Eva Srejber: Are we ready to deal with a cross-border banking crisis in
Europe?
Speech by Ms Eva Srejber, First Deputy Governor of the Sveriges Riksbank, at the seminar on
Financial Institutions' Value Management in the Integrated Market in Light of the Lisbon Strategy,
Gdansk, 12 May 2006.
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Introduction
Thank you very much for inviting me to Gdansk and this seminar on Financial Institutions' Value
Management in the Integrated Market in Light of the Lisbon Strategy.
The financial system plays a crucial role in the economy. It provides households and companies with a
number of important tools as well as the infrastructure for channelling savings into funding of
productive projects, managing and allocating various kinds of risk, and facilitating efficient transfer of
payments. The more efficiently the financial system works, the better the rest of the economy will
work. One could say that the financial system is the oil that makes the machinery run more smoothly.
The European financial markets have long been very fragmented. As Europe's economies have
become more integrated, however, the drawbacks of this financial market fragmentation have become
increasingly evident. A more integrated market for financial services could, for instance, lead to
enhanced cross-border competition and better opportunities to make use of economies of scale and
synergies. Greater competition in turn should result in a wider range of investment and financing
services and more efficient pricing of these services. With that, expanding SMEs, for example, could
gain easier access to risk capital and incur lower financing costs, in the same way that a more evolved
and integrated market for corporate bonds has led to a lower cost of capital for large companies.
Consumers, too, would benefit from lower borrowing costs and access to a broader range of financial
services. Moreover, both companies and households would have better opportunities to diversify risk.
Better use of scale economies should also mean less expensive and more secure ways to pay for
goods and services. So, with all these potential efficiency gains, it is clear that further integration of the
markets for financial services is vitally important, if we are to succeed with the Lisbon agenda and
improve growth in Europe. And this is also the prime reason for the Financial Services Action Plan,
which was launched a few years ago.
However, at the same time as the financial system is important for growth in the real economy, it is
also inherently unstable. In particular, banks could be prone to bank runs due to the liquidity
imbalance between their assets and their liabilities. This inherent instability is an important reason for
the existence of financial regulation, supervision and macro-prudential oversight of financial firms in
the first place. The costs to society from a bank failure could be enormous due to potential contagion
to other financial companies, thus posing a threat to the financial system as a whole. When
crossborder financial institutions are involved, the systemic risks become even more complicated to
manage. This, of course, entails some new challenges for authorities with tasks pertaining to financial
stability, i.e. financial supervisors, central banks and ministries of finance.
Some of the challenges that I will discuss here today are inspired by discussions that occurred at a
workshop that was hosted by the Riksbank in Stockholm in February on the topic of the future
regulatory framework for banks in the EU. At the Stockholm workshop some interesting papers were
presented by Arnoud Boot, David Mayes, and Charles Goodhart and Dirk Schoenmaker. These
papers will shortly be published in the Riksbank's Economic Review and I can warmly recommend
them as inspirational reading.
A changing banking landscape
All in all, there are roughly around 8 300 credit institutions in the EU today. Among these, of course,
the vast majority of banks are small, purely national institutions, with no or almost no cross-border
activity.
But cross-border banking activities are picking up. There is an increasing number of banks conducting
at least some cross-border activities. So far, cross-border retail activities of most banks have been
fairly limited and typically conducted in subsidiaries. Also these subsidiaries have often been
independent and not fully integrated into the operations of the parent bank. This is the type of bank the
current system with a home-country control was mainly designed for and is best suited to handle. The
current system has worked reasonably well so far for these banks, and is expected to do so in the
future. At least as long as their cross-border activities are relatively limited in relation to their overall
size.
