Banque de France11/12/2012 Ring-fencing the banks Frederic Malherbe London Business School

Motivation Observations linked to the crisis ٧ Rise of securitization – financial innovation ٧ Banks were holding such assets ٧ Banks were seen as “well capitalized” ٧ 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 Representative bank ٧ Initial capital, maximize value of equity ٧ Takes insured deposits ٧ CRS investment opportunity − − Measure 1 of risk averse households ٧ Endowed with 1 unit of consumption good ٧ Storage technology ٧ Utility from end-of-period consumption A single period model

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

A possible logic Deposit insurance distorts incentives ٧ But is necessary to preserve confidence ٧ 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 If no-bailout clause credible => internalize cost of risk ٧ If fails, deposit institutions are preserved

In practice Volcker Rule: prevent side bets Vickers and Liikanen propose to restrict bank “activities” Remarks ٧ Deposit insurance Vs taking deposits ٧ 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? Commercial Bank AL Debt Equity Investment bank Funny business These links are problematic These links seem fine Loans & Bonds Stocks AL Deposits & Debt Equity Commercial bank 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 Credibility (TBTF?) ٧ No restriction at all? −Externalities (among IB and/or towards the fenced institutions) Crisis? ٧ Contingent rules? ٧ Repatriate business within the fence? ٧ Reward the survivors?

Frédéric Malherbe (LBS) Thank you very much!