## _wp11236 - 1. Utility Banking Proposals

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### Why Redefine Scope?
- Core problem: banking involves leveraged intermediation, limited liability, and profit sharing contracts that create incentives for risk-taking potentially excessive from creditors' perspective.
- Creditor guarantees such as deposit insurance weaken creditors’ incentive to monitor management and exacerbate risk-taking incentives.
- SIFIs magnify these problems due to size, interconnectedness, or complexity; market perceptions of too-important-to-fail (TITF) imply implicit creditor guarantees beyond explicit deposit insurance.
- Pre-crisis effects of perceived public support:
  - Enabled SIFIs to carry thinner capital buffers at lower cost.
  - Encouraged complex business models and accumulation of systemic risk.
  - Reinforced by a diversification premium attributed to universal banks, allowing integration of retail, investment, and wholesale banking without adequate firewalls.
  - Resulted in dense networks of interconnections that were costly to unravel, making taxpayer support during the crisis seem less costly than allowing failures and restructuring.
- Trade-offs of diversification:
  - Benefit: protection against idiosyncratic shocks to individual lines of business.
  - Cost: increased intra-group exposures and higher likelihood of intra-firm contagion.
  - Retail banking customers often lack alternatives; ensuring continuity of retail services is a clear social welfare objective.
- Policy objectives for restricting bank scope:
  - Limit contagion within and across firms (financial stability).
  - Ensure efficient continuity of retail banking services (consumer protection).
  - More credibly restrict taxpayer-funded creditor guarantees to depositors, reducing social cost.
- Concrete post-crisis proposals described:
  - Narrow Utility Banking — revert deposit-funded banks to traditional payment-function outfits; lending and investment banking carried out by independent finance companies funded by non-deposit means.
  - The Volcker Rule — prohibit banks from carrying out certain investment banking activities if they retain deposit funding and banking licenses.
  - A Retail Ring-fence — mandate legal subsidiarization of certain retail activities, prohibit that subsidiary from undertaking other businesses/risks, establish minimum solo capital and liquidity standards, limit capital/liquidity transfers from the retail subsidiary to non-ring-fenced affiliates.
- Implementation challenge:
  - Distinguishing permissible market-making and underwriting from prohibited proprietary trading is difficult in practice.
  - Supervisors face difficulties assessing hedging tools and contracts used by ring-fenced banks.
  - Policy dilemma: invest resources to gather detailed information to create better filters versus broader prohibitions that risk shifting activity to the shadow banking sector.

### Narrow Banking Ideas
- Utility Banking (general design):
  - Licensed, regulated, deposit-funded entities constrained to invest in high credit quality, liquid securities.
  - Lending, where permitted, restricted to limited sectors such as consumer and mortgage credit; commercial lending and investment banking undertaken by legally separate finance companies funded by debt and equity.
  - Holding company structures permitted if legal, financial, and managerial separation strictly enforced.
- Potential benefits if functional separation achieved:
  - Lower leverage in deposit-funded institutions by eliminating investment banking activities.
  - Improved asset-liability matching by restricting permissible assets to liquid, high credit quality securities.
  - Isolation of systemic risk in non-utility finance companies by restricting payments-system access to narrow banks.
  - Sharpened creditor incentives for non-utility institutions if public guarantees restricted to utility banks.
- Measured impacts (financial system, economy, costs, efficiency):
  - Strengthened banking stability through detachment of high-leverage investment banking and associated asset-liability mismatches.
  - Risk of transferring systemic risk to an unregulated or weakly regulated shadow sector.
  - Consumers may face lower deposit returns and loss of “one-stop” banking convenience.
  - Lending transferred to non-bank finance companies could raise average credit costs or reduce credit supply for some products (e.g., small and medium enterprise loans, prime credit cards, prime auto loans).
  - Higher adjustment and operational costs for universal banks; higher overall funding costs for bank holding companies combining utility banking with lending activity.
  - Competition and focus on core activities could enhance efficiency; simpler structures may gain franchise value.
- Challenges and caveats:
  - Informational advantages and synergies between deposit-taking and lending (reference to Kashyap et. al. (2002) in source) may argue against full separation.
  - Cross-border regulatory arbitrage could thwart national utility banking reform; harmonization necessary but difficult.
  - Risk migration to shadow banks could undermine stability and reduce role of utility banks.
  - Market risk (e.g., steepening of the treasury curve) could produce mark-to-market losses on tradable fixed income securities; may require caps on duration or restrictions to variable-interest or short-term notes.
  - Adjustment costs: unwinding universal banks is costly and time-consuming, especially for European TITF institutions that are predominantly universal banks.
  - Utility banking may be infeasible in emerging/low-income countries lacking deep, liquid secondary markets.

### Narrow Funding Banks (NFBs)
- Objective (Gorton and Metrick (2010)): bring securitization within regulatory perimeter by housing ABS purchases within licensed, regulated institutions.
- NFB design features:
  - Chartered institutions subject to prudential ceilings on leverage, market and liquidity risk; restrictions on eligible assets collateralizing ABS; portfolio quality and concentration constraints (minimum proportions above given ratings thresholds).
  - Periodic examinations and access to central bank discount window facilities.
  - Capital structure: issued as medium-term notes (MTNs) with scheduled maturities extendible if regulatory capital requirements are breached; switching to "no growth" or "natural amortization" modes during stress; prohibition on dividend payouts in stress.
  - Non-equity funding via commercial paper, MTNs, bonds, and repos.
  - Business model: pure spread business; barred from making loans or engaging in proprietary trading and derivatives; sole activity to purchase ABS, with allowance to invest in other high-grade assets and treasury securities for liquidity management.
  - Standalone, separately ring-fenced legal entities with no direct cross-ownership linkages to commercial banks.
- Assessment and limitations:
  - Benefits: ring-fencing securitization within regulated firms could support resolution and creditor incentives.
  - Risks:
    - Concentration Risk: NFBs concentrating securitization risk may be vulnerable in deteriorating credit conditions.
    - Originate-to-distribute incentive problems remain; chartering NFBs alone will not resolve low credit risk retention by originators or conflicts among originator-servicers, trustees, and underwriters.
    - Complementary measures needed: changes to remuneration contracts and securitization waterfall structures.

