Stefan Ingves: Cross-border banking regulation - a way forward: the European
case
Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank, at the Conference on International
Financial Instability: Cross-Border Banking and National Regulation, Federal Reserve Bank of
Chicago, Chicago, 16 October 2006.
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Introduction
It is an honor for me to address this distinguished audience on a very timely topic. I have spent many
years dealing with distressed banks in my own and by now a large number of other countries. One
conclusion I have drawn from this rather odd line of work is that efficient banking regulation is needed
both to reduce the risk that banks run into problems and to minimize the externalities that arise if
banks actually fail. At the national level, many countries - including my own - still need to implement
regulations to ensure that these risks are fully mitigated.
Let me also take this opportunity to congratulate the organizers on their choice of subject for this
conference. The importance of the international dimension of the regulatory set-up is growing steadily.
It is only now that many banks are becoming truly cross-border, with substantial retail activities in
several countries. At the same time banking regulation, in terms of supervision, oversight, deposit
guarantee schemes and responsibility for financial stability, remains predominantly national. This
imposes additional challenges for financial regulators. These challenges are particularly acute in
Europe given the rapid growth of cross-border banks on that continent. However, the issues raised are
of global concern.
With this in mind, let me start out by stating my main message but before doing so let me stress that
these are my personal views and do not represent the official opinion of any institution. In my view we
need to plan for a special body - let us call it a European Organization for Financial Supervision
(EOFS) - to gather information and produce a coherent and consistent assessment of the risks in the
major cross-border banks in Europe.
As you all know, a separate regulatory framework for banks is based both on consumer protection
arguments and on financial stability considerations. Banks provide fundamental services to the
economy but could be subject to bank runs. There are also large contagion risks in banking activities
so that problems in one bank could easily spread to other banks. Here, I will concentrate on the
financial stability perspective.
Banking developments in the EU
Until not so long ago, most banks had a clear national (or local) character with most of the activities
limited to one country. Sure, many banks have had international operations for many decades but that
has typically been limited to wholesale markets and services to large corporations. Financial services
to retail customers and small and medium sized companies (SMEs) have been provided on a national
or local basis. In this setting the national character of the regulatory framework has been appropriate.
Now this is rapidly changing, especially in Europe - but also elsewhere.
First, banks in different countries are increasingly merging and creating some genuinely cross-border
banking groups, targeting retail customers and SMEs in several countries. There are now about 40
banking groups with substantial activities in more than three countries in Europe. Just to take few
examples: Unicredit Group has, after the merger with Germany's HypoVereinsbank, a market share of
at least 5 percent (in terms of total assets) in Italy, Germany, Austria, Bulgaria, the Czech Republic,
Hungary, Poland, Luxembourg, Slovenia as well as Slovakia. Barclays and Grupo Santander are
major players in both Spain and the UK. Fortis and ING are both important in the Benelux region.
Erste Bank is large in Austria, the Czech Republic, Slovakia and Hungary; KBC in Belgium and a
number of eastern European countries. Nordea is central to the banking market in Sweden, Denmark,
Finland and Norway.
Second, banks are increasingly dependent on the international financial markets for funding, risk
management etc. The inter-linkages and contagion risk between banks are probably increasing even
for the banks that stick to a purely national focus.
Third, many of the cross-border banks are progressively concentrating various functions, such as
funding, liquidity management, risk management, internal controls, compliance, credit
decisionmaking, auditing etc, to various centers of competence. As a consequence cross-border linkages are
rising.
Fourth, with the increased cross-border specialization, the distinction between a branch and a
subsidiary is becoming increasingly blurred. Subsidiaries are becoming less self-contained. If the
parent bank of a cross-border banking group defaults, it is getting more and more unrealistic to
assume that the foreign subsidiaries could continue their business as usual. It would take time to
establish all the necessary competence to transform such a subsidiary to an independent bank. Also,
the possibilities for the host country to successfully ring-fence the assets is diminishing given the
speed at which funds can be transferred across borders. When there still is a clear legal difference
between branches and subsidiaries with clear consequences for supervision, the distinction becomes
less important both in practical and in economic terms.
Fifth, and as a consequence of this merger activity, the banking market in some countries is
dominated by foreign banks. In the ten new EU member states, about 70 per cent of the banking
sectors are foreign owned. In Estonia, foreign groups account for more than 90 per cent of all lending.
My worry is that the next financial crisis in Europe could have serious cross-border implications and
not be bounded by national borders. As a central banker, I see it as a major responsibility to be
prepared for such an event, both in terms of handling the acute problem and in finding more long-term
solutions.
One reason why this cross-border development is more pronounced in Europe than in many other
parts of the world is the long-term project of creating a single market for financial services in Europe.
Let me be clear here. I strongly support this project. It has freed banking from its national restrictions
and fostered a more efficient financial sector. It has created an environment to support higher
economic growth. Cross-border banking should not be seen as an economic problem but rather a
challenge for the regulators and supervisors. The problem is that the regulatory framework for
ensuring financial stability has not adapted as quickly and as thoroughly as needed.
Let me stress that historically, regulatory and supervisory convergence across borders has taken time.
