Structural Reform of Banking Systems: The Global Impact of Legal Fragmentation

One of the key issues in the on-going overhaul of the global financial system is the structural reform of banking systems. Legislatures in different states, e.g. the United States, France, Germany, and the United Kingdom, have all taken measures to protect individual depositors’ assets against losses from risky bank activities. On 29 January 2014, the European Commission joined the transnational effort by publishing its own proposal on the subject. Each measure is slightly different. There are good reasons to wonder about the effect that this type of legal fragmentation will have on the global financial system. In a recent paper (available here), I have asked not so much which of the measures is most likely to achieve the economic goal of making deposits safer, but what their combined effect on the global banking market will be.

These are my conclusions: The first of the possible effects concerns competition. In the global banking market, there will be a number of banks or banking groups that may receive deposits and engage in speculative activities, while others may not. The result is that some of them will recoup bigger returns, although they may at the same time become more risky. There is simply no level playing field between these fundamentally different actors. Each of them will have a very different background. In the future, this may lead to the risk of encouraging regulatory arbitrage. When looking for a country to incorporate a bank, the bank’s founders may be influenced first by the structural requirements that respective laws provide. To counter these effects, a recent proposal by the European Commission suggests extending the prospective EU regime to the bank branches of third countries. But this would only provoke insoluble clashes with other legal systems and further increase restrictions within the EU market. The Commission has already backtracked by providing an exception that applies where the legal framework in the foreign bank’s country of origin is deemed ‘equivalent’ to that in the EU.

The second effect concerns the efforts to establish a worldwide uniform regulation of finance. As a result of the structural reforms, it will be much more difficult to treat credit institutions established in different nations consistently. Some of them will no longer be bailed out, but will instead be left high and dry in cases of insolvency, while others may still enjoy some support by their parent institution or by their state of origin. This makes it more difficult to draft uniform standards to safeguard financial stability around the globe. So far, banks are basically subject to similar capital requirements drawn up by the Basel Committee on Banking Supervision (Basel I-III). But what good are they in ensuring global financial stability if the banks that are subject to these rules are very different in nature? Should a bank that is allowed to engage in proprietary trading not be subject to much stricter rules than a bank that is not? Similarly, resolution requirements that have been suggested by the FSB may not be suitable for all types of credit institutions. It is much more complicated to rescue a deposit-taking bank that is a member of a French or German banking group, for instance, than it is to save a British ring-fenced body.

The third effect will be on the banks’ clients. They may be confused as to the reliability and robustness of the banks to which they entrust their deposits. Banks may offer their services anywhere in the world. Some legislation specifically requires a separate name for deposit-taking institutions and trading entities, while others do not. Customers may be enticed to put their money in a foreign bank that offers retail services without being aware of its peculiar design, or its involvement with other members of its group. It will be quite difficult to explain to laymen the different banking structures that exist under the different national laws, and the respective repercussions that impact the safety of their deposits.

To be perfectly clear, my conclusion is not that we would be better off with a global reform of the banking system. On the contrary, some experimentation with the appropriate bank structures is welcome. Nobody knows for certain which regime works best. Thus, unless different structures are tested out, we may possibly never reach a sound conclusion. Moreover, if the structural regime were to be globally uniform, any shortcomings would affect all banks across the world, and not just those incorporated and supervised in one country. As a result, the global system would become much more vulnerable. It is, of course, also true that each state has the right to decide how it wants to structure its banks so that they pose no risk for taxpayers and depositors.

However, one must also bear in mind that with today’s interconnected markets, the failure of one credit institution has the potential to trigger a worldwide financial crisis. Even if one national legislator makes his bank particularly safe, he cannot prevent foreign banks from becoming insolvent. When it comes to financial stability, states are dependent on each other. There is thus no point in each of them working on structural reform independently. Some coordination is necessary. At a minimum, global soft law regulators, such as the BCBS or the FSB, should assess the potential repercussions of different national banking structures in their work. It would be even better to see them give guidelines to help smooth out the greatest divergences between national banking structures.

Dr. Matthias Lehmann, D.E.A. (Paris II), LL.M., J.S.D. (Columbia), is a Professor and Director of the Institute for Private International and Comparative Law at the University of Bonn, Germany. His Article is entitled ‘Volcker Rule, Ring-Fencing or Separation of Bank Activities – Comparison of Structural Reform Acts Around the World’, and has been published as LSE Legal Studies Working Paper No. 25/2014. It can be downloaded here.