### Full Institutional Separation of Functions: The Volcker Rule
- Rationale:
  - Section 619 of the Dodd-Frank Act separates some investment banking activities from commercial banking to reduce conflicts of interest and risk-taking when banks combine lending, underwriting, market-making with proprietary trading and investing on own account.
  - Concerns: conflicts of interest, systemic risk (proprietary trading, exposure to structured credit and hedge funds), capital arbitrage, and disclosure/transparency failures.
- Empirical/statistical context:
  - Qualified support for associations between trading activity, returns volatility, and increasing correlation with the business cycle (see Box 1 and references to Stiroh and Rumble (2006) and Standard and Poor’s (2011)).
  - Pre-crisis capital treatment encouraged placement of credit exposures in the trading book; composition shifted toward credit derivatives and subprime securities.
- Core prohibitions and timetable (as presented in source):
  - Deposit-funded licensed U.S. commercial banks or BHCs with U.S. banking affiliates are barred from engaging in proprietary trading and investing or sponsoring in hedge funds and private equity funds, subject to listed exemptions.
  - Rule becomes effective on the earlier of either two years after enactment of the Act (i.e., July 21, 2012), or within nine months of issuance of accompanying regulations (due by October 21, 2011).
  - Compliance required from eligible institutions two years hence (so by July 21, 2014); Federal Reserve may provide up to 3 one-year extensions upon application beyond 2014.
  - Illiquid fund investments undertaken prior to May 1, 2010 are eligible for a single 5 year extension upon application to the Federal Reserve.
- Identification and supervisory challenges:
  - Distinguishing proprietary trades from permissible transactions is difficult: exemptions align with market-making, underwriting, hedging, agency transactions.
  - Bright-line prohibitions (dedicated proprietary trading desks) are easier to enforce; hard cases include proprietary trading disguised as hedging or market-making and portfolio-level hedging with residual exposures.
  - Proposed supervisory approaches: develop metrics based on granular financial information; programmatic regime with internal audits and CEO compliance declarations (FSOC (2011)); FSB (2010) suggested frequency distribution of daily trading profits to distinguish market-makers from proprietary traders.

### Box 1 — Filter Rule Test and Sample: Do Trading Activities Increase the Vulnerability of Banks?
- Objective: Test hypothesis that “banks with high shares of trading income-to-total revenue pre-crisis were most vulnerable to public bailout.”
- Methodology: Compute Mean +/- k*SD of trading income-to-total revenue ratios for 1999–2007; Filter 1: k=1 (Mean+1*SD), Filter 2: k=2 (Mean+2*SD). Any bank whose %Trading Income in 2008 exceeds the filter within its geographic sub-sample is screened as ‘vulnerable.’ Vulnerable banks compared with those receiving official support in 2008/2009.
- Sample: 79 SIFIs across Europe, the U.S., and Asia (commercial, investment and universal banks).
  - U.S.: 15 LCFIs with 234 data points.
  - Europe (including UK): 46 LCFIs with 708 data points.
  - Asia (including Australia & Japan): 18 LCFIs with 163 data points.
- Filter 1 (Mean+1*SD) results:
  - Europe (including U.K.)
    - "Vulnerable Banks" identified by Filter Rule (A): 62
    - No. of Banks which received Official Support in 2008/2009 (B): 52
    - No. of "Vulnerable Banks" receiving Official Support in 2008/2009 as predicted by Filter Rule (C): 41
    - Predictive Ability of Filter Rule (C)/(A): 66.7%
    - Percentage of "Vulnerable Banks" receiving Official Support against total no. of banks which received Official Support (C)/(B): 80.0%
  - U.S.
    - (A): 58
    - (B): 31
    - (C): 41
    - Predictive Ability (C)/(A): 66.7%
    - (C)/(B): 80.0%
  - Asia (including Australia & Japan)
    - (A): 21
    - (B): 23
    - (C): 3
    - Predictive Ability (C)/(A): 12.5%
    - (C)/(B): 13.0%? [table shows mixed presented values; preserve presented results as above]
- Filter 2 (Mean+2*SD) summary statements:
  - Repeating analysis with 2*SD confirms similar observations.
  - Little change in predictive ability for European banks.
  - Overall improvements for U.S. and Asian banks versus Filter 1.
  - Filter 2 results confirm significant association between extreme-tail trading ratios and need for state assistance for U.S. and European banks; in Asia only a weak association is obtained at best.
- Interpretation:
  - Conditional support that higher trading-income shares are associated with greater susceptibility to distress for U.S. and European banks; similar results do not hold for Asian banks (only weak association).
  - Possible explanations for regional divergence: regional effects (Asian resilience) and lower Asian exposure to toxic assets (subprime mortgages, RMBS and their derivatives).
  - Proprietary trading likely only part of the problem; losses also can arise from non-proprietary trading activities (market-making, investment banking, hedging).
  - Problem may be cyclical rather than structural; a blanket prohibition on proprietary trading could be suboptimal through-the-cycle.
- Caveats and data limitations:
  - Reported data are on an accounting basis; trading income includes revaluation of Trading Book securities, net realized gains/losses from proprietary trading and disposal of AFS securities, mark-to-market valuation of derivatives for hedging.
  - Proprietary trading is often high-frequency; an appropriate volatility measure would be average daily volatility of trading income rather than annual total trading income used in the filter.

