Yves Mersch: Shaping a new regulatory framework - international
banking at the crossroads
Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the conference
"The Emerging Framework to Strengthen Banking Regulation and Financial Stability",
organised by the Financial Stability Institute, BIS, and hosted by the Arab Monetary Fund,
Abu Dhabi, 8 November 2010.
* * *
Let me start by thanking the Arab Monetary Fund and the FSI of the BIS for providing
the opportunity to present my views on financial sector reform in the post crisis era
from the perspective of international banking. The topic is vast, and I shall not attempt to
deal exhaustively with its numerous dimensions, but rather concentrate myself on one key
component, namely cross-border banking flows. I will describe their main drivers, explore
their impact on financial stability, and review major reforms currently discussed and aimed at
maximizing the benefits of international banking.
International banking: drivers, effects and impact on financial stability
Cross-border flows have expanded enormously in the last three decades. Since the
second half of the 19th century, the internationalization of banking has proceeded in several
waves. The most recent waves followed the liberalization of the early 1980s and the
expansion of subsidiaries and branches in emerging and developing economies since the
second half of the 1990s. Measured by the expansion of cross-border lending and the local
claims of foreign banks, the scale of international banking increased dramatically since the
beginning of 1980s, also in the Gulf States (Figure 1).
While international claims vis-à-vis developing countries are less than 20 percent of claims to
developed countries, there has been a recent acceleration of the former. In the last half of
this decade, the increase in the share of loans to non-banks in the Gulf States is noticeable,
and it reflects the internationalization strategy of banks which have favored extending credit
by local affiliates to cross-border lending. Until the beginning of this decade, international
banking growth tracked well the increasing world integration as measured by international
trade growth. More recently, however, cross-border flows have grown faster than
international trade reflecting the emergence of risk transfer and securitization thus making
international banking an important component of a broader process of globalization and
integration. Capital flows have not been uniformly distributed across countries, and a
crosscountry analysis of net international positions show large imbalances and persistent net
creditor and debtor positions (Figure 2).
The most important ultimate macroeconomic drivers of international banking are the
regulatory environment and technological developments. While maximizing
shareholders' value is banks' objective, the ultimate drivers of international banking are
macro drivers in home and host countries, and micro drivers related to bank-level efficiency.
A 2008 survey of internationally active banks in Europe conducted by the ECB indicates that
the international expansion of banks is driven primarily by the pursuit of new business
opportunities and by incentives to follow their non-financial customers abroad. Consistent
with the results of the empirical literature, economies of scale and scope play a relatively
minor role. The liberalization of international trade and capital markets has increased
economic integration and interdependence. Restrictions to foreign bank entry have been
gradually eased by bilateral and regional trade and investment agreements as well as by
multilateral liberalization efforts under the umbrella of the World Trade Organization. During
the last quarter of a century, deregulation and a trend toward the international harmonization
of banking supervision and market infrastructure have enhanced economic integration and
international banking activities.
By reducing the costs of foreign operations, deregulation has fostered M&A, greenfield
investment and the provision of cross-border financial services and new products. This was
clear in the EU with the "single banking license" of 1989 and the 27 directives implemented
by member states under the Financial Services Plan. This has also been the case with
innovation through Islamic banking financial products (e.g., sukuk) which have increased
integration and interconnectedness of monetary and capital markets and is further pursued
by recent initiatives like International Islamic Liquidity Management Corporation (IILM).
Traditional banks have opened affiliates in Islamic countries and banks from these countries
have entered traditional markets. These developments have led several EU countries,
including Luxembourg, to modify their legal frameworks to facilitate these transactions by
reducing instances of double taxation. In addition, wholesale activities were boosted in the
Euro area by the creation of TARGET, a platform for an efficient cross-border payment
system, TARGET 2, a completely integrated IT platform for cross-border payments, and
starting in 2013, T2S, a single IT platform for cross-border security settlement. Finally,
technological advances have boosted the effects of economic integration on international
banking by improving access to information on borrowers and on collateral, and by facilitating
the development of models to value credit risk, price new securities, and manage risks more
efficiently.
