker Topic: European Macroeconomics & Governance, House of Lords, Parliamentary Testimonies Date: September 15, 2016
Read article More on this topic More by this author

Blog Post

Nicolas Véron

The City will decline—and we will be the poorer for it

Just as the City owes much of its current awe-inspiring prosperity to European integration, the brutal realities of Brexit will make it shrink, not thrive. All this is bleak news, not just for the City but for the UK's economy.

By: Nicolas Véron Topic: European Macroeconomics & Governance Date: September 14, 2016
Read about event More on this topic

Past Event

Past Event

From crisis management to launching economic growth

What have been the most effective strategies in limiting the impact of the economic crisis in Europe? What challenges lie ahead? Bruegel's 10th anniversary event in Budapest will foster discussion of these important topics.

Topic: European Macroeconomics & Governance Location: Budapest, Hungary Date: September 14, 2016
Read about event More on this topic

Upcoming Event

Nov
21-22
13:30

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
Read article Download PDF More on this topic

Policy Contribution

cover

What are the prerequisites for a euro-area fiscal capacity?

In this Policy Contribution, Maria Demertzsis and Guntram B. Wolff discuss three progressive steps for strengthening the fiscal framework at the euro-area level. These lead to less interference in national fiscal policymaking thanks to a more credible no-bailout clause, increased risk sharing and different degrees of provision of euro-area-wide public goods and fiscal stabilisation.

By: Maria Demertzis and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: September 9, 2016
Read article More on this topic More by this author

Blog Post

Dijsselbloem photo

Speech by Jeroen Dijsselbloem at Bruegel Annual Dinner 2016

Jeroen Dijsselbloem, President f the Eurogroup, delivered the keynote speech at Bruegel's Annual Dinner 2016, held on 6 September 2016.

By: Jeroen Dijsselbloem Topic: European Macroeconomics & Governance Date: September 7, 2016
Load more posts