Size is not necessarily evil

By Michael Hellbeck

Chairman, Foreign Bankers Group Korea

We warmly welcome the G-20 central bank governors and finance ministers to Korea and appreciate the gargantuan efforts that the G-20 has made to stabilize the financial system and promote financial regulatory reform in an internationally consistent and globally coordinated fashion.

We all understand the public pressures on politicians to act to stabilize domestic conditions after the use of taxpayers' funds on a large scale to support financial institutions. However, we must continue to resist the temptation of national solutions outside an agreed G20 framework.

A re-fragmentation of financial markets, whether by intent or as an unintended consequence, is in nobody's interest as it will inevitably lead to "regulatory arbitrage," as business activity moves to the lesser regulated markets.

Cumulative impact of reforms

As acknowledged in the Financial Stability Board's (FSB) report dated April 19, 2010, it is important to consider the cumulative impact of the various proposed capital and liquidity reforms on the one hand, and financial levies and taxes on the other hand, in order to lessen the risk of unintended consequences on the real economy.

The financial industry fully accepts the need to raise capital levels in the financial system. However, considering the multitude of changes in the pipeline, a thorough impact assessment is more important than ever before.

At the moment, whenever there is talk about large financial institutions the phrase seems to carry a negative connotation. We believe this is unfair. Size is not an end in itself and it is not a good thing per se ― but size is not necessarily evil either.

The idea that we could run modern, sophisticated, prosperous economies and finance multinational corporations with a population of mid-sized savings banks is misguided. Similarly, systemic relevance is not necessarily tied to the size of financial institutions. Even a small institution can be systemically relevant - as we learned to our cost during the financial crisis.

A reasonable leverage ratio may be acceptable if calculated on a U.S. GAAP basis with full recognition of netting in the derivatives books (The International Financial Reporting Standards (IFRS) does not currently recognize "netting" and accounting standards should be harmonized to this effect). There is also some merit in thinking about setting up a pool of funds available to fund the recapitalization of a failing bank.

Broad agreement exists that firms that pose a greater risk to the financial system should justifiably be subject to stricter capital requirements ― however; it is the risk content, not the size of an institution that counts.

Likewise, there is consensus that we must further develop market infrastructure that insulates markets from the failure of any single market participants. Central Clearing Platforms for derivatives markets, and real-time settlement systems, such as CLS (continuous linked settlement system) for foreign exchange trading, exist and are being enhanced in this connection.

Separation of good and bad banks

Let us have a few words on the discussion about a return to a Glass-Steagall banking model. The broader ideas of splitting supposedly safe narrow banks from supposedly unsafe "casino banks" is not very convincing. The implicit assumption of a split banking system is that governments could safely ignore the failure of a so-called casino banking system.

This is dangerous thinking: Firstly, it is an illusion to think that governments could ignore systemic damage in that part of the financial system that handles foreign exchange risk, provides interest hedges for companies, helps firms raise capital and is a counterparty to the hedging needs of institutional investors, such as pension funds and so on.

Secondly, it is an equally dangerous illusion to think that we can make a clear distinction between allegedly risky and allegedly safe activities ― and that we could do this without suffering serious economic costs. Therefore, the answer to the problem may be to develop institutional arrangements that allow for an orderly wind-down of large and complex financial institutions.

If this is ensured then there is no need to worry about the separation of banking activities in the first place.

Financial safety net

The recent crisis has emphasized the need for a global financial safety net to help emerging markets dealing with highly volatile capital movements. While capital controls may seem appealing as a "stop-gap" measure, they may entail unwanted stigma effects.

The combination of sufficient foreign exchange reserves, a multi-lateral foreign exchange swap framework and potentially some form of an Asian monetary union or fund might be better mitigants to deal with abrupt capital flows. As in the example of Korea, the agreement on foreign exchange swaps with the United States, China and Japan proved very effective to deter foreign exchange speculators and calm the markets.

Michael Hellbeck is the chairman of Foreign Bankers Group Korea, and chief of Deutsche Bank's Korean operation.