Structuring Finance to Enhance Economic Growth and Stability

Editor’s Note: The following summarizes the ideas discussed at a December 4, 2012 Brookings event on structural reform of the finance industry. Additional resources, including panelist presentations, are available on the event page.

Governments around the globe are making major strides in transforming the regulation of the financial sector, in response to the financial crisis of 2007-9 that did such damage to the world economy. However, for all its virtues, that reform has focused too much on fighting fires – focusing on specific problems that arose in this crisis – and too little on why we have a financial system, what we want it to do, and how it should best be structured to accomplish those goals. We are in a uniquely good period to restructure the financial system, since there is a clear recognition that the old system had to change.

This is not to say that structural issues, particularly the problem of Too Big to Fail institutions, have been completely ignored. For example, there have been some proposals to force major changes in the way in which our core financial institutions are structured, rather than just how they operate. These include:

    • Proposals to “restore Glass-Steagall”, re-splitting investment and commercial banking
    • The Hoenig proposals for a kind of modernized and more limited Glass Steagall
    • The Volcker Rule to abolish proprietary trading by banks and their affiliates
    • The Vickers Commission proposals to “ringfence” traditional banking services
    • The Liikanen Group proposals, including a different approach to ring-fencing
    • Various proposals to break up the big banks

The Economic Studies Department of the Brookings Institution convened a conference on December 4, 2012 in Brookings’ Washington offices. We brought together leading experts in finance to discuss the structure of the financial industry and proposals for its transformation. The keynote address was given by Daniel Tarullo, the member of the Board of Governors of the Federal Reserve System (Fed) who has been the lead there on financial regulatory reform. Speeches were also given by Martin Baily, a Senior Fellow at Brookings and a former Chair of the President’s Council of Economic Advisers, and by Donald Kohn, a Senior Fellow at Brookings and a former Vice-Chair of the Federal Reserve Board. In addition, two panels of experts discussed the current structure of the financial system in the US and the rest of the world and proposals to transform finance and its regulation going forward. These experts were:

    • Sujit “Bob” Chakravorti, Chief Economist of the Clearing House Association
    • John Lester, Partner, Oliver Wyman & Co.
    • Nicolas Veron, a Senior Fellow at Bruegel and at the Peterson Institute for International Economics
    • Charles Calomiris, Professor of Finance at Columbia University
    • Marcus Stanley, Chief Economist, Americans for Financial Reform
    • Douglas Elliott, Fellow in Economic Studies, the Brookings Institution

This paper explores the key themes of structural reform by presenting the range of views expressed by the speakers and panelists in their formal remarks and in their answers to questions from the panel moderators and the audience. The reader will note that there is far from a complete consensus among these experts, although there are some important areas of common agreement.

This paper presents my own interpretation of the views expressed at the event and I am solely responsible for any errors in my understanding or presentation of those views. A complete transcript and presentation slides are available for those who wish more detail or who want to form their own impressions of the statements of the experts.

The Importance of Considering the Industrial Organization of Finance

The conference was driven by a belief that the structure of the financial industry has critical implications for how effectively it operates to achieve its societal purposes. There has long been a discipline of management science and economics, known as “Industrial Organization,” (or “IO”), which focuses on how industries are structured to achieve their purposes. Sadly, traditional industrial organization theory has fallen out of vogue with academics, supplanted by game theory and high-powered econometrics. However, there remains a rich heritage of research on multiple industries and some current work continues.

Governor Tarullo devoted his keynote address to a strong call for researchers to bring together the principles of finance and of Industrial Organization in order to design new financial regulations that will stand the test of time by enhancing financial stability without sacrificing economic growth unnecessarily. To his credit, this is a call that he has been making since soon after he joined the Fed’s board in 2009.

There appears to have been a strong, probably even complete, consensus among the experts present at the conference that it was important to analyze the structure of the financial industry, although this underlying assumption was not always explicitly stated. Governor Tarullo addressed it most explicitly and thoroughly, so the remainder of this section will largely focus on his remarks.

He argues that much can be learned from Industrial Organization that is relevant to redesigning the financial system. As he put it, “the value of an IO research agenda for shaping a regulatory system to protect financial stability lies both in ascertaining costs that may result from specific regulatory measures and in revealing industry dynamics that may suggest how regulatory measures may be more effective.” For example, an understanding of the extent to which there are economies of scale and scope in finance has implications for regulation. If these are economically significant, then there would be societal costs to actions which go too far in pushing banks to shrink or to step away from securities or other activities that extend beyond their traditional activities. If, however, the advantages of size and scope only result from excess market power or from the perception of a government guarantee, then there would be a stronger case for structural reforms.

