The tenth anniversary of the 2008 financial crisis marks an appropriate time to review the cumulative impact of the legislative and regulatory responses. Do these responses continue to strike the appropriate balance among the multiple constituencies that depend upon both the safety and the effectiveness of the banking system?
Since 2008, there have been major enhancements to the basic building blocks of bank safety, soundness, and resilience: capital, liquidity, stress-testing, risk management, and resolution planning. The success of these core enhancements suggests, however, the need for a re-examination of the more peripheral regulatory tools that have also been adopted. Are those other regulatory responses reducing risk, and are they taking an undue toll on the capacity of financial institutions to serve the economy?
Ring-fencing is one of the most consequential peripheral regulatory responses. Although ring-fencing is a somewhat protean term, it can be defined as the government-required isolation of operations, assets, or activities. There are two basic types of ring-fencing that are applied to financial services companies: jurisdictional and activities.1
Jurisdictional ring-fencing involves a legislative or regulatory determination that the assets, capital, liquidity, and/or governance of a banking operation should be captured by the rules and regulations of the jurisdiction in which the operations are located. It represents an attempt to superimpose a nationally based regulatory structure on a global banking system.
In the immediate aftermath of 2008 and the losses resulting from failures of major banks, the push for jurisdictional ring-fencing by host-country regulators was understandable. They had been left to fend for themselves, and the result in several notable cases was severe losses and the deployment of unprecedented host-country financial support to the local operations of foreign banks.
The issue, however, is whether the jurisdictional ring-fencing response that was understandable then remains the right course today in view of subsequent developments. These developments include implementation of international standards for external total loss-absorbing capacity (TLAC), the availability of recapitalization and liquidity support through single-point-of-entry (SPOE) resolution plans, adoption of automatic stays on early terminations in financial contracts from the International Swaps and Derivatives Association, and international cooperation protocols.
Some trace the current debate on jurisdictional ring-fencing to the Federal Reserve’s 2012 decision to impose an intermediate holding company (IHC) requirement on foreign banks with $50 billion or more in U.S. subsidiary assets.
To be fair, the Federal Reserve was responding to legitimate stimuli: statements by certain European regulators that they would not support the large U.S. broker-dealer affiliates of their major banks, the curtailment of the Federal Reserve’s own emergency lending powers by Dodd-Frank, and the role thrust upon the Federal Reserve throughout the crisis as the global provider of U.S. dollar liquidity. Moreover, the Federal Reserve stopped well short of total jurisdictional ring-fencing, as the IHC requirement does not apply to the U.S. branch operations of foreign banks.
With respect, however, to the entities covered by the IHC requirement, the jurisdictional ring-fencing that is imposed is comprehensive. The IHC rules apply capital, stress testing, liquidity, and governance requirements – almost the entire panoply of the enhanced prudential supervisory regime. Furthermore, the IHC requirement encompasses all U.S. subsidiaries of the foreign bank – even those companies that are not controlled in fact by the foreign bank, but are deemed subsidiaries under the Federal Reserve’s expansive definition of control.
The European Commission appears to be following the U.S.’s lead with its own IHC-type proposal for large non–European Union institutions. Other jurisdictions could follow. Moreover, the European Central Bank is advocating for total jurisdictional ring-fencing through a subsidiarization requirement that would eliminate the ability of non-European Union banks to establish or maintain branches in European Union countries.
National Actions Have International Implications
National actions that affect the global economy are likely to have global consequences. One of the lessons of the Smoot-Hawley Tariff Act of 1930 is the miscalculation by its supporters, who maintained that other nations would be “passive” to its enactment. Just as with tariffs, jurisdictional ring-fencing is unlikely to go unnoticed and unmatched. If just one jurisdiction engaged in ring-fencing, it could be the net winner. But if other jurisdictions ring-fence in response, which is the more likely result, it is likely that everyone loses.
A second form of post-crisis jurisdictional ring-fencing with a substantial impact is an internal TLAC requirement imposed by host countries on global systemically important banks (G-SIBs). Under the Financial Stability Board’s TLAC framework, a material host-country subsidiary of a G-SIB is required to maintain a substantial debt obligation to the home-country parent, and the value of this debt obligation is ring-fenced because the host-country regulator can require it to be converted into equity.
Internal TLAC can serve a useful purpose in fostering international cooperation if calibrated appropriately, but there can almost always be too much of a good thing.
