Ring-fencing of risks may be a useful tool for financial sector regulators, but it isn’t a solution to systemic risk. In a systemic event, one cannot fence in trust and fence out fear.
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Ring-Fencing Described
Ring-fencing is used very effectively in many regulated industries. But these companies are much smaller than the biggest banks. Further, they aren’t tied together the way the biggest banks are. Ring-fencing does not work with systemic risk and the largest financial institutions which carry it. Here’s why.
To understand what ring-fencing is, one needs to understand a simple organization chart for a bank holding company. Every corporation and each of its subsidiaries has its own balance sheet. Assets (what it owns) on the left equal liabilities (where it got funds to acquire its assets) on the right. Click on the link below to see the basic components of our TBTF banks, as I used in a speech to the New York Society of Securities Analysts.
NYSSASpeech122014SimpleBankHoldingCompany
At the top, as in all large corporations, is the “parent level” legal entity. The asset side of its own balance sheet is its investments in its subsidiaries. On the liability side, it finances these assets by issuing equity to public investors and possibly some form of debt.
All the biggest banks have complex organization structures with many subsidiaries, organized around business activity, geography, and taxes. To be a “bank holding company” (as contrasted with other financial holding companies) the organization needs to own an FDIC-guaranteed bank taking deposits and making loans. The largest TBTF banks also own broker/dealer subsidiaries that underwrite, sell, and trade securities. They may also have subsidiaries for other business lines or some of their derivatives activities like credit default swaps.
All the biggest banks list among their major risk factors the risk that they would not be able to upstream dividends from their subsidiaries. They need that flow of funds for parent purposes, such as paying dividends or salaries. Ring-fencing first of all is regulatory limitations on upstreaming dividends to the parent out of the ring-fenced banking subsidiary.
The Swaps Push-Out Rule Debate
During the debate leading up to the passage of Dodd-Frank, Senator Blanche Lincoln proposed that derivatives should not be located within an organization which has access to Federal assistance such as the Fed discount window or the FDIC deposit guarantee. That would have meant the taxpayer-guaranteed bank subsidiary. She was the Senate Agriculture Committee Chairman at the time, a committee that oversaw futures markets, the organized exchanges essential to agricultural markets. (Futures are a subset of derivatives that involve rather short-term, standardized contracts and a high degree of regulation over many decades.)
This “swaps push-out rule” proposal would have required the largest banks to move their derivatives trading outside the FDIC-guaranteed bank. Politics prevailed, and the language was softened. JPMorgan Chase with its huge FDIC-guaranteed bank would continue to challenge investment banking powerhouse Goldman Sachs.
Certainly, a mid-sized bank can find an interest rate swap contract a very useful derivative for its own business purposes. But the size of engagement in derivatives trading and other securities trading by the biggest banks has nothing to do with hedging their own financing requirements.
Derivatives trading is a fundamental investment banking business activity with its own risk profile that differs from traditional banking, as explained in Reason #10. Investment banking risks also include packaging and trading opaque securities. Derivatives-trading banks are chained together in a series of interlocking contracts now including exchanges.
The sole point of this post is that it doesn’t matter where the derivatives are traded within the organization. When the risks from investment bank trading overwhelm financial markets in a systemic event, the government bailout isn’t at the bank level. It’s at the parent. On October 26, 2008, the Federal government invested $25 billion in JPMorgan Chase, Citigroup, Wells Fargo, and Bank of America and $10 billion in historically-investment-banks Goldman Sachs and Morgan Stanley. This was very even-handed so as not to give away which might be the weaker among them. They also had no choice in this matter. All were summoned to the U.S. Treasurer’s office and made to sign the agreement.
Every one of those agreements the biggest bank CEOs signed was for preferred stock issued by the parent of their bank holding company, not their FDIC-guaranteed bank subsidiary.
In a systemic event it is parent equity where the government bails. Where the risk was located within the large financial organization is totally irrelevant. The investing and depositing public assumes that the government will support these institutions because of the guarantee within the large organization.
Trading must be isolated OUTSIDE THE ENTIRE ORGANIZATION to isolate taxpayers from having to bail out TBTF banks.