Governor Tarullo went on to say that IO research could “inform financial stability regulation by illuminating industry dynamics that may not be intuitively apparent,” such as the patterns of competition and cooperation among financial institutions that are central to the functioning of the financial markets. It may be that findings from other industries can suggest better ways to limit contagion in financial markets while preserving the virtues of cooperation.

At the same time, there are clear differences between finance and most other industries, particularly the very high prevalence of what economists call “externalities”, indirect effects of the financial system on the rest of the economy. This was very evident in the recent crisis, when the troubles of the financial system spilled over to send the economy as a whole into a deep recession, so widespread and deep that it is often called “The Great Recession” as an analogy to “The Great Depression” of the 1930’s. These externalities are exacerbated by aspects of the industrial structure of finance that lead to “contagion,” such as: the interconnectedness of competing firms, strongly correlated asset holdings across the industry, the centrality of maturity transformation, with its resulting liquidity risks, and mark-to-market accounting that spreads the effects of fire sales quickly throughout the system.

Much of Governor Tarullo’s speech focused on the key questions of the existence and extent of economies of scale and scope. Despite the critical importance of this issue in any discussion of potential structural limitations, there is too little good research and no consensus on these related topics. He outlined some of the ways in which such economies could exist, going on to say that “the paucity of empirical work means we can only hypothesize these scale and scope economies, though intuition and observation may make some hypotheses stronger than others. Even assuming, as I think reasonable, that most or all of the economies that I have identified would hold up to empirical assessment, the crucial questions would remain as to how big or how integrated financial firms need to be in order to attain these economies.” He then proceeded to describe some of the challenges in doing sound empirical work in this area, but went on to urge further research in this area nonetheless, given its importance.

Governor Tarullo illustrated the value of IO theory, when appropriately adjusted for the peculiarities of finance, by addressing three particular issues under debate. First, the idea of breaking firms up by business line, such as through the restoration of the former Glass-Steagall non-affiliation provisions, is difficult to consider without a good IO analysis. For example, there are theoretically significant diversification advantages of combining lending and securities activities. The Governor considered it informative that the firms that suffered most in the crisis were generally firms that specialized in securities markets or specialized in lending, although he acknowledged this might not be true in a future crisis. Further, there are non-trivial economies of scope from combining commercial banking and securities activities, which would be lost in a break-up. As he stated, “with the present state of research, it is virtually impossible to quantify the social benefits of these economies. However, what seems the likelihood of non-trivial benefits from current affiliations is a good reason to be cautious about adopting this proposal.”

Second, he focused on proposals to cap the level of non-deposit liabilities that banking groups are allowed to gather. He noted that “many studies of the financial crisis demonstrate that the reliance of large financial firms on nondeposit funding made them, and the financial system as a whole, susceptible to the dramatic runs that peaked in the fall of 2008.” In addition to the potential reduction in systemic risk, “another attraction of this form of proposal is that, even as it places constraints on the potential size and composition of a firm’s balance sheet, it allows relative flexibility to the firm in meeting that constraint, particularly when compared with proposals for prohibitions on commercial banking affiliations with other financial firms.”

Governor Tarullo pointed out that a combined IO-finance perspective would be needed to help answer three key questions raised by this proposal. “First, of course, is the key issue of how the functioning of funding markets is affected by the participation of very large counterparties using very large amounts of short-term wholesale funding, particularly under conditions of financial stress.” “Second, is the question of scale and scope economies associated with nondeposit funding, the answer to which would help determine the limit at which significant social benefits might be lost, to be balanced against the avoidance of social costs arising from systemic events.” ”A third question is how second- and third-tier institutions might respond as the largest firms reposition, and perhaps shed, parts of their balance sheets.” After elaborating on each of these points, he concluded that “the IO-finance perspective could contribute significantly to an elaboration and evaluation of this policy proposal. In the process, it could advance what I regard as the most important task of financial regulatory reform – determining the most effective and efficient ways to deal with short-term funding markets, often characterized as the shadow banking system, that are inherently subject to runs.”

His final example related to proposals for requiring minimum levels of long-term debt at large financial firms as “a way to facilitate the orderly resolution of such firms.” As he put it, “the basic idea is that the maintenance of minimum levels of long-term debt at the top holding company level will allow a resolving authority to transfer operating subsidiaries of the failed firm to a functioning bridge entity, while leaving behind in receivership the equity and sufficient long-term debt to absorb the original firm’s losses.” After reviewing the benefits and likely effects, he concludes that the IO-finance perspective “did not immediately suggest any unfavorable unintended consequences, thereby strengthening its appeal as a near-term policy priority.”

