The Cinderella of regulatory reform? Why cross-border resolution shouldn’t be neglected

Stijn Claessens interviewed by Viv Davies, 16 July 2010

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<p><em>Viv Davies interviews Stijn Claessens for Vox<br />
<p><em>July 2010<br />
<p><em>Transcription of an VoxEU audio interview []</em></p>
<p><strong>Viv Davies: </strong>Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from CEPR. It's the 13th of July, 2010, and I'm speaking to Stijn Claessens, assistant director in the research department of the IMF and professor of international finance policy at the University of Amsterdam.</p>
<p>We discussed the recently published 12th Geneva Report on the World Economy, which Professor Claessens authored with Professor Richard Herring and Dirk Schoenmaker.<br />
The report is titled &quot;A Safer World Financial System: Improving the Resolution of Systemic Institutions.&quot; I began by asking Stijn to explain why cross border resolution is so important yet, at the same time, is such a neglected part of banking regulatory policy and financial stability more generally.</p>
<p><strong>Professor Stijn Claessens: </strong>Well, we were asked by Charles Wyplosz, who is the originator of this report, to look at supervision of international financial institutions. And quickly, when we put together the team, we realized that, really, we had to start from the end game. And in many ways, this is similar to what Raghuram Rajan, last week, in his interview, also at Vox, stressed. You have to think about incentives. And incentives drive a lot in economics in general, but I think, in the financial sector, even more so.<br />
And when we think about incentives, we have to think about the number of players involved in the financial sector. So we have the institutions themselves, which, of course, have their owners and their managers and their creditors. But it's also about the regulators and supervisors. And if you think about these incentives that they face, of course, it's about the money for the financial institutions and the creditors. And they like to know, in the end, if there were to be a problem, what is the end game, what are the potential haircuts that they might be facing, the losses that they might be facing, the managers, whether they might be changed or not.</p>
<p>Applying the same kind of thinking to the regulators and supervisors, we have the same incentive problems. Regulators will collaborate with each other and this is on the cross border side if they have some joint interest at stake. And I always found it very interesting that, in spite of the many agreements that have been signed among regulators, in the end, in the crisis itself, there was very little use made of these agreements. These so called &quot;memorandums of understandings&quot; were pretty much thrown in the wastebasket. And they also say that, formally, there's no legal binding concept to it.</p>
<p>So the incentives are very important. And a lot of it is dictated by the end game: where might you end up in this important state of the world? And besides the two parties, the institutions and the regulators, the system as a whole also needs clarity.</p>
<p>We saw it very much in the crisis, when people just didn't know where the system was going, and that created a lot of turmoil in the fall of 2008. And to some extent, we see a little bit of that in the European context today. In the Euro context, not knowing exactly where this is and this is going to go, creates turmoil.</p>
<p>So, working back from that, we realize that the end game is very important to address, but it hadn't been addressed at all in the international context. And that's important, because cross border financial institutions and the reports make it very clear, through the looking at the 30 largest institutions around the world are very international these days. They have more than half of their assets abroad. They have many, many subsidiaries abroad. They operate in many countries around the world. And as a consequence, the end game has to be designed across all countries, in a consistent manner.</p>
<p>And unfortunately, for a variety of reasons, that hasn't been done yet. Although the Basel Committee has acknowledged this problem for some time, they haven't been able to get a consensus on it. They have just come up with a working group on it, with a report, and other parties are involved as well. But we did feel that the conceptual and empirical basis for some of that was not full yet, so we hope to contribute to that debate through this report.</p>
<p><strong>Viv: </strong>OK. The report identifies what you refer to as a &quot;trilemma&quot; of preserving national regulatory authority, fostering cross border financial integration, and maintaining global financial stability. Could you explain a bit more about what you mean by this?</p>
<p><strong>Stijn: </strong>Well, because national authorities have, really, a tendency to focus on their national domestic financial system. And that's perfectly understandable, because they are mandated by national agencies, by national laws, by taxpayers to look at the national interest foremost. So when it comes down to potential failure of large financial institutions that cross many borders, they tend to ignore the wider aspects. They tend to ignore the global dimensions, or the externalities, so to speak.</p>
<p>And that means that you basically end up with a coordination failure. And the people that modeled this in a very rigorous way, took their crack at some others, of how you can get this kind of prisoner's dilemma where the national authority, each of which is looking at their own interests, don't re capitalize or support an institution that is sufficiently at risk. As a consequence, the overall interests are suffering.</p>
<p>We call this a financial &quot;trilemma,&quot; in the sense that there's a conflict between three policy objectives. On one hand, you want to preserve national autonomy, so sovereignty in the fiscal or monetary sense. At the same time, you do want to foster cross border banking because we realize the gains from an integrated financial system. And you want to maintain global financial stability. Those three objectives are not consistent unless you give up on one or the other, and it's very similar to the &quot;trilemma&quot; that we know in open market economy of monetary policy, action grades, and fiscal independence. Similarly, we have a &quot;trilemma&quot; here.</p>
