TWN Info Service on Finance and Development (Sept11/01)
19 September 2011
Third World Network

Restructure banking for more balanced and diversified system
Published in SUNS #7216 dated 13 September 2011

Geneva, 12 Sep (Chakravarthi Raghavan*) - The three-year-old global economic crisis, originating in the financial sector, but quickly spreading to the real economy and resulting in the "Great Recession", underscores the need not only for effective re-regulation and supervision of the sector, but also restructuring it for a more balanced and diversified banking system - with public, private and cooperative banks, according to the UN Conference on Trade and Development (UNCTAD).

In advocating this view in its Trade and Development Report 2011 (TDR), UNCTAD says that "the ongoing financial and economic crisis, which originated in private financial institutions, has significantly undermined many of the arguments repeatedly advanced over the past few decades against publicly-owned banks. In Europe and the United States, large private banks have been subsidized based on the belief that they are too big to fail. Indeed, when the crisis struck large banks were able to survive only because they received government funding and guarantees."

In promoting the re-regulation of the financial sector, and for restructuring the banking system, the UNCTAD report has a section analysing the WTO's General Agreement on Trade in Services (GATS), to argue that it would or could come in the way of re-regulation and restructuring of the financial sector.

However, the analysis of the GATS provisions appears to be based on a mixing up and misunderstanding of the GATS articles, rules and frameworks.

GATS has rules applicable to all members, provisions for negotiating market access and modalities for scheduling commitments by member countries (Articles XVI and XVII) - applicable to the entire trades in various services sectors in the four modes of supply - and there are provisions in separate annexes relating to particular service sectors (Air Transport, Financial Services, Maritime Transport, Telecommunications, and Basic Telecommunications).

While GATS has provisions for developing disciplines on domestic regulations, the GATS Annex on Financial Services has some provisions relative to trades in this sector. These include special provisions on domestic regulations in the sector, a very wide ‘escape clause' (prudential measures defense, or PMD), a definition of financial services with an illustrative but non-exhaustive list of such services, and provisions for dispute settlement panels having needed expertise.

While modalities under Articles XVI and XVII apply also to the scheduling of market access commitments in Financial Services (used by most of the developing countries excepting three or four), at Marrakesh, some countries (mainly those belonging to the Organisation for Economic Cooperation and Development) negotiated an additional or alternative modality: ‘the Understanding on Commitments in Financial Services' or in short ‘the Understanding'.

The use of this additional modality, but on an MFN (Most-Favoured Nation) basis, was a voluntary option. A group of countries did so, at Marrakesh and subsequently in Geneva, in 1997 in the Financial Services Agreement.

However, unlike Articles XVI and XVII, the Understanding is not part of the Uruguay Round legal texts, nor even a part of the Uruguay Round (UR) protocol. Those who used it did so, either referencing the Understanding in a headnote and only entering limitations in their schedules, or used the methodology/language of the Understanding in entering market access commitments for each of the modes of supply, and the limitations, if any.

[A forthcoming (and soon to be published) paper by Ambassador Bal Krishan Zutshi (Indian ambassador to the GATT from 1989-1994 and a key negotiator, who also coordinated the positions of developing countries in the UR GATS negotiations, and acknowledged by trade officials as one of the key architects of the GATS regime) has dealt in detail with all these aspects. The paper points out that none of the GATS provisions preclude the proposed reform and regulatory measures (either enacted or regulations under consideration in the US, under the Dodd-Frank Act, or those in Europe and UK), and that even for those who scheduled commitments using the Understanding, the PMD would be a defense; and that in any event members who find their scheduled commitments coming in the way of reforms can invoke Article XXI, and modify their schedules - much easier procedurally and substantially than a similar course on trade in goods under the General Agreement on Tariffs and Trade (GATT). Also, this is the only way that any member can revise its commitments under GATS and take the reform and regulatory steps.

[Zutshi, in his paper, has analysed the TDR, and some (more nuanced) civil society views including those cited by the TDR, about the alleged contradiction in the wording on domestic regulations in GATS Article VI, and that relating to financial services in the Financial Services annex, to explain that the purported contradiction is based on a misunderstanding of the rules of interpretation of public international law: that signatories to more than one agreement are expected to abide by all of them, that clarification and interpretation of such provisions must be done harmoniously by dispute panels, that the words and phrases used in any agreement have to be given their ‘ordinary meaning' and that no particular provision or part could be made superfluous or inutile.]

In the case of Article XI of GATS (relating to payments and transfers), the TDR, on page 100, purports the article as stipulating that "unless a serious balance-of-payments situation can be claimed, no restrictions on international transfers of payments related to a country's specific commitments are permitted."

However, Article XI (1) actually says: "Excepting under the circumstances envisaged in Art XII (Balance of Payments - BOP - safeguards), a Member shall not apply restrictions on international transfers and payments for current transactions relating to its specific commitments." The omission of the words "for current transactions" in the TDR, perhaps inadvertently, gives a different meaning.

