Saturday, October 27, 2012

Too Many for Too-Big-To-Fail Institutions

The Vickers Commission in the United Kingdom has advocated ring fencing of core banking activities and on the other hand The Volcker Rule in the United States prohibits banks from engaging in certain kind of investment activities.

These rules and regulations have come to fore after the loopholes in the banking sector were magnified during the sub-prime crises and the consensus on the implementation of these rules is still debatable. In the Vickers Commission, core activities of the bank like taking deposits from and making loans to individuals and small and medium sized organization would be “ring-fenced”. Some activities like trading, purchase of loans and securities, transactions outside the European Economic Area and with non ring-fenced banks would be prohibited. It is also stated that the ring-fenced entity would require more capital than advocated by the Basel 3 committee.

The Volker Rule attempts to limit banks’ exposure in certain investment activities like in hedge funds and private equity. Proprietary trading, which is banks trading on their own account is completely banned. Demise of Lehman Brothers and Bear Stearns is because of these trading acts. The Glass- Steagall Act that was repealed in 1999 had the rationale of keeping the investment banking separate from the commercial banking activity and now the new founded acts and rules are trying to advocate the same thought which was envisaged by Glass and Steagall long ago.

Sandy Weill, the former chairman of the Citigroup advocates the return of Glass-Steagall Act altogether and there are many academicians who are carrying Sandy’s point of view forward too. But the question here arises that by demarcating the commercial and investment activity of the bank can the big institutions survive? In today’s time where the customers don’t have much time to spare on different investment instruments to choose from and want everything on a single platter in a quick and organized manner, a simple commercial bank became a universal bank by providing one shop investment solutions coupled with core banking  to retain their customers.

But has this opportunity been over utilized by the bankers and has put on stake the security of investors’ money? But what can be the solution to this dilemma? Limiting the scope of the banks and raising the capital requirement won’t answer these questions appropriately. Multiple approaches are required to unearth the solution to these issues. Mr. Raghuram Rajan, CEA to GOI, advocates that setting limits on all trading assets or income can help the big institutions to be in the limits and so they can also manage the risk properly. Mr. TT Ram Mohan of IIM-A states that the problem is not the scope of activities carried out by the banks but the sheer bigness of these institutions that pose a challenge. If the size of bank’s asset to GDP is controlled and looked carefully upon then the risk can be mitigated in a better way.

Though many solutions by the eminent leaders of the world are advocated and discussed upon but the lag in adoption and implementation of certain rules and regulations can again pose a challenge for the financial sector because of the paucity of time and the anemic growth which the world is witnessing.
Acting fast and shielding the global economy from another financial headwind is the only solution.

  • Investopedia: Glass-Steagall Act
  • “How do we resolve the Too big to fail problem?” by Mr. TT Ram Mohan from IIM-A, EPW, September issue.

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