However, on top of this, there is also a category of banking group in Europe with significant
crossborder activities for which the current system may not be so well adapted. Some banking groups, for
example, have extensive activities in several countries. The Italian Unicredit Group will, following the
merger with the German HypoVereinsbank (HVB), be a significant banking group - not least - here in
Poland, but also in, for example, Austria, the Czech Republic, Germany, Hungary, and Italy. Moreover,
the British group Barclays has extensive operations in Spain, while the Spanish Grupo Santander has
substantial activities in the United Kingdom. Fortis and Dexia are similarly important in the Benelux
region.
And then there are banking groups that have a systemic significance in their host countries. For
example in countries such as the Czech Republic, Finland, Hungary, Lithuania, Poland and Slovakia
foreign banking groups have a dominant position in the domestic bank markets. Generally speaking,
foreign penetration of the banking market is substantial in the New Member States (NMS). According
to an ECB report, about 70% of the NMS banking sector is foreign-controlled, mostly by other
EEAcountries. Speaking from a Nordic-Baltic perspective, more than 90 percent of lending in Estonia is
granted by Swedish and Finnish banking groups.
To bring you another example that is close to my home, the Danish bank Danske bank has significant
operations in many parts of Northern Europe. With its network of branches, it is now the fifth largest
bank in Sweden and is on the verge of becoming systemically significant, at least by some standards.
There are also some banking groups that have a significant share of their operations outside of their
home country. Interestingly, banks from some small countries such as Belgium and Austria are
responsible for a large part of cross-border banking investments.
It is banks that may have systemic relevance in several countries, or are perhaps systemic in one
country but not in another, or which are simply very large, and complex, with geographically
widespread operations, that pose the greatest challenges to authorities. Fortunately, there are not too
many of these critical banking groups in Europe at this point in time. According to an ECB study, there
are 43 banks with operations in three or more countries. Of these only nine are truly pan-European
banks. Nevertheless, a crisis scenario in any of these may pose serious difficulties to resolve.
In the current system, the organisational structure of a cross-border bank - specifically, whether the
bank is organised according to a subsidiary structure or a branch structure - affects the distribution of
responsibilities between the home country authorities and host country authorities. Moreover, the
relationship between home and host authorities may be affected differently depending on which
function of authority, for example, supervision, emergency liquidity assistance or deposit guarantees,
that is being employed. An interesting development is, however, that the distinction between
subsidiaries and branches is becoming more and more blurred. Banks increasingly concentrate
different functions, such as funding, liquidity management, risk management and credit
decisionmaking to specific centres of competence in order to reap the benefits of specialisation and economies
of scale. With the financial integration in the EU, this specialisation also occurs cross-border. As a
consequence, foreign subsidiaries (and branches) become less self-contained. It can no longer be
taken for granted that even a large subsidiary will be able to continue its business, if the parent bank
defaults - at least not in the short run. And I believe that the idea that a subsidiary could be
successfully ring-fenced in its host country is merely history today, as accounts could easily be
transferred from one country to another at the push of a button. Even if many of the examples I will
use today formally will have bearing mostly on cross-border banks with a branch structure,
economically and practically, they can often just as well apply to cross-border banks with a subsidiary
structure.
Challenges ahead
Although increasing cross-border integration of the financial industry is essentially a positive - and
even necessary - development to enhance the economic potential for the EU area, it also means new
challenges for the authorities involved. The first dimension of these challenges concerns efficiency. So
far, much has been done in order to create a harmonised regulatory framework that provides a more
level playing field and reducing the regulatory burden on financial institutions by creating European
passports for financial services, improving supervisory cooperation and convergence, etc. The second
dimension, which I will concentrate on today, concerns financial stability. More specifically, I will focus
on the challenges pertaining to our ability to manage financial crises in Europe. The increased risk of
cross-border contagion means that it seems less likely that the next financial crisis in Europe will be
contained within national borders, and much more likely that it will have far-reaching consequences in
a number of countries. This basically means a greater need for coordination of information and
decision-making between authorities in different countries. In a crisis situation it is important to know
who will do what and when. Things can be seriously complicated by the existence of a number of
potential conflicts of interest between the different countries involved. Moreover, as the actions of one
authority could have effects on other countries' financial systems, there are some obvious
accountability concerns. The national authorities are only accountable to their respective national
governments and ultimately their constituencies.
