Burden sharing: From theory to practice

Dirk Schoenmaker 18 October 2010

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Burden sharing is very controversial in political as well as academic circles (Pauly, 2009). The common opinion is that having an ex ante burden sharing arrangement in place to bailout a cross-border bank or a sovereign state is asking for trouble. The moral hazard of such arrangements would be overwhelming. But I argue the opposite. The absence of an adequate cross-border framework can do much damage to the global financial system (Claessens et al. 2010, see also Buiter and Rahbari 2010).

What does theory suggest?

The handling of cross-border banks in financial difficulties gives rise to coordination problems between home and host countries. The resolution of ailing cross-border banks is typically a rare event with high financial stakes for the authorities. The uncooperative equilibrium dominates for this type of non-repeated events (Freixas 2003). The repeated game solution is not applicable for this coordination problem. While financial supervision is an ongoing exercise (repeated game), crisis management is a rare event (non-repeated game).

In a 2009 article with Charles Goodhart (2009), we suggest ex ante mechanisms for burden sharing in Europe to overcome the co-ordination failure in ex post negotiations. The key element is a credible pre-commitment between countries to address a cross-border bank failure jointly. In a joint assessment, countries decide to share the burden of a rescue when the systemic impact of the failure would exceed the cost of recapitalisation. Otherwise, the bank should fail.

Moral hazard is a key concern. At the national level, the ministry of finance bears the financial risk of support operations and therefore decides on these operations. Clarity at the European level over how to share the costs of a European bank failure among treasuries does not increase moral hazard. We propose full transparency on crisis management arrangements (the “how” question), while maintaining constructive ambiguity on the application of these arrangements (the “whether” question).

Moving to sovereign states, Buiter and Rahbari (2010) argue that a minimal fiscal Europe is necessary to make up for the loss of independent monetary policy as a sovereign default prevention mechanism. They support the creation of the European Financial Stability Facility as national sovereign default becomes an issue of common concern in the Eurozone. Again it is important to contain moral hazard. In parallel with the European Financial Stability Facility, an orderly procedure for sovereign debt restructuring may be useful.

Burden sharing in practice

There are two main mechanisms for burden sharing. The first is a general scheme financed collectively by the participating countries (generic burden sharing). The newly created the European Financial Stability Facility for Eurozone countries is an example of general burden sharing. Another example is the lender of last resort function of the ECB. The second relates the burden to the location of the assets of the bank to be recapitalised (specific burden sharing). The Nordic Baltic authorities have recently endorsed a specific burden sharing scheme for their banking system. I review these burden sharing schemes below (Schoenmaker 2010).

General burden sharing for Eurozone member states

An application of general burden sharing is the financial stability facility for Greece. The Greek tragedy reached its climax on 9 May 2010. In a historical declaration, Eurozone leaders have agreed to a package of IMF assistance and Eurozone burden sharing through a new European Financial Stability Facility (2010). This general form of burden sharing is based on the ECB capital key. In good times, the capital key is used to share the benefits of monetary union, the seigniorage. In bad times, the same key is used to share the (potential) costs of keeping the monetary union together.

How does the burden sharing system work? The European Financial Stability Facility is a special purpose vehicle agreed by the 27 member states of the EU, aiming at preserving financial stability in Europe by providing financial assistance to Eurozone states in difficulty. In order to reach these goals the Facility is ready to issue bonds, notes, or other debt instruments on the market and use the money so raised to make loans up to a maximum of €440 billion to Eurozone member states in need. Eventual emissions of bonds are backed by guarantees given by the Eurozone member states on a pro rata basis, in accordance with the ECB capital key. The ECB capital key for a country is the arithmetic average of a country’s share in total GDP and its share in total population. The ECB capital key (c) needs to be debased from the full set of 27 EU member countries to the 16 Eurozone members. The contribution of each EMU member state is then: cj / Σj cj ( j is EMU member countries). The resulting key for the burden sharing is given in Table 1.

Table 1. Burden sharing key for Eurozone member states (in %)

Country
Key
Country
Key
1. Austria
2.8
9. Italy
17.9
2. Belgium
3.5
10. Luxembourg
0.3
3. Cyprus
0.2
11. Malta
0.1
4. Finland
1.8
12. Netherlands
5.7
5. France
20.4
13. Portugal
2.5
6. Germany
27.1
14. Slovakia
1.0
7. Greece
2.8
15. Slovenia
0.5
8. Ireland
1.6
16. Spain
11.9
 
 
Total Eurozone-16
100.0

General burden sharing by the ECB as lender of last resort

Another case of (implicit) burden sharing is the application of the lender of last resort function of the ECB during the financial crisis. The ECB can act as general lender of last resort flooding the interbank market with liquidity when needed. Art 18.1 of the Statute of the European System of Central Banks provides the basis for this classical central banking tool:

“In order to achieve the objectives of the ESCB and to carry out its tasks, the ECB and the national central banks may … conduct credit operations with credit institutions and other market participants, with lending based on adequate collateral”.

