A safer world financial system: Improving the resolution of systemic institutions

Stijn Claessens, Richard Herring, Dirk Schoenmaker 08 July 2010

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Financial reform legislation is finally being put in place in the US and EU in response to the 2007-2009 global financial crisis. Much is riding on these reforms: fostering more robust yet profitable financial systems, preventing a repeat of the biggest crisis since the Great Depression, and supporting efficient financial intermediation that helps economies grow. A crucial dimension of the reforms is how to deal with large cross-border financial institutions when they run into trouble.

This has been a long-standing but much neglected issue. After 26 years of negotiations aimed at harmonising international bank supervision and regulation, the Basel Committee on Banking Supervision has only recently turned its attention to harmonisation of the resolution of cross-border banks (Basel Committee, 2010). And even then it has been a slow haul. While taken up by the G20 at their London and Pittsburgh summits, the recent Toronto communiqué accorded the topic low priority. So far only the UK and, quite recently, the US (with the not-yet-passed Dodd-Frank bill) have taken the issue seriously.

The twelfth Geneva Report argues that, rather than being an afterthought, resolution of cross-border systemically important (i.e., "too big to fail") financial institutions should be the centrepiece of any serious reform of the international financial system. It shows how essential it is to integrate capital regulation, supervision, and resolution policies to minimise failures and reduce international spillovers should they, nonetheless, occur.

The need to integrate resolution becomes obvious once one considers the endgames for both financial institutions and regulators. As we have seen (too often) recently, financial institutions that encounter serious difficulties may need to be liquidated, closed, broken up, sold, or recapitalised. The allocation of responsibilities and costs in this resolution stage will have a strong impact on incentives and behaviour of both financial institutions and regulators long before difficulties arise. As a consequence, regulating financial institutions is much more difficult in the absence of an effective resolution framework for systemically important financial institutions.

Increased financial integration, but with increased complexity

Designing such a resolution framework at the national level is no easy matter, but the difficulties multiply across borders. And the international dimension is important.

  • On average, the thirty largest systemically important institutions have 53% of their assets abroad, with European ones being especially international (Figure 1).
  • Many are very complex. On average, the top 30 systemically important institutions have close to 1000 subsidiaries, of which 68% operate abroad and 12% in offshore financial centres. These institutions have not only complex corporate structures but also complex business structures that seldom correspond to their legal structures.

Figure 1. Average percentage of foreign assets

This complexity makes many of these institutions difficult to manage; it can also cause them to have systemic consequences. While there are other channels, such as financial markets and critical market infrastructures, this relatively small group of institutions appeared to have been an important channel for cross-border contagion in the 2007-2009 financial crisis.

Importantly, a systemically important financial institution can be very difficult to resolve and thus be "too complex to fail". Many argue that if one of these institutions which are deeply involved in a wide range of countries were permitted to fail, repercussions would affect financial systems and national economies around the world. The internationalisation of finance has thus projected the "too complex to fail" problem onto a global setting.

In this context, the question of resolving – i.e., restructuring, winding down or liquidating – such an institution is of crucial importance for the global financial system to be made safer. Indeed, during the recent financial crisis, advanced economies had to provide extensive support to their financial sectors, with contingent liabilities adding up to some 25% of GDP, to stave off financial collapse.

The ‘financial trilemma’

National authorities have a natural inclination to focus on their domestic financial system (national externalities) when dealing with the failure of a systemically important financial institution. They tend to ignore the wider impact on the global financial system, i.e. the cross-border externalities. Theory and practice suggest that the dominance of the national perspective arises for two reasons.

  • First, the direct costs of resolution have been borne by domestic taxpayers.
  • Second, insolvencies and bankruptcies are dealt with by national courts and resolution agencies derive their powers from national legislation.

This combination means that the resolution of cross-border banks can produce coordination failures – a situation where each national authority mainly looks after its own national interest with little emphasis on the global interest.

In the report, we summarised this situation as a "financial trilemma"; the three policy objectives – preserving national autonomy, fostering cross-border banking, and maintaining global financial stability – are not always mutually consistent. Solutions to the trilemma are to be found in giving up some fiscal and legal sovereignty, or putting restrictions on cross-border banking in the event of crises.

The theoretical possibility of coordination failure is borne out in practice. For example, our report shows that the events surrounding the failures of Fortis, Lehman, and the Icelandic banks illustrate how damaging the absence of an adequate cross-border resolution framework can be for the stability of the global banking system. This lack of coordination undermines confidence in the international financial system and increases the costs borne by domestic taxpayers. By contrast, authorities reached a cooperative solution in the restructuring of Dexia and facilitated the continuation of Western bank operations in Central and Eastern Europe. In still other cases, (AIG and Citibank, Bank of America as well as RBS) a single country provided massive subsidies to avoid both domestic and international spillovers.

The need for better national resolution frameworks for systemic institutions

A better framework needs to start with effective market discipline and sound national supervisory and resolution procedures – elements that many countries lack. Our Report recommends starting with a reinforcement of market discipline using two new mechanisms to prevent insolvency from happening in the first place.