Purpose of the Financial Sector

There was clear agreement among the experts that the purpose of the financial sector is to serve the “real economy.” In fact, the agreement was so universal that it was implied rather than explicitly stated by most of the experts. The belief was most explicit in reply to a question from the audience that touched directly on the social purposes of finance. This came in the first panel, moderated by me, with participation from Bob Chakravorti, John Lester, and Nicolas Veron. All of them agreed that there was little reason for public policy to support the financial sector for its own sake, but that its proper working was critical for overall economic activity and growth.

I, and other of the experts, have written elsewhere about the social purposes of finance. There is general agreement that the provision of credit to businesses and households is a crucial role as is, more generally, the allocation of funds within the economy, whether through debt, equity, or a hybrid or more novel form of finance. As the other side of the coin, savers and investors need to be given the opportunity for reasonable returns on their excess funds through participating in financial transactions, directly or through intermediaries. Finance is also important for providing risk management products that allow businesses or households to protect themselves from volatility in interest rates, exchange rates, prices of commodities and other assets. In furtherance of these higher-order objectives, finance also needs to provide for liquid markets in which to trade a wide variety of financial instruments.

Marcus Stanley and some of the audience members raised questions about the extent to which the financial sector had lost its focus on these societal objectives and instead generated a large number of transactions and instruments whose only real objective was to enrich the participants in the financial sector. This is a very difficult and subjective topic. Everyone accepts that there are specific transactions that served no particular social purpose and may have done harm. However, it requires a great deal of judgment to conclude whether these are isolated anecdotes or whether there were large volumes of transactions in categories that clearly did not need to exist. One of the reasons for this subjectivity is that virtually all speculative transactions have at least the theoretical advantage of increasing liquidity in markets by raising the volume and frequency of activity. In some cases it is difficult to argue that the modest increase in liquidity could be worth the risks caused by the speculation, but in most cases it is a more difficult judgment call.

It is important in this regard to keep a focus on the potential for market failures that distort market signals that would otherwise tend to optimize economic activity. The pursuit of individual profit objectives, no matter how seemingly venal, can come together to produce overall good for society, a concept that goes back at least as far as Adam Smith. The key question is therefore whether something about the current market structure encourages speculation to do more harm than good.

In his concluding remarks, Don Kohn appropriately emphasized the need to find the right trade-off between financial stability and economic growth. He noted that these two goals are not in inherent conflict, as the recent crisis demonstrated how badly economic growth is hit by financial crises, bringing down the long-term average of economic activity. However, it would also be possible to take such extreme actions to avoid systemic risk that the financial system would fail to adequately fulfill its role, thereby slowing the economy. Therefore, it is critical to consider the balance between costs and benefits.

The Right Size for the Financial Sector

An underlying question that affects one’s view of whether structural reforms are needed for the financial system is whether the financial sector is too big as currently constituted. This ties, of course, directly back to the question of the purpose of the sector and how well participants have fulfilled their roles. That is, if a significant portion of transactions and instruments do not provide value for the real economy, then one is much likelier to conclude that finance has grown to be too big.

I raised this question for the participants in the first panel, in my role as moderator. None of the three panelists was prepared to argue that they knew that the financial sector was too large. John Lester answered that it probably was not too large. While admitting that we simply do not know enough to definitively answer the question, his intuition is that the financial sector was not too big, in aggregate, in the US. He would not, however, expect the financial sector to usefully grow faster than the overall economy going forward, as we have a very mature financial system at this point. For his part, Bob Chakravorti gave a defense of the existence of large banks, and a large banking system in absolute size, by pointing to various advantages of economies of scale and scope, as well as diversification and innovation benefits. He also argued that once we remove the problem of some banks being Too Big to Fail, which he thinks new law and regulation is achieving, then there will be a market test for the size of banks and of the banking sector. As he stated, “credit intermediation is a market determined thing. The whole financial sector is there because there is a demand for financial products. So I do not think it is the case that the financial sector is too big.”

Nicolas Veron pointed out that whatever the concern about the size of the financial sector globally, the banking sector in the US is significantly smaller in relative terms than it is in Europe and Japan. Further, he argued that “financial intermediation is increasingly high value added if you move to a service economy,” implying that we should expect to have a substantially larger financial sector as we have moved away from manufacturing and agriculture over time. He explicitly stated that “I think finance has to be big, but profits were too large in the recent past.” That is, there are reasons to have a very large finance sector, even accepting that the recent boom was excessive.

