## _sdn1304

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---

### Executive summary — key findings and purpose
- Structural constraints on banks proposed by a number of countries aim to address the too-important-to-fail (TITF) problem by reducing the risk that these institutions will fail and by simplifying their resolution if they do fail.
- Structural measures can contribute to financial stability in combination with enhanced, post-crisis price-based regulations, supervision, and cross-border bank resolution frameworks.
- Activity restrictions, when appropriately designed and judiciously implemented, can work in tandem with strengthened capital requirements to limit bank management’s capacity for excessive risk taking.
- Corporate structures aligned to business activities and limits on intra-group exposures and on their pricing can shield systemically important financial services from idiosyncratic shocks impacting other activities.
- The nations proposing structural banking reform are global financial centers and systemically important economies; enhancing financial stability in these countries can have positive spillovers on the global economy and financial system.
- These policies will also have potentially significant global costs because they will be imposed on internationally active and systemic financial institutions; a global cost-benefit exercise encompassing extra-territorial implications is necessary.
- Subjecting a global institution to different structural measures in different jurisdictions could exert further pressure on consolidated supervision and cross-border resolution.
- With firm political support, a “targeted” approach—with structural measures tailored to the specific risk profiles of individual banks at a global group level—would promote global financial stability more effectively than an across-the-board approach. Absent confidence in supervisory capacity for the targeted approach, across-the-board measures would be appropriate provided their global benefits exceed their costs.
- Core policy implication: International coordination and a global cost-benefit assessment are required to determine whether national structural measures’ benefits exceed their global costs.

### I. Introduction — context, scale, and challenges
- Context and scale:
  - A relatively small number of large, complex financial institutions account for a vast majority of cross-border financial intermediation.
  - The 73 banks identified as systemically important by the Basel Committee on Banking Supervision (BCBS) account for almost two-thirds of global bank assets.
- Dual role of large institutions:
  - Facilitate cross-border capital flows and allocation of global savings; benefit from diversification and scale.
  - Can propagate distress because of interconnectedness; size gives funding advantage and influence over regulatory and legislative processes.
- Challenges:
  - Large, complex institutions are difficult to regulate, supervise, and resolve owing to complex, integrated group structures with multiple legal entities across borders and business lines.
  - Complexity complicates aggregation of data and information systems and contributes to inadequate risk management.
- Two broad policy approaches to TITF:
  - (1) Price-based regulations accompanied by enhanced supervision and effective resolution.
  - (2) Structural limits on the size and scope of activities of these institutions.
- Post-crisis FSB/G20 measures exemplifying approach (1) include:
  - Higher quantity and quality of loss-absorbing capital; tougher liquidity standards; systemic risk surcharges.
  - Proactive and intensive supervision consistent with institution-specific risks.
  - Effective resolution frameworks, including debt that can be bailed in, cross-border arrangements, and firm-specific structural measures as needed.
  - Enhanced transparency and disclosure.
  - Strengthened market infrastructure to limit contagion risks.

### II. Decision framework and effectiveness of structural measures
- Decision framework (policy decision tree) assesses:
  - Are regulations robust? Can price-based rules address tail risks? Are rules incentive compatible and enforceable? Is supervision robust? Is business model amenable to low-cost resolution? Can politics impede firm-specific resolution?
  - Possible outcomes: improve regulations, improve supervision, firm-specific structural constraints, structural constraints for all banks, or reevaluate later.
- Effectiveness in reducing probability of failure:
  - Structural measures and price-based tools seek to curb excessive risk taking.
  - Four premises supporting structural measures:
    1. Effectiveness limits of price-based tools in mitigating tail risks because complexity can outstrip model/regulatory capabilities.
    2. Robustness of regulations: gaps in coverage, inadequate calibration, inconsistent national gold-plating increase regulatory arbitrage.
    3. Incentive compatibility and enforceability: weak supervision or legal impediments reduce compliance; some structural constraints may be easier to supervise.
    4. Limiting public support and facilitating orderly resolution: reducing intra-group exposures can aid separability and reduce fiscal costs.
- Effectiveness in reducing loss given failure:
  - Proliferation of intra-group exposures can impede resolution and magnify real and fiscal impacts.
  - Structural measures aim to insulate financial activities vital to the real economy (deposits, payments) from contagion originating elsewhere in banking groups.

### Box summary — price-based regulation limits and complexity
- Pre-crisis capital treatment differences between trading and banking books created incentives that elevated risk.
- Basel 2.5 and subsequent adjustments aimed to require banks to hold more capital against market risks and to close capital arbitrage opportunities.
- Implementation remains challenged by complexity, particularly for A-IRB banks whose internal models can materially compress RWAs relative to standardized approaches.
- Complex combinations of trading, investment, and hedging can increase vulnerability to market and basis risk without corresponding calculated risk exposure changes (example: J.P. Morgan Chase 2012 CIO synthetic credit portfolio losses).
- Conclusion: where business lines are too complex for accurate risk measurement and effective supervision, activity restrictions or separation may be warranted.

