Staff Working Paper No. 1,046
By Marco Bardoscia and Raymond Ka-Kay Pang
Ring-fencing is a reform of the UK banking system that requires large banks to separate their retail services from other activities, such as investment banking. We consider a network of bilateral exposures between banks in which financial contagion can spread because banks incorporate the creditworthiness of their counterparties into the valuation of their interbank assets. Ring-fenced entities are insulated from contagion because they cannot be exposed to other financial institutions. Instead, the exposure of non-ringfenced entities can increase or decrease when compared to their banks before ring-fencing, depending on how assets and liabilities are allocated between ring-fenced and non-ringfenced entities. We find conditions on this allocation that lead to safer ring-fenced entities and less safe non-ring-fenced entities than their banks before ring-fencing, and vice versa. We also show that implementing ring-fencing can decrease or increase both the equity of individual banking groups and the aggregate equity of the banking system.
Ring-fencing in financial networks