WHY THE SIGN MUST SAY : NO UBS IN THE USA / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Why the sign must say: no UBS in the USA

By Thomas Hoenig

Published: June 16 2011 23:06

Politicians and regulators in the US, Britain and Europe are concerned about relative advantages and disadvantages in the global financial system. The real outrage, however, is that taxpayers have seen billions in lost wealth due to fundamental flaws in this system’s structure and incentives that have yet to be addressed.


For example, it is persistently rumoured that some major international banks, including Switzerland’s UBS and Barclays in Britain, are considering moving their investment banking operations to another country. In the case of UBS, such a move could help them escape Switzerland’s new 19 per cent capital requirement. Recent news reports, however, suggest that Swiss regulators may even favour UBS moving its investment banking activities abroad, so that their government no longer would face the risk of bailing out a company that is twice the size of the Swiss economy. Speculation about this then raised a question, posed in an editorial in this newspaper: “Any takers?”


Based on the current US financial structure and regulatory framework, my answer would be a clear “no!” Of course, a foreign bank could base its investment bank’s headquarters in the US. But once here, why would they not expand into commercial banking, to gain full access to the public safety net of deposit insurance and the Federal Reserve discount window? Any such move would then bring the liability of yet another systemically important bank able to take excessive risks.


Some argue that both the US Dodd-Frank Act and Basel III capital requirements have now ended US bail-outs. But these efforts do not solve the fundamental flaw in the system: there are highly complex and opaque banking organisations engaged in a variety of non-core, high-risk activities while backed by a public safety net. The problem is not that banks take risk, but that some are too complex for anyone to assess and control that risk.

These new regulatory changes actually extend, or make more complicated, what we have tried to do before. For example, Dodd-Frank requires enhanced prudential supervision and regulation that increases incrementally with the systemic risk of the largest financial companies. Yet that design simply cannot be effective if the risk cannot be monitored or assessed.


Similarly, the new Financial Stability Oversight Council is to look for evolving systemic risk and take appropriate actions – an impossible task because problems are only obvious after the fact. There are many examples over the past 20 years, but one need look no further than the recent housing bubble. I applaud the Swiss for requiring significantly higher capital ratios, but if that were enough, Swiss authorities would be more interested in having UBS retain its investment banking activities.


I would welcome UBS and any other financial company to the US if we first reform our banking and financial structure. I recently offered a proposal* to improve our financial system. It builds on the Volcker rule in the US, and the Vickers Commission’s ringfencing proposal in the UK, but its restrictions are stronger and include more reforms for the shadow banking system.


The proposal is based on the principle that banks should not engage in activities beyond their core services of loans and deposits, if this disproportionately increases complexity and impedes the ability of the market, bank management, and regulators to assess, monitor and control bank risk-taking.

Specifically, in addition to providing payment and settlement services, granting loans, and offering deposits, banking companies could underwrite securities, offer merger and acquisition advice, and provide trust and wealth and asset management services. They could not conduct broker-dealer activities, make markets in derivatives or securities, trade securities or derivatives for either their own account or customers, or sponsor hedge or private equity funds.


Such proposals would provide limited benefits if the restricted activities migrated to shadow banks. Indeed, much of the instability in the shadow banking system stemmed from using short-term wholesale funding for longer-term investment. Thus the proposal also includes reforms to reduce volatility caused by wholesale funding through money market funds and repos. Specifically, money market funds should be required to have floating net asset values, and the 2005 change in repo bankruptcy rules that exempted mortgage-related assets from an automatic stay would be reversed.


The global economy needs a more stable financial system. The rules I propose increase transparency and allow a bank’s success to flow from the value it adds to the economy rather than the risk it poses to the public. Until such rules are introduced, however, we should put up a clear sign for any foreign banks thinking of setting up shop in the US: “No, thanks.”


The writer has been president of the Federal Reserve Bank of Kansas City for 20 years and previously worked in banking supervision for 18 years.


*The white paper “Restructuring the Banking System to Improve Safety and Soundness” is posted at http://www.kansascityfed.org.


Copyright The Financial Times Limited 2011.