The financial crisis: Financial trilemma in Europe

Dirk Schoenmaker 19 December 2009

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The single banking market was built on the premise that banks conduct the majority of their business at home and only branch out to other EU countries on a modest scale. This premise is no longer true. Some of the major European banks such as Deutsche Bank, BNP Paribas and UniCredit currently conduct more business cross-border than at home. The single market is now weighed down by its own success (Persaud 2008).

Indeed, the single market in banking is falling apart. Following the debacle with the Icelandic banks, Glitnir, Kaupthing and Landsbanki, supervisors want to move to stand-alone subsidiaries – but this will result in significant efficiency losses. Can we save the single banking market in the EU?

“Yes” is the answer I would argue for – if national policymakers can find the courage to give up some of their national sovereignty.

National crisis resolution

This crisis has made clear that national governments are only prepared to use taxpayers’ money to support domestic depositors. A prime example is Iceland providing help to depositors domiciled in Iceland. UK and Dutch depositors were literally left in the cold. Although legally the depositors in the UK and Dutch branches should have been treated on an equal footing with the depositors in the Icelandic parent banks, this was not the case. Similarly, when Fortis was falling down last autumn, the Belgian and Dutch governments each took care of the company's separate national segments.

The logical conclusion would be that cross-border banks should be organised as a string of subsidiaries abroad (Pomerleano 2009). To establish stand alone units, each subsidiary should have its own treasury, risk management models, internal controls and so on. But even then, there is no certainty whether such stand alone subsidiaries could survive the failure of the parent bank or a subsidiary due to reputation risk. One can easily imagine a downward spiral in which supervisors increasingly ask banks to run each subsidiary as a separate banking unit, up to the point where there are no efficiency gains in being part of a wider banking group.

But there is an alternative.

New insight: Financial trilemma suggests a choice

In recent research I outline the financial trilemma, stating that the three objectives of financial stability, financial integration and national financial policies cannot be combined (Schoenmaker 2009).1 One of these objectives has to give. The current combination of financial integration and national financial policies for financial supervision and crisis management has lead to financial instability. To solve the trilemma, supervisors propose to reverse integration by requiring cross-border subsidiaries.

But another solution to the trilemma is to move away from national financial policies and to look for European solutions.

On the supervisory front, finance ministers have taken a small step towards putting financial supervision on a European footing in the recent Economic and Financial Affairs Council meeting of December 2009. The council endorsed the establishment of a European Banking Authority which will work in tandem with a network of national financial supervisors. This is the so-called European System of Financial Supervisors. A crucial element is that an independent chairman will have the power of binding mediation in case two or more national supervisors are in conflict. This independent chairman will have a drive to build and strengthen the role of the European Banking Authority at the centre of the system.

But on the crisis resolution front, finance ministers have disappointed. In particular the UK has been adamant that the European Supervisory System cannot take decisions on crisis resolution with fiscal implications - notably providing capital support to cross-border banks. Such fiscal decisions should stay fully in the realm of national governments (Pauly 2009).

To get out of this conundrum, Charles Goodhart and I have proposed binding burden sharing rules among national governments (Goodhart and Schoenmaker 2009). If a cross-border bank faces difficulties, the governments would share the costs according to some predetermined key – for example, according to the distribution of the troubled bank’s assets over the respective countries. Under such a burden sharing approach, a common solution can be found upfront. By pre-committing to burden sharing, governments would give up some of their sovereignty. But in return, the single market in banking serving Europe’s businesses and consumers would be saved.

Footnotes

1 The classic trilemma in economics relates to monetary policy (see, for example, Obstfeld et al, 2005). It states that the three objectives of a fixed exchange rate,

References

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

Obstfeld, Maurice, Jay Shambaugh and Alan Taylor (2005), “The Trilemma in History: Tradeoffs among Exchange Rates, Monetary Policies, and Capital Mobility”, Review of Economics and Statistics, 87, 423-438.

Pauly, Louis (2008), “Financial Crisis Management in Europe and Beyond”, Contributions to Political Economy, 27, 73-89.

Persaud, Avinash (2008), “The Financial Crisis May Hasten European Integration But Slow Global Banking”, VoxEU.org, 6 October.

Pomerleano, Michael (2009), "A Solution to Financial Instability: Ring-fence Cross-Border Financial Institutions”, VoxEU.org, 7 August.

Schoenmaker, Dirk (2009), “The Trilemma of Financial Stability”, Working Paper, SSRN #1340395.

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Topics:  EU institutions Global crisis

Tags:  EU, global crisis, banking regulation, bank bailouts

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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