### Quantitative Metrics Proposed by FSOC
- Revenue-based metrics:
  - Examples: Historical revenue comparison; Revenues relative to industry sample; Day 1 Profit & Loss; Bid-Off Pay-to-Receive Ratio.
  - Rationale/limitations: Filters unusual patterns; Day 1 revenues relate to liquidity and perform worse in illiquid asset markets.
- Revenue-to-risk metrics:
  - Examples: Proportion of profitable trading days; Sharpe ratios; Revenue-to-Value at Risk; Value at Risk.
  - Rationale/limitations: Market-making may yield higher revenue per unit of risk; may perform poorly for high-frequency or non-linear trades.
- Inventory metrics:
  - Examples: Inventory turnover; Inventory aging.
  - Rationale/limitations: Market-making returns tied to inventory flow; will underperform in illiquid markets.
- Customer flow metrics:
  - Examples: Customer initiated trade ratio; Customer initiated flow-to-inventory; Revenue-to-customer initiated flow ratio.
  - Rationale/limitations: Customer-initiated trades indicate market-making/hedging; inter-dealer transactions and portfolio-level hedging complicate interpretation.
- Supervisory challenges:
  - Metrics may be better suited to ex-post enforcement than ex-ante identification.
  - Granularity of information required is substantial; programmatic regimes with internal audits and executive attestations proposed by FSOC.

### Retail Ring-fencing (ICB Proposals)
- Objectives:
  - Make it easier to restructure and resolve retail and non-retail banks without extensive public funds.
  - Insulate vital banking services for households and small businesses from exogenous shocks.
  - Credibly restrict public creditor guarantees to explicitly pre-defined beneficiaries.
- Activity classification (ICB):
  - Services that must be offered within the ring-fence: retail deposits and over-drafts to individuals and small and medium-sized enterprises (private banking customers excluded).
  - Activities permitted within the ring-fence: consumer and SME loans, mortgages, credit cards, corporate lending, leasing, factoring, wealth management advisory services, and other non-prohibited services; funding modes not restricted so long as they do not result in assumption of market risk.
  - Activities excluded from the ring-fence: services provided outside the EEA; transactions with non-ring-fenced financial firms that are not affiliates (except regulator-approved payments services); services that result in a trading book asset or the need to hold capital against market and counterparty credit risks; secondary market activities such as purchase of loans or securities. Prohibitions include securities underwriting, market-making, M&A advisory, loans and ABS warehousing, and sponsoring securitization deals.
  - Activities necessary to support permitted services: derivatives contracts with non-ring-fenced banks within group; investment in liquid assets eligible for central-bank repos; contracting with counterparties outside the group offering prohibited services is excluded.
- Implementation and functional subsidiarization:
  - Ring-fenced banks to be separate legal entities within financial groups; branch-based structures pose monitoring difficulties.
  - Operationally independent management and board required.
  - Independently and separately capitalized on a solo basis.
  - Restrictions on intra-group transactions: transactions with non-ring-fenced affiliates must be on a third-party basis, at market prices or imputed fair values; large/single exposure limits apply.
- Prudential capital constraints (ICB summary):
  - All ring-fenced banks: Tier I > 3 percent.
  - RWA between 1-to-3 percent of U.K. GDP => sliding scale min equity-to-RWA between 7-to-10 percent; sliding scale min leverage ratio between 3-to-4.06 percent; sliding scale for minimum capital + bail-in bonds between 10.5-to-17 percent of RWA; supervisor discretion to increase primary loss absorbing capacity by up to 3 percentage points.
  - RWA of more than 3 percent of U.K. GDP: Minimum equity-to-RWA of 10 percent; Minimum leverage ratio of 4.06 percent; Capital and bail-in-bonds should be at least 17 percent of RWA; Supervisor discretion to increase primary loss absorbing capacity by up to 3 percentage points.
- Assessment:
  - Benefits: preserves some diversification benefits of universal banking while limiting contagion to retail depositors and small businesses; facilitates restructuring and resolution and restricts public guarantees.
  - Challenges: achieving genuine functional separation is difficult; intra-group contracting for risk management raises intra-group exposures and complicates spin-off in resolution; filtering prohibited from permissible transactions remains challenging; increased compliance, operational, and supervision costs; potential permanent increase in cost of banking services.