### III. FSB Key Attributes (KAs), firm-specific measures, and intra-group exposures
- KAs include scope for firm-specific structural measures to facilitate efficient recovery and resolution.
- KAs require legal frameworks setting out powers, tools, and safeguards for resolution by national authorities to facilitate least-cost resolution at the group level.
- Resolvability assessments and recovery and resolution plans (RRPs) for G-SIFIs may require firm-specific structural measures, including changes to business scope, size, or groupwide corporate organization.
- Examples of resolvability frictions from intra-group guarantees (IGGs) and back-to-back booking practices (BPs):
  - IGGs and BPs permit consolidated entity to reduce capital/liquidity for affiliates, consolidate market risk and netting, and hedge global exposures cost-efficiently.
  - IGGs can be blanket or transaction-specific; they can impede recovery (consent requirements) and resolution (cross-default acceleration), while BPs increase operational complexity and impede unwinding or transfer of positions.
  - Failure of information systems to track IGGs and BPs complicates resolution or recovery.
- Advantages of firm-specific structural constraints:
  - Mapping business lines into groupwide corporate structure and tailored measures can reduce complexity, facilitate supervision, reduce failure risk, and lower resolution costs.
- Limitations:
  - Weak cross-border resolution regimes or political/legal constraints could necessitate uniform, across-the-board structural constraints.
  - Without firm political support for supervisors and resolution authorities, firm-specific measures may not be implementable.

### IV. Do business models matter? Evidence summary
- Crisis evidence suggests failures resulted from combinations of risk factors rather than a single business model being uniquely vulnerable.
- Liikanen report studies and other evidence found no business model fared particularly well or poorly in the crisis; trading in highly complex instruments and real estate lending—both driven by excessive leverage and short-term wholesale funding—presented especially risky combinations.
- Empirical observations:
  - Relative loss experience and market-assessed default probabilities (PDs) indicated largest institutions in universal and investment bank categories had similar loss experiences.
  - After Lehman’s bankruptcy, CDS-spread-implied PDs for both universal and investment banks converged to a similar, higher level within six months.
  - Implied probability of distress is computed from the 5-year CDS spreads assuming a recovery rate of 30 percent.
- Case studies:
  - Lehman: vulnerability from high leverage, liquidity mismatches, reliance on interbank funding; large intra-group exposures impeded resolution.
  - Northern Rock, RBS, Hypo Real Estate-Depfa, German Landesbanken: failures reflected strategic increases in leverage, shifts from deposits to short-term wholesale funding, elevated liquidity risk.

### V. Design elements of recent structural reform proposals (comparative features)
- Objective: shield deposits and payments functions from financial market volatility.
- National proposals differ: US, UK, EU (Liikanen), France, Germany.
- Examples of policy features:
  - UK retail ring-fence pushes most investment banking activities outside UK ring-fenced deposit-taking banks.
  - U.S. Volcker rule mandates separation of proprietary trading and hedge and private equity fund investments.
  - EU (Liikanen) would disallow depository institutions from engaging in market making, proprietary trading, and investments in hedge funds and private equity; other group subsidiaries may conduct these businesses.
  - French and German proposals are modified Liikanen variants allowing market making by the depository institution in certain cases.
- Selected comparative provisions and thresholds (examples preserved from source):
  - Holding company with banking and trading subsidiaries: Liikanen group (Permitted), United Kingdom (Permitted), United States (Not permitted).
  - Deposit-taking institution dealing as principal in securities and derivatives: Liikanen (Not permitted (but other group companies may do so)), United Kingdom (Not permitted (but other group companies may do so)), United States (Not permitted).
  - Deposit-taking institution providing market making services: Liikanen (Not permitted (but other group companies may do so)), United Kingdom (Not permitted (but other group companies may do so)), United States (Permitted).
  - Liikanen size thresholds: applies to all banks with trading books larger than €100 billion, or trading assets more than 15-25% of balance-sheet.
  - United Kingdom size threshold: applies to all banks and building societies with deposits greater than £25 billion.
  - United States: Dodd-Frank Act subjects US banks with assets in excess of $50 billion to more stringent prudential requirements.
  - Notes: Volcker exemptions include U.S. federal government and agency securities, debt and securities issued by US state and municipal governments and government sponsored enterprises, and derivatives on these securities.