Again, the TDR purports that Article XVI, on market access commitments, stipulates that once a commitment of market access has been made for a specific kind of service, capital movements that are "essentially part of" or "related to" the provisions of that service are to be allowed as a part of that commitment.

In fact, what Article XVI does is to define what is full ‘market access' for a services transaction (where unlike in goods, there is no physical movement across borders): it sets out an exhaustive and closed list of six types of measures whose absence as limitations in a member's schedule, constitute ‘full market access'. In other words, in undertaking a specific commitment, a member can set out as limitations on market access, any or all of these measures, fully or partially. If the member has not mentioned in its schedule any limitations, such measures cannot be applied, where a commitment has been undertaken.

In this context, one of the six measures is: "limitations on the participation of foreign capital in terms of maximum percentage limit on foreign shareholding, or the total value of individual or aggregate shareholding."

Put another way, any member giving a market access commitment, but wanting to restrict foreign capital participation, must set down these limitations in its schedule.

This is different from what the TDR rendering suggests is the stipulation of Article XVI.

In terms of capital movements and transfers, Article XI:2 asserts International Monetary Fund (IMF) jurisdiction on capital transactions, including exchange actions, but permits restrictions on capital transactions only for BOP reasons under Article XII, or at the request of the IMF.

Article XI:2 also prohibits restrictions on capital movement in case where a specific commitment undertaken is for a service involving capital transactions - as for cross-border capital movement under mode 1 of service delivery or Foreign Direct Investment (FDI) under mode 3. This is logical and clarified in Footnote 8 to Article XVI.

On the main issue of need for stronger re-regulation and enforcement, this is being blocked in the US and Europe, not by any GATS provisions, but as a result of the regulatory capture (by powerful financial firms) of legislative, executive and even the judicial pillars of the state.

UNCTAD, or civil society groups (whose advocacy views have been adopted by UNCTAD), whether on financial sector reforms or on regulating capital flows, should thus focus on these forces (and the IMF roles) and not on GATS - which did not contribute in any way to the financial crisis, nor in fact is coming in the way of reforms, except may be in some cases of scheduled commitments.

These commitments, if any, have to be renegotiated and changed and that too only in cases where the regulations are not for "prudential reasons", "or to ensure the integrity and stability of the financial system" (Paragraph 2(a) of the annex on financial services).

On the wider issue of the role of finance, the TDR points out that financial markets are supposed to mobilize resources and allow their efficient allocation for productive investment.

In addition, they are expected to facilitate transactions and reduce transaction costs, as well as reduce risk by providing insurance against low probability but high-cost events. Therefore, those markets are often seen as instrumental in promoting economic growth and broad social development.

However, the hard reality is that they often serve as a means of speculation and financial accumulation without directly contributing to economic development and improving living standards, and throughout history they have been fraught with crises.

Also, the increasing financialisation of the world economy (strongly driven by securitization) has led to the growing dominance of capital-market financial systems over bank-based financial systems - a process that has strengthened the political and economic power of the rentier class.

There was also an explosion of financial trading, associated with a myriad of new financial instruments aimed at short-term private profit-making. However, such trading was increasingly disconnected from the original purpose of financial markets, that of allocating resources for long-term investment.

The global financial and economic crisis, the TDR notes, has prompted a debate about re-regulation and restructuring of the financial sector so as to avoid crises in the future, or at least crises of such magnitude. To a large extent, this debate, both at national and international levels, has been about strengthening of financial regulations and improving supervision of their implementation.

However, says the TDR, re-regulation alone will not be sufficient to prevent repeated financial crises and to cope with a highly concentrated and oversized financial sector that is dominated at the global level by a small number of gigantic institutions.

In addition, even if the sector were to be better regulated and less prone to crisis, there is no guarantee that it would be able to drive growth and employment, particularly in low-income countries, or to make credit more easily available to small and medium-sized firms or to the population at large.

As for the desirable restructuring of the banking system, UNCTAD points out that whereas during the boom period private institutions and individuals enjoyed large profits and bonuses, during the bust, governments - or the "taxpayers" - had to bear the costs. Hence, the criticism against state-owned banks that they have the advantage of access to public resources is no longer valid.

Governments generally have had full control of the operations of public banks throughout both boom and bust cycles, whereas private banks have retained their own management and control and have continued to pay themselves handsome bonuses, even when they have received large government bailouts. The allegation that State-owned banks are "loss-making machines" are more appropriately applicable to large private banks.

As for alleged differences in efficiency between public and private banks, the crisis has revealed that even the largest private banks failed to collect and assess information on borrowers and to estimate the risks involved in lending. The latter function was transferred to rating agencies instead.

In advocating the restructuring of the banking sector and for state-owned banks, the TDR highlights three beneficial aspects of State-owned banks.

The first one relates to their proven resilience in a context of crisis and their role in compensating for the credit crunch originating from the crisis. A second aspect is that they support activities that bring much greater social benefits than the private banks and provide wider access to financial services. Finally, they may also help promote competition in situations of oligopolistic private banking structures.