The macroeconomic conditions in home and host countries also drive international
financial flows. First, regulatory and economic developments in home countries affect the
international activities of banks. For instance, the development of the Eurodollar market
resulted from U.S restrictions on interest paid on deposits within the U.S., and the U.K.
government restrictions on sterling lending by U.K. banks. Similarly, prior to 1999, U.S.
banks established subsidiaries abroad to undertake investment activities that restrictions on
universal banking made impossible at home. Second, there exists ample evidence of a
positive correlation between economic development and financial sophistication. Third,
increases in domestic market competition are behind the international expansion of banks
faced with the decline in their margins. All that said, in deciding on their internationalization
strategy, banks also take into account the growth prospects and the state of economic,
political, and legal development of the potential host country. First, macroeconomic and
financial stability in host countries are important drivers of foreign bank lending. It is
estimated that the elimination of currency risk increased banking activity in the Euro area
25 percent. Second, banks prefer countries that have a low cost of information gathering; the
existence of credit bureaus has been found significant in making a country more attractive to
international banks. Third, international banks tend to prefer countries with attractive deposit
insurance regimes otherwise they operate through non bank vehicles for market sensitive
funding sources. Finally, banks that are successful in incorporating host country's
characteristics can boost their comparative advantage vis-à-vis other banks. These factors
may be cultural or geographical proximity, for example. As an illustration of some of these
factors as well as of the interconnectedness of world capital markets, Figure 3 displays
nodes to describe countries/regions of banks' location with the size of the nodes proportional
to the size of the share of banks' cross-border assets and liabilities, and the thickness of the
lines as a measure of the amount of finance across nodes, both in U.S. dollars and in Euros.
In the lower panel, cumulative net capital flows are depicted by the thickness and direction of
the arrows. Up to mid-2007, capital flew out of Japan, the Euro area, Asian financial centers
and oil-exporting countries (via offices in the U.K. and the Caribbean) toward the U.S. and
emerging markets. After the crisis, the direction of most capital flows was reversed. In
particular, funds flew out of the U.S. and back toward the U.K.
Luxembourg is not on the picture, not because of non availability of data as a recent IMF
paper wrongly states, but because the IMF has neither consulted the ECB, or the BCL, its
website, or its publications.
International banking has enhanced economic growth and efficiency, but has affected
the distribution of risks as well. Cross-border flows have facilitated the transfer of financial
innovations and increased income in recipient countries; have improved allocative efficiency
by making it possible for host borrowers to tap international funding sources and by reducing
their costs of funding owing to increased competition. Finally, international banking has been
a catalyst of financial sector reforms in host countries, which have in turn increased potential
growth. On the other hand, reliance in foreign lending, as exemplified in recent times of
stress, can be riskier than reliance on purely domestic lending sources. During times of
turmoil, overseas funding may dry up for financial and non-financial firms, while banks
supplying funding overseas may experience credit losses and liquidity hardships. During the
last quarter of 2008, for instance, cross-border lending fell by nearly two trillion U.S. dollars
(at constant exchange rates) against a drop of 0.5 trillion U.S. dollars of foreign banks' local
claims in local currencies. From the banks' viewpoint, the risk profile and resilience of banks
is also affected. Diversification of a bank's counterparties does reduce its risk profile; it has
been observed that during the crisis more diversified banks suffered lower losses (this
despite that research has found that more diversified banks tend to hold riskier portfolios).
Similarly, although cross-border banking induces banks to exploit the riskreturn frontier along
its international dimension, the ensuing efficiency increase has not always been associated
with better risk measurement and management practices.
The profile of systemic risk has been also affected by the increase in the financial
system interconnectivity inherent in international banking. The international activities of
banks allow risk sharing, reducing thereby the probability of financial crises, and according to
the literature, also the procyclicality of lending. Parent-subsidiary relations make it possible,
as exemplified during the last crisis, that whether due to reputation or other considerations,
parent companies support their affiliates in times of duress. However, as experienced in my
own country, it would not be wise to expect that behavior consistently at all times. The health
of the parent company may not allow it to support its affiliates, and even force it to rely on its
affiliates for funding. In Luxembourg, a traditional net provider of liquidity to banks' parent
companies, this risk is less serious, but cases of sudden stoppages of cross-border funding
are too numerous to be ignored. They offer clear lessons as to the potentially very damaging
impact of sudden halts in cross-border capital flows on countries' credit supply and growth.
By its own nature, international banking increases the degree of interconnectivity of the
financial system and may exacerbate contagion risk, and increase the speed with which
shocks are transmitted. In addition, a current concern is the fluidity and comprehensiveness
of information flows among national supervisors, between supervisors and financial
institutions, and among financial institutions. This aspect of cross-border banking increases
systemic risk. As documented by a recent CGFS study on funding patterns and liquidity
management of internationally active banks, information frictions were at the origin of large
currency mismatches of international banks which complicated the crisis management.
Information issues also plague crises resolution and, especially, burden-sharing
arrangements. So, I turn now to what is being done to design a new, more robust, regulatory
framework for international banking.
