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

2. 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

3. 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

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 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

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 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

11. 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

12. 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

13. 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 !

14. 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?

15. Frédéric Malherbe (LBS) Thank you very much!