The Risky Business of Ring-Fencing
34 Pages Posted: 13 Dec 2017 Last revised: 15 Dec 2017
Date Written: December 12, 2017
This working paper examines the impact of imposing multiple ring-fencing regimes on bank safety, including a ‘prisoner’s dilemma’ effect that can arise from host country incentives. It discusses these issues first on a qualitative basis to establish intuition, and then quantifies the risk of different structures via a Merton-style option model. The results suggest that there is a material advantage (i.e. reduced probability of local failure) for a jurisdiction that ring-fences its subsidiary if other jurisdictions do not match that decision. This host jurisdiction benefits from both (i) local capital and (ii) the ability to tap a large central reserve. However, if other jurisdictions adopt similar ring-fencing policies, then the benefit of a pooled ‘central reserve’ capital is voided and all jurisdictions become worse off.
Under our model, we find that failure risk increases by a large multiple if ring-fencing becomes pervasive. In some cases, the increase in risk is 5x or more, compared to a structure where internal capital is fully mobile. This is caused by ‘misallocation risk’ – the risk that a bank has enough capital resources overall, but cannot get those resources to the right subsidiary in time to avoid a local failure.
The paper concludes with suggestions on possible policy alternatives that could mitigate these issues. We consider a few hybrid cases, which suggest that a ‘partly ring-fenced bank’ can mitigate a substantial amount of misallocation risk if the central reserve is significant and not committed too early.
We then explore alternatives which build on the Financial Stability Board’s post-crisis bank resolution architecture. Large amounts of ‘bail-in’ capital are now being issued by the biggest global banks, and these resources can fund an alternative to the hard legal entity bankruptcies (or emergency bail-outs) seen in the 2008 crisis – events that appear to motivate many of the recent ring-fencing initiatives. We conclude with a ‘straw man’ proposal that aims to produce a more resilient overall outcome for the group while addressing legitimate host concerns. We believe the paper is relevant for the ongoing policy debates on bank structure, capital allocation and resolution.
Keywords: Banking, Resolution, Ringfencing, Diversification
JEL Classification: G20, G21, G28
Suggested Citation: Suggested Citation