Marcus Stanley took the opposite viewpoint, explicitly arguing that finance has indeed grown too large. In fact, the first two slides of his presentation focus specifically on the high growth rate of finance from 2000 to 2008 and some empirical studies that find that economic efficiency declines with rapid financial growth and high levels of financial activity. He pointed out that gross international banking positions rose by a factor of 3.5 times from 2000 to 2008 and that the notional value of over the counter derivatives positions grew from 3 times global gross domestic product (GDP) to 10 times over that period. There is a strong consensus, in retrospect, that financial activity grew excessively in the boom, that this helped create the conditions for the financial crisis, and that the crisis did enormous economic damage. Thus, few would argue with the desirability of avoiding bubble conditions in financial markets, although there is disagreement about how to go about this and even whether it is feasible.

More controversially, Marcus Stanley argued that there is evidence in the academic literature that the rapid growth of finance did not bring with it very much economic benefit during the upswing. He cited a recent study by Phillipon that found the efficiency of credit intermediation declined as finance grew. Further, Cechetti and Kharroubi found that rapid growth in financial intermediation is correlated with slower productivity growth in the wider economy.

I believe the question of the right size is a subjective one, given our current knowledge. We do not have enough data points to be able to do a statistical comparison of different financial sectors that are similar enough in most dimensions but differ in size. Nor, given the many other factors that vary over time is it definitive to compare financial sectors in one country over time. Marcus Stanley and, as will be discussed later, Charles Calomiris, are on the right track in trying to identify structural problems that create market failures which distort incentives and cause the financial system to be too big. However, I do not think we know enough to draw definitive conclusions.

That said, the answer is almost certainly that the US financial sector is either roughly the right size or is too big. I cannot think of an expert at this point who makes the argument that finance is too small, although that does not exclude the possibility that future analysts will look back and reach this conclusion. Intuitions are not always accurate. I have been struck by the fact that Confucian philosophy treated merchants as relatively unimportant, since they did not actually produce anything but merely dealt with the distribution of items. With the benefit of hindsight and more modern theories, we have come to realize just how important the business sector is. There remains the possibility that future analysts will conclude that our financial sector is still growing towards its right size. Or, of course, they may confirm the intuition of many that finance is too big.

Distribution of Tasks Within the Financial Sector

A key structural question is how financial tasks should be divvied up between commercial banks, investment banks, insurers, non-bank credit intermediaries, funds managers, markets, etc. The two biggest live questions are: (1) where to draw the line between banking activities and those that can be conducted by non-banks and (2) which activities should be allowed to be undertaken by depository institutions and their affiliates and which should be undertaken only by non-banks.

Underlying both questions is a consensus that certain banking activities are central to the economy and therefore are, and should be, protected by government-backed safety nets such as deposit insurance funds. Deposit-taking is clearly among these core activities, since households and businesses need the ability to use transactional accounts and to deposit spare cash without concern about the safety of the banks with which they deal. As the recent crisis showed, anything that creates widespread suspicions in this regard is very detrimental to the economy. Thus, the money-market funds received government guarantees, even though their shares are not legally deposits. Too many people were using these funds as if they were deposit-takers for the economy to handle a “run” on the money market funds. Similarly, deposit guarantee limits were expanded widely in order to avoid runs from spreading at the commercial banks.

The size and importance of deposits, and their federal safety net, have led many analysts to concentrate on ensuring that deposit-taking institutions do not engage, directly or through affiliates, in transactions that are either excessively risky or where the implicit subsidy for deposits might encourage too great a volume of activity. This is discussed in more detail below.

“Shadow banking” is another structural issue of great importance. This refers to bank-like activities that take place in entities that operate with little or no regulation because they are not organized as banks, insurers, or other highly regulated legal entities. Some examples include finance companies that borrow short-term money and lend it out for longer periods and money market mutual funds that take quasi-deposit money. Certain types of activities are also often considered part of shadow banking, regardless of what entity performs them, such as repurchase (“repo”) agreements where very short term borrowing occurs using securities as collateral. These activities share the characteristic that they involve very short-term borrowing, often overnight, which is then used to support longer-term lending.

Shadow banking was not a prime focus at this conference. However, a number of the experts share a concern that shadow banking is insufficiently controlled by regulation and that it could grow substantially as a result of increased regulatory burdens on the banking sector. At the same time, Don Kohn stressed that there is an appropriate role for non-bank financial activities, including securitization, so we should not throw out the baby with the bathwater by attempting to eliminate everything that might be seen as “shadow banking”.

