Can the Plight of the European Banking Structural Reforms Be a Blessing in Disguise?

Abstract

One of the problems perceived to be at the heart of the global financial crisis was an amalgamation of various commercial and investment banking activities under one entity, as well as the interconnectedness of the banking entities with other financial institutions, investment funds, and the shadow banking system. This paper focuses on various measures that aim to structurally separate the banking entities and their core functions from riskier financial activities such as (proprietary) trading or investments in alternative investment funds. Although banking structural reforms in the EU, UK, and the US have taken different forms, their common denominator is the separation of core banking functions from certain trading or securities market activities. Having reviewed the arguments for and against banking structural reforms and their varieties in major jurisdictions, including the EU, UK, US, France, and Germany, the paper argues that a more nuanced approach to introducing such measures at the EU level is warranted. Given the different market structures across the Atlantic and the lack of conclusive evidence on the beneficial impact of banking structural reforms, the paper concludes that the withdrawal of the banking structural reforms proposal by the European Commission has been a prudent move. It seems that in the absence of concrete evidence, experimenting with structural reforms at the Member-State level would be less costly and would provide for opportunities for learning from smaller mistakes that could pave the way for a more optimal approach to introducing banking structural reforms at the European level in the future.The literature on financial regulation includes various measures for addressing the risks of financial institutions. From among these measures, three overarching approaches to reducing the externalities emanating from the financial institutions stand out. The first set of these measures include price-based regulations such as emission taxes in environmental regulation and capital or liquidity requirements in banking regulation. These regulations are normally introduced in tandem with enhanced and effective supervisory and resolution mechanisms. Such measures can also be combined with the structural limits on the size and scope of the activities of financial institutions. 15 Price-based regulations for addressing systemic risk may include the enhanced regulatory framework in the form of higher quantity and quality of lossabsorbing capital and stricter liquidity standards. 16 Second, quantity-based regulation such as emission quotas in environmental regulation. 17 In the banking industry, concentration limits, the regulations encouraging the allocation of certain ratios of loans to underprivileged segments of the society or regulations requiring gender balance on boards oftentimes take this form. Third, structural regulations are often imposed on the size, structure or scope of activities of financial institutions. 18 Its scope includes separating and moving risky and complex businesses to stan...