Implications of Ring-Fencing for European Cross-Border Banks

Eugenio Cerutti (with A. Ilyina, Y. Makarova and C. Schmieder)

Vienna – October 3 , 2011

Bankers Without

Borders?

Bankers without Borders? - Motivation

Statement at the end of the European Bank Co-ordination Initiative’s Second Full Forum

MeetingIMF Press Release No. 10/106

March 22, 2010 “The large bank groups with systemic presence

in those [Eastern European] countries have committed to maintain their exposure and keep

their subsidiaries well capitalized.”

On the one hand,

many cross-border banking

groups acted as Lenders of Last

Resort for their CESE subsidiaries

during the crisis.

Bankers without Borders? - Motivation

The Croatian National Bank Governor, Željko Rohatinski,

Press conference held on 18 February 2009“the CNB would not look favorably upon

attempts [by foreign parent banks] to withdraw capital, deposits or pay out total accumulated

profits, because that would destabilize the domestic banking system. In such a case, the CNB would be forced to undertake protective measures, regardless of thus connected risks.”

On the other hand, host country

regulators might ring fence foreign

affiliates within their jurisdictions

due to:

• Banking-stability considerations (e.g. the need to protect the domestic banking system from negative spillovers from the rest of the group)

• Macro-stability considerations (e.g. avoid capital outflows)

Bankers without Borders? - Motivation

Ring Fencing Outcome: cross-border banking groups’

ability to re-allocate funds from subsidiaries with excess

capital/liquidity to those in need of capital/liquidity is

limited.

The Question we attempt to answer in the paper:

What are the capital needs of banking groups under

different ring-fencing assumptions?

A “stylized” cross-border banking group:with subsidiaries in countries A, B, C

Parent Bank Sub A Sub B Sub C

Losses (net of provisions) at each of the subs Sub A Sub B Sub C

Regional credit shock

Buffers Profits and Capital at each of the subs

Sub A Sub B Sub C

Outcome Recapitalization needs (if any) at each of the subs

Sub A Sub B Sub C

Bankers without Borders? – Stylized Example

Bankers without Borders? – Stylized Example

Degree of ring-fencing

Capital needs (post regional credit shock) under different ring-fencing assumptions

No ring-fencing CN(1) = sum of recapitalization needs of all subsidiaries – sum of excess profits and capital of all subsidiaries – profits of the parent bank

Partial ring-fencing CN (2) = sum of recapitalization needs of all subsidiaries – sum of excess profits of all subsidiaries – profits of the parent bank

Complete ring-fencing

CN (3) = sum of recapitalization needs of all subsidiaries – profits of the parent bank

Stand-alone subsidiarization

CN (4) = sum of recapitalization needs of all subsidiaries

At the group level, the capital need (CN) is the total amount of capital required to restore the CARs of all of the group’s affiliates to their regulatory minimums.

Bankers without Borders? – Stylized Example

25 Banking Groups/113 CESE subsidiaries

Parent Bank Parent bank's home country Sl

oven

ia

Cze

ch R

epub

lic

Slov

akia

Pola

nd

Turk

ey

Bul

garia

Rom

ania

Hun

gary

Alb

ania

Bos

nia

Cro

atia

Serb

ia

Esto

nia

Latv

ia

Lith

uani

a

Rus

sia

Ukr

aine

Bel

arus

Erste Group AustriaRZB AustriaVolksbank AustriaBank Austria 1/ AustriaHypo Alpe Adria Group 2/ AustriaDexia BelgiumKBC BelgiumDNB Nord DenmarkBNP Paribas FranceSocGen FranceCredit Agricole FranceBayern LB GermanyCommerzbank GermanyDeutsche GermanyAlpha GreeceEurobank EFG GreeceNBG GreecePiraeus GreeceAllied Irish Bks IrelandIntesa Italy Unicredit Italy ING NetherlandsNordea SwedenSEB Sweden Swedbank Sweden

Bankers without Borders? – Data Sample

Description and Calibration of the shock

Time frame: 2009-2010 (2 years):Description of the shock:

2009: Use of preliminary data (GFSR) 2010: Use regression models to determine (a)