A major structural topic at the conference was the extent to which traditional banking activities should be conducted in the same corporate groups as securities and derivatives activities. At an extreme, a re-imposition of Glass-Steagall would forbid most of these activities from being conducted by affiliates of a deposit-taking institution. Such limitations are discussed in considerably more detail below.

Too Big to Fail

Virtually all analysts believe that the largest banks benefitted from the perception that the federal government was likely to provide assistance if they got into too much trouble, usually expressed as those banks being “Too Big to Fail”. Shareholders did not rely to any great extent on this, since it was clear, and proved true in practice, that the government could and would allow them to lose close to the entirety of their investments. However, bank creditors and uninsured depositors in the aggregate almost certainly charged less and supplied more funds because of this implied safety net.

There are considerable arguments on two key points about the implicit subsidy. First, what was its size in the run-up to the financial crisis? It clearly became much larger during the height of the crisis, when many institutions could not have borrowed or would have paid far more for their funds without the knowledge that governments stood behind them. This leads to the second question, has it vanished or been very considerably reduced? Dodd-Frank and other new laws and regulations are intended to make it feasible for the government going forward to allow any bank to fail without triggering an infusion of taxpayer money.

Bob Chakravorti argued very strongly that the Too Big to Fail problem has largely been solved by Title II of the Dodd-Frank Act, which provides a new means of resolving troubled financial institutions that are systemically important, in combination with other parts of Dodd-Frank and new regulations. In addition to addressing a number of specific points, he mentioned a symposium that his organization had put together at which participants from all across the financial sector, including ex-regulators, explored how Title II might work in a hypothetical future crisis. I also attended this symposium and would concur with his assessment that the results were encouraging, although I certainly did not view them as definitive.

Marcus Stanley, on the other hand, indicated serious doubts about whether Dodd-Frank had gone far enough to truly remove the potential of a government rescue of one or more large financial institutions. Charles Calomiris concurred, although coming at this from a different angle. His overall view of the regulatory reforms is that they largely fail to get at the heart of the problem, which is the capture by financial interests of the politicians and regulators, leading to “reforms” that purport to reduce government support and require prudent operation of financial institutions, without actually creating the necessary changes in constraints and behaviors. Truly effective changes would reduce profits and executive compensation by draining away economic rents that are currently captured by the sector. In his presentation, he focused on a series of proposed reforms that he believes would be truly effective, which I will not summarize here because they generally do not involve changes to the overall structure of the financial sector, but rather aspects of the specific operations of the players. The most relevant aspect of his remarks for the structural reforms discussed at the conference is the idea that the system can be made safe without such changes, if the reforms he suggests are put into place. After that, he believes, the structure of the industry will adjust sensibly over time based on the underlying economics, but he is effectively agnostic about the optimal structures, since the safety of the system depends instead, in his view, on these other actions.

Concern about the implicit subsidy has led many to suggest that the largest banks be broken up or forced to shrink or given strong incentives to choose on their own to be smaller. The major counter-argument to this is that there are true economic benefits to having banks of this large a size and scope of activity. A number of the experts tackled this question.

Governor Tarullo made a strong argument, as noted earlier, for more research on this area, since he believes the question of the scale of economic benefits created by the largest institutions remains open. There are clearly some benefits, but he is unsure how much they are offset, or even more than offset, by harm done by the size of these organizations.

Bob Chakravorti referred to an extensive study by the Clearing House Association, an industry body, which concluded that large banks in the US provide a series of important economic benefits that would not be achievable to the same extent by smaller banks. The study found that the existence of big banks created $20 to $45 billion a year in benefits from economies of scale, figures they reached by looking in detail at various areas of banking where one would expect scale to matter. Similarly, benefits of a wide scope of product offerings at these banks and their affiliates produced another $15 to $35 billion a year of economic benefits. Finally, benefits that big banks provide through encouragement of financial innovation came to another $15 to $30 billion, bringing the total to $50 to $110 billion a year. He argued that these findings were relatively conservative, pointing to a finding by Wheelock and Wilson of the Federal Reserve Bank of St. Louis that even capping banks at $1 trillion in size, a relatively high limit compared to some proposals, would result in a loss of $79 billion in benefits.

Nicolas Veron, a public policy expert, did not express a strong position on the Too Big to Fail issue, but did show in a series of data tables that European banks are quite substantially larger in relation to the size of their national economies than is true for US banks. He believes that the Too Big to Fail problem, to the extent it exists, is distinctly worse in Europe. This, of course, would change if the Europe achieves a true banking union in which the relative comparison becomes the size of each bank relative to Europe as a whole.

John Lester, a consultant to financial firms, came down on the same side of the question, for similar reasons to Bob and also in light of the relatively lower concentration of banking in the US, as pointed out by Nicolas.