It cannot be expected that the optimal regulatory set-up will emerge immediate when market
conditions change. The single market for financial services in Europe has definitely changed the
market environment for financial firms. Now it is up the regulators to do their bit.
Regulatory challenges
The question is then how the regulatory and supervisory framework could be adapted to face up to a
situation where some banks play important roles in providing banking services in several countries.
Let me - for the sake of argument - assume that a problem occurs in a major cross-border bank under
the present framework in Europe. Apart from the challenges to solve a problem in a purely national
bank it becomes both more important and more complicated to address such a crisis. There are a
number of challenges.
The first challenge concerns the sharing of relevant information. For a cross-border banking group the
number of authorities involved multiplies. As a consequence information sharing may be slowed down.
Also, compared to purely national banks, many cross-border banking groups have a more complex
structure. This makes the analysis and information gathering more difficult. The functional
specialization of cross-border banks also complicates supervision and information gathering. If a
cross-border banking group concentrates all its credit assessments in one country it will be difficult for
the supervisor in another country to assess the risk of the bank in that country without efficient
supervisory cooperation and exchange of information. Further, if the bank puts all its liquidity
management in a third country, extensive information sharing will be needed in order for any
supervisor to get the full picture of the group's total risks. In principle the parent bank - and therefore
the parent bank's supervisor - should have a full overview but in a crisis, positions may change quickly
and thus complicate the collection of all relevant information. Such extensive information sharing
becomes acute in a crisis but is also necessary in the day-to-day supervision.
A second challenge is that conflicts of interest multiply. Banking problems can be very costly and the
ultimate guarantee for financial stability can only be given by the government, since only the
government has the power to tax. In most countries the deposit guarantee schemes are only able to
finance the problem if it is confined to minor banks. For systemic problems, the government would
have to intervene. With predominantly national banks, how this is done is fairly straight-forward.
With the emergence of truly cross-border banks the question is how to share the burden. To what
extent would the taxpayers in one country be willing to support the depositors in another country? And
to what extent would the depositors in the second country be willing to rely on the potential future
support of the taxpayers in the first country?
A similar problem applies when a central bank considers providing emergency liquidity assistance to a
cross-border bank. Such funding is inherently risky. If not, the market would typically be able to
provide the funding. Such assistance is also likely to affect the entire banking group. What happens if
a bank is systemically important in one smaller country but not in another perhaps larger country? The
smaller country will probably have greater incentive to save the bank but may end up paying for the
entire group, if the larger country refuses.
Also, there are conflicts of interest if the bank is reconstructed. Any such reconstruction is risky and it
is therefore uncertain whether the taxpayers would be willing to take these risks in another country.
A third challenge is how to achieve joint assessments. In Europe, there is an agreement to share
views and assessments if there is a crisis. However in my opinion, that is not sufficient. In a crisis,
most countries are likely to present assessments that support their national interests. With the present
supervisory set-up, there is unfortunately a risk that it will be time-consuming to achieve joint
assessments, and time is a scarce resource, especially in crisis management.
A fourth challenge is how to coordinate decisions by the authorities. The central bank must decide
whether to grant emergency liquidity assistance or not and occasionally a bank may have to be placed
under public administration. All of these decisions have to be made at short notice and typically with
limited information. For this to be effective there is a need for a clear line of command. For
crossborder banks where many supervisors, many central banks and many ministries of finance are
involved, this is complicated to achieve. Without prior agreements on responsibilities this is going to be
even more complicated, and may very well lead to suboptimal solutions.
The potential inefficiencies are probably enhanced by the differences in language and legal structure.
The problem is further inflated by the inter-dependencies between the different countries. The
decisions by one authority will typically have repercussions in many other countries.
To alleviate these problems there are today many MoUs between the authorities in the different
countries - both regional and on an EU basis. Such MoUs are important to foster cooperation and
information sharing but are, in my view, not sufficient. They are not legally binding and address neither
the need for joint assessments nor the underlying conflicts of interest. Instead they should be seen as
an important first step in facilitating the handling of cross-border institutions. However we need to go
further.
Potential solutions
To address these challenges four potential solutions have been discussed in various fora.
The first is to establish supervisory colleges. The idea is to create specific standing committees for
each individual cross-border banking group with representatives from the relevant supervisors. The
recently proposed operational networks of the Committee of European Banking Supervisors (CEBS)
can be seen as a first step in this direction. This is a good start but also generates a series of
problems. The supervisory framework becomes very complex and scattered. Which supervisors
should be part of which college? It could also undermine the likelihood of equal treatment among
banks.
The second is to enhance the home country's responsibility, by giving the home supervisor additional
powers not only for the group but also for all its foreign subsidiaries. One agency would thus get the
responsibility for assembling information, formulating a joint assessment and coordinating decisions
for all subsidiaries as well as the group level. A general problem with this solution is that it does not
address the conflicts of interest. Will the home country authorities take the situation in the host
countries fully into account in their decisions? How will host countries that do not share the
assessment or disagree with the decision act? Also, will the authorities in a host country be willing to
delegate such responsibilities to an authority in another country?