### VI. Benefits and costs — empirical and qualitative assessment
- Benefits:
  - Structural reform reduces complexity and interconnectedness and facilitates lower-cost bank resolution.
  - Enhanced financial stability domestically in global financial centers yields positive spillovers to the global economy and financial sector.
  - Forcing proprietary trading and high-risk investments out of banks may increase effectiveness of capital requirements for high-complexity activities.
  - Ring-fencing can reduce interconnectedness risk for deposits, payments, and lending by imposing restrictions on scale and pricing of intra-group exposures.
- Costs and risks:
  - Implementation challenges:
    - Distinguishing proprietary from permitted trading is difficult (relevant for Volcker rule and some ring-fence proposals).
    - Differentiating hedging or market making from proprietary trading is challenging; Liikanen recommended placing market making outside the ring-fence.
    - Substantial compliance and reporting requirements under the Volcker rule extend to foreign operations of U.S. banks and foreign parents of U.S.-licensed banks.
    - Unwinding and decoupling integrated businesses can be time consuming (example: AIG derivatives subsidiary took two and a half years to unwind bulk of its US$2 trillion portfolio with 45,000 individual trades).
  - Risk migration:
    - Tightening activity restrictions may push activities to unregulated entities (shadow banking), which can still exert systemic risk.
    - Exemptions could motivate migration of prohibited activities to institutions just below thresholds; EMs may attract relocation of certain investment banking activities.
  - Market liquidity and borrowing costs:
    - Under the Volcker rule, banks will be unable to trade equities, corporate debt, private label asset-backed securities, and derivatives on a proprietary basis on U.S. exchanges or with U.S. counterparties; this may adversely affect liquidity for non-U.S. sovereigns, financial institutions, and nonfinancial corporates issuing in U.S. exchanges or the U.S. dollar market.
    - Domestic borrowing costs could rise where affiliates of U.S. banks are systemically important (examples: Mexico; market making for sovereign bonds in Japan and the EU).
    - Subsidiarization and restrictions on intra-group exposures can affect market making and cross-subsidization, potentially raising costs and reducing market liquidity.
  - Lower diversification benefits:
    - Separating retail, wholesale, and trading segments can reduce diversification and amplify idiosyncratic risk at group level.
    - Empirical analysis of seven G-SIBs for 2003–07 shows retail businesses as most profitable, followed by wholesale and trading; total banking performance lay between segment bands. During 2008–11, retail suffered losses while wholesale and trading mitigated overall performance in different ways.
- Complementarities:
  - HLA requirements in the U.K. and Liikanen proposals could be complementary: U.K. proposal tougher for ring-fenced retail bank; Liikanen tougher for trading affiliate—together increasing resilience on both sides of the ring-fence.

### VII. Cross-border implications and supervisory/resolution challenges
- Simultaneous implementation of materially different national proposals could:
  - Create scope for cross-border regulatory arbitrage by internationally active banks.
  - Exacerbate burdens on consolidated supervision and cross-border resolution.
  - Force global institutions to move to the highest common denominator, leading to higher costs than compliance with any single measure.
  - Produce cumulative real and financial sector costs for host countries; ring-fencing with independent funding may prohibit potential new entrants in host markets and dampen competition.
- Supervision and resolution challenges:
  - Cross-border supervision is complicated by national incentives; consolidated supervision remains challenging (Basel Core Principles assessment).
  - Movement of riskier businesses across countries could require more cooperation, information sharing, and adjustments to supervisory colleges if some hosts become more systemically important.
  - Structural measures that reduce complexity and corporate structure could facilitate consolidated supervision.
  - Differing national measures can create imbalances in resolution (example: hedging executed by a proprietary trading subsidiary in country C without structural requirements while entities are ring-fenced in other jurisdictions).

### VIII. Conclusions and policy recommendations
- Main conclusions:
  - Structural measures can address the TITF problem and complement prudential regulation and resolution tools when appropriately designed and implemented.
  - Activity restrictions may be justified where risk assessment, regulation, and supervision are inherently difficult; mandatory corporate-structure constraints (ring-fencing or subsidiarization) can be justified to improve resolvability.
  - Bank-specific measures arising from resolvability assessments are preferable to across-the-board application; a two-tiered approach is feasible: across-the-board constraints for clearly identifiable very high-risk businesses plus bank-specific measures as needed.
  - A credible strategy for resolving banks when they fail is critical, including imposing discipline on managers, shareholders, and junior debt holders and cross-border collaboration arrangements (example: 2012 FDIC/Bank of England initiative).
  - The Liikanen “Avenue 1” construct: add a non-risk-based capital requirement on trading activities for banks with large trading portfolios; consider activity restrictions and corporate restructuring as firm-specific options informed by resolvability assessments.
- Need for international coordination:
  - Structural measures have positive spillovers for global financial stability but also potentially significant global costs; there is a clear case for ex ante coordination and for developing principles to evaluate cross-border implications.
  - Suggested principles include:
    - Clear articulation of objectives of structural measures; close gaps across countries where objectives are similar, especially for G-SIBs.
    - Analysis of implications for internationally agreed reform of prudential regulation, supervision, and resolution, focusing on: (1) impact on Basel III capital and liquidity rules; (2) consistency with effective resolution regimes and RRPs for G-SIBs; (3) incentives for risk migration into the shadow banking system.
    - Assessment of implications for risk-based supervision, including potential freeing up of supervisory resources via ring-fencing and increased verification/compliance costs and incentives for migration of risk into shadow banking requiring enhanced oversight.
    - Assignment of monitoring of extra-territorial implications of national structural measures to an international body such as the FSB, with periodic updates including impacts on domestic markets, institutions, and supervisory resources in home and host countries.
- Final policy stance:
  - Given potential international spillovers and distributional implications where national net benefits could coincide with global net costs, it would be difficult to justify structural measures without a global cost-benefit exercise and international coordination.