For my part, I argued strongly that there are indeed very substantial economies of scale and scope at the largest banks. Some of this has been shown by studies using more modern analytical tools that have been done recently at the Federal Reserve Bank of Philadelphia and the Federal Reserve Bank of Saint Louis. Further, work by Ronald Anderson, a professor at the London School of Economics, and colleagues have demonstrated that economies of scale and scope at the banks are likely to be much larger when one takes into account that some of the

benefits have been captured as “economic rents” by bank employees. This matters because we need to know the full extent of the economic benefits, whether they are retained by shareholders, passed along to customers in lower prices or better products, or captured as higher compensation. We might wish to take other actions to squeeze out the rents captured by employees or shareholders, but this may be preferable to reducing the size or scope of activities and losing the genuine economic benefits altogether.

I find these economic studies convincing in part because they mesh with my experience of almost twenty years as an investment banker, primarily focusing on financial institutions as clients. During that period, I saw many mergers put together by very smart industry leaders who believed that there genuinely were substantial synergies that would yield economic benefits of scale and scope. Further, these promises largely appear to me to have been borne out afterwards, although I did no formal study. These instances are not definitive, of course. They may not have represented the universe of transactions and it is possible that accounting or other factors confused what was actually going on. However, I tend to place weight on the opinions of industry leaders who are committing their own money and/or careers when they make decisions of this nature.

In my talk, I also emphasized that the benefits of breaking up the big banks may be much less than is sometimes argued. For example, if in the run-up to the financial crisis the major banks had each been broken up into 20 pieces, I maintain that the great bulk of the problems of the crisis would still have occurred. There would still have been excessive investments in both residential and commercial real estate, financial institutions would still have operated with far too little capital and liquidity, opaque and excessively complicated securitizations and derivatives would still have been in vogue, compensation structures would still have encouraged excessive risk-taking, markets would have much too cavalier about the risks that were taken, etc. In fact, it is difficult to find many significant ways in which the crisis would have been different. The best argument is that creditors would have been more careful about the risks the banks were taking if they did not perceive a government safety net. However, it seems unlikely that this would have happened to a significant extent, since most market participants were making bets across the spectrum of investments that indicated that the types of risks the banks faced were not of concern to investors. Another argument would be that individual troubled banks could have been allowed to fail, given their smaller size, however I find this unconvincing in the context of a crisis this wide. The S&L crisis, for example, demonstrated that taxpayers can end up paying large sums when a herd of smaller institutions all encounter the same problems, even though each could theoretically have been allowed to fail were there not the larger crisis.

Don Kohn, in his concluding remarks, emphasized the importance of increasing competition within the financial sector. He noted that dealing with Too Big to Fail is of critical importance in this regard, since implicit subsidies otherwise give the major firms too great an advantage over smaller competitors. He noted that considerable progress has been made in tackling these implicit subsidies, but did not indicate whether he thought enough was being done to contain the problem.

Limitations on Interconnections Between Financial Entities

One way of limiting the Too Big to Fail phenomenon is to reduce the connections among large financial institutions and between them and other parts of the financial sector. At the extreme, if a very large financial institution could exist without being crucial to any other financial institution or market, then its size would largely cease to be a concern. It could be allowed to fail without serious harm to the economy. In a less extreme version, reducing the importance of interlinkages in the financial system would reduce the direct effects of the failure of a single institution on the rest of the system and might reduce contagion effects resulting from fears of the indirect effects of such a failure. (It would not eliminate the “common shock” problem, where contagion occurs because the failure of an institution makes the market aware of a problem shared by many other institutions. Many argue that the Lehman failure revealed that government support was not necessarily available to troubled financial institutions, despite the seeming lesson from the Bear Stearns rescue, as well as emphasizing just how bad the problems of toxic assets were.)

One important move in this direction is the set of regulations mandated by Dodd-Frank and proposed by the Fed on Single Counterparty Credit Limits (SCCLs). These limits are intended to ensure that no large banking group has too much exposure to any other party, with the proposed limits particularly binding in regard to the very largest banks, those with $500 billion of assets or more.

The key question in dealing with interlinkages within the financial system is how to reduce the contagion risks without stifling useful market activities. Imposing the equivalent of a plague quarantine would certainly limit financial contagion, but it would also sharply limit all financial activities.

The subject of interconnections was touched on only fairly lightly at the conference, except in Governor Tarullo’s opening remarks. For my part, I expressed a concern that the combination of the Volcker Rule, discussed below, and the proposed SCCL rules could make it particularly difficult for securities and derivatives markets to fulfill their important economic roles effectively.

