ringfencing retail banking: an illusory comfort ringfencing retail

Ringfencing retail banking:an illusory comfortThis document was drafted by Eurofi with input from its members. It does not engage in any way the EU Danish Presidency or the Danish financial authorities.

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The Eurofi High Level Seminar 2012 // Copenhagen // 29 March


Ringfencing retail banking: an illusory comfort

This document was drafted by Eurofi with input from its members. It does not engage in any case EU Danish Presidency or the Danish Financial Authorities

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Executive summary

States have had on several occasions to mobilise taxpayers’ money tobail out financial institutions. This happened for example during the“subprime” crisis, which strongly affected certain countries. In somecountries the impacts of the financial crisis have been so importantthat “structural” prudential legislations have been proposed in anattempt to isolate from investment banking risks both depositors andthe key functions of the financial sector (payments and credit lendingcapacities). In addition some regulators are in favour ofcomplementing the risk based international regulatory frameworkswith structural backstops expected to limit the spill over of risk withinthe financial system, notably if supervisors were to fail in their task orif unpredictable risks were to occur.

Although the crisis hit pure retail and pure investment banks as wellas diversified banks, which demonstrates that the business modelwas not the cause of the crisis, the structural reforms envisagedusually involve separating retail and investment banking activities.Such approaches raise many questions among market observers inparticular in Europe.

While the specific benefits of such reforms in terms of risk mitigationare not obvious, separating retail and investment banking activitiesmay jeopardize the economic sustainability of financial institutionsoperating with a diversified banking model in which both types ofactivities co-exist. The loss of the positive effects of diversifingfinancial activities could represent significant costs for financialinstitutions and their customers while the potential for synergies mayalso be reduced, in particular for medium enterprises andmunicipalities, which increasingly need both traditional credit andaccess to capital markets.

Separating retail and investment banking activities does not helpeither to reduce the risks related to the interaction between bothtypes of activities alongside the securitisation process, revealednotably by the subprime crisis, and which have been addressed byBasel regulatory improvements. In addition ring-fenced retailactivities will remain exposed to wholesale risks since wholesalebanks will continue to provide them with hedging instruments andfinancing (e.g. money market financing, securitisation, etc.).

Moreover, separating activities does not reduce risk per se, since itdoes not improve the capacity to manage the risks of each individualactivity i.e. retail and investment banking activities, unlike the Baselframework. As a consequence separation does not suppress eitherthe systemic risks that may develop in each type of activity, i.e. risksthat originate in capital markets or risks such as those that were atthe origin of the subprime crisis, which was a real estate bubble. Inaddition moral hazard may increase as ring-fencing makes explicitthat retail banks will in any case benefit from state aids and bailouts.

More generally with such a structural reform, states cannot beassured of no longer having to intervene to bail out the financialsystem. Indeed, while retail banks may be safeguarded from internalcontagion resulting from the default of an investment bank part ofthe same financial group, the economy would not be protected fromthe consequences of the failures of either the investment or retailpart of a bank. It turns out to be highly theoretical to think that stateswill not intervene to prevent the consequences on the economy of amajor crisis in financial markets. In addition ring fencing does notaddress the fact that retail depositors will be increasingly exposed to“unknown sources of risk which accumulate in the financialsector 1” through the so-called "shadow banking", which offersinvestors alternatives to bank deposits. The EU Commission is nowtackling this specific risk.

1Taking action on shadow banking: avoiding new sources of risk in the financial sector -

Michel Barnier - 19/03/2012

Lastly separation, which is expected to be challenging in practice forbanks’ managers and supervisors, is not justified either by aiming toavoid a misuse or abuse of retail deposits by market activities. Suchrisk is indeed limited in Europe by the fact that deposits in EUuniversal banks are not used on a regular basis to finance marketactivities, as the loan to deposit ratio in the banking book is generallyover 100%.

Therefore, the main expected benefit of separating retail andinvestment banking activities would be to protect retail activitieswithin a diversified institution, from a default of the investment bankpart of the same bank. This benefits could however be achieved moreeffectively by the implementation of the forthcoming EU resolutionlegislation, which is being defined in particular to avoid contagionwithin financial groups and to reduce the exposure of the financialsystem as a whole.

