Ringfencing and consolidated bank stress tests

Eugenio Cerutti, Christian Schmieder 13 April 2013

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The global crisis has spurred efforts, both by the public and the private sector, to enhance the stress-testing toolbox in recent years, in ways that have addressed a number of methodological issues (i.e. the sophistication of stress tests in technical terms and the inclusion of liquidity and contagion) and scenario-related considerations (i.e. the severity and scope of shocks). Nevertheless, several weaknesses and challenges remain, many of them related to the lack of adequate data, especially from a cross-border context.

In this context, we have developed (2012) a straightforward conceptual approach to how unconsolidated and consolidated balance-sheet data can be combined in order to take into account the potential risks embedded in banking groups’ geographical structure, including the potential impact of ringfencing.1 This ringfencing approach builds on Cerutti, Ilyina, Makarova, and Schmieder (2010), the first paper to measure the potential important impact of different degrees of ringfencing through simulations on banks’ subsidiaries in emerging Europe. Although ringfencing is currently extensively discussed in the policy arena, very little empirical work has been done in this area. Two exceptions are Schoenmaker (2010) and Van Lelyveld and Spaltro (2011) that estimated the cost associated with ex-ante burden-sharing agreements, but not the impact of ringfencing on banks’ capital buffers.

How to incorporate bank structures into stress tests?

Most of the current stress tests follow a ‘traditional’ consolidated top-down approach, typically based on consolidated bank balance-sheet data. In the ‘best’ case (e.g. EBA stress tests), this consolidated top-down approach partially takes into account the geographical structure of banking groups’ business when the macroeconomic scenario includes specific foreign countries/regions assumptions/parameters when projecting profits, credit and valuation losses.

Yet, this is not enough to take fully into account the geographical structure of the world’s largest banking groups, which usually includes multiple independent foreign-incorporated bank subsidiaries. These geographical characteristics can be incorporated into the analysis using a bottom-up approach, which we refer to as the ‘group-structure approach’.

Take the example of the right hand side of Figure 1 of a parent bank with three subsidiaries:

  • In our setup, the group-structure approach allows for a more granular view of stability, but is more complex and burdensome.
  • In our scenario design, the group-structure approach explicitly forces one to come up with a consistent global macroeconomic scenario that is broken down to scenarios for the subsidiaries.

The scenarios could also include one or more scenarios for the degree of ringfencing (see the green colored box in Figure 1). Together, this determines how the banks’ business structure affects its solvency and/or liquidity position under specific circumstances.

Figure 1. conceptual difference between ‘traditional’ stress test and stress tests taking into account group structures

The key advantages of the group structure approach is that it forces stress testers to go through a number of thought processes, namely:

  • The design of a consistent global scenario, broken down to different entities (often into scenarios for specific countries).
  • A thorough understanding of the banks’ business model and how it can be affected by different shocks and policy actions.
  • Help uncover policy challenges that could emerge under certain circumstances and allow, in principle, for contingency planning.

How to introduce ringfencing?

We show that after doing the ‘usual’ solvency stress test through computing the impact of the macro assumptions for each subsidiary – in terms of solvency and/or liquidity, and taking into account the different national regulations (e.g. hurdle rates) – the next step is to define a set of assumptions as to how banks’ profits, excess capital and/or liquidity can be transferred within the banking group (2012). Three different alternatives are proposed to simulate ringfencing, but the final choice should be tailored to the objectives of the stress test at hand and the severity of the scenario:2

  • ‘No ringfencing’ assumes that parent bank’s profits, as well as subsidiaries’ excess liquidity and excess capital buffers can be used to cover capital shortfall in any of the subsidiaries.
  • ‘Partial ringfencing’ assumes that parent bank’s profits and only subsidiaries’ profits and/or excess liquidity, but not excess capital, can be reallocated within a group.
  • Full ringfencing assumes that no transfers between any of the group’s affiliates (including from the parent bank to subsidiaries) can take place.

Illustrative example: 2011 EBA stress test

Using figures from the June 2011 EBA stress test, this section illustrates, with a cross-country example, potential implications if the tests had explicitly considered ringfencing. The example is meant for illustrative purposes and does not necessarily reflect the current situation of banks, many of which have raised capital and changed their legal and/or geographical structures since (e.g. in the context of the 2012 EU Capital Exercise). Nevertheless, the magnitude of the impact can provide a benchmark of what cross-border banks might encounter under highly adverse conditions.