“baseline” (WEO forecast for GDP, CPI and interest rates); (b) “Adverse Shock” (same as baseline, except for GDP growth - half of the one in 2009)

Method: Use of dynamic panel models to forecast i) NPLs and ii) Profit for 2010

Bankers without Borders? – Scenario Analysis

Capital Needs arising from a regional credit shock affecting the CESE subsidiaries (in percent of group’s regulatory capital):

CN(1) – no ring-fencing (both excess capital and profits can be re-allocated)CN(2) – partial ring-fencing (only excess profits can be re-allocated)CN(3) – complete ring-fencing (only transfers from parent bank are allowed)CN(4) – stand-alone subsidiarization (no intra-group transfers are allowed)

Bankers without Borders? – Scenario Analysis

• The capital needs of cross-border banking groups to ensure adequate capitalization of all parts of the group (after a shock) are higher under complete/partial ring-fencing than under no ring-fencing.

• These differences are more significant for more geographically diversified banking groups.

• Hence, the standard stress tests of cross-border banking groups based on consolidated balance sheet data (which implicitly assume no restrictions on intra-group transfers) may lead to the wrong conclusions about the adequate level of the group’s capitalization.

Bankers without Borders? – Conclusions

• A credible and well-designed framework for the resolution of cross-border banking groups could help to avoid unilateral and likely more costly solutions.

• Setting minimum capital requirements for cross-border banking groups would have to take into account the potential presence of ring-fencing.

• The capital buffer needs for cross-border banking groups could be even larger in future crises if recent reforms, pursuing logical individual country perspectives (e.g. UK), trigger new higher levels of ring fencing during crisis.

Bankers without Borders? – Policy Implications

Background Slides

The Dynamic Panel Regression: CESE NPLs

Variable Fixed Effects Arellano-Bond Arellano-Bover

NPL (t-1) 0.6113*** 0.6445*** 0.728***

GDP (t) -0.2597*** -0.2902*** -0.3558***

Interest (t) 0.1544*** 0.1758*** 0.1048**

Inflation (t) -0.0352 -0.0577 -0.0514

Constant 2.1217*** 1.9921*** 2.173***

# of Observations 170 143 161

# of Groups 18 18 18

R2 0.69 NA NA

Wald Chi2 NA 359 425

Calibration of the shock: NPL assumptions

2008 Median

2009 Median 1/

2010 Baseline

Median 2/

2010 Adverse

Median 3/Baltic

countries3.6 15.0 16.0 18.5

CEE-4 3.3 5.5 6.3 7.9

CIS/4 3.8 9.5 9.3 10.9

SEE 4.3 6.1 7.5 8.4

Footnotes:

1/ Most recent provisional data is available for each country (GFSR);

2/ Estimated based on a dynamic panel regression;

3/ Adverse scenario assumes a double-dip recession, i.e., 2010 GDP growth is equal to ½ of 2009 GDP growth

The Dynamic Panel Regression: CESE ROAs

Variable Fixed Effects Arellano-Bond Arellano-Bover

ROA (t-1) 0.0856 0.1326** 0.0834

GDP (t) 0.0723*** 0.0840*** 0.0768***

Interest (t) -0.0523*** -0.0318*** -0.0230***

NPLs (t) -0.0479*** -0.0514*** -0.0799***

Constant 1.7519*** 1.5055*** 1.7181***

# of Observations 157 139 157

# of Groups 18 18 18

R2 0.52 NA NA

Wald Chi2 NA 146 232

Calibration of the shock: ROA assumptions

2008Median

2009Median /1

2010 Baseline

Median 2/

2010 Adverse

Median 3/Baltic

countries1.2 -0.1 0.1 -0.5

CEE-4 1.2 1.1 1.3 1.0

CIS 1.4 0.5 0.9 0.4

SEE 1.7 0.8 0.9 0.8

Footnotes:

1/ Actual data from GFSR (and model output for Albania, Croatia, Romania and Slovenia)

2/ Estimated based on a dynamic panel regression using CESE 1999-2008 NPLs, GDP growth, nominal interest rates and NPLs;