Implications of Ring-Fencing for European Cross-Border Banks

1. Bankers Without Borders? Implications of Ring-Fencing for European Cross-Border Banks • Eugenio Cerutti (with A. Ilyina, Y. Makarova and C. Schmieder) • Vienna – October 3 , 2011

2. Bankers without Borders? - Motivation On the one hand, many cross-border banking groups acted as Lenders of Last Resort for their CESE subsidiaries during the crisis.

3. Bankers without Borders? - Motivation • 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)

4. 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?

5. Bankers without Borders? – Stylized Example A “stylized” cross-border banking group:with subsidiaries in countries A, B, C Sub A Sub B Sub C Parent Bank Regional credit shock Losses (net of provisions) at each of the subs Sub A Sub B Sub C 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

6. Bankers without Borders? – Stylized Example

7. Bankers without Borders? – Stylized Example 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.

8. Bankers without Borders? – Data Sample 25 Banking Groups/113 CESE subsidiaries

9. Bankers without Borders? – Scenario Analysis • 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

10. 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)

11. Bankers without Borders? – Conclusions 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.

12. Bankers without Borders? – Policy Implications 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.

13. Background Slides

14. The Dynamic Panel Regression: CESE NPLs

15. Calibration of the shock: NPL assumptions 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

16. The Dynamic Panel Regression: CESE ROAs

17. Calibration of the shock: ROA assumptions 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;