In the past year, many suggestions have been made on how to strike the right balance between efficient use of capital and systemic risk. More recently, Paul Volcker, former chairman of the Federal Reserve, has proposed that deposit-taking banks should be prohibited from engaging in proprietary trading. The so-called Volcker Rule is advocating the segregation of “utility” banking from “casino” banking. Earlier, Paul Krugman had pointed out the benefits of a reversion to “boring” (read utility) banking. Separately, on January 26, 2010, Mervyn King, Bank of England governor, stated at a Parliamentary treasury committee meeting that “after you ring-fence retail deposits, the statement that no one else gets bailed out becomes credible”. According to King, higher capital requirements and better regulation would not be sufficient to reduce the risk of another protracted banking crisis. On January 28, 2010, Volcker’s suggestions were politically endorsed by the US President in his State of the Union Address. Subsequently, on February 2, 2010 at a Senate Banking Committee hearing, the treasury deputy secretary confirmed that the US administration would submit specific proposals “soon”.
Taking a step back, let us review some elements of investment banking which purportedly enhance the efficiency with which capital is used. For instance, activities such as trading, derivatives markets, securitisation or mergers and acquisitions do provide relatively high rates of return on equity (RoE) and raise market liquidity. However, the profits are usually a zero-sum game between providers of such services and their clients. Further, investment banking as a whole cannot consistently provide RoEs which are much higher than nominal GDP growth rates. This would be possible only if it is accompanied by low-to-negative RoEs for the rest of the economy.
On a separate note, it is suggested that investment banks are able to provide higher returns because they are more leveraged. More leverage is synonymous with higher risk. Hence average RoEs for the innovative segments of the financial sector, on a risk-adjusted basis, have to be comparable with nominal GDP growth rates. If it is claimed that investment banks, insurance companies, hedge funds or asset management firms can forever provide higher returns, the assumption has to be that governments will not allow them to fail when the inevitable black swan events occur. This is so basic that it is surprising there is unquestioning reporting on the renewed profitability of investment banking activities.
Another argument in favour of persisting with low capital requirements is that risk-adjusted RoEs reflect only a fraction of the value added by innovative finance. It is correct that niche market intermediation through venture capital provides the much-needed capital to start-ups, triggering economic activity. However, CEOs of real sector companies could argue that the same holds for their upstream and downstream linkages, which correspondingly should justify bailouts of auto and steel companies among others.
Moving to remedial actions to limit solvency risk, it is relevant to recall the 1933 Glass-Steagall Act (G-S) which segregated commercial from investment banking. The Federal Deposit Insurance Corporation (FDIC) was set up under the same statute. In contrast, when G-S was repealed in 1999, there was no rethink on whether universal banks should be covered by FDIC. If G-S were to be re-imposed, deposit-taking banks would find it difficult to lay off risk from their loan books. However, if this reduces the ability of issuers and distributors of asset-backed securities to disguise default risk, the resulting lower efficiency in the use of capital would not be the worst possible outcome. As we know, the distribution of risk through securitisation does not make the underlying credit risk disappear.
Of course, even if deposit-taking banks were to be separated from investment banks, the latter could continue to attract funds and again become too big to fail. For that matter, insisting that banking has to be made boring will not prevent the next crisis. There were many financial breakdowns between 1933 and 1999, the two years the Glass-Steagall Act was passed and repealed, respectively. However, none of these crises were anywhere near the size or intensity of the Great Recession of 2008-09.
Another idea, which is doing the rounds, is Counter-cyclical Contingent Capital (CoCo). CoCo debt is deemed to carry less risk since it would become equity when pre-agreed stress levels are breached. The fly in the ointment in this seemingly attractive proposition is that if investors price the highly valuable embedded option correctly, the cost of such debt would be prohibitively high. There is also a proposal to impose a levy on liabilities above a prescribed level. In practice, such charges would probably be passed on to customers. Therefore, taxpayers could end up paying in advance instead of ex-post for banks to recover from the next crisis.
In India, the financial sector has considerable catching up to do in several areas, including securitisation, derivatives and venture capital. Consequently, at this point we do not share the West’s preoccupation with improving the regulatory and legislative framework to constrain irresponsible risk-taking. The sense is that we should not impose inefficiently high capital requirements and overcautious regulation. Given the dominance of public sector banks and insurance companies, investment banking interests probably do not have a controlling vote as yet. Hence, we have a window of opportunity to enact forward-looking legislation, namely an improved Indian version of the Glass-Steagall Act.
To sum up, many innovations, including mortgage-backed securities which have made financial intermediation more efficient, should be promoted. Concurrently, we have to review a number of prevailing practices, e.g. should mutual funds continue to offer money market schemes or should this be the exclusive preserve of utility banks to help them garner resources. At a global level, a return to a Glass-Steagall world would be prudent. Clearly, proprietary trading cannot be fully disentangled from trading on behalf of clients. It is also true that Glass-Steagall would reduce the efficiency with which capital is used. The unpalatable reality is that we need to be prepared to give up some of the upside since periodic meltdowns more than erode cumulative efficiency gains. As empirical evidence has shown, public debt invariably replaces private debt post a financial crisis. Therefore, it is important for our regulators to work out “living wills” for systemically important financial institutions and have contingency plans for orderly default.
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The government today said it would infuse Rs 16,500 crore into public sector banks to ensure that they had a minimum Tier-I capital adequacy ratio of 8 per cent by March 2011.
