Narrow banking isn’t even on the reform agenda — merging Merrill and BofA is, in fact, a move in the opposite direction.
“In a generalized crisis of
confidence, the banking system
rests not on slivers of bank capital
or on individual reputations for
solvency, but on the government’s
ability to run the printing presses.” — Holman W Jenkins, Jr,
in The Wall Street Journal, on September 17, 2009.
Supporting troubled commercial banks with public funds is perhaps inevitable given that deposits (at least up to a limit) are insured and, in any case, democratic governments find it easier to get the cost borne by the citizens as taxpayers rather than citizens as depositors. The question, therefore, is whether insured deposit-taking institutions should function as tightly regulated ‘narrow banks’, undertaking only low-risk business; those who wish to undertake riskier businesses like proprietary trading and complex derivatives should fund themselves in the capital market, with uninsured loans or bonds placed with qualified institutional investors or wealthy individuals. The implication is that while the latter world then be managed solely in the interests of the shareholders, the former would be more like utilities with limited and regulated profits. The risks of mixing the two together have been manifested in the recent global crisis: With one exception, Lehman Brothers, every large bank has been rescued, in one way or another, at huge public cost. The ‘moral hazard’ is that it encourages banks to take huge risks; the rewards are pocketed by the traders, the management and the shareholders; and when they incur losses, the public picks up the bill — in other words, ‘private profits, public losses’ is the accepted model.
There is, however, one problem with the narrow banking model: Since financial market participants regularly undertake transactions with each other in the money, currency and derivatives markets, problems in the high-risk segment could affect the narrow banking segment as well through counterparty exposures. One possible solution is to stipulate that all deals between insured deposit-taking institutions and financial players in riskier businesses should be through exchanges — whether in assets or in derivatives. In India, we have an excellent, well functioning example of what is, effectively, an exchange-traded money/repo market: The collateralised borrowing and lending obligations (CBLO) window of the Clearing Corporation of India Ltd. It is perhaps unique in the world and its success can be gauged from the fact that its transaction volumes today are well in excess of the OTC inter-bank call money and repo market taken together! Of course, CCIL also guarantees settlement of trades in bond and currency markets also, and it is not difficult to expand the model to include plain vanilla derivatives as well. If this were done, all trades between narrow banks and riskier players would be effectively carried out through exchanges, shielding the former from the latter’s risks. And, in any case, complex derivatives are not needed for genuine hedging.
Whatever the logic of narrow banking, the idea seems to be outside the scope of the regulatory reform currently being debated. On the contrary, by merging Bear Stearns with J P Morgan and Merrill with Bank of America, recent regulatory moves have been exactly in the opposite direction — and in the case of many banks, even bond holders have been rescued.
There are two other issues in terms of bank regulation. The first is that banks like Northern Rock, Bear Stearns and Lehman Brothers were hugely dependent on short-term money market funding to finance long-term assets. In other words, they were taking a huge liquidity and interest rate risk in their asset:liability book. Basle II had no capital charge for interest rate and liquidity risks. There is obviously a strong case for prescribing capital for these risks, but one has not found anything much on this issue in the various reform proposals under discussion. While the Group of Thirty report on Financial Reform, which came out early this year, refers to “standards for liquidity risk management”, it falls short of recommending a suitable capital charge.
The other issue is in relation to management of the interest rate risk a bank runs through the mis-match in the timing of re-fixation of interest rates on assets and liabilities. In terms of the applicable accounting standard, this interest rate risk can be hedged through a derivative contract by way of a cash flow hedge. (The accounting treatment depends on whether a derivative is a fair value hedge or a cash flow hedge.) The problem is that hedge effectiveness standards prescribed by the accounting standards for cash flow hedges are so complex that, in my view, they are not capable of being fulfilled by banks. (Even non-bank entities would find it difficult to meet with the prescriptions.) The principal reason is the ever-changing nature of a bank’s assets and liabilities. The result is that most genuine cash flow hedges would be treated as trading positions by the accounting standard: They would be marked-to-market through the profit and loss account even as the deposits and loans are carried at historical costs. This obviously deters banks from hedging the interest rate risk.
The author blogs at avrajwade.blogspot.com