*Source: _sdn1304 - IMF Staff Discussion Note (executive summary and selected sections extracted from the provided PDF).*

### EXECUTIVE SUMMARY _________________________________________________________________________ 4

### EXECUTIVE SUMMARY

### Key findings and purpose
- Structural constraints on banks proposed by a number of countries aim to address the too-important-to-fail (TITF) problem by reducing the risk that these institutions will fail and by simplifying their resolution if they do fail.
- Structural measures can contribute to financial stability in combination with enhanced, post-crisis price-based regulations, supervision, and cross-border bank resolution frameworks.
- Activity restrictions, when appropriately designed and judiciously implemented, can work in tandem with strengthened capital requirements to limit bank management’s capacity for excessive risk taking.
- Corporate structures aligned to business activities and limits on intra-group exposures and on their pricing can shield systemically important financial services from idiosyncratic shocks impacting other activities.
- The nations proposing structural banking reform are global financial centers and systemically important economies; enhancing financial stability in these countries can have positive spillovers on the global economy and financial system.
- These policies will also have potentially significant global costs because they will be imposed on internationally active and systemic financial institutions; a global cost-benefit exercise encompassing extra-territorial implications is necessary.
- Subjecting a global institution to different structural measures in different jurisdictions could exert further pressure on consolidated supervision and cross-border resolution.
- With firm political support, a “targeted” approach—with structural measures tailored to the specific risk profiles of individual banks at a global group level—would promote global financial stability more effectively than an across-the-board approach. Absent confidence in supervisory capacity for the targeted approach, across-the-board measures would be appropriate provided their global benefits exceed their costs.

### Core policy implication
- International coordination and a global cost-benefit assessment are required to determine whether national structural measures’ benefits exceed their global costs.

---

### I. INTRODUCTION

### Context and scale
- A relatively small number of large, complex financial institutions account for a vast majority of cross-border financial intermediation.
- The 73 banks identified as systemically important by the Basel Committee on Banking Supervision (BCBS) account for almost two-thirds of global bank assets.

### Dual role of large institutions
- These institutions facilitate cross-border capital flows and allocation of global savings, and benefit from diversification and scale.
- They can also propagate distress due to interconnectedness, and their size gives them greater influence over regulatory and legislative processes and a funding advantage over other institutions.

### Challenges
- Large, complex institutions are difficult to regulate, supervise, and resolve owing to complex, integrated group structures with multiple legal entities across borders and business lines.
- Complexity contributes to inadequate risk management by complicating aggregation of data and information systems.

### Two broad policy approaches to TITF
- (1) Price-based regulations accompanied by enhanced supervision and effective resolution.
- (2) Structural limits on the size and scope of activities of these institutions.

### Post-crisis FSB/G20 measures exemplifying approach (1)
- Enhanced regulatory framework, with higher quantity and quality of (loss-absorbing) capital, tougher liquidity standards, and systemic risk surcharges;
- Proactive and intensive supervision consistent with the risks an institution poses to the financial system;
- An effective resolution framework with tools to enhance orderly recovery and wind-down in the event of failure, including effective burden-sharing with the private sector through debt that can be bailed in, cross-border arrangements, and firm-specific structural measures as needed;
- Enhanced transparency and disclosure to improve market discipline and monitoring;
- Strengthened market infrastructure to limit the risks of contagion arising from interconnectedness and the limited transparency of counterparty relationships.

### National-level structural proposals
- Structural measures proposed by the US, the UK, the EU, France, and Germany range from moving risky/complex businesses into stand-alone subsidiaries to prohibiting banks from engaging in these activities altogether.
- These proposals presume that price-based regulations alone do not go far enough in some areas and may not be implemented consistently in others (examples cited: bail-in, net stable funding ratio, cross-border resolution framework).

### Purpose of the paper
- Offer a framework (decision process) to assess when structural measures are warranted alongside traditional prudential instruments, and outline principles to guide their design—requiring enhanced international coordination.

---

### II. CAN STRUCTURAL MEASURES ELIMINATE THE TOO-IMPORTANT-TO-FAIL PROBLEM?

### Overall assessment
- Recent evidence from the crisis does not implicate specific bank business models as susceptible to greater risk of failure.
- Structural measures could be a useful complement to traditional prudential tools under certain conditions.
- Targeting structural measures to firm-specific risk profiles increases effectiveness relative to one-size-fits-all approaches, but requires firm political commitment and supervisory capacity.