Activities ring-fencing involves the separation of deposit-taking from certain other activities – banking, nonbanking, or both. The mandated separation can be implemented as a total prohibition on certain activities for both banks and their affiliates or require that the relevant activities be conducted in separate affiliates. Activities ring-fencing takes multiple forms. For example, until the end of the last century, banking in the United States was ring-fenced not only from commerce but, as reinforced by the Glass-Steagall Act, from investment banking and most other financial activities. The 1999 Gramm-Leach-Bliley Act enabled bank affiliates, but not banks themselves, to engage in most financial activities, while leaving the demarcation between banking and commerce substantially in place. As a prominent part of the Dodd-Frank Act, the Volcker Rule reintroduced a limited form of activities ring-fencing, and Sen. Elizabeth Warren and others have been advocating for a wholesale reintroduction of Glass-Steagall. A more comprehensive activities ring-fencing approach is soon scheduled to come into effect in the United Kingdom, where the demarcation would be between wholesale and retail banking.
How effective Is Ring-Fencing?
Two issues determine the desirability and efficacy of ring-fencing in our post-crisis environment. First, does ring-fencing actually enhance bank safety and soundness, in particular because of the direct tension with such regulatory prudential objectives as enterprise risk management, reliance on the parent company as a source of strength, and risk diversification? Second, do the objectives achieved by ring-fencing outweigh the burdens imposed? As a general premise, limitations on the ability of financial institutions to serve their customers impose a cost on both those customers and financial institutions.
These are not questions that can be answered once and forever. As conditions change, so too should the evaluation. The near catastrophe that occurred in 2008 may be viewed as justifying regulatory actions that, in the context of the times, were deemed necessary to ensure against a reoccurrence. But the efficacy of the major actions taken by the regulators and the financial institutions themselves since 2008, which have created far greater stability and resilience as well as greater perspective, should call for a new assessment.
With respect to activities ring-fencing, the empirical record does not provide credible evidence that a combination of financial activities within a single banking organization either created or intensified the 2008 financial crisis. Specifically, the assertion that the Gramm-Leach-Bliley Act’s partial repeal of Glass-Steagall was responsible for the financial crisis is as demonstrably invalid as the claim by Glass-Steagall proponents that securities activities of banks and their affiliates were responsible for the wave of bank failures in 1929–1933.
The debate over activities ring-fencing, however, should not be limited to whether it is unnecessary but whether it is counter-productive and detracts from safety and soundness. One of the basic elements of risk minimization is risk diversification. It is undeniable that some diversified financial institutions encountered severe, on occasion fatal, financial distress during the financial crisis, but there is seemingly no basis for concluding that the distress was a consequence of diversification. To the contrary, there appears to have been a correlation between the monolinear nature of an institution, in particular certain forms of investment banking and real estate lending, and the institution’s susceptibility to financial distress.
Likewise, jurisdictional ring-fencing cannot be justified if it makes banks or the banking system riskier or banks more difficult to resolve. A principal concern with jurisdictional IHCs, and, even more so, if accompanied by high internal TLAC requirements, is that they may actually increase rather than reduce systemic and individual bank risk. The inevitable consequence of these constraints is reduced flexibility – not only in a bank’s ability to provide customer-needed products and services in a “business as usual” mode, but when an institution most needs it.
Crises are by their very nature unpredictable because, if it were otherwise, actions could almost always be taken to prevent them. Consequently, if there is one lesson that should have been learned from the 2008 financial crisis, it is that flexibility is paramount. Because participants in both the public and private sectors must act immediately and decisively in response to unforeseeable and constantly changing circumstances, artificial constraints are very much in the way. If capital or liquidity is trapped in one part of a global institution, irrespective of the actual need for it, the flexibility to deal with a crisis in any other affiliated entity is curtailed. Human nature being what it is, in a time of great uncertainty, a regulator or government is unlikely to be sufficiently confident of the financial soundness of an entity in its jurisdiction that it will make the hard decision that there is excess capital or liquidity that can safely be transferred to another jurisdiction.
Jurisdictional ring-fencing is designed to ensure that the operations of a financial organization in that jurisdiction have sufficient resources to avoid a financial meltdown – or, at worst, if a meltdown occurs, that a local wind-down can occur with only limited damage to that jurisdiction’s other financial institutions and overall economy. The unpredictability of a severe financial problem means, however, that, if one occurs at an individual host-country subsidiary, the resources that are locally available to it may well be insufficient to restore the subsidiary’s financial health or enable an orderly wind-down. In a ring-fenced world, the local institution cannot anticipate any support from its affiliates because of their own ring-fenced regimes.