Figure 2 shows that several banks included in EBA stress tests exhibit substantial heterogeneity in terms of their geographical structure.3 About two thirds of the banking groups operate almost exclusively within the EU and the portion of their income (average of 2006-2010), capital and assets (not shown in the graph) outside the EU are below 5%. On the other hand, 15% of the banking groups have a large presence outside the EU, with many of them having more than 20% of their profits and capital from bank-deposit affiliates located outside the EU.

Figure 2. Banks’ share of profits and capital outside EU

Source: Authors’ estimates based on Bankscope and Central Bank data as of December 2009. Note: 1/ Banking groups share of outside EU activities through deposit-taking.

Ringfencing adjustments

The base case, which implies no ringfencing, is given by EBA figures. Two adjustments – partial and full ringfencing – are calculated to account for the possibility that non-EU regulators ringfence the foreign deposit-taking affiliates (i.e. bank subsidiaries) in their jurisdictions.

The partial ringfencing adjustment deducts, from the EBA profit projections, the share of profits generated outside the EU. Accordingly, the result is an overestimation of banks' core Tier I capital ratios by zero to 0.7 percentage points (see Figure 3, upper chart). This impact is a function of the share of profits from outside the EU, with the remaining heterogeneity being a function of the importance of stress-test profit projections on bank capital buffers. Several banks with sizeable profit buffers partly earned outside the EU exhibit the largest adjustments to their Core Tier I capital ratios. Other banks with large shares of profit from outside the EU have relatively lower adjustments in their Tier I capital ratio (due to the fact that their profit buffer under stress is less sizeable relative to their capital buffers). This partial ringfencing context, where ‘only’ profits cannot be re-allocated within the group, is important under the current circumstances for some countries/banks.

Figure 3. Partial and full ringfencing adjustments under the baseline scenario

Source: Authors’ estimates based on EBA, Bankscope and Central Bank data.

The full ringfencing scenario assumes that both the profits and the excess capital buffers of non-European affiliates cannot be reallocated to Europe. The impact for the European part of the international banking group tends to be larger than in the partial ringfencing context. In a full ringfencing context, where a European parent bank cannot access the excess capital buffers of outside EU affiliates (i.e. subsidiaries) and the subsidiaries cannot be sold without incurring book losses, the adjustment could be up to 3% of their core Tier I capitalisation in Europe (see Figure 3, bottom panel). As expected, full ringfencing mostly affects the same banks, i.e., those with meaningful income and capital outside the EU.4 

Conclusions

Our 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.

Authors' note: The views expressed here are those of the authors and do not necessarily represent those of the institutions with which they are affiliated.

References

Cerutti, E, A Ilyina, Y Makarova, and C Schmieder (2010), “Bankers without Borders? Implications of Ring-Fencing for European Cross-Border Banks”. IMF Working Paper No. 10/247, November.

Cerutti, E and C Schmieder (2012), “The Need to ‘Unconsolidated’ Consolidated Banks’ Stress Tests”, IMF Working Paper No. 12/288, December.

Schoenmaker, D (2010), “Burden Sharing: From Theory to Practice”, DSF Policy Paper 6.

Van Lelyveld, I and M Spaltro (2011), “Coordinating Bank Failure Costs and Financial Stability”, DNB Working Paper 306, De Nederlandsche Bank, Amsterdam.


1 Note that this geographical perspective of ringfencing is different from the activity restrictions embedded in the Volcker Rule (section 619 of the Dodd Frank Act), which restricts deposit-taking banks from engaging in certain types of activities (e.g., proprietary trading).

2 Besides ringfencing in a narrower sense, the scenarios could also consider limits on any profit, capital or liquidity generated by sales of assets. Parent banks could try to overcome some form of ringfencing by local authorities through selling part or all of the subsidiaries’ assets. This case is especially relevant when assuming full ringfencing. In such circumstances, the macroeconomic environment that is being modelled would be important, with significant repercussions on the asset value of banks.

3 The outside EU profits included only banking related activities (e.g. profits in affiliates that operate as banks), but not subsidiaries that perform non-banking activities, which are more difficult to ring fence. This explains why some banks have a low share of banking profits outside the EU. In addition, to reduce the impact of income volatility, we use five year 2006-10 averages of net income.

4 The difference in the order of banks most affected in the full ringfencing case versus the partial ringfencing captures the full ringfencing assumption that capital buffers cannot be re-allocated. The ring-fencing adjustments in the EBA adverse scenario projections are not much different in size from those calculated with the EBA baseline scenario figures, but the final adjusted Core Tier I capital levels in the adverse scenario are lower since both the ringfencing adjustments and lower EBA projected profits interact together.

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Topics:  International finance

Tags:  bank stress tests, ringfencing

Assistant to the Director at the Research Department, IMF

Christian Schmieder

Economist, IMF

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CEPR Policy Research