A well-functioning EU resolution framework operated by sufficientlyempowered and demanding supervisors, seems preferable in manyways to a “one size fits all” approach such as ringfencing. Indeedringfencing imposes on all institutions a similar and static solutionwhatever their structure and the evolution of their activities, whichreduces the capacity for supervisors to adapt their recommendationsto the risk profile of the company. Such measures may also leadsome supervisors to over-rely on the effects of ringfencing and to notpay sufficient attention to the development of risks within thefinancial institutions concerned.

The forthcoming EU resolution legislation indeed targets the set up offirm-specific recovery and resolution plans designed to limit internalcontagion, ensure the continuity of vital financial services andfacilitate, when necessary, an orderly resolution. These so called“living wills” will be regularly revised to be adapted to financialinnovation, and factors in the evolution of banking business models.Moreover this EU resolution framework will increase early interventionpowers for supervisors, enforce bail in clauses and recourse to bankfunded resolution funds, etc. which should help to effectively preventor reduce the impacts of possible financial difficulties.

Last but not least, to prevent the consequences of a possible failureof one of the national supervisors at least at the EU level andfacilitate a cross-border perspective on risks, such living wills will beset up within the colleges of supervisors of each EU cross borderfinancial group and under the aegis of the EBA.

There is no silver bullet against financial instability. Appropriate riskmitigation requires combining complementary regulatory reforms andimproving the risk management of institutions and their supervision,which is under way. As a consequence although the regulatory capitalof market activities requires permanent surveillance, the risk attachedto investment banking has already been seriously reined.

In this context a key question to be addressed is the potentialadditional value of ringfencing retail activities: in particular whetherthe possible benefits in terms of protection of retail deposits frominvestment banking risks within a diversified financial institutionwould compensate the increase of the moral hazard provoked inretail-banking and the possible downsides for diversified financialgroups and their clients. The additional question is whether the sameobjectives cannot be achieved by alternative mechanisms such aseffectively enforced living wills.



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1. Certain countries are adding structural financial reformsin order to reduce the possibility of taxpayers’ money beingused for financial institution bailouts

States are regularly required to bail out financial institutions in orderto avoid the consequences of their difficulties, both for depositors(losses sustained by depositors) and for any key functions theyperform within the financial system (blockage of payment systemsand reduction in financing for the economy). This requirement washighlighted again during the subprime financial crisis with theextraordinary consequences of not bailing out Lehman Brothers,whose systemic importance as counterparty on OTC derivativesmarkets was revealed at this time. The crisis has also revealed thatsuch a bailout could prove vital for institutions that were relativelysmall, but whose difficulties were enough to compromise depositors’confidence in the overall banking system, as illustrated by the case ofNorthern Rock.

In addition, states’ exposure to the risks of financial institutionsrepresents a source of moral hazard, further heightening theirexposure. Indeed, staff in such institutions has relatively limitedexposure to the risks involved with the operations they structure,while their compensation packages may be based on a portion of theprofits generated through these operations. Such a situation mayencourage them to take excessive risks compared with what would beaccepted by the banks’ various creditors, further increasing thelikelihood of the public authorities having to intervene.

Lastly, handling proprietary activities (financial activities that directlybenefit the shareholder) alongside activities for customers (financialactivities which indirectly benefit to the shareholder on the basis ofthe margin on the service or profit-sharing, which are agreed with thecustomer) within the same institution leads to possible conflicts ofinterest.

In such a context, the objective of “structural” prudential legislation isto reduce state exposure to banking risks, excluding certainexposures: international banking, wholesale banking, financialcompanies, proprietary trading, hedge funds, etc. - especially sincethe moral hazard contributes towards increasing them.

Although prudential regulations are designed to appropriately assessrisks and provide institutions with sufficient capital or liquidityreserves, and although these regulations are aimed in particular atreducing the moral hazard, structural legislation is sometimes beingadded on top of the prudential regulations.

Such legislation, depending on the priorities they set - paving the wayfor the emergence of regulated institutions intended to receivedeposits, ensuring financing for certain assets, separating market andbanking risks, avoiding conflicts of interest, etc. – may take variousforms: subsidiarisation of retail banking activities (Vickers), exclusionof proprietary activities (Volker), restriction of the assets that can beinvested in by banks receiving deposits (Utility Banking Model), etc.(cf. Appendix 3).

2. It is understandable that the states that have had tomake major efforts on the banking system during thesubprime crisis are taking initiatives to move towardsadditional prudential legislation.

