Meeting at the Halfway House on Banking Reform

Includes: BAC, C, GS, JPM, KBE, MS, XLF
by: William Armstrong

The struggle over banking reform drags on in the house and senate. Several issues from these debates hit the headlines frequently. How much regulatory authority should the Fed have? Should there be a systemic regulator? If so, where should such an agency be housed? Does consumer protection deserves its own agency? What to do about user-hostile credit card practices?, etc. While all of these issues are important and must be dealt with in their own time, a more urgent issue should be decided first. This issue is to decide which basic regulatory philosophy should guide the nation’s regulatory framework.

Fortunately, there are only two such frameworks to chose from, unless one is willing to consider more radical alternatives like free banking, supported by some libertarian economists, or nationalized banking, supported by the left.

Both of these “non-radical” frameworks recognize the importance of limiting the risks that the financial system’s deposit base is exposed to, but they seek to control these risks in quite different ways. One of these permits financial groups to offer a broad range of financial services ranging from simple deposit facilities for savers to making markets in esoteric derivatives and insurance products. The risks that losses in the more recherché parts of these organizations affect bank deposits is controlled by requiring these organizations to set aside larger cushions of equity capital against different parts of their business, depending on their risk.

This kind of system, sometimes called universal banking, has existed in Europe for decades, and was more recently imported to the U. S. when the Gramm, Leach Bliley Act replaced the Glass-Steagall Act as the country’s main banking law.

The other central or orthodox regulatory philosophy harkens back to the GS days and has as its primary risk control mechanism a separation of functions among different kinds of financial intermediation. In the GS scheme, deposit-taking organizations are not permitted to engage in the risky activities like (some) securities trading, or owning hedge funds, or underwriting insurance risks. The underwriting of risky securities is usually limited in such a scheme, since it involves proprietary trading.

Recently, Paul Volcker has convinced president Obama that a GS kind of reform philosophy is the better way to go. His proposal is now famously called the Volcker Rule.

The logic of such a policy is solid in my view since the alternative puts resources guaranteed by the taxpayers into the hands of traders at investment banks who then effectively gamble with these funds. Astonishingly, these traders are permitted to keep much and in some cases most of the gains when they win while passing the losses to shareholders (if the losses are small) and back to the taxpayer (if they are large). If there is a set of facts that would support such a practice, please let me know.

The introduction of the Volcker Rule has thrown the cat in amongst the pigeons since the Congressional committees were drafting legislation that was headed in the direction of some kind of universal banking. They are now trying to deal with this new wrinkle, and the going has not been easy.

The proponents of a Volckeresque or Glass-Steagallesque separation of commercial banking functions from investment banking risks cite the logic of not providing resources subsidized by taxpayers to investment bankers and the reduced systemic risk that would result from such a separation. Detractors cite the fact that such a separation could fragment our financial institutions, leaving them without the economies of scope and scale that are necessary to compete with large international financial groups, like Deutsche Bank, Santander, or Barclays. There is a way out of this impasse, I believe, one that would reduce systemic risk while preserving some of the economies of the financial supermarkets.


The solution is for the two sides of the debate to meet each other half way. This half way house would require different kinds of financial intermediation (commercial banking, investment banking and insurance) to be done in different legal entities, but it would allow them to be owned by a single holding company.

The holding company would be strictly that – it would not be an operating company taking on risks of its own. The holding company, which would normally be the quoted company, could own investments in deposit-taking banks, investment banks, and insurance companies. Strict limits would be placed on the degree to which the commercial bank could finance the activities of the other group companies in order not to put depositors at risk.

While the holding company could not itself do any financial intermediation, it could undertake certain activities itself -- activities related to the general administration of its financial intermediation businesses. It could do the accounting for the group, for example, and it could also, if it wished, do clearing and settlements for the group, or market the brand and the services of the group as a whole and of the different companies in the group. (Alternatively, it could undertake these ancillary activities through subsidiaries.)

In this way, the financial groups would continue to enjoy many of the economies of scale that they claim they would lose under a strong form interpretation of the Volcker Rule.

However, the taxpayer would be protected from the kinds of losses that we are all now suffering from. Many will complain that such a regime is difficult in practice to implement, however, it tends to be simpler to implement than the kind of complex capital requirements that are necessary to control the risks in a regulatory framework that organized around financial supermarkets.

Also, the financial statements of single function financial companies are much easier to understand, which itself reduces risks. I will deal with the objections that are typically raised in a future post.

Disclosure: The author holds a long position in JPM