The Elephant in the Room: The Need to Deal with What Banks Do

"Contagion risk and counterparty failure have been the main hallmarks of the current crisis. While some large diversified banks that focused mainly on commercial banking survived very well, others suffered crippling losses. Sound corporate governance and strong riskmanagement culture should enable banks to avoid excessive leverage and risk taking. The question is whether there is a better way, via leverage rules or rules on the structures of large conglomerates, to ensure volatile investment banking functions do not dominate the future stability of the commercial banking and financial intermediation environment that is so critical for economic activity. While there is a main consensus on the need for reform of capital rules, dynamic provisioning, better co-operation for future crises, centralised trading of derivatives etc., the question is whether such reforms will be sufficient if they do not address contagion and counterparty risk directly. The world outside of policy making is waiting for a fundamental reassessment of banks’ business models: what banks are supposed to do and how they compete with each other. It is the “elephant in the room” on which some policy makers have not yet had the time or inclination to focus. This article emphasises not only the need for transparent and comparable accounting rules and for improvements in corporate governance, but also supports the imposition of a group leverage ratio to provide a binding capital constraint (that Basel riskweighted rules have been unable to achieve) and proposes a Non- Operating Holding Company Structure (NOHC) – reforms that are essential to deal with contagion and counterparty risk that are so integral to the ‘too big to fail’ issue. "
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* Adrian Blundell-Wignall is Special Advisor for Financial Markets and Deputy Director of the OECD Directorate for Financial and Enterprise Affairs, Gert Wehinger and Patrick Slovik are Economist and Junior Economist, respectively, in the Financial Affairs Division of the Directorate for Financial and Enterprise Affairs. The article has benefitted from comments by Carolyn Ervin and other OECD staff members. All remaining errors are those of the authors. This work is published on the responsibility of the Secretary-General of the OECD. The opinions expressed and arguments employed herein do not necessarily reflect the official views of the Organisation or of the governments of its member countries.

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