How US and UK banking proposals threaten global growth and financial stability

A protectionist push is underway in the world’s two leading financial services economies. This threatens to undermine not only the already-weak recovery, but perhaps more importantly the ability of the financial sector to address future crises without recourse to taxpayers.

The UK Parliament is still drafting its domestic ‘ring-fencing’ plan. The plan will force banks catering to retail consumers to separate retail and wholesale banking functions into individually capitalised units. Limitations will be placed on the movement of capital and liquidity among units; and the retail unit will be subject to heightened capital requirements. At this point the plan may well apply to only a handful of banks, resulting in a two-tier regulatory system.

Meanwhile on the other side of the Atlantic, the United States’ Federal Reserve issued a much criticised ‘foreign banking organization’ proposal, seeking to transform the corporate structure under which non-US banks carry out their US business, reversing decades of regulatory practice.

The proposals share a common theme – that policymakers believe the organisational or corporate structures of large banking groups, rather then the activities and risk profiles, are a threat to financial stability. Banks must therefore undertake costly restructuring exercises to mitigate the risk. Yet both proposals interfere with the ability of global banks to allocate capital and liquidity in a manner they deem to be most efficient. This may be an acceptable price to pay if the overall result were enhanced stability. However, trapping capital and liquidity in particular jurisdictions (as with the US proposal) or corporate entities (the UK plan) is likely to make large banks less resilient in times of crisis, not more.

The 2008 financial crisis would have been much worse had liquidity not flowed freely across borders. The danger of these proposals is that they limit the ability of private firms to deal with liquidity shortages before it becomes domestic taxpayers’ problem. Imposing costly and inflexible corporate restructuring reduces the funds available for recapitalisation, and makes banks more inefficient and less capable of speedy adjustments. It also makes foreign banks less likely to step outside of their domestic markets.

In the UK, the ring-fencing scheme is designed to give retail depositors added security, but it is unlikely to work in practice. If the wholesale unit were to fail, depositors would still flee. As the 2008 crisis showed, depositors run when a bank’s group share price drops, regardless of whether or not protection is given to retail depositors. It would be far better practice to avert a large bank failure in the first place by allowing the group to deploy funds in a way that serves the interests of the bank as a whole.

A probable effect of this growing capital protectionism will be a retreat by globally active banks to their home markets. Ironically, this will lead to more home market concentration and less global diversification, making banks in all countries more susceptible to failure.

Although the common goal – to protect domestic taxpayers – is a noble one, the proposals are unlikely to achieve it. Andrew Bailey, Deputy Governor of the UK’s Prudential Regulatory Authority, put it bluntly when he noted recently that since the crisis, ‘We have gone backwards’. And, as a recent McKinsey study noted, these initiatives could lead to a ‘balkanized structure that relies more heavily on domestic capital formation … [providing] too little financing for long-term investment’. With global capital flows having dropped by more than 60 per cent since 2008, the time to act is now.

Louise Bennetts is the co-author (with Arthur S. Long) of The New Autarky? How U.S. and UK Domestic and Foreign Banking Proposals Threaten Global Growth, published by the Cato Institute.