Securities Regulation Daily Wrap Up, EXCHANGES AND MARKET REGULATION—Volcker Rule prohibitions may not end threat to financial stability says German Central Banker, (Jan 23, 2014)

By Jim Hamilton, J.D., LL.M.

The Volcker Rule prohibitions on proprietary trading and hedge fund sponsoring may not end the contagion threat to financial stability, nor would the Vickers Commission ring-fencing proposal in the U.K., said Andreas Dombret, a member of the Deutsche Bundesbank executive board. Noting that universal banks have served well for Germany and other countries, he spoke highly of the E.U. Liikanen proposal, which would maintain the universal bank within a holding structure, but ring-fence deposit-taking units. The remarks, delivered at a recent conference, give credence to a recent statement by House Financial Services Committee Chair Spencer Bachus (R-Ala.) at a committee hearing on the Volcker Rule, that the E.U. would not be adopting a version of the Volcker Rule.

Germany has a bank-based system of corporate finance. German companies procure a wide range of services from their banks. The boundaries between customer business, hedging transactions, market making, and traditional proprietary trading are consequently fluid. Finding the right dividing line in the grey area between those activities would be difficult and prone to lobbyism, noted Dombret, who is the Bundesbank member in charge of financial stability.

Volcker Rule. The fact that recent legislative proposals are so different in content and scope partly reflects these problems. In the U.S., the Volcker Rule seeks to prohibit proprietary trading by banks and severely restricts certain forms of investment. In the U.K., the Vickers proposal seeks to ring-fence deposit-taking and the provision of credit facilities in legal, organizational, and operational terms.

Dombret said that people should ask the macro question of why the combination of commercial and investment banking is perceived as a source of systemic risk. In this context, he noted that Lehman Brothers was a pure investment bank, yet when it failed in 2008, it brought the financial system to the brink of collapse because it was so interconnected.

Dombret also warned that separating commercial and investment banking might provide incentives to export more and more risky activities to the realm of shadow non-bank banking. This is why the ongoing efforts to regulate the shadow banking system have to continue.

Dombret said that higher capital requirements and credible resolution authorities were more critical to financial stability than the forced separation of commercial and investment banking. Moreover, compensation schemes that reward excessive risk-taking need to be replaced with more sustainable solutions. Relevant regulation exists, he noted, but to be really effective these rules must become part of the culture at financial institutions.

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