  • Each systemically important institution should have contingent capital – triggered by market indicators – that would automatically recapitalise in the event of difficulties.
  • If the institution’s condition continues to worsen, it needs to be subject to prompt corrective action measures. This should strengthen the incentives for the owners and managers to find a private solution to the problems. Coordination, even when it is possible, is costly so it is important to take all possible measures to avoid the necessity of resolving such an institution.

If the institution still hits regulatory insolvency (which must be substantially above zero economic net worth), then it has to be subject to resolution. The ideal system begins with a competent supervisory authority that has access to a wide range of information, some of it derived from so-called resolution plans, sometimes called ‘living wills’. The resolution plan should ensure that systemically important institutions can be dismantled without interrupting the provision of any systemically important services or creating any other major spillovers. A robust national resolution system needs to minimise the probability that failure of a systemically important institution threaten broader financial stability. Finally, the legal system must assure that the costs of failure fall only on shareholders and creditors who have been paid to take these risks.

Cross-border resolution: A comprehensive and consistent response

While effective internationally harmonised resolution policies can lay the groundwork, they will not avoid all failures of cross-border financial institutions. There will still be coordination problems related to the financial trilemma. Our Report analyses three reform models for solving the trilemma. Public attention is largely focused on the first two options, but they represent either end of a spectrum, and none of them can work effectively as a general principle.

  • The first is a universal approach under which all global assets are shared equitably among creditors according to the legal priorities of the home country.

This approach – which is most relevant for single entities (e.g., home bank and its branches) – can be combined with agreements for burden sharing among countries. Those burden-sharing agreements can strengthen the incentives for coordination in resolution and supervision. In this model, the financial trilemma is solved by a partial pooling of national autonomy. This universal approach is most suited for closely integrated countries, such as those in the EU.

  • The second is a territorial approach under which assets are ring-fenced so that they are first available for resolution of local claims.

There is no need for burden sharing or coordination, as each country manages the resolution of its own part of the cross-border group and passes on any excess assets to the central liquidator. This approach creates inefficiencies for managing an integrated international financial institution and undermines the fundamental assumption of the Basel agreements that rely on the assumption of consolidation. If all countries practice ring-fencing, an international financial institution has to manage capital and liquidity separately in each country. In terms of the financial trilemma, this solution eliminates the problem by restricting cross-border integration, but in essence, it means de-globalisation of financial integration. Our Report rejects this general approach (but it urges that countries that nevertheless intend to practice ring-fencing to state their intentions clearly, before a crisis arises).

  • The third reform model is a modified universal approach, an intermediate approach to tackling the financial trilemma.

The modified universal approach implies countries adopt improved and converged resolution rules and require systemically important financial institutions to have better resolution plans. Under this model, national authors agree to expand the principles for international supervision and adopt an enhanced set of rules governing cross-border resolutions while not giving up national sovereignty. Basically it means ex ante preparations for ex post burden sharing – something like a new Concordat1–complemented by much more heavy reliance on market-based incentives and resolution plans that are tested by international colleges of supervisory and resolution authorities formed for each institutions.

For all approaches, the report stresses the need for a new paradigm in international policy coordination. The recent financial crisis has shown that:

  • Ex ante there was too much deference and too little willingness to challenge others’ supervisory efforts;
  • Ex post there was too little international cooperation.

The reform model should move from one in which national authorities may cooperate in international supervision and resolution, as reflected in the current harmonisation model, to one where national authorities must cooperate, because they have joint interests at stake.

References

BIS (1983). “Principles for the supervision of banks’ foreign establishments”, BIS, May.

Basel Committee on Banking Supervision (2010), Report and Recommendations of the Cross-Border Resolution Group, March, Basel.

Claessens, S, R.J. Herring and D. Schoenmaker (2010), A Safer World Financial System: Improving the Resolution of Systemic Institutions, 12th Geneva Report on the World Economy, International Centre for Monetary and Banking Studies, Geneva, and CEPR.

Group of Twenty, (2009), “Declaration on Strengthening the Financial System,” Issued by the U.K. Chair of the London G-20 Summit, 2 April.

Group of Twenty, (2009), “Progress Report on the Action to Promote Financial Regulatory Reform,” Issued by the US Chair of the Pittsburgh G-20 Summit, 25 September.

Group of Twenty, (2010), “The G-20 Toronto Summit Declaration,” Issued by the Canadian Chair of the Toronto G-20 Summit, 27 June.


1 This was an agreement, overseen by the BIS, which governed the supervision of banks' foreign establishments by parent and host authorities. See, for example, BIS (1983).

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Topics:  Financial markets International finance

Tags:  financial regulation, global crisis, too-big-to-fail

Head of Financial Stability Policy and Deputy Head of Monetary and Economic Department, Bank for International Settlements, and CEPR Research Fellow.

Jacob Safra Professor of International Banking and Professor of Finance at The Wharton School, University of Pennsylvania

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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