### Comparing Volcker Rule and ICB Ring-fence; Policy Implications
- Key structural differences:
  - Volcker Rule:
    - Applies to all U.S. banks and bank-holding companies and foreign BHCs with U.S. subsidiaries/branches.
    - Prohibits proprietary trading and funds investing (a subset of investment banking activities).
    - Legal structure: banks or holding companies subject to the rule cannot house affiliates that engage in prohibited activities.
  - ICB ring-fence:
    - Applies to all U.K. banks and bank holding companies that engage in ring-fence services plus U.K. subsidiaries of foreign BHCs offering ring-fenced services.
    - Prohibits trading, market-making, securities underwriting, services resulting in trading book exposures or holding regulatory capital against market and counterparty credit risks, and services offered outside the EEA.
    - Ring-fenced banks can co-exist within same group as affiliates offering prohibited services but must be separately capitalized and independently managed; intra-group transactions subject to arms-length/prudential constraints.
- Unintended costs and competitive distortions:
  - Narrowing eligible suppliers of investment vehicles to non-bank providers may disadvantage U.S. investors via new pricing-to-market.
  - U.S. banks/BHCs could be disadvantaged relative to non-U.S. BHCs that can conduct proprietary trading/fund investing outside the U.S.
  - Restricting trading in non-U.S. government securities to U.S. banks could disproportionately impact liquidity and capital supply for some non-U.S. sovereign or private-sector debt.
  - Banning proprietary trading likely amplifies risk migration to shadow banking (hedge funds, mutual funds, SPEs), increasing unmonitored systemic risk.
- Recommended complementary measures and implementation considerations:
  - Rescoping SIFI business models requires complementary prudential strengthening: strengthened regulation, more intensive oversight, and more effective recovery and resolution frameworks.
  - Enhance oversight of the shadow banking sector to prevent migration of systemic risk.
  - Consider higher capital surcharges overall and on the trading book as a complement where transaction identification is difficult.
  - Harmonize regulatory tool-kit internationally to avoid competitive distortions and regulatory arbitrage between regimes (e.g., Volcker Rule vs. ICB ring-fence).
  - Consider higher risk weights on trading and securitization under Basel and buffering common equity with contingent capital instruments.
  - Ultimately prioritize improved governance frameworks and strong supervision.

*Source: _wp11236 - 1. Utility Banking Proposals — https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11236.pdf*

### 1. Utility Banking Proposals ...........................................................................................

### _wp11236 - 1. Utility Banking Proposals

### Chapter and Section Structure
- 1. Utility Banking Proposals ......................................................................................................7
- 2. Impact Analysis of Utility Banking .......................................................................................8
- 3. Results for U.S., European, and Asian LCFIs .....................................................................15
- 4. Volcker Rule of the Dodd-Frank Act...................................................................................18
- 5. Quantitative Metrics Proposed by FSOC .............................................................................21
- 6. Capital Constraints for Ring-fenced Banks .........................................................................26
- 7. Comparing the Volcker Rule and the ICB Ring-fencing Proposals ....................................29

### Figures Included
- Figure 1: Transformation of Universal Banking into Utility Banking ..................................................6
- Figure 2: Rescoping of Banks’ Businesses Under the Volcker Rule ..................................................17
- Figure 3: Rescoping of Bank’s Businesses Undwer the ICB Ring-fence ...........................................27
- Figure 4: Comparing the Proposals: A Summary................................................................................32

### Key organizational emphasis (as indicated by section headings)
- Examination of "Utility Banking" as a proposal (Section 1).
- Quantitative and qualitative impact analysis of applying utility-banking frameworks (Section 2).
- Empirical results focused on U.S., European, and Asian large complex financial institutions (LCFIs) (Section 3).
- Detailed treatment of the Volcker Rule within the Dodd-Frank Act and its implications for bank activity scope (Section 4).
- Presentation of "Quantitative Metrics Proposed by FSOC" indicating measurement approaches (Section 5).
- Assessment of capital constraints in the context of ring-fencing banks (Section 6).
- Direct comparison between the Volcker Rule and the Independent Commission on Banking (ICB) ring-fencing proposals (Section 7).

*Source: _wp11236 - 1. Utility Banking Proposals — https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11236.pdf*

### Box 1. Do Trading Activities Increase the Vulnerability of Banks? .......................................14

### Box 1. Do Trading Activities Increase the Vulnerability of Banks?

### I. WHY REDEFINE SCOPE?
- Core problem: banking involves leveraged intermediation, limited liability, and profit sharing contracts that create incentives for risk-taking potentially excessive from creditors' perspective.
- Creditor guarantees such as deposit insurance weaken creditors’ incentive to monitor management and exacerbate risk-taking incentives.
- Systemically important financial institutions (SIFIs) magnify these problems due to size, interconnectedness, or complexity; market perceptions of too-important-to-fail (TITF) imply implicit creditor guarantees beyond explicit deposit insurance.
- Pre-crisis effects of perceived public support:
  - Enabled SIFIs to carry thinner capital buffers at lower cost.
  - Encouraged complex business models and accumulation of systemic risk.
  - Reinforced by a diversification premium attributed to universal banks, allowing integration of retail, investment, and wholesale banking without adequate firewalls.
  - Resulted in dense networks of interconnections that were costly to unravel, making taxpayer support during the crisis seem less costly than allowing failures and restructuring.
- Trade-offs of diversification:
  - Benefit: protection against idiosyncratic shocks to individual lines of business.
  - Cost: increased intra-group exposures and higher likelihood of intra-firm contagion.
  - Retail banking customers often lack alternatives, so ensuring business continuity for retail services is a clear social welfare objective; complex integrated models complicate rapid separation of retail operations.
- Policy objectives for restricting bank scope:
  - Limit contagion within and across firms (financial stability).
  - Ensure efficient continuity of retail banking services (consumer protection).
  - More credibly restrict taxpayer-funded creditor guarantees to depositors, reducing social cost.
- Concrete post-crisis proposals described:
  - Narrow Utility Banking — revert deposit-funded banks to traditional payment-function outfits; lending and investment banking carried out by independent finance companies funded by non-deposit means.
  - The Volcker Rule — prohibit banks from carrying out certain investment banking activities if they retain deposit funding and banking licenses.
  - A Retail Ring-fence — mandate legal subsidiarization of certain retail activities, prohibit that subsidiary from undertaking other businesses/risks, establish minimum solo capital and liquidity standards, limit capital/liquidity transfers from the retail subsidiary to non-ring-fenced affiliates.
- Implementation challenge highlighted:
  - Distinguishing permissible market-making and underwriting from prohibited proprietary trading is difficult in practice.
  - Supervisors also face difficulties assessing hedging tools and contracts used by ring-fenced banks.
  - Policy dilemma: invest resources to gather detailed information to create better filters versus broader prohibitions that risk shifting activity to the shadow banking sector.
- Sections II, III, and IV discuss narrow banking, the Volcker rule, and retail ring-fence; Section V concludes (structure noted in source).

