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Financial Reform: Unfinished Business

The Independent Commission on Banking in the United Kingdom—the so-called Vickers Commission—proposed in September a more sweeping structural change for organizations engaged in commercial banking. In essence, within a single financial organization the range of ordinary banking operations—taking deposits and making loans—would be segregated in a “retail bank.” That bank would be overseen by its own independent board of directors and “ring fenced” in a manner designed to greatly reduce relations with the rest of the organization, which may be involved in investment activities, proprietary trading, and underwriting.

Apparently, customers could deal with both parts of the organization, and some limited transactions permitted between them. But as I understand it, the “retail bank” would be much more closely regulated, with relatively high capital and other stringent requirements. The emphasis of such rules would be to insulate the bank from failures of the holding company and other affiliates. There seems to be at least a hint that public support may be available in time of crisis. That presumably would be ruled out for other affiliates of the organization.

The practical and legal implications of the UK proposal remain to be defined. Surely problems abound in trying to separate the fortunes of different parts of a single organization, reflected in the length and detail of the commission’s report. Perhaps most fundamentally, directors and managements of a holding company are ordinarily assumed to have responsibility to its stockholders for the capital, profits, and stability of the entire organization, which doesn’t fit easily with the concept that one key subsidiary, the “retail bank,” must have a truly independent board of its own.

As a matter of day-to-day operations, some interaction between the retail and investment banks is contemplated in the interest of minimizing costs and facilitating full customer service. American experiences with “firewalls” and prohibitions on transactions between a bank and its affiliates have not been entirely reassuring. Ironically, the philosophy of US regulators has been to satisfy themselves that a financial holding company and its nonbank affiliates should be a “source of strength” to the commercial bank. That principle has not been highly effective in practice.

In any event, while there are differences in the structural approaches to reform in the US and UK, they are in fundamental agreement on the key importance of protecting traditional commercial banking from the risks and conflicts of proprietary trading and other investment activity. Both are consistent with developing a practical authority for resolving bank and other failures of systemically important institutions. If it is widely agreed upon internationally, that will be the keystone in a stronger international financial system.

One thing is sure: we have passed beyond the stage in which we can expect the officials of central banks, regulatory authorities, and treasuries to rely on ad hoc responses in dealing with what have become increasingly frequent, complex, and dangerous financial breakdowns. Structural change is necessary. As it stands, the reform effort is incomplete. It needs fresh impetus. I challenge governments and central banks to take up the unfinished agenda.

—October 27, 2011

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