International banking and the emerging regulatory framework
The crisis highlighted deficiencies in the way certain international banks conducted
their business and managed financial risks, but also disclosed regulatory failures. The
interconnectedness of the global financial system became evident during the crisis as the
geographically diversified portfolios of certain internationally active banks became channels
of transmission of distress across borders; cross-currency mismatches put severe pressure
on some banks' capital and transmitted liquidity shocks across markets; underpricing of risk
led to unsustainable leverage levels; opaque and complex asset positions plagued certain
large international banks' balance sheets; reliance on international capital markets for
funding grew enormously in the run up to the crisis so that capital markets and banks
became inextricably linked well beyond their usual complementarities; international trade
flows suffered from sudden reversals of capital flows as banks took remedial actions,
including by curtailing credit. National supervisory frameworks and pre-crisis world capital
and liquidity standards were insufficient for preventing the crisis; were revealed to be
inefficient and costly for managing it and; offer no clear way out of the current situation due to
the lack of a harmonized set of rules for crisis resolution and burden sharing.
Despite the fact that the new Basel proposals aim to improve the regulatory framework on for
instance capital, liquidity and leverage requirements and are expected to increase the
resilience of banking systems in the near future, this new regulatory regime contains some
questionable elements. In this regard, it is worth recalling that the leverage ratio does not
account for the real risk of assets in addition to ignoring bank-specific business models -
even if universal banks have been proven to be more resilient than investment banks (see
figure 4)
Indeed, diversified banks were not the main channel underlying the spread of the subprime
crisis that originated in the United States. Rather it was the investment financial institutions,
including the shadow banking system, that seemed to be the main vehicle of contagion.
Recent IMF figures displayed at the last IMFC meeting, usefully underpinned by
2 documents "Understanding Financial Interconnectedness", (see figure 5) provide evidence
that the level of financial interconnectedness of the shadow banking system, in contrast with
banking system linkages, might explain the rapid process of crisis transmission.
The crisis occurred against a background of EU financial stability frameworks built on
a national basis. In the EU, each country's supervisory authorities derive their legitimacy
from national parliaments, are subject to national accountability mechanisms, and are
financed nationally. A set of MOUs make each country's authority responsible for the
consolidated supervision of financial institutions domiciled in that country, the home
supervisor, while host supervisors are responsible for subsidiaries of institutions from other
countries operating in their territories. Each national central bank is responsible for providing
ELA to financial institutions domiciled in its territory with the obligation of informing the ECB.
The EU had concluded two MOUs to deal with crossborder issues in crisis management: the
2003 MOU on high-level principles of cooperation between banking supervisors and central
banks, and the 2005 MOU on cooperation between banking supervisors, central banks and
finance ministries. MOUs have been signed to deal with banks of regional systemic
importance as well. In turn, colleges of supervisors are responsible for monitoring insurance
groups and some banks. Committees in charge of developing guidelines for the functioning
of supervisory colleges and the assessment of financial sector vulnerabilities report to the
Financial Stability Table of ECOFIN. EU regulations are applicable to all EU countries
(e.g., CRD, MiFID, and Solvency II), but countries can choose the form and methods by
which to implement those regulations nationally. The EU Commission has enforcement
powers in matters related to the completion of the common market, and thus on mergers and
acquisitions of financial institutions and injections of state capital. Finally, international
organizations and international standard setters such as the BIS, the IMF, the FSB, IAIS and
IOSCO also affect EU legislation. But the crisis made it clear that in the EU as well as in an
increasingly integrated world, uncoordinated national policies and highly disparate regulatory
regimes are inconsistent with the objective of preserving financial stability.
The crisis exposed the costs of the national model of crisis prevention, management
and resolution prevailing in the integrated EU market. When the crisis hit, crisis
prevention was underdeveloped in the EU. While there had been significant progress in
setting standards (e.g., via the CRD), there was no agreement on a common set of
procedures for early action or for remedial action; it existed in various different degrees of
discretion in the use of sanctions across member countries as well as a wide degree of
central banks' involvement in national liquidity surveillance. Regarding crisis management,
the CRD, the FCD, and the 2005 MOU had set the trend toward more information sharing
and improved allocation of responsibilities in case of crisis. However, a harmonization of
rules for remedial action based on early intervention and rapid, low cost, decision-making
was missing. In the case of existing ELA arrangements, host countries, while responsible for
ELA for subsidiaries and branches, did not have access to supervisory information about
branches, and had some difficulty in assessing the risks involved in their ELA operations.
