Will ‘ring-fencing’ work better than ‘firewalls’ did?

We’re hearing a lot about “ring-fencing” these days.

That sounds suspiciously like “firewalls” to some of us who covered the S&L calamity 20 years ago.

Sheila Bair, chairman of the Federal Deposit Insurance Corp., thinks bank holding companies should ring-fence their investment banking operations to protect their commercial banks, according to the Financial Times. The UK’s Independent Commission on Banking thinks bank holding companies should ring-fence their commercial banks to protect them from their investment banking operations.

Ring-fencing means the bank that is ring-fenced is isolated in some ways from its parent company and its affiliates so that it will not be affected if trouble develops in other parts of the company, and it will not affect affiliates if it has troubles of its own. 

Survivors of the S&L crisis will remember that after the thrift industry imploded in the late 1980s, regulators and politicians wanted to let commercial banks, investment banks and insurance companies merge or affiliate. This new business model would be called universal banking. 

Universal banking would not pose a threat to the FDIC-insured bank or thrift, experts assured Americans,  because there would be a firewall between the FDIC-insured bank and the risky affiliates.

In 1991 author Stephen Pizzo and RepoWatch editor Mary Fricker told Congress:

Bankers assure their critics that the potential dangers of corporate ownership and securities and insurance underwriting are moot issues because bankers will agree to impenetrable firewalls between their corporate, banking, securities and insurance affiliates.  If the securities company gets into trouble, for example, firewalls will protect the bank’s federally insured deposits, they claim. Apparently, through some magical osmosis that only works one way, American are asked to believe that banks will enjoy the benefits of having securities affiliates without ever being affected by their problems.

In 1999 Congress decided to let commercial and investment banks affiliate under a single bank holding company umbrella.

After that, how well did firewalls protect commercial banks from the pecadillos of the investment banks?  Rampant repoing infected affiliates throughout the financial markets between 2000 and 2008, as did other systemically important transactions like derivative deals.

But more importantly, in 2008 prudent commercial banks could not even be protected from investment banks they were not affiliated with, mainly because of repo entanglements. The run on repo that felled the five major investment banks infected all financial markets, including the commercial banks, as repo financing dried up and the value of everyone’s securities holdings plummeted.

Now regulators want to try ring-fencing.