Also, says UNCTAD, under certain circumstances, cooperative and community development banks might also be an important component of the restructuring of the banking sector. During the global financial crisis, small savings banks, such as the Sparkassen in Germany, did not have to resort to central bank or treasury support.

Moreover, these institutions may give greater attention to small businesses and other agents that do not normally have access to banking credit.

While the TDR has cited examples of publicly owned banks in Europe and many more in the developing world, that have done well by themselves and their communities, and have not needed tax-payer-funded aid and guarantees, perhaps an even more important example is the state-owned bank in North Dakota (in the US heartland), namely, the Bank of North Dakota (BND).

In a recent article at , Ms. Ellen Brown (author of the book, ‘Web of Debt') has brought out how the ‘economic miracle' of North Dakota - an unemployment rate of 3.3% (in contrast to the over nine percent in the US as a whole), and fastest job growth rate - is not due to its oil sector as mistakenly characterized by the New York Times recently, but due to its state-owned Bank of North Dakota (BND).

The BND, she says, does not compete with local banks, but partners with them, helping with capital and liquidity requirements, participates in loans, provides guarantees, and acts as a sort of mini-Fed for the state. In 2010, the BND provided secured and unsecured Federal Fund Lines to 95 financial institutions, with combined lines of over $318 million, as well as a loan programme ‘Flex PACE' enabling local communities to provide assistance to borrowers in areas of jobs retention, technology creation, retail, small business, and essential community services.

The BND has also contributed to state revenues - $300 million to the state treasury over the last ten years, an amount equal to the oil and gas tax revenues of the state.

The TDR meanwhile notes that from a regulatory point of view, information asymmetries could be overcome if the authorities had complete access to information, which, at present, is often retained as confidential by private banks.

In addition, "if private banks are making significantly higher profits than public banks, this may provide a warning signal [to regulators] that they are taking too much risk or exploiting their monopoly power".

The TDR further notes that in spite of large-scale privatisations during the 1990s, State-owned banks continue to play an important role in the banking systems of many developing countries. In 2003, these kinds of banks accounted for 30 percent in the transition economies, more than 20 percent in Africa and slightly less than 20 percent in Latin America. But there were large variations within each region. In Argentina and Brazil, for instance, almost a third of the banking assets were held by State-owned banks.

In addition to stronger public banks, restructuring of private banks, UNCTAD says, would create a more balanced banking sector. As previously discussed, the loss of diversity of the banking system has been one of the major factors behind the latest crisis.

Some responsibility for this development, the TDR says, lies with the regulatory bodies, most specifically the Basel Committee in its misguided attempt to design a "level playing field" both within and across borders.

As barriers between different institutions fell, deposit-taking banks became involved in investment banking activities, and as a consequence, they were more fragile and exposed to contagion. Since these banks play a crucial role in the payments system, their higher exposure to systemic risk had the potential to make a greater adverse impact on the entire economy.

This problem could be addressed in two ways. First, deposit-taking and payment systems should be separated from investment banking operations, as was done under the Glass-Steagall Act in the United States in 1933. In other words, commercial banks should not be allowed to gamble with other people's money.

Second, and even more ambitious, large institutions should be dismantled, to overcome the too-big-to-fail or, as coined by Yaga Venugopal Reddy, the former governor of the Reserve Bank of India, the even "too powerful to regulate" problem.

There are many possible ways, UNCTAD says, to separate deposit-taking institutions from investment banks.

Some authors advocate "narrow banking", whereby financial institutions should be forced to choose between becoming a commercial bank or an investment bank. The former would be allowed to take deposits from the public and other commercial banks, and place their funds in loans that carry a longer maturity while keeping them in their balance sheets.

These banks would have access to a discount window at the central bank, lender-of-last-resort facilities and deposit insurance. However, their activities would also be subject to strict regulation and supervision. On the other hand, investment banks would be required to avoid maturity mismatches, and therefore would not be able to purchase illiquid assets financed by short-term lines of credit from commercial banks.

A recent proposal that would grant commercial banks more latitude is based, according to UNCTAD, on the concept of "allowable activities", along lines that also establish a separation between commercial and investment banks.

Thus, deposit-taking institutions would be permitted to underwrite securities, and offer advice on mergers and acquisitions as well as on asset management. However, they would not be allowed to pursue broker-dealer activities, or undertake operations in derivatives and securities, either on their own account or on behalf of their customers.

Neither would they be allowed to lend to other financial institutions or sponsor hedge funds and private equity funds. Separating the two activities could be an additional way to reduce the size of institutions, and would therefore address the too-big-to-fail problem.

In this vein, the Governor of the Bank of England has proposed splitting banks into separate utility companies and risky ventures, based on the belief that it is "a delusion" to think that tougher regulation alone would prevent future financial crises, says UNCTAD.

(* Chakravarthi Raghavan, Editor-Emeritus of the SUNS, contributed this comment.)