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Cross-border stability framework:
Lessons from the global financial crisis
Jerzy Pruski
BFG 15th Anniversary Conference
Warszawa, 21 May 2010
1
Domestic financial stability framework
Completeness & efficiency of the system
2
Low effectiveness of existing crisis management tools
Global financial crisis 2007 – 2010 / response options
Scope
Examples
Private sector solutions
Bailout/nationalization
Standard bankruptcy proceedings
Very limited
Broadly used
Very limited
Important M&A
- Bear Stearns (JP Morgan)
- Merrill Lynch (BoA)
Negative examples:
ABN Amro (RBS, Santander
and 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 collapse
of Lehman Brothers for fear of
systemic risk
Standard legislation
Ineffective:
- need for quick decisions
- inadequate for specific
circumstances
Significant changes required
Fiscal burden of financial turmoil must to be drastically limited
3
Robust domestic stability network
as prerequisite for effective cross-border safety net
• Regulations
• Rescue function
(temporary)
Ministry of
Finance
MoF
DGS
Rescue function:
to be extended
& implemented
Central
Bank
• Liquidity
Financial
Services
Authority
• Regulations
• Supervision
• Pay-box
• Rescue function
strong & complete
domestic
financial stability system
Deposit
Guarantee
Scheme
?
Special resolution
regimes:
to be implemented
Periodic financial crises remain inevitable in a market economy
even despite strong domestic stability network
4
Need for effective rescue and resolution functions
Complete toolkit of instruments a pre-condition for effective crisis management
Rescue
Resolution
Change of ownership required
Bailout/Temporary
nationalisation
Private sector
solutions
No change
of ownership
Bank restructuring
or capital injection
Private sector solution not available
Rescue activities not justified
Moral hazard
Tools
to support M&As
Assistance for
existing shareholders
Rescue function (capital injection and/or liquidity support)
Insurance
Special receivership powers
Authority for Purchase and Assumption
Orderly liquidation
Pay-box function
5
Resolution function
Sell the whole bank
Cost and systemic
risk assessment
Quick decision
Receivershi
p
Failed Bank
Sell asset pools
Liquidate assets
Sell deposits & branches
Coverage for
insured deposits
(DGS)
Alternative
model
Insured deposit pay-out
Reduction of:
systemic risk
amount of required funds
moral hazard
6
Significance of special resolution regimes
Fiscal and stability costs*
Advantages
*based on Čihák & Nier (2009)
(Indirect costs)
„Bailout”
Fiscal costs
1. Reduction of systemic risk of default
2. Transfer of control to regulators
2. Reduction of fiscal cost
Ordinary
resolutions
3. Costs transferred to existing shareholders
Disorderly
bankruptcy
(Direct costs)
5. Reduction of moral hazard
6. Better market discipline
Special
resolution
Stability costs
Systemic financial stability impact
7
Cross-border interconnectedness
Additional risks and challenges
8
Cross-border interconnectedness
Global economy
Broad range of benefits of
globalisation
cross- border
dimensions
• Insufficient information
• Crisis contagion
Increased risk of crisis
&
Extraordinary challenge for crisis management
9
Cross-border risk management
Cross-border banking groups imply:
•
•
enormous complications for financial safety net
modifications in the toolkit of stability instruments and new regulatory authorities
Domestic market risk
External risk
Microprudential
Default
risk
Country 1
Macroprudential
Country 2
Bank 11
Cross-border dimensions
Bank 21
Bank 12
Prevention instruments
Bank 1
Bank 22
Bank 13
Bank 14
Bank 2
Crisis management
interbank links
10
Cross-border connections
Risk monitoring limitations
Limitations
Systemic risk
Identification of systemically important
institutions requires access to data on entire
cross-border network
Capital surcharge to risk-weighted assets
Country
Banks
Country 1 Bank 1
Bank 2
Bank 3
Bank 4
Country 2 Bank 5
Bank 6
(in % of initial risk-weighted assets)
Network
Country 1 Country 2
charges
charges
charges
0,74
1,43
0,44
0,41
1,56
1,06
0,97
1,11
0,54
0,50
?
Total picture of the risk is not visible
from the perspective of a single country
?
0,58
0,34
Source - IMF
In addition to a local component, the risk imposed on domestic banks depends
on external foreign risk, which is only partially visible
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Limiting the risk of crisis
Available solutions for mitigation of cross-border crisis risk
Robust domestic safety net
Harmonization + cooperation
Integrated solutions
Effective domestic financial
stability system
Mostly non-binding
Some decisions are transferred
to international level
Pending construction
Difficult to implement
Involves the issue of individual state independence
• legal aspect – different legal rules
• burden sharing aspect
12
European Union
Financial stability system enhancement
13
Existing cross-border stability framework in the EU
European
Euro
Area
ECB
• monetary policy
• stabilization policy
Regulations
New solutions
ESRB, EBA
not authorized to impose
fiscal cost
Union
Harmonisation
Coordination
Crucial important
importance
however
Crucially
but
remain:still:
• non-binding
• limited efficiency
Urgent need for new and rigorously enforced fiscal rules
14
Proposed cross-border stability framework
European stability framework legs behind domestic standards
Fragmented
Non-binding
Lack of funds
Currently discussed solutions
Basel III
ESF
European Stability Fund
Limitations and barriers
ERA
European Resolution Agency
- lack of ex-ante burden sharing
EDGS European DGS
- non – existant legal framework for transfer of assets
- legal differences
IES
Integrated European Supervisor
EMF
European Monetary Fund
- lack of common bankruptcy law
15
Risk of overregulation
Sources of global financial crisis
Macroprudential
European Systemic Risk Board
Microprudential
Macroeconomics
New regulations
Theory and practice
of macroeconomic policy
essentially unchanged
- selective scope
(only banking sector)
- effectiveness not fully proved
- incomplete cost-benefit analysis
- limited territorial scale
- limiting the scale of operations
Remains to be tested
Risk of overregulation
- focus on stability of consumer prices
- not oriented to asset prices and
monetary aggregates
- fiscal policy
- FX regime
Outstanding:
• fiscal problems
• global imbalances
• asset bubbles
16
Risk of suboptimal policy mix
Monetary policy
Low interest rates and monetary
easing despite improvement
of economic situation
Fiscal policy
Recently reached deficit and debt
levels force budgetary restraint
Supervisory and regulatory
policy
Focus on new regulation rather than
more effective supervision
Banking regulations
Restrict the range and scope
of banking activity
Counter-cyclical measures
Pro-cyclical measures
Pro-cyclical measures
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
17