Ringfencing the banks Frederic Malherbe London Business School

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

Motivation • Observations linked to the crisis ٧ ٧ 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 ٧ Ring-fencing − Limit exposure − Ensures continuation of essential services

A single period model • A Representative bank ٧ ٧ ٧ Initial capital , maximize value of equity Takes insured deposits CRS investment opportunity − − • Measure 1 of risk averse households ٧ ٧ ٧ Endowed with 1 unit of consumption good Storage technology Utility from end-of-period consumption

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 distribution ٧ 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 ٧ Overestimate diversification Make side bets • Can we trust internal models? ٧ Information asymmetry • Mechanism design ٧ ٧ In a static world… In reality… − Full joint distribution matters − Supervisor’s human capital • “Ring fencing” may make sense

A possible logic • Deposit insurance distorts incentives ٧ ٧ But is necessary to preserve confidence Continuation of essential services • Financial innovation is useful ٧ By nature, its impact is hard to assess • If cannot confidently supervise ٧ Separate entities • If other gains from conglomerate ٧ “Ring-fencing” • Deposit taking are insured and do safe stuff • Others can innovate but are not insured ٧ ٧ If no-bailout clause credible => internalize cost of risk If fails, deposit institutions are preserved

In practice • Volcker Rule: prevent side bets • Vickers and Liikanen propose to restrict bank “activities” • Remarks ٧ ٧ Deposit insurance Vs taking deposits 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? Investment bank A L Funny business Commercial Bank Debt Equity Commercial bank A Loans & Bonds Stocks L Deposits & Debt These links seem fine These links are problematic Equity Beware of credibility !

Some questions and caveats • Inside the fence ٧ 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 fence ٧ ٧ Credibility (TBTF? ) No restriction at all? − Externalities (among IB and/or towards the fenced institutions) • Crisis? ٧ ٧ ٧ Contingent rules? Repatriate business within the fence? Reward the survivors?

Thank you very much! Frédéric Malherbe (LBS)