The size of financial institutions is again in the spotlight, following President Obama’s somewhat surprising proposals to restrict the size and activities of US banks last week and European Central Bank President Jean-Claude Trichet’s supportive comments this week.
Obama's proposals coincided with an event we organised here in London which asked the question 'Are banks different?'. High-profile speakers - including Lord Turner, chairman of the UK Financial Services Authority, Ackermann of Deutsche Bank, Agius of Barclays and Haddrill of the UK Financial Reporting Council - attended. Simultaneously, the UK Treasury Select Committee is looking into whether UK financial institutions are too important to fail, an inquiry to which the ICAEW has submitted comments.
It's a topic that is being looked at all over the world as a potential response to the global crisis. Whilst we all agree that change is required following a massive regulatory failure , it is questionable whether this is the right type of change. Here are some considerations:
It is important to remember that size isn’t all, as size and risk don’t necessarily correlate. A large institution isn’t by default riskier, as its size might allow it to spread the risk more successfully than a smaller institution can afford to do. Inevitably, however, it is obvious that a large institution failing will have a greater impact on the financial system than a smaller one.
Splitting financial institutions into two categories based on their size – systemically important and other – is too simplistic, as there can be large firms with few links to other institutions and small, complex firms with many. Their risk also depends on the state of the financial system at the moment.
I would suggest that the term ‘too big to fail’, which is now so often used, is somewhat misleading and simplistic. The question is rather whether an institution is ‘too complex to fail’ or has ‘too-big-an-impact to fail’. And if that argument is accepted, introducing a legal split between investment and retail banking will not necessarily solve the problem. It might not create a more resilient system. It would also be impractical and difficult to implement.
Focus therefore has to be on the risk of financial institutions’ activities – and on how risk increases when institutions in tough times often act like herds and adopt the same strategies. Monitoring of concentration risk is therefore critical.