### Decision framework (Figure 1: Policy Decision Tree)
- Two complementary objectives: reducing the probability of failure and reducing losses in the event of failure.
- The decision tree assesses: Are regulations robust? Can price-based rules adequately address tail risks? Are rules incentive compatible and enforceable? Is supervision robust? Is the business model amenable to low-cost resolution? Can politics impede firm-specific resolution?
- Outcome possibilities in the decision tree include: improve regulations, improve supervision, firm-specific structural constraints, structural constraints for all banks, or reevaluate later.

### Effectiveness of structural measures in reducing probability of failure
- Both structural measures and price-based tools seek to curb excessive risk taking.
- Four main premises supporting structural measures:
  1. Effectiveness limits of price-based tools in mitigating tail risks (complexity can outstrip model/regulatory capabilities).
  2. Robustness of regulations underpinning price-based tools (gaps in coverage, inadequate calibration, and inconsistent national gold-plating can increase regulatory arbitrage).
  3. Incentive compatibility and enforceability of rules (weak supervision or legal impediments reduce compliance; some structural constraints may be easier to supervise).
  4. Limiting public support and facilitating orderly resolution (reducing intra-group exposures can aid separability and reduce fiscal costs).

### Box 1: Effectiveness of Price-Based Regulations in the Face of Complexity (summary)
- Pre-crisis capital treatment differences between trading and banking books created incentives that elevated risk.
- Basel 2.5 and subsequent adjustments aimed to require banks to hold more capital against market risks in the trading book and to close capital arbitrage opportunities.
- Implementation remains challenged by complexity, particularly for A-IRB banks whose internal models can materially compress RWAs relative to standardized approaches.
- Highly complex combinations of trading, investment, and hedging can increase vulnerability to market and basis risk without corresponding calculated risk exposure changes—example: losses at J.P. Morgan Chase in 2012 in its Chief Investment Office (CIO) synthetic credit portfolio highlighted model, control, and supervisory challenges.

### Effectiveness of structural measures in reducing loss given failure
- Proliferation of intra-group exposures can impede resolution and magnify real and fiscal impacts of crises.
- Structural measures aim to insulate financial activities vital to the real economy from contagion originating elsewhere in banking groups, thereby making it easier to restrict public guarantees to core services (deposits, payments) and subject high-risk businesses to market discipline.

---

*Source: _sdn1304 - EXECUTIVE SUMMARY*

### 16.      The FSB’s Key Attributes of Effective Resolution Regimes for Financial Institutions (KAs) include

### 16.      The FSB’s Key Attributes of Effective Resolution Regimes for Financial Institutions (KAs) include

### Key principles of the KAs and firm-specific structural measures
- KAs include scope for construction of firm-specific structural measures designed to facilitate efficient bank recovery and resolution.
- KAs require the adoption of legal frameworks setting out powers, tools, and safeguards for resolution by all concerned national authorities, which will facilitate least-cost resolution at the group level.
- Resolvability assessments and recovery and resolution plans (RRPs), to be conducted for or prepared by each of the G-SIFIs, may require firm-specific structural measures, including changes to business scope or size or to groupwide corporate organization.
- In the US, big banks have established resolution blueprints in the form of living wills and complementary recovery plans as part of their obligations under the Dodd-Frank Act; many European G-SIBs are in the process of finalizing their RRPs.
- Resolution costs, unless otherwise stated, are to be understood to refer to cost to the taxpayer.

### Box 2 — Dealing with complex intra-group exposures (IGGs and BPs)
- Intra-group guarantees (IGGs) and back-to-back booking practices (BPs) enable firms to support affiliates with the consolidated strength of the firm and can:
  - permit the consolidated entity to reduce the amount of capital and liquidity devoted to the business relative to a model wherein the affiliate faces clients on the basis of its own financial strength;
  - consolidate market risk picked up by separate affiliates, maximize netting efficiencies at a consolidated level, and hedge outstanding global exposures in a cost-efficient manner.
- IGGs can be extended as blanket guarantees to affiliates or as transaction-specific guarantees.
- While IGGs and BPs can have material benefits, their use can impede recovery and resolution:
  - In recovery, IGGs can add time and cost to transferring positions and portfolios owing to requirements to obtain consent from clients on open-ended guarantees.
  - In resolution, insolvency of the firm can trigger insolvency of the affiliate (for example, through acceleration of claims implied by cross-default clauses).
  - BPs increase operational complexity, impeding unwinding or transfer of positions.
  - Failure of information systems to adequately track IGGs and BPs can complicate resolution or recovery efforts.
- Supporting references: Basel Committee on Banking Supervision (2012a), Fiechter and others (2011), and U.S. FDIC and Bank of England (2012).

### Advantages and limits of firm-specific structural constraints
- Imposing firm-specific structural constraints aligned with resolvability assessments offers advantages over ex ante, across-the-board structural measures:
  - By mapping business lines into groupwide corporate structure, tailored structural measures could reduce complexity and facilitate better supervision, reducing failure risk and lowering resolution costs.
- Limitations and caveats:
  - Weaknesses in cross-border resolution regimes or political/legal constraints could still necessitate uniform, across-the-board structural constraints.
  - Without firm political support for supervisors and resolution authorities, firm-specific structural measures may not be implementable, strengthening the case for preemptive across-the-board constraints.

