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Cross-border stability framework: Lessons from the global financial crisis

Jerzy Pruski

BFG 15th Anniversary Conference

Warszawa, 21 May 2010

Domestic financial stability frameworkCompleteness & efficiency of the system

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Low effectiveness of existing crisis management tools

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Global financial crisis 2007 – 2010 / response options

Standard legislation

Ineffective:- need for quick decisions- inadequate for specific circumstances

Private sector solutions Bailout/nationalization Standard bankruptcy proceedings

Examples

Important M&A- Bear Stearns (JP Morgan)- Merrill Lynch (BoA)Negative examples:ABN Amro (RBS, Santanderand Fortis)

TARP, AIG, CitiGroup, RBS, Lloyds TSB, Northern Rock, Fortis,Dexia, KBC, AIB, Commerzbank, Hypo Real Estate

Available only for small banks.Not resorted to after the collapseof Lehman Brothers for fear ofsystemic risk

Scope Very limited Very limitedBroadly used

Significant changes requiredFiscal burden of financial turmoil must to be drastically limited

Robust domestic stability network as prerequisite for effective cross-border safety net

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• Regulations• Rescue function (temporary) Rescue function:

to be extended & implemented

• Liquidity

• Regulations• Supervision

• Pay-box• Rescue function

MoFDGS

Special resolution regimes:to be implemented

?

Periodic financial crises remain inevitable in a market economy even despite strong domestic stability network

Ministry ofFinance

CentralBank

Financial Services Authority

Deposit Guarantee

Scheme

strong & completedomestic

financial stability system

Need for effective rescue and resolution functions

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Bank restructuringor capital injection

Private sectorsolutions

Bailout/Temporarynationalisation

Assistance forexisting shareholders

Tools to support M&As

Moral hazard

No change of ownership

Change of ownership required

Rescue function (capital injection and/or liquidity support)

Rescue activities not justified

Special receivership powersAuthority for Purchase and Assumption

Private sector solution not available

Complete toolkit of instruments a pre-condition for effective crisis management

Orderly liquidation

Pay-box function

Rescue Resolution

Insurance

Resolution function

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Sell the whole bank

Sell asset pools

Liquidate assets

Failed Bank

Cost and systemic risk assessment

Receivership

Quick decision

FDIC

Alternative

model Insured deposit pay-out

Sell deposits & branchesCoverage for

insured deposits(DGS)

Reduction of:systemic riskamount of required fundsmoral hazard

Significance of special resolution regimes

Advantages

1. Reduction of systemic risk of default

2. Transfer of control to regulators

2. Reduction of fiscal cost

3. Costs transferred to existing shareholders

5. Reduction of moral hazard

6. Better market discipline

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Fiscal and stability costs*

*based on Čihák & Nier (2009)

Fis

ca

l c

os

ts

Stability costsSystemic financial stability impact

Special resolution

Disorderly bankruptcy

„Bailout”

Ordinary resolutions

(Direct costs)

(Indirect costs)

Cross-border interconnectedness Additional risks and challenges

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Cross-border interconnectedness

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Increased risk of crisis&

Extraordinary challenge for crisis management

Broad range of benefits of globalisation

• Insufficient information • Crisis contagion

Global economy

cross- border dimensions

Country 1

Cross-border risk management

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Bank 1

Bank 11

Bank 12

Bank 13

Bank 2

Bank 21

Bank 22

Country 2

Domestic market risk

Cross-border dimensions

Prevention instruments

Crisis management

Microprudential

Macroprudential

Bank 14

Cross-border banking groups imply:• enormous complications for financial safety net• modifications in the toolkit of stability instruments and new regulatory authorities

interbank links

Defaultrisk

External risk

Cross-border connections Risk monitoring limitations

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Systemic risk Limitations

Identification of systemically importantinstitutions requires access to data on entirecross-border network

Total picture of the risk is not visiblefrom the perspective of a single country

In addition to a local component, the risk imposed on domestic banks depends on external foreign risk, which is only partially visible

Capital surcharge to risk-weighted assets

(in % of initial risk-weighted assets)Country Banks Network Country 1 Country 2

charges charges charges

Country 1 Bank 1 0,74 0,97

Bank 2 1,43 1,11Bank 3 0,44 0,54Bank 4 0,41 0,50

Country 2 Bank 5 1,56 0,58

Bank 6 1,06 0,34

?

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Source - IMF

Limiting the risk of crisis

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Robust domestic safety net Harmonization + cooperation Integrated solutions

Effective domestic financial stability system

Some decisions are transferred to international level

Mostly non-binding

Involves the issue of individual state independence

• legal aspect – different legal rules• burden sharing aspect

Difficult to implement

Available solutions for mitigation of cross-border crisis risk

Pending construction

European UnionFinancial stability system enhancement

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Crucial importance however still:

• non-binding

• limited efficiency

Euro Area

Existing cross-border stability framework in the EU

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European

Union

• monetary policy

• stabilization policy

ECB

Regulations

Coordination

ESRB, EBAnot authorized to imposefiscal cost

New solutions

Urgent need for new and rigorously enforced fiscal rules

Crucially important but remain:Harmonisation

Proposed cross-border stability framework

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Currently discussed solutions

European stability framework legs behind domestic standards

Limitations and barriers

- lack of ex-ante burden sharing

- non – existant legal framework for transfer of assets

- legal differences

- lack of common bankruptcy law

Basel III

ESF European Stability Fund

ERA European Resolution Agency

EDGS European DGS

Fragmented Non-binding Lack of funds

IES Integrated European Supervisor

EMF European Monetary Fund

Outstanding: • fiscal problems• global imbalances• asset bubbles

Risk of overregulation

Risk of overregulation

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Sources of global financial crisis

Macroprudential Microprudential Macroeconomics

European Systemic Risk Board New regulations

- focus on stability of consumer prices- not oriented to asset prices and monetary aggregates- fiscal policy- FX regime

Theory and practiceof macroeconomic policy

essentially unchanged

Remains to be tested

- selective scope (only banking sector) - effectiveness not fully proved- incomplete cost-benefit analysis - limited territorial scale- limiting the scale of operations

Risk of suboptimal policy mix

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Monetary policy

Recently reached deficit and debtlevels force budgetary restraint

Pro-cyclical measures

Low interest rates and monetaryeasing despite improvementof economic situation

Restrict the range and scopeof banking activity

Fiscal policySupervisory and regulatory

policy

Focus on new regulation rather thanmore effective supervision

The risk of inconsistent monetary – regulatory policy mix

The entire burden of emerging from the crisis rests on monetary policy with successively lower interest rates and a familiar potential for future assets bubbles

Counter-cyclical measures Pro-cyclical measures

Banking regulations