This document discusses optimal bank structure and reforming business models of banks. It argues that separation of high risk securities activities from core deposit banks is essential. Risky activities such as derivatives, prime brokering and market making should be put in ring-fenced non-operating holding company subsidiaries if they exceed 10% of a bank's business. A simple leverage ratio of 5% for core deposit banks would make them safer. Separating risky activities prevents cross-subsidization of risk and guarantees, reducing bank size and risk taking.

1. AN OPTIMAL BANK
STRUCTURE, STOCKHOLM, S
EPTMBER 2013
Adrian Blundell-Wignall
Special Advisor on Financial Markets to the OECD
Secretary General.

2. US Financial Sector Share of the S&P500
2

3. The Financial Problem is Not Solved
3
• 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.

4. What Changes With Basel III?
4
• 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.

5. RWA / TA GSIFI & Traditional Banks
5

6. Tier 1 Capital / RWA (2008 & 2013)
6

7. Tier1 / Total Assets GSIFI Banks (2008 &
2013)
7

8. Complexity & Interdependence in
Derivatives and Repo’s
8

9. Derivatives vs Primary Securities % World
GDP & the Crisis
9
• 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.
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0 %GDP
Total
PrimarySecurities
Derivatives

10. Gross Credit Exposure versus Collateral
10

11. Distance to Default (3 Std. Dev.= Safe) :
The USA Doing it Better than Europe
11

12. DTD Model—What Factors Matter for Bank
Default Risk
12

13. Policy Issues Arising From New Research
13
• 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.

14. DTD Calculations: No Capital Rule is
Enough in a Crisis. Separation Essential
14

15. REBUILDING BUSINESS MODELS OF BANKS:
OECD
15
• 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.

16. Firewalled NOHC Separation
16
SIFI EXPOSURE TO LOSS BEFORE SEPARATION
UNEXPECTED TRADITIONAL
VOLATILITY BANKING
EVENT (STD. DEV.'s) (Amortised Cost Accounting)
5
SECURITIES TRADING
PRIME BROKING
4 OTC DERIVATIVES
(Fair Value Accounts)
3
2
1
Loan loss: Traditional Banking
0 Bank Capital 5%
Leverage Ratio
POST SEPARATION
Retail Bank
5
4 Separated IB
Little Capital/Counterparties
Require 100% Collateralisation
3
SECURITIES TRADING
PRIMEBROKING
2 OTC DERIVATIVES
(Fair Value Accounts)
1
0

17. UBS Balance Sheet & Ratios
17

18. Credit Suisse Balance Sheet & Ratios
18

19. Wells Fargo Balance Sheet & ratios
19

20. Credit Suisse: Model Breakdown of Risk &
Separation Effects
20

21. Problems with Alternative Approaches to
Separation
21
• 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.