### Do business models matter?
- Crisis experience suggests bank failures result from a combination of risk factors rather than a single business model being inherently superior or inferior.
- Studies preparing the Liikanen report concluded no business model fared particularly well or poorly in the crisis; trading in highly complex instruments and real estate lending—both based on excessive leverage and short-term wholesale funding—presented an especially risky combination.
- Strong linkages between and within financial institutions created high levels of systemic risk.

### Summing up: Is there a case for structural measures?
- Activity restrictions can be useful in managing risks difficult to measure and address using price-based tools. Business lines judged too complex for accurate risk measurement and effective supervision may require outright separation; such operations would need monitoring but would not be subject to the same supervision imposed on entities with access to the safety net.
- Where efficient resolution requires structural reform, well-designed firm-specific RRPs may be more effective than across-the-board structural measures provided adequate cross-border cooperation, especially vis-à-vis burden sharing, can be arranged.
- Without firm political support, firm-specific structural measures may not be implementable, increasing the case for preemptive across-the-board structural constraints.
- The Liikanen group proposal envisaged:
  - a baseline of structural reform for banks that meet or exceed certain size or activity thresholds and
  - the possibility of adding firm-specific constraints on the basis of their resolvability assessments.

### Box 3 — Evidence on business models and crisis vulnerability
- Two independent channels of evidence support the view that no single business model was unambiguously riskier:
  1. Relative loss experience and market-assessed default probabilities (PDs) of banks with different business models.
  2. Analysis of factors fundamental to explaining major bank failures during the crisis.
- Empirical observations:
  - Loss experiences and market risk indicators for U.S. universal and investment banks during the crisis show that while universal banks suffered greater loss, the largest institutions within either category had very similar loss experiences.
  - After Lehman’s bankruptcy, CDS-spread-implied PDs for both universal and investment banks converged to a similar, higher level within six months, indicating markets priced in higher distress risk for both types.
  - Implied probability of distress is computed from the 5-year CDS spreads assuming a recovery rate of 30 percent.
- Case studies:
  - Lehman Brothers’ failure owed to a higher-risk strategy adopted years before the crisis; what made it vulnerable were high leverage, liquidity mismatches, and reliance on interbank funding—risk factors targeted by international price-based reforms. Large intra-group exposures and groupwide risk management impeded efficient resolution across differing home and host bankruptcy frameworks.
  - Northern Rock, RBS, Hypo Real Estate-Depfa, and the German Landesbanken failures reflected strategic increases in leverage and shifts from deposits to short-term wholesale funding, producing elevated liquidity risk. In some cases, leverage arose from the replacement of common equity with subordinated debt or from acquisitions that expanded undercapitalized trading exposures.
- Conclusion: These experiences highlight weaknesses in pre-crisis prudential regimes and the need for enhanced price-based regulations and supervisory intensity. Current proposed structural measures, on their own, would not have prevented the bank failures described.

### III. The design elements of recent structural reform proposals
- Objective: Shield deposits and payments functions of banks from financial market volatility.
- National proposals (US, UK, EU, France, Germany) differ in institutional/geographic coverage and scope of separation due to variation in business models and crisis experiences.
- Key features noted:
  - UK retail ring-fence pushes most investment banking activities outside UK ring-fenced deposit-taking banks.
  - U.S. Volcker rule mandates separation of proprietary trading and hedge and private equity fund investments.
  - EU (Liikanen group) would disallow depository institutions from engaging in market making, proprietary trading, and investments in hedge funds and private equity; other subsidiaries in the same banking group may conduct these businesses.
  - French and German proposals are modified Liikanen variants allowing market making by the depository institution in certain cases.

### Comparative elements of structural proposals (selected provisions and thresholds)
- Permitted organizational forms and activities:
  - Holding company with banking and trading subsidiaries: Liikanen group (Permitted), United Kingdom (Permitted), United States (Not permitted).
  - Deposit-taking institution dealing as principal in securities and derivatives: Liikanen group (Not permitted (but other group companies may do so)), United Kingdom (Not permitted (but other group companies may do so)), United States (Not permitted).
  - Deposit-taking institution investing in hedge funds and private equity: Liikanen group (Not permitted (but other group companies may do so)), United Kingdom (Not permitted (but other group companies may do so)), United States (Not permitted).
  - Deposit-taking institution providing market making services: Liikanen group (Not permitted (but other group companies may do so)), United Kingdom (Not permitted (but other group companies may do so)), United States (Permitted).
  - Deposit-taking institution's non-trading exposures to other financial intermediaries: Liikanen group (Unrestricted), United Kingdom (Restricted), United States (Unrestricted).
- Higher loss absorbency (HLA) rules:
  - Liikanen group: Yes, via leverage ratio for trading business that exceeds size threshold.
  - United Kingdom: Yes, as add-on to the conservation buffer for UK ring-fenced bank.
  - United States: For SIBs with substantial US footprint.
- Size thresholds:
  - Liikanen group: Yes; applies to all banks with trading books larger than €100 billion, or trading assets more than 15-25% of balance-sheet.
  - United Kingdom: Yes; applies to all banks and building societies with deposits greater than £25 billion.
  - United States: No.
- Legislative status (as table notes):
  - Liikanen group report: Enacted into law (No); Implementing regulations finalized? (No).
  - United Kingdom: Enacted into law (Scheduled for completion by 2015); Implementing regulations finalized? (No).
  - United States: Enacted into law (Yes); Implementing regulations finalized? (No).
- Notes:
  - Exemptions under Volcker rule include U.S. federal government and agency securities, debt and securities issued by US state and municipal governments and government sponsored enterprises, and derivatives on these securities.
  - Dodd-Frank Act subjects US banks with assets in excess of $50 billion to more stringent prudential requirements. Similar requirements have been proposed under the Intermediate Holding Company proposal for non-US banks with more than $50 billion in global assets with a systemically important US presence.