The “subprime” crisis has particularly affected certain countries. Morespecifically, this is the case for the Swiss Confederation, the UnitedStates, the United Kingdom and Ireland (see Chart below – DB research).

Estimates show that the costs of financial crises for nationaleconomies represent an economic decline of around 2.8% of GDP onaverage (§ 5.69 of the ICB report).

However, for the UK, the cost of the subprime crisis has been fargreater. The ICB report reveals that the British economy has lostalmost 10 points of its annual GDP (cf. Figure 5.1, extracted from thereport). This decline has been combined with a sharp rise inunemployment (Ibid).

In addition, support for the financial sector has required public debtto be raised to extraordinary levels of around 150% of GDP (cf.Figure 5.1, extracted from the ICB report below) due to the bailoutplan put in place, which could reach 400 billion pounds.

For its part, the Swiss Confederation has had to mobilise resourcesrepresenting approximately 12% of its GDP, taking on UBS’ illiquidassets (USD 60 billion) and injecting capital into it, funded by a SwissFranc 54 billion loan from the Swiss National Bank and Swiss Francs 6billion of capital contributed by the Swiss State.

The states’ attitudes to possible structural regulations also depend ontheir exposure to the financial sector: in the UK, the IndependentCommission highlights the considerable increase in the proportion offinance’s gross value added within its economy (average gross valueadded multiplied by two between 1975 and 2007, and by 3.5 forfinancial intermediation). One can also highlight the growing level ofbanking assets in relation to GDP - cf. Chart 20, extracted from apresentation by a Bank of England executive - which shows that theyrepresent more than six times the UK’s GDP.

For the Swiss Confederation, banking sector assets represent ninetimes the country’s GDP2.

2 La vie économique, Economic policy review, 12-2008



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3. Structural legislation is specifically impacting certainbanking models even though no specific model has proven tobe a decisive factor in terms of the financial crisis we areexperiencing

In Europe, the importance and the extent of the universal bankingmodel is raising questions in particular about the opportunity ofseparating retail banking from investment banking.

The objectives of such a structural financial reform would be to:- Eliminate risk taking that is not necessary for providing “vital retail

banking services3”,- Reduce the exposure of vital retail banking services to systemic

risk,- Reduce the moral hazard and taxpayer liabilities,- Better target macroprudential regulation.

In this respect, the structural constraint would be “to isolate thosebanking activities where continuous provision of service is vital to theeconomy and to bank’s customers”, which “would require banks’ retailactivities to be legally, economically and operationally separate fromthe rest of the banking groups to which they belong”. (…) “Theywould have distinct governance arrangements, and should havedifferent cultures”.4

However, have some of the banking models proven to haveparticularly exposed taxpayers during the subprime crisis, and do theyrepresent an actual factor behind the crisis? The fact that a rootcause of the subprime crisis was a real estate bubble and that thebanking models of the institutions affected by the crisis andbenefiting from state aid were very diversified indicates that theanswer to this question is no.

Indeed, money market funds, small and large retail banks (NorthernRock or Dexia, and more recently the Spanish Cajas), small and largepure players on the financial markets (Bear Sterns, Merrill Lynch,Landesbanken, etc.) as well as universal banks (UBS, Citi, Lloyds,RBS, Commerz) have experienced major difficulties and required stateaid.

As such, the natural conclusion would be that nothing justifies aparticular regulatory focus on universal banks. Only regulations whichare focused on the early and cautious identification of risks,particularly those relating to financial innovation, and on constantlyidentifying the moral hazard and possible conflicts of interest, basedaround demanding and competent supervisors, as well as onindependent and effective risk divisions are likely to effectively reducethe cost of financial shocks for financial institutions and society.

3 Independent Commission on Banking Final report – September 2011 – Executive summary,Structural reform: practical recommendations4 Ibid

Moreover, the subprime crisis, which resulted from an inappropriateinterplay between retail and wholesale banks, suggests that theappropriate structural financial regulation to be imagined should focusprimarily on the interaction of wholesale banks with retail institutionsin this particular case within the securitisation value chain.

4. Illusory and anaesthetising comfort of legal separation

It is worth precisely describing and assessing the actual exposure ofretail activities to possible difficulties stemming from the bank’swholesale banking section.

