Banque de France 11/12/2012

Ring-fencing the banks

Frederic MalherbeLondon Business School

Motivation

• Observations linked to the crisis٧ Rise of securitization – financial innovation٧ Banks were holding such assets٧ Banks were seen as “well capitalized”٧ Basel II

− Risk-weights− Internal-Rating-Based (IRB) Approach

• Tax-payer exposure• Volcker Rule, Vickers, and Liikanen Reports

٧ Ring-fencing− Limit exposure− Ensures continuation of essential services

• A Representative bank٧ Initial capital , maximize value of equity٧ Takes insured deposits٧ CRS investment opportunity

− −

• Measure 1 of risk averse households٧ Endowed with 1 unit of consumption good٧ Storage technology٧ Utility from end-of-period consumption

A single period model

The policy trade-off

• Bank net-worth:• Bailout tax:• Regulator objective

• First order condition

The policy trade off

Financial innovation (1/2)

• Imagine a second (symmetric) economy• Investment opportunity

٧ ٧

• Imperfect correlation• Risk sharing “trade”

٧ Assume they swap 50% of their portfolio

• Effect on portfolio return distribution٧ Interpretation

− Securitization− Buying CDS

New policy trade off

Financial Innovation (2/2)

Financial innovation (2/2)

Bottom line

• Financial sophistication has value• But incentives are very strong to

٧ Overestimate diversification٧ Make side bets

• Can we trust internal models?٧ Information asymmetry

• Mechanism design٧ In a static world…٧ In reality…

− Full joint distribution matters− Supervisor’s human capital

• “Ring fencing” may make sense

A possible logic

• Deposit insurance distorts incentives٧ But is necessary to preserve confidence٧ Continuation of essential services

• Financial innovation is useful٧ By nature, its impact is hard to assess

• If cannot confidently supervise٧ Separate entities

• If other gains from conglomerate٧ “Ring-fencing”

• Deposit taking are insured and do safe stuff• Others can innovate but are not insured

٧ If no-bailout clause credible => internalize cost of risk٧ If fails, deposit institutions are preserved

In practice

• Volcker Rule: prevent side bets• Vickers and Liikanen propose to restrict bank

“activities”• Remarks

٧ Deposit insurance Vs taking deposits٧ I assume main goals are

− Preserving deposit institutions− Allowing for financial innovation

٧ Prevent adverse alteration of joint distribution

Where to put up the fence?

Commercial Bank

A L

Debt

Equity

Investment bank

Funny business

These links are problematic

These links seem fine

Loans & Bonds

Stocks

A L

Deposits & Debt

Equity

Commercial bank

Beware of credibility !

Some questions and caveats

• Inside the fence٧ Assets

− Regulator should be able to assess joint distributions− Restrictions on assets, validation?− Interbank positions within the fence?

٧ Liabilities− Collateralized borrowing?− Hybrid liabilities?− Full guarantee?

• Outside the fence٧ Credibility (TBTF?)٧ No restriction at all?

− Externalities (among IB and/or towards the fenced institutions)

• Crisis?٧ Contingent rules?٧ Repatriate business within the fence?٧ Reward the survivors?

Frédéric Malherbe (LBS)

Thank you very much!