### IV. How do the benefits and costs stack up?
- Benefits:
  - Structural reform reduces complexity and interconnectedness and facilitates lower-cost bank resolution.
  - Enhanced financial stability domestically in global financial centers yields positive spillovers to the global economy and financial sector.
- Potential costs and risks:
  - Implementation costs may be significant, and reforms could encourage regulatory arbitrage.
  - Structural measures could adversely impact market liquidity and efficiency of groupwide bank risk management.
  - Divergent national structural reforms applied to common global banks risk adding pressure on consolidated supervision and cross-border resolution.
- Complementarities:
  - Some components of the U.K. and Liikanen proposals related to tougher capital requirements on separated subsidiaries can be expected to work in complementary fashion.

*Source: _sdn1304 - 16.      The FSB’s Key Attributes of Effective Resolution Regimes for Financial Institutions (KAs) include*

### 23.      A comprehensive cost-benefit analysis is outside the scope of this paper. Our qualitative

### _sdn1304 - 23.      A comprehensive cost-benefit analysis is outside the scope of this paper. Our qualitative

### A. The Benefits of the Proposals
- Objective: decrease the probability of bank failure and its systemic implications by reducing complexity and interconnectedness.
- Key points:
  - Forcing proprietary trading and high-risk investments out of banks may increase the effectiveness of capital requirements as a prudential tool because complexity and tail risks of these business lines are especially high.
  - Only the Volcker rule can capture these benefits at the group level; the other proposals would permit these business lines to survive within the banking group, albeit outside the ring-fenced entity.
  - Ring-fencing can reduce interconnectedness risk for deposits, payments, and lending by imposing restrictions on the scale and pricing of intra-group exposures.
  - Retail banks may remain susceptible to reputational risk and group contagion even under ring-fencing; the failure of a trading subsidiary could lead to a loss of market confidence in the whole group.
  - Ring-fencing promotes resolvability at the level of the retail bank but not necessarily at the group level because material activity restrictions are not imposed on the non-ring-fenced affiliates under either the U.K. or Liikanen proposals.
  - Authorities tied to a certain corporate structure or activity restrictions may face Northern Rock–style crises driven by banking-book losses, reducing feasible restructuring options and potential buyer pools.

### B. The Costs of the Structural Reform Proposals
- Categories of costs: implementation challenges; risk migration; adverse impact on market liquidity, efficiency, and risk management capacity; and lower diversification benefits.
- Implementation-related costs:
  - Distinguishing proprietary from permitted trading is difficult; particularly relevant for the Volcker rule and the French and German ring-fencing proposals.
  - Differentiating hedging or market making from proprietary trading is challenging; Liikanen recommended placing market making outside the ring-fence alongside proprietary trading for this reason.
  - Substantial compliance and reporting requirements apply to banks covered by the Volcker rule, including foreign operations of U.S. banks and foreign parent firms and holding companies of banks licensed in the US; countries have expressed concern that U.S. banks may not be able to continue some of their foreign operations under these elevated cost conditions.
  - Unwinding and decoupling integrated businesses are likely to be challenging; the unbundling of derivatives and structured products may be particularly difficult and time consuming (example: American International Group’s derivatives subsidiary took two and a half years to unwind the bulk of its US$2 trillion portfolio with 45,000 individual trades).
- Risk migration:
  - Tightening activity restrictions may push certain activities to unregulated entities where they can still exert systemic risk; a widespread collapse of such units could adversely affect confidence and liquidity and implicate the real economy and retail banks.
  - Exemptions could motivate migration of prohibited activities to institutions just below the threshold; risk management capacity of exempt institutions must be commensurate.
  - Emerging market economies (EMs) may attract relocation of certain investment banking activities; corresponding capital flows could exert substantial impact on EMs with challenging absorption and monitoring/supervision.
- Market liquidity and borrowing costs:
  - Under the Volcker rule, banks will be unable to trade equities, corporate debt, private label asset-backed securities, and derivatives on a proprietary basis on U.S. exchanges or with U.S. counterparties; this may adversely affect liquidity for non-U.S. sovereigns, financial institutions, and nonfinancial corporates issuing in U.S. exchanges or the U.S. dollar market.
  - Domestic borrowing costs could rise where affiliates of U.S. banks are systemically important (example: Mexico) or play a key role in market making for sovereign bonds (examples: Japan and the EU).
  - Subsidiarization and restrictions on intra-group exposures can affect market making and cross-subsidization, potentially raising costs and reducing market liquidity.
- Lower diversification benefits:
  - Returns from retail, wholesale, and trading activities complement each other and provide diversification benefits; separating these segments can substantially reduce diversification and amplify idiosyncratic risk to the group level.
  - Empirical analysis: segment-wise returns for a sample of seven G-SIBs (including five U.S. and two U.K. banks) for 2003–07 show retail businesses as most profitable, followed by wholesale and trading; diversification is visible in the volatility-adjusted return band for total banking business lying between retail, wholesale, and trading.
  - During 2008–11 (global financial crisis), retail banking suffered losses, but overall performance was cushioned by wholesale returns; trading outperformed retail in the lower tail during the crisis despite negative ratios.