So, the ECB needs to take adequate collateral. During the 2007-2009 financial crisis the ECB has expanded the range of eligible collateral. As the range of collateral expands beyond safe assets such as Treasuries, credit risk increases. The ECB has made a provision of €5.7 billion for the increased credit risk of its general lender of last resort operations in 2008. The national central banks have underwritten this provision according to the ECB capital key. As each central bank is backed by its own government, the ECB’s expansion of collateral rules is implicitly underwritten by the national governments of the Eurozone.

Specific burden sharing in the Nordic Baltic region

A few large banks, such as Nordea, Swedbank, and Danske Bank, are operating throughout the Nordic Baltic region. The economies are very much interwoven through these banks creating potential contagion effects. A shock can spread swiftly through the region. Rather than changing the structure of the banking system, the Nordic and Baltic authorities have chosen to share the costs of financial stability reflecting the joint exposure to externalities. In August 2010, they agreed to a burden sharing scheme to make up for lack of proper diversification (Nordic Baltic Memorandum of Understanding 2010). Under this burden sharing scheme, the ministries of finance share the costs of a possible bank failure.

The burden sharing key is based on two components:

  • the relative importance of the relevant bank in the countries as measured by asset shares (summing to 100%); and
  • the supervisory responsibility for the same bank in the same countries (summing up to 100%).

Both components get an equal weight. Relative importance is calculated on the basis of the amounts of assets in the countries concerned. Assets used are risk weighted and calculated using the latest official balance sheet figures of at least 12 months earlier (this would prevent gaming with the asset key during a crisis). Supervisory responsibility depends on the factual supervisory powers. A home country with full and exclusive powers to supervise host country branches is given a 100% weight. If a supervisory college is in operation for host country subsidiaries, the relative home country weight will be less than 100%.

Finally, enforcement of burden sharing mechanisms is important. While the European Financial Stability Facility is legally binding, the Nordic Baltic MoU is not legally binding. The Nordic Baltic arrangement can be strengthened by incorporating the burden sharing arrangement in the Living Wills of the Nordic banks. The Living Will is a new concept to deal with too-big-to-fail banks and consists of a recovery and resolution plan to be used when a bank may get into difficulties. Living Wills may enable burden sharing specific by institution.

Conclusion

Burden sharing is politically very controversial. But the recent financial crisis – both banking and sovereign – has provided some impetus to act. The sovereign crisis of Greece has lead to a general burden sharing scheme for Eurozone countries. On the banking side, the Nordic and Baltic authorities have agreed to specific burden sharing. These burden sharing schemes can overcome the sort of coordination failure that is bound to take place in the stress of a financial crisis.

References

Buiter, W and E Rahbari (2010), “Greece and the Fiscal Crisis in the Eurozone”, CEPR Policy Insight 51.

Claessens, S, R Herring and D Schoenmaker (2010), A Safer World Financial System: Improving the Resolution of Systemic Institutions, 12th Geneva Report on the World Economy, London, CEPR.

European Financial Stability Facility (2010), “EFSF Framework Agreement”, Luxembourg.

Freixas, X (2003), “Crisis Management in Europe”, in J Kremers, D Schoenmaker and P Wierts (eds.), Financial Supervision in Europe, Edward Elgar, 102-119.

Goodhart, C and D Schoenmaker (2009), “Fiscal Burden Sharing in Cross-Border Banking Crises”, International Journal of Central Banking, 5:141-165.

Nordic Baltic Memorandum of Understanding (2010), Cooperation Agreement on Cross-Border Financial Stability, Crisis Management and Resolution between Relevant Ministries, Central Banks and Financial Supervisory Authorities of Denmark, Estonia, Finland, Iceland, Latvia, Lithuania, Norway and Sweden, August.

Pauly, L (2009), “The Old and the New Politics of International Financial Stability”, Journal of Common Market Studies, 47:955-975.

Schoenmaker, D (2010), “Burden Sharing: From Theory to Practice”, DSF Policy Paper 6, Amsterdam: Duisenberg School of Finance.

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Topics:  Global crisis Global economy Global governance

Tags:  financial regulation, global crisis, Eurozone crisis, burden sharing

Professor of Banking and Finance at the Rotterdam School of Management, Erasmus University Rotterdam; Non-Resident Fellow, Bruegel; and Research Fellow, CEPR

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