Streetwise Professor

October 6, 2012

Don’t Fence Me Out

Filed under: Economics,Financial crisis,Financial Crisis II,History,Politics,Regulation — The Professor @ 6:56 am

The UK’s Vickers Report and the EU’s recently released Liikanen Group report both recommend a fundamental structural change to the banking system to reduce systemic risk and the likelihood of taxpayer bailouts of banks: “ringfencing.”    The taxpayer guaranteed deposits of a financial institution would be inside the ringfence, and the ringfenced entity that can fund itself with these deposits can engage only in a limited array of activities that are deemed to be of low risk.  Riskier activities, such as derivatives trading and securities underwriting, would have to be undertaken through separately capitalized affiliates that cannot be funded by the ringfenced entity.

This is, in essence, a variation on the Glass-Steagall approach of separating commercial and investment banking.  The Volcker Rule is another way of achieving a separation of deposit taking and trading and underwriting activities.

These structural approaches are completely misguided, in my opinion.  They are unlikely to have the desired effect of reducing systemic risk or insulating taxpayers from the fallout of risky trading activities.

Insured deposits are a potential source of moral hazard, and there is a case to be made for limiting the risks that can be funded with insured deposits.  But historically these activity limits have proved to be a very poor defense against risk taking.  Banks have gotten into trouble while engaging in traditional lending activities; the Latin American debt crisis and the S&L crisis are two prominent examples.  Ditto Northern Rock in the UK.

Moreover, it is beyond naïve to believe that making insured depositors whole is the only, or even the most important, cause of taxpayer funded bailouts.  A failing  investment bank-or a bank-owned trading entity outside the ringfence-poses a potential systemic risk that would likely result in a bailout even if insured deposits are not directly at risk.  Its derivatives counterparties-which are likely other big financial institutions, and which could well be ringfenced banks-would suffer losses if it went other.  Its lenders-which could include, for instance, money market funds that buy its short term debt-are also at risk.   This could lead to destabilizing runs on the money markets.  In brief, even entities outside the ringfence would be highly interconnected with the broader financial system, and with entities inside the ringfence.  The Fed or the ECB would likely deem problems at such interconnected institutions to be systemically threatening, and would find a way to provide support to prevent a failure.

Put differently, an investment bank-like entity outside the ringfence can be too big to fail.

Indeed, looking at the 2008 experience, the most vulnerable institutions were not funded by deposits.  Bear Stearns was an investment bank-it was bailed out.  AIG was not deposit funded-it was bailed out, in large part (IMO) to prevent the failure of another non-deposit funded entity, Goldman Sachs (i.e., the AIG bailout was in part, and likely in large part, a backdoor bailout of Goldman).  Merrill was foisted on Bank of America to prevent its failure.  And of course there is Lehman.  It wasn’t bailed out-but you can be metaphysically certain that inaction won’t be repeated again.

It is quite easy to envision that there will be firms outside the ringfence that are deemed TBTF.  If one of these firms looks acutely vulnerable, central bankers and regulators concerned about systemic contagion will find some way to prop it up.  Taxpayer money will be at risk.

Moreover, the ringfencing idea creates a particular kind of vulnerability that proved to be an acute problem in 2008, and which is pretty well understood theoretically.  The funding of non-deposit funded entities is often quite fragile, and vulnerable to runs.  Like investment banks in ’08, entities outside the ringfence are likely to depend on short-term wholesale funding that can-and will-run if the entity looks shaky, and there is doubt that a bailout would be forthcoming.

Deposit funding is stickier, and a destabilizing-and inefficient coordination game equilibrium-run is less likely to occur with sticky funding.  Thus, putting trading activities outsie the ringfence, and funding these risky activities through the wholesale markets exacerbates a source of financial fragility.

Thus ringfencing increases the risk of liquidity/funding crises that trigger a bailout.  It exacerbates a form of fragility that was devastating in 2008, when it was financial institutions that were outside the Glass-Steagall ringfence that proved most vulnerable to the fallout from the decline in real estate prices.

The knotty issue here is why the funding of trading, market making, securities underwriting and similar activities is typically quite fragile.  The Diamond-Rajan story is that runs are a way of disciplining opportunistic intermediaries.  With the potential for externalities from runs (due to contagion effects) one could make a case that funding is excessively fragile.  But that is hardly an argument for ringfencing, which precludes the ability to use less run-prone deposits to fund these activities: indeed, if anything, it is an argument against ringfencing.

The nostalgia for Glass-Steagall-like structural “fixes” is pervasive.  But structural separation of certain forms of financial intermediation, and separation of certain forms of activity from deposit taking, don’t address a fundamental source of systemic risk: the reliance on short-term, wholesale funding that is vulnerable to runs.  Indeed, it likely makes the problem worse because it increases the reliance of the segments outside the ringfence on such funding.  It is delusional to think that just because taxpayer-guaranteed deposits are not directly at risk, that taxpayers are not on the hook for bailouts.  If a big, interconnected entity that sits outside the ringfence teeters on the brink, regulators and central banks may well deem it too big to fail: No More Lehmans is their motto.  Ringfencing does not isolate derivatives trading, underwriting, etc., from the broader financial system: entities outside the ringfence will still be interconnected.