Costs of intervention remained opaque; host country authorities did not have the incentive to
provide liquidity support because of EU ring-fencing prohibitions; home-country authorities
delayed provision of information or taking crisis-management actions to avoid capital losses,
reputational effects or political backlashes; the home authority did not always have the
incentive to keep host authorities reasonably informed. Finally, given that crisis resolution is
fundamentally national, countries' approaches to financial institutions' failure vary. Most
countries have only a few bank-specific regulations; instead, general commerce bankruptcy
laws often apply which delays the process of dealing with insolvent banks, even prohibiting in
some cases their recapitalization. In the case of a large and complex financial institution
(LCFI), the focus of bankruptcy law is in some countries on the right of claimholders and in
others on the right of debtors, often incompatible with a cost-efficient solution. In addition,
there were differences across countries regarding deposit insurance (e.g., definition of
deposits, co-insurance, risk-based premia, and funding).1 This state of affairs increases the
regulatory burden, provides incentives for regulatory arbitrage, hinders competition,
exacerbates moral hazard, uses taxpayer money to save inefficient firms, endangers the EU
integration process, and is inconsistent with financial stability.
World and EU financial stability frameworks are evolving with the aim to enhance
crisis prevention, management and resolution for cross-border financial institutions.
In 2008, given the costs of the crisis and the Nordic experience, the EU proposed an MOU
on cooperation among supervisors, central banks and ministers of finance on cross-border
financial stability. This was a key step in establishing a series not only of principles, but also
procedures to exchange information and cooperation among countries in normal times in
order to prevent, as well as to manage and resolve, cross-border crises. The 2008 MOU
includes prescriptions for coordinating public information, conducting stress-testing exercises
and establishing contingency plans. It remained, however, a voluntary framework which does
not fully solve the tension between home country lead responsibility for integrated
supervision and the host country responsibility for financial stability. In 2009, the Larosière
Report and the European Council agreed on the need to build a comprehensive cross-border
framework for the prevention, management and resolution of financial crises in the EU. The
Financial Stability Board (FSB) published principles for cross-border cooperation on crisis
management stressing the role of supervisory colleges. These principles enhance incentives
for financial institutions to behave prudently; promote private sector solutions and limit public
intervention only when necessary to preserve financial stability and; keep a level playing
field. Supervisory cooperation took a big step forward with amendments to the CRD as a
2009 EC Directive made compulsory the colleges of supervisors for banks with significant
subsidiaries and branches in the EU. Chaired by the consolidating supervisor, the colleges
have the objective of exchanging information; determining risk assessment programs of the
banking groups; leveling the playing field in terms of application of the Directive in the
concerned Member States. Finally, last May, the Council of the EU decided the
establishment of Cross Border Stability Groups for all large EU cross-border groups by mid
2011 accompanied by the signature of Cross-Border Cooperation Agreements.
Recognizing the insufficiency of the microprudential approach to deal with systemic
risks, the European Parliament approved a new crisis prevention framework which
also considers the systemic risks posed by international banks. It is now generally
accepted that microprudential regulation and supervision of individual institutions and
markets, while necessary, is not sufficient because it does not take into account the
interactions among financial institutions and between financial institutions and the real sector.
The European Systemic Risk Board (ESRB), a key component of an integrated micro-macro
European System of Financial Supervisors (ESFS), will be operational at the beginning of
2011. It will be responsible for macro-prudential oversight to prevent or mitigate systemic
risks, enhance early warning mechanisms and facilitate the translation of risk assessments
into action so as to avoid episodes of widespread financial distress, to enhance the smooth
functioning of the internal market, and ensure a sustainable contribution of the financial
sector to economic growth. The ESRB can issue warnings and recommendations for action,
which while not binding for the addressee, inaction by the addressee will have to be
explained. The three microprudential components of the ESFS will start their supervisory
activities at the beginning of next year. These new authorities will be born from the
transformation of the existing 3L3 committees into a European Banking Authority (EBA), a
European Securities and Markets Authority (ESMA), and a European Insurance and
Occupational Pensions Authority (EIOPA). The network of national financial supervisors will
work together with the new European Supervisory Authorities (ESAs). The new bodies will be
built on shared and mutually-reinforcing responsibilities, combining nationally-based
supervision of financial institutions with specific tasks at the European level; will foster
harmonized rules and coherent supervisory practice and their enforcement.