The fact that loan-to-deposit ratios in the banking books ofcontinental European banks are generally over 100% means thatdeposits are far from being allocated to finance market activities.Indeed, retail lending requires additional financing to be raised on themarkets since retail deposits are not sufficient.

Overall, the possible impact of wholesale banking difficulties on retailactivities would stem mainly from retail-liquidity excesses temporarilybeing lent to the wholesale part of the bank and frozen there.

By contrast, although the ringfencing approach protects against therisk of internal contagion, one should bear in mind that retail activitieswould remain exposed to the wholesale risk – market illiquidity,financial institution’s counterparty risk. Indeed, wholesale banksprovide them with vital financial components:

- Hedging imposed to achieve an appropriate Asset and LiabilityManagement

- Liquidity wholesale facilities complementing retail deposits- Excess liquidity investment tools (repos, etc.)- Refinancing wholesale techniques including securitisation

In addition, ringfencing increases the moral hazard in retail bankingactivities. Per se, forcing retail financial activities to be ringfencedexplicitly means that retail banks will in any case benefit from stateaid and bailouts, which may encourage inappropriate risk-takingbehaviours in a financial area that is already prone to frequent creditbubbles (consumer credit, real estate).

These facts show that ringfencing leads to an illusory andanaesthetising comfort.

5. Ringfencing does not protect against financial marketcrises and only slightly reduces the probability of a retailbanking crisis

The structural reform is separating retail banking activities frominvestment banking activities, without leading to any changes interms of risk management for either segment. Moreover, it is only byadding capital on top of the levels recently demanded by Basel thatthese reforms are supposed to reduce the probability of a retailbanking crisis occurring; capital addition that may also beimplemented without incurring costs for the separation of activities.

Under these conditions, offsetting the cost of the reform, asdetermined by the Independent Commission and expected torepresent around 0.1 to 0.2% of GDP per year, the expected benefits(reduction in the probability of financial crises occurring measured as% of annual GDP) for the economies, according to the model appliedby the BCBS when justifying Basel 3, come to:

- Zero in terms of financial crises due to the capital markets,- At best, 0.15%5 of annual GDP for financial crises resulting fromretail activities, thanks to the additional strengthening of their capitallevels.

5 We are working with the cautious assumption that the Basel reforms will double the banks’capital, all things being equal. Under these conditions, given that the average pre-crisis levelof capital is estimated by the BCBS at 7%, the new capital ratio required by Basel comes out



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To sum up, structural regulations do not in any way reduce theprobability of financial market crises occurring and, at best, are onlycost neutral as far as financial crises resulting from retail activities areconcerned (e.g. bursting of a real estate bubble, etc.).

Indeed, according to the BCBS model (Appendix 2), which estimatesthe reduction in the probability of crises based on incrementaladditions of prudential capital, Basel 3, which is leading to a majorstrengthening of liquidity and capital levels, is introducing most of thesteps towards reducing the probability of crises.

In practice, given the average pre-crisis level of capital, which isestimated by the BCBS at 7%, and the new capital ratio required byBasel, which comes out at 14%, the additional capital required by thestructural reform offers only a hypothetical and marginal benefit.

The marginalisation of the impact of successively adding prudentialcapital, which is intuitively understandable, is illustrated in the chartsbelow, extracted from the BCBS documents. As the capital ratioincreases (horizontal axis), the additional benefits expressed as a %of GDP (net of costs of the increase - vertical axis) fade then becomenegative.

6. The in-depth review of international regulations, asreshaped following the financial crisis, reveals a significantstrengthening of control over financial risks

Indeed, in view of the lessons learned from the 2007-2008 financialcrisis, various waves of reforms have further strengthenedinternational banking regulations. More specifically, this concerns theimprovements to Basel 2, Basel 2.5 and Basel 3. In addition, criteriahave been defined for identifying systemic institutions andsubsequently adding to their prudential capital.

In this way, the assessment of risks linked to securitisation andresecuritisation has been improved - more specifically, this concernsrisks relating to liquidity lines granted to off-balance sheet conduits,and those linked to resecuritisation, ABS CDOs – while particular caremust now be taken with externally-rated exposures.

Moreover, regulators have considerably improved the assessment ofrisks linked to complex trading activities (factoring in specificmigration risks and default risks for un-securitised credit products;aligning capital charges between trading and banking books forsecuritised products).