So even if there is no explicit taxpayer obligation (as with insured deposits), there is an implicit one.  We’ve seen that implicit guarantee invoked before, and we could see it again.  Ringfencing does not address the problem of a non-depository SIFI that is highly interconnected.  Indeed, by increasing the number and size of such entities, it almost certainly makes this problem worse.

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  1. Cutting through all the BS, if you get into trouble YOU FAIL! Bankruptcy cleanses MORAL HAZZARD. The same FRAUDSTERS are still in control and possession of their ILL GOTTEN GAINS!

    Comment by Bob — October 6, 2012 @ 7:49 am

  2. I thought the main argument for ring-fencing is that by insuring deposits, we have, essentially, given banks a free “call option” where they get to choose the underlying. Therefore, some banks (not all) choose a really risky underlying for that call option and take on risk inefficiently. I understand that “[w]ith the potential for externalities from runs (due to contagion effects) one could make a case that funding is excessively fragile. But that is hardly an argument for ringfencing, which precludes the ability to use less run-prone deposits to fund these activities: indeed, if anything, it is an argument against ringfencing.” However, that assumes that risk-taking is exogenous. Given the incentives problem, it’s more likely to be endogenous.

    Now, I totally get your interconnectedness argument. The “call option” analogy doesn’t fully capture that issue; however, we are left with a questions: How do we blunt the incentive problem created by insured deposits while mitigating financial fragility? I haven’t seen an answer to that one yet.

    Comment by Highgamma — October 6, 2012 @ 9:51 am

  3. @Highgamma. You are exactly right re ring-fencing. An entity with access to riskless funding has an incentive to take on excessive risk, and moreover, its depositors have no incentive to monitor that risk taking.

    That’s the rationale for ring-fencing, but the point of the post is that won’t address other, more serious risks, including risks like those that gave rise to the last crisis, which centered on firms that weren’t de jure ring-fenced, but which were de facto.

    Yes, risk-taking is endogenous, which is why the conventional deal with insured deposits includes capital requirements (which effectively make the call you refer to out-of-the-money, reducing its lambda/vega-and yes, its gamma!, thereby reducing the risk taking incentive), heightened monitoring, and often restrictions on the class of acceptable investments. The last could be viewed as a form of ring-fencing.

    But my sense is that it wasn’t the underpriced deposit insurance option that was-or is-the big problem with TBTF institutions. Small banks, S&Ls in the 80s, definitely. But not Bear, Lehman, Merrill, Goldman, Morgan Stanley, AIG, and even the big banks which do have insured deposits, because that represents only a modest fraction of their funding.

    The moral hazard problem that is more important arises from the provision of emergency aid to TBTF institutions funding through the wholesale markets, or of aid to the suppliers of the funding (e.g., guaranteeing money market funds out the wazoo). Ring-fencing does nothing about that. Moreover, this sort of funding can lead to bad outcomes even when moral hazard isn’t involved, due to the multiple equilibrium/coordination game/run problem. Indeed, the whole purpose of deposit insurance is to eliminate the incentives to run (inefficiently). That’s how deposit insurance can enhance efficiency: the cost of that is moral hazard, and the restrictions/monitoring necessary to reduce it.

    So your question at the end is exactly the right one. And no-there’s no good answer on offer. My basic point is that as long as there is implicit insurance of wholesale funding because of TBTF, moral hazard still exists and taxpayers are at risk. Ring-fencing essentially puts more institutions/assets/liabilities in the implicitly insured category, and that’s not obviously an improvement. Indeed, I think it could well make things worse. Perhaps I’m fighting the last war, but my view of ’08 is that it was the implicit insurance that was the real source of problems. It entailed the incentive problems of deposit insurance, but without the benefit of reduced incentives to run. My sense is that the likelihood of a crisis is greater in that situation, than when there is just moral hazard but reduced incentives to run (which is the case under deposit insurance).

    The ProfessorComment by The Professor — October 6, 2012 @ 11:06 am

  4. So essentially letting financial institutions grow too big, so that they can be perceived as TBTF is the source of the problem. And banks have strong incentives to amalgamate to become TBTFs as it has been happening since the late 80’s. Regulatory mechanisms only make it more easier to amalgamate as the combined institutions can effectively reduce regulatory expenses. However, these days I am getting the sense that even the super big banks find all the compliance prohibitively that it might be cheaper to get smaller. This can be evidenced by the successes of smaller firms like Jefferies lately.

    Comment by Surya — October 6, 2012 @ 11:17 am

  5. @Bob-I’m guessing you’re not a fan of the Dukes of Moral Hazzard.

    The ProfessorComment by The Professor — October 6, 2012 @ 9:39 pm

  6. I’m a fan of “Laissez Faire Capitalism” which is to the current bunch of crony capitalist Dems and Repubs is like light to a vampire!

    Comment by Bob — October 7, 2012 @ 4:45 pm

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