### II. NARROW BANKING IDEAS
A. The Utility Banking Proposals
- Concept: define institutional/regulatory boundaries along functional lines, distinguishing ‘non-risky’ utility banking services from ‘risky’ non-utility activities; inclusion limited to services that facilitate real sector activity and sustainable economic growth.
- Post-crisis emphasis: lower asset-liability mismatches and leverage via drastic restrictions on deposit-funded banks’ permissible activities (see source’s Figure 1 and Table 1 references).
- Most radical form: institutional separation between payment-function banks and companies engaged in commercial lending and other activities.
- Typical features of utility banks (per source):
  - Licensed, regulated, deposit-funded entities constrained to invest in high credit quality, liquid securities.
  - Lending, where permitted, restricted to limited sectors such as consumer and mortgage credit; commercial lending and investment banking undertaken by legally separate finance companies funded by debt and equity.
  - Holding company structures permitted if legal, financial, and managerial separation strictly enforced.
- Potential benefits if accurate functional separation achieved:
  - Lower leverage in deposit-funded institutions by eliminating investment banking activities.
  - Improved asset-liability matching by restricting permissible assets to liquid, high credit quality securities.
  - Isolation of systemic risk in non-utility finance companies by restricting payments-system access to narrow banks.
  - Sharpened creditor incentives for non-utility institutions if public guarantees restricted to utility banks.
- Measured impacts (referenced in Table 2 in source):
  - Financial system and economy:
    - Potentially strengthened banking stability through detachment of high-leverage investment banking and associated asset-liability mismatches.
    - Risk of transferring systemic risk to an unregulated or weakly regulated shadow sector if lending/investment banking shift out of regulated banks.
    - Narrower structures and firewalls may increase resilience of regulated banks and facilitate spinning off healthy utility banks during resolution.
    - Breaking up banks could reduce diversification benefits when correlations between lines are low during normal times.
  - Costs:
    - Consumers may face lower deposit returns and loss of “one-stop” banking convenience.
    - Lending transferred to non-bank finance companies could raise average credit costs or reduce credit supply where public creditor protection is absent, potentially harming small and medium enterprise loans, prime credit cards, or prime auto loans.
    - For universal banks, higher adjustment and operational costs from unwinding established contracts and losing back-office synergies; overall funding costs for bank holding companies combining utility banking with lending activity will be higher.
  - Efficiency:
    - Competition could spur improvements in core banking services.
    - Focus on core banking activities might enhance bank efficiency.
    - Simpler, segregated structures that manage risk better may gain reputation and franchise value.
- Challenges and caveats:
  - Separation rationale: prevent contagion and moral hazard exacerbated by combined deposit funding and risky lending; but complete institutional separation of deposit funding from credit intermediation is not clearly supported by pre-crisis events.
  - Banks possess informational advantages in relationship lending and synergies between deposit-taking and lending that can lower joint provision costs (reference Kashyap et. al. (2002) in source).
- Operational challenges limiting practical scope:
  - Cross-border regulatory arbitrage could thwart national utility banking reform; harmonization across jurisdictions necessary but difficult.
  - Utility banks may constrain managerial moral hazard but risk-taking may shift to shadow banks; depositors may seek higher returns in shadow banks during normal times, reducing the role of utility banks and potentially prompting later taxpayer rescues.
  - Narrowing the regulated perimeter may not follow from utility banking because systemic risk can build in shadow banks, demanding possible extension of regulation to those entities.
  - Market risk remains: e.g., a steepening of the treasury curve could cause large mark-to-market losses on tradable fixed income securities; caps on duration or restrictions to variable-interest or short-term notes may be necessary.
- Adjustment costs:
  - Unwinding complex universal banks is costly and time-consuming, especially for European TITF institutions that are predominantly universal banks.
  - Interlinkages (e.g., structured finance manufactured by structuring desks and hedged by trading desks) complicate unbundling.
  - Utility banking may be infeasible in emerging/low-income countries lacking deep, liquid secondary markets for government and private debt securities.

B. Narrow Funding Banks (NFBs)
- Proposal objective (Gorton and Metrick (2010)): bring securitization within regulatory perimeter by housing ABS purchases within licensed, regulated institutions.
- NFB design features per source:
  - Chartered institutions subject to prudential ceilings on leverage, market and liquidity risk; restrictions on eligible assets collateralizing ABS; portfolio quality and concentration constraints (constraints measured by minimum proportions above given ratings thresholds).
  - Subject to periodic examinations and access to central bank discount window facilities.
  - (Equity) capital structure: issued as medium-term notes (MTNs) with scheduled maturities that are extendible if regulatory capital requirements are breached; switching to "no growth" or "natural amortization" modes during stress, with prohibition on dividend payouts to equity holders; capital takes on a debt-like structure in normal times and reverts to equity-like in stress.
  - Non-equity funding via non-deposit means: commercial paper, MTNs, bonds, and repos.
  - Business model: pure spread business; barred from making loans or exposing own-funds to proprietary trading and derivatives; sole activity to purchase ABS, with allowance to invest in other high-grade assets and treasury securities for liquidity management.
  - Legal/economic organization: standalone, separately ring-fenced legal entities with no direct cross-ownership linkages to commercial banks.
- Assessment and limitations:
  - Benefits: independently regulated securitization firms could promote ring-fencing of regulated banks’ retail operations during stress; conversion of NFB debt into equity during stress may strengthen incentives to limit borrower leverage in housing.
  - Risks and remaining incentive problems:
    - Concentration Risk: NFBs concentrating securitization risk may be vulnerable in deteriorating credit conditions; Fed discount window access may ease liquidity but solvency depends on ABS underlying credits.
    - Originate-to-distribute incentive problems remain: chartering NFBs alone will not resolve low credit risk retention by originators, conflicts between senior and junior lien holders, or coordination problems among originator-servicers, trustees, and underwriters.
    - Complementary measures needed: changes to remuneration contracts and securitization waterfall structures to reduce misrepresentations, mortgage defaults, foreclosures, and associated dead-weight costs.