Functional Limitations for Banks

As noted, there are strong advocates of placing stronger functional limitations on banks, particularly to prevent deposit-taking institutions and their affiliates from engaging in certain securities and derivatives activities. The Volcker Rule is a prime example of this, since it forbids “proprietary trading” by any commercial bank or affiliate of a commercial bank. The next section deals with a related issue, the series of proposals to prevent deposit-taking institutions and their affiliates from undertaking securities activities or forcing those activities to be kept more separate than they currently are.

There was surprisingly little said about the Volcker Rule during the conference, given that it is the prime structural restriction that we know will occur in the US. Several speakers mentioned it, but in little detail. Marcus Stanley did argue in favor of activity limitations and for the Volcker Rule in particular, while expressing a concern that regulatory discretion would weaken its effectiveness substantially.

Charles Calomiris had an interesting take, arguing that the Volcker Rule would be unnecessary if there were instead a requirement for margin to be put up on any transactions between banks and their affiliates, thereby protecting banks from losses on the securities transactions in all cases except where there is an extreme movement in a very short period of time. He indicated that several prominent supporters of the Volcker Rule have told him in private that they would be quite comfortable with that alternative approach to the problem.

I only touched briefly myself on the Volcker Rule, but have written and testified about my serious concerns about the damage it could do by making useful market activities substantially more expensive. It is also not clear to me that there is any particular safety benefit to be gained. For that matter, the overall rationale for the Volcker Rule has always seemed quite unclear to me and the explanations of its benefits rather strained.

Ring-fencing and Bank Affiliations with Securities Dealers

One of the more common proposals for dramatically restructuring the financial sector is to remove deposit-taking institutions from securities market activities or to substantially reduce their scope and level of activity. Glass-Steagall, for example, had forbidden commercial banks from undertaking much of this type of activity either directly or through affiliates. (There were always exceptions, such as the ability of banks to engage in activities involving US government securities and those of states and localities. It is noteworthy that the US government almost never produces regulations that limit the ability of banks to buy its own products and to sell them on to others. This continues to be true with Dodd-Frank and, for example, the SCCL rules.)

There was a very lively discussion in the Q&A period after the last panel between Charles Calomiris, Marcus Stanley, and a member of the audience who strongly advocated the reimposition of Glass-Steagall. (It should be noted that Glass-Steagall has actually never been repealed. It was only the crucial anti-affiliation provisions that were repealed. Many other important aspects of the law remain, including those that prevent commercial banks from engaging directly in forbidden securities transactions, even though affiliates are now allowed to do so.)

Professor Calomiris, who is a financial historian as well as an expert on regulation, strongly asserted that the arguments of the Pecora Commission that conflicts of interest harmed bank depositors and therefore required a separation of banking and securities activities are now completely discredited. He further argued that much of Senator Carter Glass’ thinking that led to Glass-Steagall was based on an economic theory known as the “real bills” doctrine, which is also now discredited. Overall, he believes that Glass-Steagall was established for unsound reasons and he further asserted that the common conception that it did no harm for 50 years is wrong. He stated, for example, that prior to Glass-Steagall, the financial system was developing ways for smaller corporations to borrow through the securities markets, but that Glass-Steagall abruptly ended these experiments, leading to hearings in the 1950’s and later about the difficulty of borrowing for small businesses.

Marcus Stanley argued that Professor Calomiris’ assertions were much overstated and sometimes wrong, although he did not go into great specifics during the Q&A period. Nor did the questioner from the audience back away from his own beliefs.

Whatever the historical basis of Glass-Steagall and its efficacy in the past, there was strong skepticism from a number of the experts about the benefits of restoring such a simple division now.

Governor Tarullo was very careful in his wording not to take a definitive position, but it does not seem a strain to read his speech as indicating a strong preference for approaches other than this kind of simple structural division. He indicated that “what seems the likelihood of nontrivial benefits from current affiliations is a good reason to be cautious about adopting this proposal.” Further, he lauds the concept of capping non-deposit liabilities at banks, saying “another attraction of this form of proposal is that, even as it places constrains on the potential size and composition of a firm’s balance sheet, it allows relative flexibility to the firm in meeting that constraint, particularly when compared with proposals for prohibitions on commercial bank affiliations with other financial firms.” (Emphasis added by me).

Similarly, Don Kohn explicitly argued against reimposing Glass-Steagall, although he does support the Vickers Commission recommendations in the UK for ring-fencing. However, he noted in that regard that his support was influenced by conditions in the UK that do not apply to the same extent in the US, such as the considerably higher degree of market concentration in the UK.

