Ring- fencing the banks

1. Ring-fencing the banks Frederic Malherbe London Business School Banque de France 11/12/2012

2. Motivation Observations linked to the crisis • Rise of securitization – financial innovation • Banks were holding such assets • Banks were seen as “well capitalized” • Basel II • Risk-weights • Internal-Rating-Based (IRB) Approach Tax-payer exposure Volcker Rule, Vickers, and Liikanen Reports • Ring-fencing • Limit exposure • Ensures continuation of essential services

3. A Representative bank • Initial capital , maximize value of equity • Takes insured deposits • CRS investment opportunity Measure 1 of risk averse households • Endowed with 1 unit of consumption good • Storage technology • Utility from end-of-period consumption A single period model

4. The policy trade-off Bank net-worth: Bailout tax: Regulator objective First order condition

5. The policy trade off

6. Financial innovation (1/2) Imagine a second (symmetric) economy Investment opportunity Imperfect correlation Risk sharing “trade” • Assume they swap 50% of their portfolio Effect on portfolio return distribution • Interpretation • Securitization • Buying CDS

7. New policy trade off

8. Financial Innovation (2/2)

9. Financial innovation (2/2)

10. Bottom line Financial sophistication has value But incentives are very strong to • Overestimate diversification • Make side bets Can we trust internal models? • Information asymmetry Mechanism design • In a static world… • In reality… • Full joint distribution matters • Supervisor’s human capital “Ring fencing” may make sense

11. A possible logic Deposit insurance distorts incentives • But is necessary to preserve confidence • Continuation of essential services Financial innovation is useful • By nature, its impact is hard to assess If cannot confidently supervise • Separate entities If other gains from conglomerate • “Ring-fencing” Deposit taking are insured and do safe stuff Others can innovate but are not insured • If no-bailout clause credible => internalize cost of risk • If fails, deposit institutions are preserved

12. In practice Volcker Rule: prevent side bets Vickers and Liikanen propose to restrict bank “activities” Remarks • Deposit insurance Vs taking deposits • I assume main goals are • Preserving deposit institutions • Allowing for financial innovation • Prevent adverse alteration of joint distribution

13. Where to put up the fence? Investment bank A L Debt Funny business Commercial Bank Equity Commercial bank These links are problematic A L Loans & Bonds These links seem fine Deposits & Debt Stocks Equity Beware of credibility !

14. Some questions and caveats Inside the fence • Assets • Regulator should be able to assess joint distributions • Restrictions on assets, validation? • Interbank positions within the fence? • Liabilities • Collateralized borrowing? • Hybrid liabilities? • Full guarantee? Outside the fence • Credibility (TBTF?) • No restriction at all? • Externalities (among IB and/or towards the fenced institutions) Crisis? • Contingent rules? • Repatriate business within the fence? • Reward the survivors?

15. Thankyouverymuch! Frédéric Malherbe (LBS)