AN OPTIMAL BANK

STRUCTURE, STOCKHOLM,

SEPTMBER 2013

Adrian Blundell-WignallSpecial Advisor on Financial Markets to the OECD Secretary General.

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US Financial Sector Share of the S&P500

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The Financial Problem is Not Solved

• The interaction between financial innovation and regulatory change, at a time of artificially low interest rates resulted in 4 key factors:

• (1) Too Big To Fail (TBTF): led to risk being under priced via the cross-subsidisation from implicit and explicit government & lender-of-last-resort guarantees for short-term bank liabilities.

• (2) Leverage: became too high and regulators made it easy for financial firms to avoid capital (Basel & other rule changes).

• (3) Complexity & Interconnectedness (counterparty) risk: Innovation in business models focused on securitisation and derivatives-based financial products raised counterparty risk, so the failure to meet margin and collateral calls can multiply through the system. Mixing traditional banking with losses in complex products resulted in deleveraging, with SME and consumer lending failing to support recovery.

• (4) Conflicts of interest: Corporate governance for self interest of managers and traders.

• Reform requires a financial system that adds value, not subtracting value for itself. This is not happening.

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What Changes With Basel III?

• Complexity: Retains core features of capital charge system but is infinitely more complex with portfolio invariance based add-ons: multiple risk-weights; Basel II bank modeling (improved?); failure to separate leverage & counterparty risk—all be woven into the RWA capital rules. The 3% leverage ratio “back-up” is too weak and allows derivatives netting. Basel III was never asked to consider bank business model issues & their interaction with leverage and the capital rules.

• Definition of capital: generally for the better, with deductions, like goodwill, deferred tax, minorities, etc, to have a core concept); T1 (hybrids back); T2 (other hybrids).

• Counterparty risk: CCR—capital buffer (3 x 10 day 99% VAR during a period of high stress) added to market risk VAR that will raise RWA. CVA up-front charge, additive across netting sets, valuing unexpected counterparty risk in bond equivalents, and applying the MR for such bond equivalents.

• LCR and NSFR: to deal with liquidity and funding.• Greater international harmonization, but a slow transition,

continuing until 2023.

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RWA / TA GSIFI & Traditional Banks

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Tier 1 Capital / RWA (2008 & 2013)

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Tier1 / Total Assets GSIFI Banks (2008 & 2013)

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Complexity & Interdependence in Derivatives and Repo’s

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Derivatives vs Primary Securities % World GDP & the Crisis

• Derivatives fund nothing, but carry all the bankruptcy characteristics of debt.

• The bulk is for socially non-useful things, such as structured products to avoid tax or to create enticing products that are risky & dangerous for naive consumers.

• Derivatives are levered, and the inability to meet contractual margin & collateral calls played a key role in defaults in the crisis.

• Rose from 3 times world GDP in 1998 to 12 times by 2007: for huge profits in the 2000’s.

• THE WORLD FINANCIAL SYSTEM DID A BIG PRIVATE EQUITY DEAL ON THE WORLD ECONOMY, GEARED IT UP, RIPPED OUT THE CARRIED INTEREST FOR THEMSELVES, & LEFT THE TAXPAYER TO CLEAN IT UP.

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16.0 %GDPTotal

Primary Securities

Derivatives

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Gross Credit Exposure versus Collateral

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Distance to Default (3 Std. Dev.= Safe) : The USA Doing it Better than Europe

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DTD Model—What Factors Matter for Bank Default Risk

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Policy Issues Arising From New Research

• Leverage ratio dominates the Basel T1 ratio. Nearly all GSIFI banks in the worst DTD categories of the study have greater than 20 times LEV. A 3% backstop is not enough.

--Dexia: leverage June 2011 59-times, Tier-1 11.4. Year-end failure of the bank follows, & Tier-1 is still 7.6%.

• Business model features. high derivatives & high wholesale funding have separate (from leverage) & highly significant negative implications for bank safety; while trading assets (which can be sold easily or pledged in the event of margin calls) significantly add to safety.

• Size and systemic importance are clear negatives. • The asset cycle is important, and hence central banks

have a role due to the macro prudential links.• Banks need little capital in the good times, but there

is no ex ante reasonable capital rule that is enough in a major crisis. Bank separation is essential.

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DTD Calculations: No Capital Rule is Enough in a Crisis. Separation Essential

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REBUILDING BUSINESS MODELS OF BANKS: OECD

• Separation of high risk securities activities from the core deposit bank in a ring-fenced non-operating holding company (NOHC) structure if the group goes beyond the 10% threshold GMV of derivatives/IFRS assets. The case is strengthened if wholesale funding is above 20% and leverage without netting of derivatives is more than 20 times.

• Banks with prime broking, market making, underwriting and derivatives origination will be caught by the rule. These activities put into non-bank subsidiaries. Derivatives in the core bank for own-hedging only.

• The NOHC structure is ring-fenced so the creditors of one can’t chase the others or the parent. Risk pricing adjusts AND size of the businesses falls (initial & variation margins & 3rd part custody adjust to the removal of guarantees).

• Basel rules are too complex, leaving banks too much scope to avoid them. We need simple rules that can’t be avoided. A simple leverage rule for the core deposit banks of 5% (=20 times leverage).

• THE CORE BANK IS SAFER. THE OTHER SUBSIDIARIES WILL NOT BENEFIT FROM IMPLICIT GUARANTEES, & WILL BE SMALLER, MORE PRUDENT & EMINENTLY RESOLVABLE.

• NB: the Lehman Brothers example is a huge fallacy that gets counterfactuals are all wrong re a global NOHC regime.

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Firewalled NOHC Separation

SIFI EXPOSURE TO LOSS BEFORE SEPARATION

UNEXPECTED TRADITIONALVOLATILITY BANKINGEVENT (STD. DEV.'s) (Amortised Cost Accounting)

5SECURITIES TRADING

PRIME BROKING

4 OTC DERIVATIVES

(Fair Value Accounts)

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2

1Loan loss: Traditional Banking

0 Bank Capital 5%

Leverage Ratio

POST SEPARATIONRetail Bank

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4 Separated IB

Little Capital/Counterparties

Require 100% Collateralisation

3SECURITIES TRADING

PRIME BROKING

2 OTC DERIVATIVES

(Fair Value Accounts)

1

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UBS Balance Sheet & Ratios

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Credit Suisse Balance Sheet & Ratios

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Wells Fargo Balance Sheet & ratios

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Credit Suisse: Model Breakdown of Risk & Separation Effects

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Problems with Alternative Approaches to Separation

• Volcker: you simply can’t have a blanket ban on short-term price speculation, and then allow banks to maintain prime broking, market making, underwriting etc: immediacy, inventory and profit making is inherent to this business.

• Vickers: closest to OECD view, but the subsidiaries other than the retail bank are not ring-fenced. Creditors can chase whoever they like—other than the retail bank.

• Liikanen: this needs a major rethinking. The 15-25% 1st stage threshold for trading securities is exactly the wrong variable—it makes banks safer not weaker (Wells Fargo is riskier that Deutsche Bank? Please!).

• Swiss single point entry for the creditors of the parent bank (which owns all the others) to be ‘bailed in’, with management then having time to restructure if they choose solves nothing of TBTF cross-subsidisation of risk. The creditors of the high-risk businesses don’t even have to pursue the creditors of the others, it is institutionalised for them. Risk will certainly not be re-priced.