With the exception of Marcus Stanley, who explicitly endorsed activity limitations and argued for some of the historical advantages perceived to arise from Glass-Steagall, the other experts appeared to disagree fairly unanimously with returning to Glass-Steagall.

There was less of a consensus about the degree to which securities and derivatives activities should be conducted in bank affiliates and how that should be governed. In this regard, it is worth noting two European efforts that are underway to use “ring fencing” to reduce the economic risks of combining these activities in a group that also takes deposits. The first to be proposed was that of the Independent Commission on Banking, in the UK, known as the “Vickers Commission”. The Commission called for core activities, such as deposit taking, to be conducted by a bank that would then be protected by a “ring fence” which would hold it separate from most securities and derivatives activities that would be undertaken in separate affiliates. The core economic activities could then be protected by deposit insurance and other safety nets without fear that the bank would be compromised in a serious way by failures in these other businesses. Some activities could only be undertaken within the ring-fenced entity, others would be forbidden to that entity, and others could be undertaken either inside or outside the ring fence, at the discretion of the management.

The second proposal is from a “High Level Expert Group” formed by the European Commission, known as the Liikanen Group after its Chair. Among other policies, the group recommended that all securities trading must be undertaken outside of a ring-fenced deposit-taking entity. This choice is an attempt to get around a problem affecting the Volcker Rule and the Vickers Commission recommendations, which is that allowing market-making activities to remain inside the ring fence means that there must be a reasonable way to differentiate between trading undertaken for its own sake and trading undertaken as part of market-making. As even proponents of these approaches generally concede, this is quite difficult to operationalize.

A number of the experts at the conference explicitly placed a high value on the economic benefits of bank-centered groups engaging in securities and derivatives activities, including Martin Baily, Bob Chakravorti, John Lester, and me. For us, there are serious dangers in the Volcker Rule and the ring-fencing proposals, although the latter could potentially be implemented in ways that would not be that harmful. For example, the US already has a ring fence around commercial banking entities, in that they are forbidden to directly undertake many securities activities and have fairly strict rules about how they undertake transactions with their affiliates that do engage in such transactions. (Credit arrangements must be on terms that approximate an arms-length transaction and the banking group cannot approach a client with a proposal where the bank provides concessionary terms in exchange for non-credit transactions that benefit the affiliates.)

I and the others expressed several concerns about the Volcker Rule and the strong form of ring-fencing. First, there are significant synergies between credit activities undertaken as loans and credit activities undertaken as securities underwriting or market-making. These economies of scale and scope would be reduced or eliminated by the regulatory proposals, with real cost to customers and the economy. Second, there are very significant operational problems inherent in these proposals that are likely to do damage to economically useful activities. This is clearest in the case of the Volcker Rule, where it is extremely difficult to tell “proprietary trading”, a term of art, from market-making. This matters, because market-making is essential to liquid markets and liquidity is essential if markets are to provide well-priced credit and equity to companies in the real economy. If the Volcker Rule forbids activities too easily or is so complicated that it pushes banks to forego those activities, then markets are likely to suffer in a significant way.

Third, even if such changes were desirable in the long run, groups centered on large commercial banks are at the very core of the current system of markets. At a minimum, there would need to be a very long and careful transition period to allow small players and new entrants to expand their activities without jumping in before they are ready. It takes time to develop the appropriate risk-management systems, to develop the right culture, and to develop the relationships with counterparties to operate safely and efficiently.

Martin Baily, in particular, went beyond discussions of securities activities to plead for a careful approach to derivatives regulation, which is central to the financial risk management of many firms in the real economy, as well as of the financial institutions and markets. I touched on this as well, as I am concerned that too little value is being placed on these risk management activities, thereby encouraging regulators to take actions that they believe increase the safety of various activities, without fully considering the economic cost of placing excessive burdens on risk management. Forcing many derivatives activities to take place outside the ring fence or, in the case of the Volcker Rule, potentially forbidding them, raises such risks.

Others among the experts at the conference support the Volcker Rule and are interested in the ring fencing ideas. Marcus Stanley was most vocal in this regard. In addition, Governor Tarullo discussed the benefits of such ideas, although in the context of the need to carefully balance the benefits and costs.


Our conference is only one step among many that must be taken to fill in the gaps of theory and fact to allow us to evaluate structural reform proposals in a way that truly reflects their benefits and costs to society. It was gratifying that Governor Tarullo gave such a strong endorsement of the need for further research and discussion of this area and that the remainder of the day produced further examples of the issues that need to be resolved and some early thoughts on their implications.