13 April 2013

Cerutti & Schmieder: Ringfencing and consolidated bank stress tests

This column discusses research into the shortcomings that arise from 'ringfencing', i.e. the implicit or explicit regulations that hope to favour domestic markets. Notably, ringfencing could significantly increase some banks' capital needs.

Conclusions

The authors' analysis is an example of how the proposed unconsolidated approach extends best-practice stress tests if one seeks to gain a better understanding of risks faced by international banking groups.

What are the policy implications of this analysis? First, the establishment of a credible framework for the resolution of cross-border banking groups would help to avoid unilateral and likely more costly solutions (in terms of capital requirements). Such frameworks could reduce the incentives for, and the incidence of, ringfencing by the home/host country authorities.

Second, in the current context without full-fledged resolution and burden-sharing mechanisms (even among EU members), setting minimum capital requirements for cross-border banking groups would have to take into account the potential risks of ringfencing, especially during crisis times. More work on estimating different ringfencing scenarios across international banks is needed in order to assess the potential additional capital buffer needs for specific banks.

Third, the analysis also highlights that not only is the size of a banking group’s capital buffers relevant but also that the geographical location of those buffers within the banking group matter. The need for higher capital buffers for cross-border banking groups could be larger if some recent reform proposals, rational from individual country perspectives (e.g. separating UK retail business from the rest of the banking group and increasing capital buffers on those operations), trigger new higher levels of ringfencing – even among OECD countries. These elements highlight that further international cooperation is essential in order to avoid undesired outcomes.

Full article

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