By Angel Gurría, Secretary-General of the OECD. Article published in the Wall Street Journal, Europe edition (see the original online version).
Financial regulators have written ever-more complicated rules to deal with increasing market complexity and to rectify past sins. Unfortunately, the results are imperfect. In a way, they are bound to be. In a celebrated 1953 essay, Milton Friedman noted the impossibility of setting out theories that purport to meet all of the intricacies of finance and economics, arguing that a model is useful only if it can explain economic phenomena by isolating the “common and crucial elements from the mass of complex and detailed circumstances.”
From the outset of this financial crisis, the OECD has argued for clear and intelligible bank regulations. The ground has now begun to move in our direction. We believe it would be most effective to implement two complementary reforms.
First, we need a simple leverage ratio—the amount of equity required for a given quantity of total assets—to control the problem of banks with too little capital. Basel rules unfortunately gave banks ample scope to avoid such limits via so-called “risk-weight optimization,” with the result that banks are still short of the capital required to conduct business safely. This is especially true in Europe, where €700 billion may be required to bring banks better into line.
Even some former members of the Basel Committee now appear to be changing their minds on the need for simpler rules. Indeed, new research at the OECD and the Bank of England suggests that the leverage ratio is far more effective than complex, risk-weighted capital ratios in influencing bank default risk.
Second, as we first proposed at the G-20 summit in 2009, the separation of commercial banking from large-scale proprietary securities businesses, notably in derivatives, is essential to avoid the cross-subsidization of excessive risk-taking linked to the too-big-to-fail phenomenon. We provided research to support this case to the U.K. Independent Commission on Banking.
Separating retail and investment banking has been addressed through the Volcker Rule in the U.S. and the Vickers reform in the U.K. Separation is also on the agenda in France, where President François Hollande has expressed interest in the subject, and in Germany, where there is growing support in some political circles. Even Sandy Weill, Citigroup‘s former chairman and one of the most influential players in the drive to remove America’s Glass-Steagall Act, suggested this summer that separation made sense. The new Liikanen Report also argues for the separation of proprietary trading of securities and derivatives related to market-making.
The OECD’s preferred model is legal separation and ringfencing in the corporate form of a nonoperating holding company. This prevents creditors of one troubled subsidiary from pursuing those of another, and facilitates the correct pricing of risk. The creation of more “bite-sized” affiliates also enhances the credibility of resolving them in the case of insolvency.
If a crisis erupts in securities businesses, a separated traditional commercial bank could go on lending to households and firms. There would also be less deleveraging in the areas where local businesses depend on bank funding to deliver jobs growth.
The securities business, meanwhile, would have to earn a proﬁt with clients aware that it would have less access to capital in the event of failure, and that failure would be unlikely to result in the socialization of losses. The risk premium associated with the securities business would appropriately rise, with more demand for properly segregated accounts and more rigorous collateral practices. The securities business would thus have to become less leveraged and more discerning when dealing with risky products. In other words, those who take the bets live with the consequences and pay for them.
We need to be aware of potential impediments to progress. Despite the evidence that complex capital rules are less effective than a simple leverage ratio, the latter is still only treated as a backstop rule under Basel III. The proposed level is 3%, implying 33 times leverage of capital—well below the median level of 5%, or 20 times leverage, recommended by the OECD.
Also, national approaches to bank separation are proceeding in a fragmented way while securities firms increasingly work without reference to national borders. With more European countries now interested in the issue of bank separation, we need more consistent approaches that deal with the issue in a simple and practical manner.
Complexity shouldn’t lead to crisis. There is a better, simpler way: Split the banks.