Alongside this, regulators have systematically introduced stressedconditions into the Value at Risk (VAR) calculation so as to avoid

at 14%. If the liquidity ratios are put in place, this leads to a reduction in the probability ofcrises, equivalent to an additional 2.6 percentage points of GDP per year (next-to-last line inthe BCBS table, Appendix 2).Similarly, this leads to expectations for a maximum impact representing an additional 0.15percentage points of GDP per year for the 3% additional capital ratio proposed by the ICB,positioning the capital ratio at (14+3=17%). The 0.15% corresponds to 3 times the marginalcontribution recorded when raising the capital ratio from 14 to 15%; although it graduallydecreases, we have put it as a constant, with 0.05% annual GDP.

underestimating the risks characterising the cycle-high periods duringwhich volatility and therefore the VAR remain lower, even thoughmarket stalling is imminent.

Such developments are leading to a radical re-evaluation of marketrisks, reducing the procyclical nature of their prudential regulationsand the incentives for regulatory arbitrage.

In parallel, the Basel Committee (Basel 3) has supplemented the driveto further strengthen risk assessment and weighting by significantlyincreasing the capacity of financial institutions to absorb losses,increasing the size of the core tier 1, tightening up capital quality,introducing countercyclical buffers, etc.

Ultimately, all things being equal, institutions will have to multiplytheir capital by five times on average.

At the same time, international regulators are introducingmechanisms limiting the liquidity risk for institutions by forcing themto hold the liquid assets needed to cope with one month of outflowsestimated under stressed conditions, while setting a structural ratio toreduce the transformation effect (mandatory coverage of 100% ofassets over one year by resources over one year).

Alongside this, supervisors’ practices have been tightened up (e.g.Pillar 2 - control process led by supervisors) so that they ensure goodgovernance and risk management by the institutions, particularly foroff-balance sheet risks, securitisation-related risks and lastly,concentration risks. These practices also incorporate monitoring forthe application of the “Financial Stability Board (FSB) principles forsound compensation practices”, notably intended to reduce the moralhazard.

In practice, these reforms are leading to major changes withinfinancial institutions (cf. Appendix 1): deleveraging, abandoning ofmarket business lines that are too risky, etc.

The scale of the reform, combined with regulations aimed atfacilitating crisis management for financial institutions in Europe,raises the question of whether additional structural legislation isrequired.

In the end, financial institutions’ risks have been dramatically reducedand the effective exposure of states significantly reduced assupervisors have specific powers and financial resources, withresolution funds, for managing institutions’ crises based on continuityand liquidation plans, prepared ex ante.

7. Structural reforms provide no extra value to living willsand resolution regimes

The forthcoming resolution legislation, and the “living wills” inparticular, is precisely set to avoid contagion within financial groups.

Indeed, they facilitate their resolution, as resolution authorities shouldregularly assess the feasibility of mandatory resolution strategies andtheir credibility in light of the likely impact of the firm’s failure on thefinancial system and the overall economy.

Moreover, to improve a firm’s resolvability, supervisory authorities orresolution authorities will have powers to require the adoption ofappropriate measures, such as changes to a firm’s business practices,structure or organisation, to reduce the complexity and costliness ofresolution and prevent in particular internal contagion.

Deposit guarantee schemes and resolution funds financed by thefinancial industry will contribute towards strengthening the resolutionregime providing special protection for households and financialsupport for the regulators in charge of the resolution plans.

In addition such living wills will be set up within the colleges ofsupervisors of each EU cross border financial group and under theaegis of the EBA, which should prevent the consequences of a



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possible failure of one of the national supervisors at least at the EUlevel and will facilitate a cross-border perspective on risks.

Yet in the case of structural ringfencing, retail activities would be lessexposed to possible difficulties stemming from the wholesale bankingsection of the bank. However, one can question the fact whetherringfencing will significantly improve the situation established by livingwills and more generally the resolution regimes. In this context,ringfencing represents a costly one–size-fits-all living wills approach.

8. Ringfencing does not prevent the economic impacts offinancial crises - retail or wholesale - although they should bethe first rationale for prudential policies

In all scenarios, the structural reform would not prevent financialcrises resulting from market activities, such as the subprime crisis. Atthe very most, the structural reform would protect retail banks insuch circumstances, although naturally without preventing theirconsequences for the rest of the economy.