If major financial institutions live globally and die nationally, the death is likely to be more violent and the ramifications more widespread. If the funding and other markets conclude that ring-fencing prevents, or at least discourages, a global bank from assisting a troubled affiliate in a foreign jurisdiction, not only will the affiliate be more likely to collapse when confronting financial difficulty, but there is an increased danger of contagion affecting both the bank’s other affiliates, wherever located, and unaffiliated financial institutions in that foreign jurisdiction. Moreover, ring-fencing is likely to weaken the potential for international cooperation in the resolution of an international bank.
Admittedly, the pure “trust me” approach is insufficient for resolution of a global institution across multiple jurisdictions. No matter how well-intentioned the government officials might be and how much pre-planning and collaboration takes place, self-interest will often be a more powerful motivator. The answer, however, should not be the total absence of trust as is seemingly reflected, for example, in the highest possible internal TLAC percentage. Rather, it should be to harness properly motivated national self-interest in the construction of a stable cross-border framework that fosters resiliency and serves critical intermediation needs of the global economy.
In establishing the terms of the debate over the appropriate amount of internal TLAC, hopefully there is an evolving consensus that more is not inevitably better. If all external TLAC is replicated downstream by mandatory, pre-positioned internal TLAC, then there are no reserves of loss-absorbing capacity that can be called upon if the capacity at a subsidiary is exhausted. Likewise, as a matter of logic, capital or liquidity is more likely to be exhausted at a single legal entity than at the combined organization. Indeed, the highest levels of internal TLAC seem inconsistent with the very concept of SPOE, which has become the foundation of much resolution planning.
We need to apply a Goldilocks Principle. Too much internal TLAC, and there are insufficient central reserves of capital and liquidity to call upon in response to stress at a subsidiary. Too little internal TLAC, and there is no trust, which can lead to precipitous action to protect what is there.
We need to strive for a balance that is “just right” to both promote confidence and maintain sufficient flexibility.
And we need to evaluate what is “just right” based on conditions as they are today – following and incorporating a decade of post-crisis reform.
Application of this principle suggests reconsideration of the seemingly settled debate about the 75% to 90% range for internal TLAC. Would not a 50% to 75% range be more consistent with all the relevant objectives, particularly in view of the high external TLAC requirements that have been imposed? At the very least, a serial push to the upper end of the current range would seem to subvert the Goldilocks Principle.
An intriguing alternative approach has recently been adopted by the Bank of England. This approach is based on reciprocity. Under this model, a host jurisdiction could assert that it was prepared to adopt a 75% internal TLAC requirement, the low end of the current range, for a material subgroup of a G-SIB if that G-SIB’s home country applies a similar requirement for the host country’s institutions.
With respect to intermediate holding companies, abolishment of the Federal Reserve’s basic requirement may be unrealistic. But in that event, there should be a meaningful attempt to reduce the burden that the IHC imposes. Possible steps include: more flexibility for foreign banking organizations to hold subsidiaries, particularly minority-owned ones, outside the IHC structure; a governance structure that recognizes that the IHC is part of a global enterprise; adoption of a tailored approach to such matters as the Comprehensive Capital Analysis and Review; and appropriate accommodation as either a tax or regulatory matter to alleviate the unfair tax burden that the IHC structure can now create. A more accommodative approach by the U.S. may encourage the EU and other jurisdictions to refrain from imposing their own IHC structural requirements, or, at least, to accommodate the business and regulatory imperatives of banks from other jurisdictions.
A final recommendation is not for any specific change. Rather, it is that our regulators and policymakers recognize and evaluate – in the context of the current relevant circumstances – the critical role that an appropriately balanced policy toward ring-fencing could play in optimizing both the stability and economic effectiveness of our financial system. n
1 The ring-fencing regimes described in this article are ex ante, in that they are implemented before an actual problem exists.
H. Rodgin Cohen
H. Rodgin Cohen is Senior Chairman of Sullivan & Cromwell LLP; he served as Chairman from 2000 to 2009. The primary focus of Cohen’s practice is regulatory, enforcement, acquisition, and securities law matters for U.S. and non-U.S. financial institutions and their trade associations, and corporate governance matters for a wide variety of organizations.
Cohen advises the financial services industry on the full range of regulatory, compliance, enforcement, and merger and acquisition matters, including multiagency investigations relating to compliance with anti-money laundering and sanctions issues. He frequently works with all the bank regulatory agencies as well as multiple other governmental agencies. Key recent matters include the Volcker Rule, numerous other provisions of the Dodd-Frank Act, international capital and liquidity standards, resolution and resolution planning, and cybersecurity. He provides corporate governance advice to a large number of financial and non-financial institutions, both regular clients and as special assignments, and is also a frequent adviser on the rise of strategic and corporate governance activism.