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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 11 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