<p>So, what it means is you have to give up on one of those. Our countries haven't done that always. And as we saw in the crisis very much, both in a general sense, and that's referring back to this problem of the large turmoil and the uncertainty, if we go back to the crisis, the governments had to come in at the last minute with massive amounts of support--amounting, according to Andrew Haldane and a number of others, to about 25 percent of world GDP in contingent liabilities--was put on the table to save these cross border banks.</p>
<p>That was a last minute resort to prevent complete collapse. But what it showed is that we hadn't thought through how to deal with these institutions beforehand. In the report, we go through a number of individual cases that illustrate this more general problem. So we discuss the failure of Fortis, which was a coordination failure between the Dutch and the Belgian governments where, in the end, the solution was pretty much along national lines. I think there would have been a better solution out there that would have saved some more growing concerned value for the entity and prevented some turmoil.</p>
<p>We look at other cases. Iceland has a number of banks that went into trouble, of course, but had repercussions for the Netherlands and the UK. And that was a clear case in which it really became everybody put their own solution, trying to preserve assets in the UK that were of the Icelandic banks.</p>
<p>But these problems are severe and they're real. And Lehman is really the one that broke the system, where not having a good cross border resolution framework created a lot of turmoil, as we know, in the fall of 2008.</p>
<p>And it really was in that one weekend where we realized that, between the UK and the US, with otherwise very integrated financial systems with a lot of huge capital flows, we lacked the legal system, the institutional system, to deal with the failure--which at that point was still not a very large institution, Lehman was not a major player--but nevertheless created enough havoc to let all these other turmoils.</p>
<p>Having said that, the paper also looks at a number of cases, where we've had more success and more cooperative solutions. Dexia between Belgium, France, and Luxemburg was a more favorable outcome. We've had the operations of a number of Western banks in Eastern and Central Europe that were dealt with in a fairly cooperative and coordinated fashion. So, it doesn't always have to be a problem.</p>
<p>But, I think what the report is saying is that we don't want to face the turmoil that we have seen before. Particularly, what we don't want to have is a situation that these large institutions, these large systemic importantly connected institutions cannot bank on the state, so to speak. They take risks. They have become very complicated and complex, when it is subsidiaries. As a consequence, they've become too complicated to unwind, to break down and to preserve in a reasonable fashion.</p>
<p>There's nothing left but for governments to come in and bail them out, so to speak, in a large amount. So, we need to have these solutions addressed beforehand, and that's what the report tries to contribute to.</p>
<p><strong>Viv: </strong>I can imagine that countries that already somewhat integrated financially, such as the Eurozone countries, for example, they find this level of cooperation relatively easier than countries that are less integrated with others. Do you think, in this respect, that all countries should be adopting the same or similar solutions?</p>
<p><strong>Stijn: </strong>The report doesn't have an it would be pretentious to say so precise solutions for specific countries. But, it does sketch out what kinds of solutions are consistent, and that goes back to the trilemma, that gives us a conceptual framework the case studies back it up as to what are approaches that can work for a country or a group of countries in a consistent manner.</p>
<p>So, it is really that we go through what we call a territorial approach. Second is the universal approach, and the last one is a modified universal approach. The first one, the territorial approach we were short on, because the territorial approach, as the name suggests, really means that you end up with a closed system, in which you only support your local institutions. You require to have them local capital or local liquidity and the like. That way, you preserve, of course, national sovereignty and authority, but you are impeding cross-border banking.</p>
<p>In my mind, what we do is, in some sense, go back to models, before the European integrated markets or before the US deregulated its regulated system, some 30 years ago, where you had union banking systems: very localized systems, very limited risk sharing, very limited economies of scale and scope, across regions or countries.</p>
<p>I don't think we want to go that way for a number of reasons. For that reason, the report rejects the territorial approach. It also acknowledges, however, the other extreme of this spectrum is the universal approach. It's probably not applicable to many countries either. The universal approach means that you pool all assets, for when a bank runs into trouble in case of a bankruptcy or restructuring, into a single [inaudible], from which you, then, reimburse the creditors and others. That, in the legal construct, is a very extreme situation of having universality. It can be applied in different ways. But, nevertheless, the bottom line of that approach is that you need a very integrated market to begin with.</p>
<p>We think the European Union is close to that and any of the discussions in Brussels as well as the PCB and elsewhere are pointing to what is a version of the final model, that would be a model with a single integrated supervisor, maybe with a bank restructuring agency. It would also be a model on which the burden sharing to the extent that it is necessary for the resolution, the unwinding a big institution, would have to be shared among many countries, the countries participating.</p>