### III. FULL INSTITUTIONAL SEPARATION OF FUNCTIONS: THE VOLCKER RULE
A. Rationale for the Rule
- Volcker Rule (section 619 of the Dodd-Frank Act in the U.S.) separates some investment banking activities from commercial banking to reduce conflicts of interest and risk-taking when banks combine lending, underwriting, market-making with proprietary trading and investing on own account.
- Specific concerns cited:
  - Conflicts of interest: banks lending to a corporation may have incentives to market and underwrite that corporation’s securities, which can create conflicts when capital is raised to retire the bank’s credit exposure.
  - Systemic risk: direct involvement of commercial banks in securities markets via proprietary trading or hedge/investment funds acquisition increases systemic vulnerability; Group of Thirty cited “unanticipated and unsustainably large losses in proprietary trading, heavy exposure to structured credit products, and ... hedge funds” as placing viability at risk.
  - Statistical analysis in the source provides qualified support for associations between trading activity, returns volatility, and increasing correlation with the business cycle (reference to Box 1 results and consistency with Stiroh and Rumble (2006) and Standard and Poor’s (2011) noted in source).
  - Capital arbitrage: prior to the crisis, capital charged against trading book exposures was relatively light compared to banking book, encouraging placement of credit exposures in the trading book; the trading book composition shifted toward credit derivatives and subprime securities over the decade preceding the crisis.
  - Disclosure/transparency failures: standards of disclosure for investment banking were relatively poor versus commercial banking (in the U.S.), exacerbated by limited regulatory reach over private label ABS and derivatives and weakening of market discipline by credit rating agencies due to conflicts of interest and modeling gaps.

*Italicized source attribution as in the original material.*

### Box 1. Do Trading Activities Increase the Vulnerability of Banks?

### Box 1. Do Trading Activities Increase the Vulnerability of Banks?

### Filter Rule Test and Sample
- Objective: Test hypothesis that “banks with high shares of trading income-to-total revenue pre-crisis were most vulnerable to public bailout.”
- Methodology: Compute Mean +/- k*SD of trading income-to-total revenue ratios for 1999–2007; Filter 1: k=1 (Mean+1*SD), Filter 2: k=2 (Mean+2*SD). Any bank whose %Trading Income in 2008 exceeds the filter within its geographic sub-sample is screened as ‘vulnerable.’ Vulnerable banks compared with those receiving official support in 2008/2009.
- Sample: 79 SIFIs across Europe, the U.S., and Asia (commercial, investment and universal banks). NOTE: Sample taken from 1999–2007 [US: 15 LCFIs with 234 data points; Europe (including UK): 46 LCFIs with 708 data points; Asia (including Australia & Japan): 18 LCFIs with 163 data points].

### Filter Rule Results (Filter 1 and Filter 2)
- Filter 1 (Mean+1*SD) results:
  - Europe (including U.K.)
    - "Vulnerable Banks" identified by Filter Rule (A): 62
    - No. of Banks which received Official Support in 2008/2009 (B): 52
    - No. of "Vulnerable Banks" receiving Official Support in 2008/2009 as predicted by Filter Rule (C): 41
    - Predictive Ability of Filter Rule (C)/(A): 66.7%
    - Percentage of "Vulnerable Banks" receiving Official Support against total no. of banks which received Official Support (C)/(B): 80.0%
  - U.S.
    - (A): 58
    - (B): 31
    - (C): 41
    - Predictive Ability (C)/(A): 66.7%
    - (C)/(B): 80.0%
  - Asia (including Australia & Japan)
    - (A): 21
    - (B): 23
    - (C): 3
    - Predictive Ability (C)/(A): 12.5%
    - (C)/(B): 13.0%? [Note: table shows 100.0% in one column; preserve presented values below]
- Filter 2 (Mean+2*SD) results and summary statements:
  - Repeating analysis with 2*SD confirms similar observations.
  - Little change in predictive ability for European banks.
  - Overall improvements for U.S. and Asian banks versus Filter 1.
  - Filter 2 results confirm significant association between extreme-tail trading ratios and need for state assistance for U.S. and European banks; in Asia only a weak association is obtained at best.

(Note: Table 3 in source shows a matrix of values across U.S., Europe (including U.K), and Asia (including Australia & Japan). Presented predictive ability and (C)/(B) percentages in the table: U.S./Europe/Asia predictive ability values under two columns read as 66.7% / 72.0% / 12.5% and 80.0% / 71.4% / 33.3%. Percentage (C)/(B) entries read as 80.0% / 78.3% / 100.0% and 80.0% / 65.2% / 100.0%.)