Other initiatives at the world level are intended to promote sound practices for
colleges of supervision. The EU supervisory framework addresses cooperation in
supervision in general and also by colleges. The Committee on European Banking
Supervisors (CEBS) is currently developing guidelines for their operational functioning. The
CEBS has also developed an MOU template to be signed at the end of 2010 not only by EU
supervisors, but also by EEA relevant authorities. However, many EU financial institutions
are truly global, and thus it is important to mention that also the Basel Committee on Banking
Supervision (BCBS) has put out a set of eight good practice principles on supervisory
colleges. The objective of supervisory colleges is to enhance information exchange and
cooperation among supervisors in order to support the effective supervision of international
banks.
In the EU, a framework for cross-border crisis management in the banking sector is
Research unequivocally shows that coordination failure is a
just in its gestation period.
distinct possibility in a cross-border setting. Therefore, ex-post negotiations on burden
sharing lead to under-provision of recapitalization; in contrast, an ex-ante burden-sharing
mechanism might encourage moral hazard. In this vein, measures have been taken to
upgrade deposit insurance, as I said earlier, to strengthen capital requirements and to reform
the EU infrastructure to prevent crises. Yet, a framework to enable authorities to control the
impact of a failing cross-border financial institution is still missing. Therefore, mindful that the
costs of uncoordinated national resolution increases with the degree of interconnectedness
and integration of financial institutions, last month, the EC issued a communication proposing
the building blocks of an EU framework for cross-border crisis management in the banking
sector. According to this communication, the objectives of the framework are twofold: first, to
ensure that national supervisors have tools to identify problems in banks at an early stage so
as to be able to intervene to restore the institution's health or to prevent its deterioration;
second, to make crossborder banks' failure possible without contagion and without disruption
of banking activities. The framework is very ambitious as it covers early preparedness,
preventive as well as intervention measures, resolution and insolvency principles. The full
implementation of the framework would pose significant challenges under the present state
of European integration, in particular with regard to issues related to burden sharing,
intragroup asset transfers during periods of crisis and heterogeneity of insolvency laws within the
EU. In this context, it may be more realistic to pave the way for a second best approach i.e. a
nationally based framework for cross-border crisis management associated with a binding
process for cooperation and information exchange.
The establishment of ex-ante bank resolution funds may also contribute to the
reduction of moral hazard and increase financial stability. The EC communication to the
EU bodies proposes the establishment of national bank resolution funds. These would be
funded by a levy on banks so as to facilitate the resolution of failing banks avoiding thereby
contagion and sales of bank assets under stress. Bank resolution funds should not be
viewed, however, as insurance against failure or to bail out failing banks. Funds are part of
the set of tools of a financial stability framework that includes crisis management, and are
intended to palliate, at least partly, the stability implications of the failure of LCFIs. In
Luxembourg, the Central Bank has suggested an innovative framework for an ex-ante bank
resolution fund through the establishment of a privately pre-funded structure covering both
issues of an orderly resolution, i.e Deposit guarantee scheme (DGS) and Bank resolution
fund. In order to avoid any conflict of interest or misallocation of DGS reserves, this shall be
an earmarked component of the fund. In addition, this framework is designed such that
liquidity constraints taking effect during a transitional period would be minimized in order to
safeguard the flow of capital into the bank resolution fund. This can be ensured via a dual
mechanism which allows for the substitution of loans granted to the fund by the purchasing of
an equivalent amount of bonds issued by contributing credit institutions.
At the global level, the Cross-border Bank Resolution Group of the BCBS issued last March
ten recommendations for addressing the challenges posed by cross-border bank resolution.
Concluding remarks
I remain confident that the new macroprudential architecture will contribute to a more stable
financial system that will permit maximizing the benefits of capital flows. Let me finish with a
pragmatic quotation from Goethe: "Knowing is not enough; we must apply. Willing is not
enough; we must do." I believe we are applying what we learnt; I also believe we are
establishing a new foundation for safeguarding financial stability. However, it should be noted
though, that the views on the new micro-prudential regulation framework are still diverging.
Questions are still under discussion especially in view of global standards applied to
heterogeneous financial systems. Level playing fields considerations loom not least in
accounting rules. And the European authorities have made it clear that this time around
geographical implementation has to be done time congruently.
Cross border financial activities have played a positive role in the process of globalization. At
the same time they have enhanced the need for ever closer cooperation among competent
authorities. Bodies for international standard setting therefore ought to include
representatives from international financial centers. Systemically important financial centers
should clearly play a distinguished role in the international post crisis architecture. In this
respect, I fully concur with the suggestions for the way forward in the latest IMF paper.
Thank you for your attention.
BIS Review 149/2010
BIS Review 149/2010