<p>That is probably the most difficult of all considerations, but, at the same time, the European Union wants to integrate. That's the single market program. It doesn't want to go back on that. So, we think there's a lot of potential for the universal approach within the European context. For other countries, we tend to be a little bit more agnostic in some sense and saying, &quot;Well, it's too much to ask them to integrate completely also on the fiscal side of the burden sharing&quot;.</p>
<p>It's probably not going to be done. So, we propose to modify the universal approach, where we start really from the national level, in terms of resolution approaches.<br />
We really stress that many countries can improve their resolution mechanisms, having better legal systems in place, better information in place, better tools for addressing large institutions. Important among those, we considered so called contingent capital: capital that becomes effective--I think Raghu talked about last week in his interview of how you can help the market work together with the regulators to create triggers that soften the blow if there is a shock to the system so that its capital becomes more easily available or even automatically.</p>
<p>We think that's an important component. Another important component is more rules-balanced regulations, where there's less forbearance, less willingness of the regulators to see how it goes, with more requirement on the regulators to intervene, at an early point in time in an institution to mitigate any kind of final problems.</p>
<p>So, working at the national level, it is important, in this modified universal approach. But, beyond that, we think, at the international level, there can be clear responsibility in the assignments of who takes care, in case of a cross-border problem.</p>
<p>If you go back to the international agreements, the one that is most relevant is the Basel Agreement on home host's supervisions, which sets out the responsibilities, for who takes care of supervision of a subsidiary abroad and a branch in certain countries.</p>
<p>That home host principle has worked quite well, but it has never really addressed resolution, who would, in the end, be responsible if there were to be a problem and who would have to, in some instances, pay for it.</p>
<p>So, what we propose is a concordat it has been proposed by others as well that would assign responsibilities explicitly to the home or host supervisor, put in place sanctions for if either party does not live up to its responsibility. And in that way, clarify where the responsibility lie, and, in that way, create more incentives for collaboration among supervisors. In the end, if you have shared resources, money at stake, so to speak, I think you will be more generally interested in collaborating among each other.</p>
<p>So, that concordat is the last piece of it. It can be complimented by many things that, again, that are on the way. There are a lot of discussions and actions in terms of better supervising these large institutions: the so called colleges of supervisors, which have been put together, between countries, monetary reliable institutions.</p>
<p>There have been a lot of talk about so called resolution plans or sometimes called living wills, where institutions are being asked to tell the regulator 'how can you unwind yourself, in case you run into trouble'.</p>
<p>Combined with this concordat, I think we have a good chance for those countries that are not willing to completely integrate, not willing to go for the universal approach, but to, nevertheless, improve the system and reduce the stress that we have seen in the past to actually...</p>
<p><strong>Viv: </strong>The new concordat that you refer to, does this suggest a transfer of powers that will require a more centralized authority? If so, do you think it's realistic to expect countries to accept something that they may consider to be politically contentious?</p>
<p><strong>Stijn: </strong>That is a deep question. I agree that many of these questions go back to the political question as to whether you are willing to transfer in some degree sovereignty. Like I said, at the European level, the question is being faced today with more on the pure sovereign side, as to how you deal with countries like Greece and others that are facing fiscal difficulties.</p>
<p>I think we have to face that same question on the banking side, if you want to prevent a system going forward the same way. I think that the concordat is a slightly lighter form of it, and it works more with sticks and carrots.</p>
<p>So, countries can sign up for it. If they don't end up participating, then the other party has the ability to start taking measures like preventing that country from expanding into the other country or imposing certain limits on the operations of the banks that operate in the other country. On that basis, there is more of a stick and carrot approach that I think can be quite successful.</p>
<p><strong>Viv: </strong>I wonder if you considered the concept of recovery, as opposed to resolution. Does that feature at all in your work? I mean, recovery in the sense of what you do before you get to the end game.</p>
<p><strong>Stijn: </strong>Very much so. So, anything you can do to prevent getting to the end game is obviously better, because the value lost in the end game grows concerned value, so to speak. The more that we can do to prevent and also importantly the more we can do to incentivize parties to limit their risky behavior that got us to that point. So, this goes back to the incentives on both bank managers, owners, creditors, as well as supervisors, so that they are better able to and willing to intervene at an earlier stage.</p>