### Interpretation and Conditional Findings
- Main finding: Conditional support that higher trading-income shares are associated with greater susceptibility to distress for U.S. and European banks; similar results do not hold for Asian banks (only weak association).
- Possible explanations for regional divergence:
  - (i) Regional effects: Asian economies were more resilient during the crisis, underpinning banking-system health.
  - (ii) Quality of assets and earnings: Low Asian exposure to toxic assets such as subprime mortgages, RMBS and their derivatives.
  - Proprietary trading likely only part of the problem; losses also can arise from non-proprietary trading activities (market-making, investment banking, hedging).
  - Problem may be cyclical rather than structural; a blanket prohibition on proprietary trading could be suboptimal through-the-cycle.

### Caveats and Data Limitations
- Economic vs. accounting considerations:
  - Reported data are on an accounting basis; trading income includes revaluation of Trading Book securities, net realized gains/losses from proprietary trading and disposal of AFS securities, mark-to-market valuation of derivatives for hedging.
  - Trading losses could reflect intentionally unhedged proprietary exposures or non-trading exposures reclassified to trading (e.g., to exploit capital arbitrage).
- Data constraints:
  - Proprietary trading is often high-frequency; an appropriate volatility measure would be average daily volatility of trading income rather than annual total trading income used in the filter.

### Proposed Policy Responses (motivated by Volcker Rule debate)
- Three complementary potential solutions suggested:
  - Imposition of higher capital requirements on commercial deposit-taking banks with high levels of trading activity, where “high level of activity” could be measured in terms of its contribution to the overall level and volatility of returns.
  - Extending the perimeter of regulation and endowing supervisors with authority to demand information from shadow banks. Give supervisors cease-and-desist and enforcement powers based on information collected from weakly supervised or unsupervised entities.
  - Imposing separation of business lines into different sets of institutions (as in the Volcker Rule in the U.S. and the U.K.’s Independent Commission on Banking (ICB)).

### Volcker Rule: Key Features and Implementation Timetable (from source)
- Core prohibitions: Deposit-funded licensed U.S. commercial banks or BHCs with U.S. banking affiliates are barred from engaging in proprietary trading and investing or sponsoring in hedge funds and private equity funds, subject to listed exemptions.
- Implementation timeline in source:
  - Rule becomes effective on the earlier of either two years after enactment of the Act (i.e., July 21, 2012), or within nine months of issuance of accompanying regulations (due by October 21, 2011).
  - Compliance required from eligible institutions two years hence (so by July 21, 2014); Federal Reserve may provide up to 3 one-year extensions upon application beyond 2014.
  - Illiquid fund investments undertaken prior to May 1, 2010 are eligible for a single 5 year extension upon application to the Federal Reserve.

### Identification and Supervisory Challenges
- Distinguishing proprietary trades from permissible transactions is difficult:
  - Exemptions often align with economic purpose (market-making, underwriting, hedging, agency transactions).
  - Bright-line prohibitions (dedicated proprietary trading desks) are easier; many U.S. BHCs have spun off such desks.
  - Hard cases: proprietary trading disguised as hedging or market-making; banks hedge at portfolio level leaving residual exposures; market-making requires capital at risk for varying periods depending on liquidity.
- Proposed supervisory approaches:
  - FSOC (2011) proposed developing metrics based on granular financial information and a programmatic regime with internal audits and CEO compliance declarations.
  - FSB (2010) suggested methodologies based on frequency distribution of daily trading profits (U.K. FSA analysis 2006–2008) to distinguish market-makers from proprietary traders; such approaches are better suited to ex-post enforcement than ex-ante identification.

### Quantitative Metrics Proposed by FSOC (summary)
- Revenue-based metrics:
  - Examples: Historical revenue comparison; Revenues relative to industry sample; Day 1 Profit & Loss; Bid-Off Pay-to-Receive Ratio.
  - Rationale/limitations: Filters unusual patterns; Day 1 revenues relate to liquidity and perform worse in illiquid asset markets.
- Revenue-to-risk metrics:
  - Examples: Proportion of profitable trading days; Sharpe ratios; Revenue-to-Value at Risk; Value at Risk.
  - Rationale/limitations: Market-making may yield higher revenue per unit of risk; may perform poorly for high-frequency or non-linear trades.
- Inventory metrics:
  - Examples: Inventory turnover; Inventory aging.
  - Rationale/limitations: Market-making returns tied to inventory flow; will underperform in illiquid markets.
- Customer flow metrics:
  - Examples: Customer initiated trade ratio; Customer initiated flow-to-inventory; Revenue-to-customer initiated flow ratio.
  - Rationale/limitations: Customer-initiated trades indicate market-making/hedging; inter-dealer transactions and portfolio-level hedging complicate interpretation.

### Unintended Costs, Competitive Distortions, and Shadow Banking Migration
- Narrowing eligible suppliers of investment vehicles to non-bank providers may disadvantage U.S. investors via new pricing-to-market.
- U.S. banks/BHCs could be disadvantaged relative to non-U.S. BHCs that can conduct proprietary trading/fund investing outside the U.S.
- Restricting trading in non-U.S. government securities to U.S. banks could disproportionally impact liquidity and capital supply for some non-U.S. sovereign or private-sector debt.
- Banning proprietary trading likely amplifies risk migration to shadow banking (hedge funds, mutual funds, SPEs), increasing unmonitored systemic risk; shadow entities often lack capital adequacy frameworks and transparent disclosures.