Indeed, structural reforms make it possible to think that the state willnot intervene due to the threats that would undermine a financialinstitution’s retail activities in the event of a financial market crisis.

Conversely, it turns out to be highly theoretical to think that stateswill not intervene to prevent the other consequences of such crises.They will do so in order to protect a systemic institution’scounterparties (financial or non-financial companies, funds, insurersand pension funds, rate and foreign exchange protection buyers, non-financial companies using the capital markets, structured projectfinancing, long assets, etc.), or to offset the impacts that such slumpsresult in for the economies, as illustrated below. In all scenarios, overand above the budgetary cost of a possible moral hazard for states,the first political priority is still to prevent the cost of financial crisesfor the economy.

Indeed, it was the bursting of the subprime securitised mortgagebubble – not the banking crisis, which it was behind – that triggeredthe financial crisis we are experiencing, and its spillover effects onsimilar assets.

And yet, this financial market crisis has led to a considerabledestruction of economic value, which has naturally weighed on all theglobal economic dynamics. In 2009, the European Commission(Economic crisis in Europe: causes, consequences and responses –European economy 7/2009 DG ECFIN), estimated that the losses onassets subject to the American “originate and distribute” model, atthe time of the crisis triggered by subprimes, came to USD 2,700billion in the US and USD 1,200 billion in Europe, representing 19.1%of American GDP and 7.3% of European GDP respectively. Suchlosses had led to considerable losses in terms of growth,consumption, investment, trade, etc. (see graphs below).

Ultimately, looking beyond the cost of the banking sector’s moralhazard for states, these data highlight the scale of the economic costof a financial crisis.

Even if certain countries have found themselves overexposed due totheir banks (see next section), a DeutscheBank Research paper(Direct fiscal cost of the financial crisis: probably much lower thanfeared – May 14, 2010) quite rightly notes that the one-off fiscalresources that have had to be deployed following the "subprime”financial market crisis represent about 4.5% of GDP on average, asimilar level to the Swedish banking crisis in the 1990s, but far lowerthan the fiscal outlays required by other crises.

However, the impacts of this crisis in terms of GDP stalling (resettingof the GDP curve some 4% lower! - see figure below), unemployment(more than 2 additional unemployment points, starting from 7%, upby almost 30%), etc., its international scale resulting from spilloverthrough the capital markets, means that it is the most serious crisisfaced since 1929.

Source: European Economic Forecast, Spring 2011

9. Doing without the universal banking model will be themain cost of ringfencing European retail activities

Ringfencing retail activities, does not significantly reduce contagionand systemic risk, and poorly contributes towards financial stability.But it would make it difficult to capitalise on the universal bankingmodel.

The universal banking model allows banks to leverage economies ofscale, better diversify their risks and spread the costs over a broaderbase of activities. It also benefits customers as cross-subsidisationbetween product lines leads to significantly lower financial costs.

Indeed, both customers and financial institutions benefit from theuniversal banking model:

Economies of Scale: The universal banking improves economicefficiency. It allows a lower cost for operations, marketing,information technology, infrastructure and human resources,and leads to a higher output.

Profitable & Risk Diversification: Universal banks diversify theiractivities and risks.



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Customer Benefits: In a single institution, universal banks offercustomers a wider range of products and services with increasedadded value, e.g. credit, loans, deposits, asset management,investment advisory, payment processing, securitiestransactions, underwriting and financial analysis, etc. Moreover,cross-selling practices make it possible to reduce the price ofplain vanilla cost-intensive products, which benefit fromwholesale high added-value sales. In the context of universalbanks, customers benefit from lower costs for their financialproducts.

10. Conclusion

States are regularly required to bail out financial institutions in orderto avoid the consequences of their difficulties. Moreover, the“subprime” crisis has strongly affected certain countries in particular.In such a context, the objective with “structural” prudential legislationis to reduce state exposure to banking risks, excluding certainexposures. In Europe, the importance and the extent of the universalbanking model is raising questions about the opportunity ofseparating retail banking from investment banking.

Ultimately, the structural reform, separating retail banking activitiesfrom investment banking activities, is not leading to any changes interms of risk management for either segment. Moreover, it is only byadding capital on top of the levels recently demanded by Basel thatthese reforms are leading to reductions in the probability of a retailbanking crisis occurring. This indicates that structural legislation islikely to offer limited additional value. Conversely, ringfencingincreases the moral hazard in retail banking activities as it explicitlymeans that retail banks will in any case benefit from state aid andbailouts.