### C. What Are the Cross-Border Implications?
- Simultaneous implementation of materially different national proposals could:
  - Provide scope for cross-border regulatory arbitrage by internationally active banks.
  - Exacerbate burdens on consolidated supervision and cross-border resolution.
  - Force global institutions to move to the highest common denominator, leading to higher costs than compliance with any single measure.
  - Produce cumulative real and financial sector costs for host countries; ring-fencing with independent funding may prohibit potential new entrants in host markets and dampen competition.
- Supervision and resolution challenges:
  - Cross-border supervision is complicated by national incentives; globally consolidated supervision remains one of the most challenging areas for supervisors (Basel Core Principles assessment).
  - Movement of riskier businesses across countries could require more innovative cooperation and information sharing and adjustments to supervisory colleges if some hosts become more systemically important from a group-risk perspective.
  - Structural measures that reduce complexity and corporate structure could facilitate consolidated supervision.
  - Cross-border resolution may be further challenged by differing national measures (example: hedging in country A could be executed by a proprietary trading subsidiary in country C without structural requirements, resulting in imbalances in resolution if entities are ring-fenced in different jurisdictions).
- Some complementarities:
  - HLA requirements in the U.K. and Liikanen proposals combined could make EU banks more resilient: U.K. proposal tougher for ring-fenced retail bank; Liikanen tougher for trading affiliate, together increasing resilience on both sides of the ring-fence.

### V. Conclusion and Policy Recommendations
- Main conclusions:
  - Structural measures address the TITF problem and can complement prudential regulation and resolution tools when appropriately designed and implemented.
  - Activity restrictions may be justified where risk assessment, regulation, and supervision are inherently difficult; mandatory corporate-structure constraints (ring-fencing or subsidiarization) can be justified to improve resolvability.
  - Bank-specific measures arising from resolvability assessments are preferable to across-the-board application; a two-tiered approach may be feasible: across-the-board constraints for clearly identifiable very high-risk businesses plus bank-specific measures as needed.
  - A credible strategy for resolving banks when they fail is critical, including imposing discipline on managers, shareholders, and junior debt holders and cross-border collaboration arrangements (example: 2012 FDIC/Bank of England initiative).
  - The Liikanen “Avenue 1” construct: add a non-risk-based capital requirement on trading activities for banks with large trading portfolios; consider activity restrictions and corporate restructuring as firm-specific options informed by resolvability assessments.
- Need for international coordination:
  - Structural measures have positive spillovers for global financial stability but also potentially significant global costs; there is a clear case for ex ante coordination and for developing principles to evaluate cross-border implications.
  - Suggested elements for principles:
    - A clear articulation of objectives of structural measures; close gaps across countries where objectives are similar, especially for G-SIBs.
    - Analysis of implications for internationally agreed reform of prudential regulation, supervision, and resolution, focusing on: (1) impact on Basel III capital and liquidity rules; (2) consistency with effective resolution regimes and recovery and resolution plans for G-SIBs; (3) incentives for risk migration into the shadow banking system.
    - Assessment of implications for risk-based supervision, including potential freeing up of supervisory resources via ring-fencing but also increased verification/compliance costs and incentives for migration of risk into shadow banking requiring enhanced oversight.
    - Assignment of monitoring of extra-territorial implications of national structural measures to an international body such as the FSB, with periodic updates including impacts on domestic markets, institutions, and supervisory resources in home and host countries.
- Final policy stance:
  - Given potential international spillovers and distributional implications where national net benefits could coincide with global net costs, it would be difficult to justify structural measures without a global cost-benefit exercise and international coordination.

*Source: IMF Staff Discussion Note content (extracted from the provided PDF).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2013/_sdn1304.pdf_