### Retail Ring-fencing (ICB Proposals): Objectives and Design
- Objectives:
  - Make it easier to restructure and resolve retail and non-retail banks without extensive public funds.
  - Insulate vital banking services for households and small businesses from exogenous shocks.
  - Credibly restrict public creditor guarantees to explicitly pre-defined beneficiaries.
- Two dimensions of proposals:
  - Location of the fence: which activities are inside vs outside the ring-fence.
  - Height of the fence: restrictions on financial interconnections between ring-fenced and non-ring-fenced entities (ceilings, risk-based pricing of intra-group transactions, minimum capital standards for ring-fenced banks).

### Ring-fence: Activity Classification (ICB)
- Services that must be offered within the ring-fence: retail deposits and over-drafts to individuals and small and medium-sized enterprises (private banking customers excluded).
- Activities permitted within the ring-fence: consumer and SME loans, mortgages, credit cards, corporate lending, leasing, factoring, wealth management advisory services, and other non-prohibited services; funding modes not restricted so long as they do not result in assumption of market risk.
- Activities excluded from the ring-fence: services provided outside the EEA; transactions with non-ring-fenced financial firms that are not affiliates (except regulator-approved payments services); services that result in a trading book asset or the need to hold capital against market and counterparty credit risks; secondary market activities such as purchase of loans or securities. Prohibitions include securities underwriting, market-making, M&A advisory, loans and ABS warehousing, and sponsoring securitization deals.
- Activities necessary to support permitted services: derivatives contracts with non-ring-fenced banks within group; investment in liquid assets eligible for central-bank repos; contracting with counterparties outside the group offering prohibited services is excluded.

### Ring-fence Implementation and Functional Subsidiarization
- Legal/operational requirements:
  - Ring-fenced banks to be separate legal entities within financial groups; branch-based structures pose monitoring difficulties.
  - Ring-fenced banks must have operationally independent management and board.
  - Ring-fenced banks must be independently and separately capitalized on a solo basis.
  - Restrictions on intra-group transactions: transactions with non-ring-fenced affiliates must be on a third-party basis, conducted at market prices or imputed fair values; large/single exposure limits apply to intra-group transactions.
- Prudential capital constraints (ICB summary table):
  - All ring-fenced banks: Tier I > 3 percent; RWA between 1-to-3 percent of U.K. GDP => sliding scale min equity-to-RWA between 7-to-10 percent; sliding scale min leverage ratio between 3-to-4.06 percent; sliding scale for minimum capital + bail-in bonds between 10.5-to-17 percent of RWA; supervisor discretion to increase primary loss absorbing capacity by up to 3 percentage points.
  - RWA of more than 3 percent of U.K. GDP: Minimum equity-to-RWA of 10 percent; Minimum leverage ratio of 4.06 percent; Capital and bail-in-bonds should be at least 17 percent of RWA; Supervisor discretion to increase primary loss absorbing capacity by up to 3 percentage points.

### Assessment of Ring-fence Proposals: Benefits and Challenges
- Benefits:
  - Preserves diversification benefits of universal banking to a degree while limiting contagion to retail depositors and small businesses.
  - Facilitates restructuring and resolution and restricts the reach of public guarantees.
- Challenges:
  - Subsidiarization must be functional, not merely legal/operational; achieving genuine separation is difficult.
  - Risk management and hedging within ring-fence likely to rely on intra-group contracting, raising intra-group exposure and complicating spin-off in resolution.
  - Filtering prohibited from permissible transactions remains challenging; identification problems similar to Volcker Rule.
  - Increased compliance, operational, and supervision costs; potential permanent increase in cost of banking services.

### Comparative Notes: Volcker Rule vs. ICB Ring-fence
- Volcker Rule:
  - Applies to all U.S. banks and bank-holding companies and foreign BHCs with U.S. subsidiaries/branches.
  - Prohibits proprietary trading and funds investing (a subset of investment banking activities).
  - Legal structure: banks or holding companies subject to the rule cannot house affiliates that engage in prohibited activities.
- ICB ring-fence:
  - Applies to all U.K. banks and bank holding companies that engage in ring-fence services plus U.K. subsidiaries of foreign BHCs offering ring-fenced services.
  - Prohibits trading, market-making, securities underwriting, services resulting in trading book exposures or holding regulatory capital against market and counterparty credit risks, and services offered outside the EEA.
  - Ring-fenced banks can co-exist within same group as affiliates offering prohibited services but must be separately capitalized and independently managed subsidiaries; intra-group transactions subject to arms-length/prudential constraints.

### Policy Implications and Recommended Complementary Measures
- Rescoping SIFI business models requires complementary prudential strengthening:
  - Restrictions on proprietary trading and risky lending should be complemented by strengthened regulation, more intensive oversight, and more effective recovery and resolution frameworks.
- Important implementation considerations:
  - Enhancing oversight of the shadow banking sector is essential to prevent migration of systemic risk.
  - Careful assessment of loss of diversification benefits; ring-fencing preserves diversification more than Volcker Rule or narrow banking.
  - Operational challenges may limit effectiveness; proposals may need to be introduced in combination with other tools.
  - Specific policy suggestions:
    - Extend perimeter of regulation and oversight to shadow banking.
    - Use higher capital surcharges overall and on the trading book as a complement where transaction identification is difficult.
    - Harmonize regulatory tool-kit internationally to avoid competitive distortions and regulatory arbitrage between regimes (e.g., Volcker Rule vs. ICB ring-fence).
    - Consider higher risk weights on trading and securitization under Basel and buffering common equity with contingent capital instruments.
    - Ultimately prioritize improved governance frameworks and strong supervision.

*Source: IMF Staff Discussion in Box 1 of the referenced chapter (data and statements as presented in the source).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11236.pdf_