In all scenarios, the structural reform would not prevent financialcrises resulting from market activities. At the very most, the structuralreform would protect retail banks, although naturally withoutpreventing their consequences for the rest of the economy. Beyondthe fact that retail activities will in any case remain exposed towholesale risk since wholesale banks provide them with many vitalfinancial components, it is in any case highly theoretical to think thatstates will not intervene to prevent such consequences.

In this respect, the subprime crisis, which notably revealed aninappropriate interplay between retail and wholesale banks, suggeststhat the appropriate structural financial regulation to be imaginedshould focus primarily on the interaction of wholesale banks withretail institutions.

In addition this type of reform is not consistent with the fact that aroot cause of the subprime crisis was a real estate bubble and thatthe banking models of the institutions affected and benefiting fromstate aids were very diversified.

Ultimately, the reviews triggered by possible structural reformsremind us that there is no silver bullet against financial instability,while highlighting the importance of certain regulatory reforms thatare underway and that we should focus the legislative efforts on:

The general adoption of the much improved risk-based prudentialregime and the compensation guidelines, reducing the moralhazard and possible conflicts of interest, and the reinforcement ofan affective and intrusive supervision

The setting up of market infrastructures aimed at reducing thesystemic risks created in particular by OTC markets in which retailbanks are regular counterparties

The forthcoming EU resolution legislation, which is precisely set toavoid contagion within financial groups and reduce the exposureof states, taking into account the specific risks for each financialinstitution

The empowerment of Systemic Risk Committees in charge ofidentifying and tackling emerging credit or asset bubbles,threatening systemic interplays and risk raising in the shadowbanking sector

The world is committed to an unprecedented regulatory effort, fromwhich legislators, regulators and financial institutions should not bedistracted.

In addition, Europe should also be cautious to continue capitalising onthe universal banking model, which allows banks to leverageeconomies of scale, better diversify their risks and spread the costsover a broader base of activities, at the very moment when credit willbe significantly more expansive and many economic agents - SMEs,local municipalities, infrastructure projects, etc. - will need to beaccompanied toward capital markets seeking the financing which thebanks would no longer be able to provide them for regulatoryreasons.



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Appendix 1: For reference, impacts to date of new financialregulations (primarily Basel reforms)

Appendix 2: BCBS cost-benefit calculations for the Basel reforms - Anassessment of the long-term economic impact of stronger capital andliquidity requirements - Table 8

Appendix 3: Description of possible structural reforms

Structuralreform

Objective Approach

Narrowbanking

- Protect deposits - Restricting authorised assets- Setting restrictive management rules:reduced maturity mismatch, reduced leverage,high credit quality standards, mainly depositfunding, etc.

Volker rule - Limit the conflicts of interestundermining customer activities- Eliminate risk taking that is notrequired for customer needs- Reduce the moral hazard- Reduce systemic risk exposurefor customer operations- Reduce regulatory trade-offs(transfer from banking book totrading book)

- Excluding proprietary activities (trading orinvestment)

Ringfencing - Eliminate risk taking that is notnecessary for providing “vitalretail banking services”- Reduce the exposure of vitalretail banking services tosystemic risk- Reduce the moral hazard andtaxpayer liabilities- Better target macroprudentialregulation

- Separating retail activities from marketactivities through the subsidiarisation of retailbanking, which may be sister or daughter, butnever the parent for market activities- Overloading capital requirements on retailactivities- Ringfenced activities meet regulatoryrequirements for capital, liquidity, funding andlarge exposures on a standalone basis- Limits on wholesale funding- Ensuring that the “parent” or “sister”investment bank is now only one of the retailbank’s various suppliers

Non-operatingHoldingCompany(NOHC)

- Eliminate risk taking that is notrequired for customer needs- Reduce systemic risk exposure- Reduce the moral hazard

- Improving the transparency of financialgroups- Maintaining sufficient distance betweenactivities by- Systematically setting up a Non-OperatingHolding Company- Subsidiarisation of each business line forbanks- Systematic contractual intra-group relations

The Eurofi High Level Seminar 2012 // Copenhagen // 29 March


ringfencing retail banking: an illusory comfort ringfencing retail

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