A third proposed solution is an extension of the second alternative. In addition, the home country will
get an explicit EU-mandate to take the interest of the other relevant countries into account in its
assessments and decisions but it is not clear how this will work in practice. There is also an
accountability problem with this solution. National authorities are both appointed by and accountable
to the national governments and in extension to the national electorate. It may be difficult for a host
country to hold the authorities in a home country responsible for a specific decision, even if its main
effect is in the host country.
A fourth possibility is the pan-European solution where both the mandate and responsibility for
supervision are transferred from the national level to the EU-level. This would imply the creation of a
European FSA, as well as granting the ECB a role as Lender of Last Resort for cross-border banks.
This solution raises a number of difficult political considerations. It basically means handing over a part
of the sovereignty to the EU-level. Also, at present the EU has no supra-national taxing power, so
some other formula on burden sharing would have to be found. Presumably the political obstacles for
this solution are large. At least in the short run, this fourth solution is not realistic.
Another approach
With this background, I draw three conclusions. First, the present situation with a growth of
crossborder banks - with some clear examples in the European region - combined with national
responsibility for supervision and financial stability is not satisfactory. If we are hit by a critical crisis in
one or more of the major financial institutions today, the regulatory and supervisory framework is not
sufficient. Second, we need to move forward and find a modified framework before problems arise. My
experience is that if a crisis hits an unprepared authority, the choice of solution will suffer. Third, we
should move ahead gradually, since there are obvious political difficulties and it is uncertain what the
first-best solution would look like. In a political world, it is difficult to achieve first-best directly. Instead
we have to move stepwise and ensure that we have our compass firmly in our hands to ensure a
move in the right direction.
To solve some of the problems of coordination of information and assessments, I propose the
establishment a new pan-European body, a European Organization for Financial Supervision (EOFS).
The idea is to create a separate agency to follow the major cross-border banking groups in Europe.
The EOFS should only focus on the presently about 40 truly cross-border banking groups and not deal
with the about eight thousand European banks with a predominately national character. The EOFS
should have three tasks: It should gather information about the banking groups and their activities in
different countries. Importantly, it should also create unified risk-assessments of each cross-border
banking group. Finally, it should also oversee the activities and risks of these banking groups.
To achieve these tasks, there is a need for a separate agency, staffed with a sufficient number of
competent employees. Initially, these employees could of course be recruited from the existing
national supervisors. Also the staff of the EOFS would have to cooperate with the national supervisors.
I also want to stress that the EOFS should be an independent agency. This independence is important
to achieve a division of labor and power. It should not be part of the European Commission and not of
the ECB. One possible solution is therefore that EOFS is established directly by the EU countries and
with an obligation to report to the European Parliament.
My proposal is therefore quite different from the existing CEBS-structure which is part of the
Lamfalussy regulatory framework in the EU. Although some of the EOFS's tasks would overlap with
those of CEBS, the focus is different. CEBS's main tasks are to advice the EU-Commission, to
enhance supervisory co-operation and to contribute to convergence of Member States' supervisory
practices. CEBS is therefore a regulator and not a supervisory agency. The EOFS would be much
more of a supervisor with as main task to produce coherent assessments of the risks and
vulnerabilities of cross-border banking groups.
In my view and to start out with, the EOFS need not have formal powers, with the exception that it
should have the right to require cross-border banks to submit information. Formal supervision could
still rest with the national supervisors according to the existing home-host arrangements and potential
sanctions be decided by the national supervisors. In this respect, the EOFS should be limited to
suggesting actions to the national supervisors. Furthermore, the work conducted by the EOFS does
not replace the oversight by the national central banks. They still need to oversee the banks as a part
of their mandate on financial stability.
The creation of an EOFS could, if the organization is successful, be seen as the embryo to a
fullfledged European supervisor - a future European FSA. It is much too early to tell whether such a
development is feasible. First the EOFS would have to prove that it can produce added-value in terms
of information gathering and assessments with real supervisory resources beyond that of a talk shop.
To be honest, my approach is not without problems either. It would make the regulatory structure
somewhat more complex and it would increase the regulatory burden on the cross-border banks by
adding a new agency for reporting. However, in my view, we need to achieve a greater coordination of
the information gathering and assessments. Sometimes you need to settle for the second-best
solution when the first-best is not possible.
Given the problems that I have sketched, a natural question is why my proposed solution has a purely
European focus. The growth of cross-border banking is not unique to Europe, even if the development
of truly cross-border banks is accelerating fast in Europe - perhaps faster than in other regions. The
reason for my European focus is that there is, within the EU, a common regulatory framework, which
includes the establishment of joint organizations. One example is the European Monetary Institute,
which was the forerunner to the ECB. There is also a tradition of using a gradual approach. One of the
underlying long-term principles in the EU is the ever increasing integration through small successive
steps. Therefore Europe is likely to be a good starting point for the establishment of such a
supranational supervisory framework for cross-border banks. In my view though, the underlying challenge is
of global nature. My forecast is therefore that the timely subject of this conference will be relevant also
for future conferences.
Thank you.