<p>The contingent capital is an important component of that, but it's not the only one that we do. Then, if it were, nevertheless, to come to that phase, the recovery can be facilitated a lot if the institution simplifies their operations. One of the issues that we stress in the report is how many of these large institutions have legal structures that don't correspond to business structures. An example is you operate in one country as a bank, but the treasury is in another country. So, legally, you're separated or importantly, for its information, a lot of the IP structure resides, often centralized, but is used by many of the subsidiaries around the world.</p>
<p>Untangling that information flow, in the bankruptcy, as we have seen in the case of Lehman is a nightmare. Even today, people saying it can take another 10 years before we can finally settle some of the aspects of Lehman, because the information has to be released by the parties may be bankrupt or they may be operating solvently where they are not able or willing to legally share that information back to the bankruptcy estate.</p>
<p>So, these are things that can be done to simplify, in the early stage and to facilitate in the recovery, if it were to come to the end game.</p>
<p><strong>Viv: </strong>I wonder to what extent your ideas in the report align with current thinking amongst the financial stability boards. Are they heading in the same direction?</p>
<p><strong>Stijn: </strong>The most closely work is with the Basel Group on cross border resolution, which came out with a report in 2010. They very much stressed the need to improve the international resolution regimes, and they are coming up with recommendations as to what that would entail. We have seen progress there. In the UK, we had a special resolution regime adopted following the Northern Rock problems. In the US, there's legislation in progress now that will improve resolution.</p>
<p>In some other countries, it's a little slower. We would like to see more progress. I think. Nevertheless, for the FSB has been one of the core recommendations of going forward.<br />
On the cross border side per se, the trilemma has held them back as well, because they realized the cross border sharing of fiscal resources in case of crisis, the cross border financing of resolution is a very difficult and charged issue. That's something that the FSB has to track more carefully.</p>
<p><strong>Viv: </strong>Thanks. Stijn, before we wrap up, I was wondering if you could just explain what are the costs of not addressing this issue of improving the resolution of SIFIs?</p>
<p><strong>Stijn: </strong>It's hard with any of these questions to be too definitive. In part, since it is hypothetical or at least I hope that we don't have to answer, if you don't address this issue. But, it's most importantly, because it's difficult to answer. Because we lack good empirical facts, analytical tools from many financial sector issues, including on this one. So, I have some trepidation and quite a bit of caveat as to how to answer this. But, now that I think conceptually, I would think of three types of costs.</p>
<p>One, for the financial institutions themselves, they do operate in a complex way, in part for the wrong reasons, we would argue they are too complex to fail is an incentive for them to become more complex. But, I think also sometimes they react to different regulatory structures, including the cross border part. They organize, in that sense, themselves inefficiently and, perhaps, operate more costly. It's a hidden cost that translates into higher spreads and margins and what have you, but it's inconsistent with the concept of an integrated financial market.</p>
<p>Regional approaches like in the European Union would elsewhere really try to minimize this to begin with. So, I think that's one cost, if we don't address this issue. Second in the report is very strong on the end game in many ways. But, one of the end games that it also highlights is that if you don't have the cross border resolution worked out, the incentives for supervisors to collaborate are simply not there, in the next crisis.</p>
<p>They won't share information, for example, beforehand. We saw that in the crisis as well. It's very understandable on one hand. I mean. If an institution has an operation in my country that I see is becoming weaker, what my incentives will be is to withhold information from the other party. Information is power. Information in this case is really money. By withholding information I may be requiring, actually, my local subsidiary to have more capital, more liquidity, I strengthen my own local operation, but I weakened the rest of the system. I end up with a worse solution, but it's a very logical one, if you don't have a common burden sharing, common cross border framework. So I see that as a big cost as well, going forward on the incentive side.</p>
<p>Thirdly, I call this a political economy cost, in the sense we would like to have integrated financial market. We have seen many of the gains from that around the world. I'm fearful that following the crisis we've already seen quite a bit more national pressures. We've seen, obviously, quite a lot of interventions by national governments in institutions, but sometimes the tendency of politicians to say, &quot;Let's make sure the money is used only for local purposes and for local taxpayers et cetera.&rdquo; This is understandable.</p>
<p>Since that pressure is there, if we don't tackle it now, through better cross border resolution, I'm afraid that we might actually increase that pressure and come up with more nationalized systems. So, differently, we would have the tendency for a supervisor to look after its own local interests, look at its own regulations and not create a global system that works for everybody.</p>
<p>So, that's a big problem for the financial sector: a lot of vested interests to begin with. So, we would want to prevent this kind of dynamics from going forward.</p>
<p><strong>Viv: </strong>Stijn, thanks very much for taking the time to talk to us today. It's been a pleasure.</p>
<p><strong>Stijn: </strong>You're very welcome. Thank you.</p>

Topics:  Global crisis Global economy

Tags:  Cross-Border Bank Resolution, SIFIs

The 12th Geneva Report on the Word Economy, ‘A Safer World Financial System: Improving the Resolution of Systemic Institutions’, is available through the CEPR website.

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


CEPR Policy Research