The fact that integration of the banking sector started relatively early in the Nordic and Baltic countries
means that we have encountered some of these challenges perhaps a little earlier than many other
European countries. And because we share similar experiences - still fresh in our memories - of
major banking crises in the Nordic countries, we have perhaps a head start when it comes to
recognizing and trying to deal with these challenges on a Nordic level, even if much worksstill remains.
Here, I might add that integration on a pan-Nordic level has also come a long way in the area of
securities exchanges and clearing and settlement facilities. Of course, the integration of the financial
infrastructure poses similar challenges for authorities to cross-border banking and some additional
complications as well. However, today I will focus on the challenges posed by cross-border banks.
And I must stress that these challenges are not merely a regional problem. Due to the dynamic
changes in the banking landscape, they will indeed require solutions on a European level.
My main message today is that increased coordination is imperative, and, in this, it is vitally important
that future arrangements for supervision, crisis management and crisis resolution of cross-border
banks must be dealt with jointly as a package, and not in isolation from each other. It is apparent that
the solutions in any one of these areas will depend on the solutions in the other areas. In particular, it
will be necessary to address the issue of burden-sharing arrangements for the eventuality that a
border-crossing bank becomes insolvent. If we don't, there is a great danger that crisis management
fails and valuable time will be lost. It will not be easy to achieve the necessary coordination and not
least to deal with some potentially complicating conflicts of interests, and much more analysis is
needed. However, I will at the end of my speech try to sketch some possible routes ahead.
Coordination issues
To make my points clear, I think a crisis scenario could be a useful starting point. Consider a large
cross-border bank encountering some financial troubles, and suppose the bank is systemically
important in at least one of the countries in which it operates. The number one concern for authorities
would be to limit the social costs of a potential banking failure and to stop contagion to other parts of
the financial system. For this, efficient crisis management is key. The successfulness of the crisis
management, in turn, critically depends on a number of factors, such as coordination of information
and decision-making, which in turn depend on how well conflicts of interests can be managed.
Information
First of all, you need access to relevant information on which to base your decisions. Ongoing
supervision is instrumental in detecting weaknesses, vulnerabilities and risks that may trigger or
enhance systemic crises in the first place. But it is also a key source of information in a crisis situation.
Given the very complex nature of some cross-border banks, these institutions are also becoming
increasingly opaque, and thus difficult to analyse. Despite EU regulations on consolidated supervision,
there is always the risk that no supervisory authority will gain sufficient oversight of and insight into all
parts of a banking group. The supervision is also complicated by the functional specialisation within
the banks, which does not always follow the national and legal divisions. If, for instance, a banking
group with operations in two countries has concentrated all of its credit risk management in its home
country, it will probably be difficult for the host country's supervisory authority to assess the total risk in
the subsidiary. On top of problems of getting a fair overall picture, there is the problem of coordinating
information. When several authorities in different countries are involved, the information flow may be
slowed down. The MoU on Cooperation between Banking Supervisors, Central Banks, and Finance
Ministries in the European Union in Financial Crisis Situations that was recently agreed among the 25
member states provides a useful framework for sharing information in a crisis.
Decision making
In a crisis you need the ability to make rapid decisions. For example, central banks might consider
providing emergency liquidity assistance. In some cases, there might also be reasons to consider a
swift take-over of the bank and temporarily placing it under public administration. For decisions like
these, you would ideally need a clear line of command. It is difficult enough to organise efficient
management of a national crisis. I think you can all imagine how complicated it could be to achieve
anything like "a clear line of command" when there is a multitude of countries - and perhaps several
authorities in each of these countries - involved in the decision-making. Then there is no longer
merely the financial supervisory authority, the finance ministry and the central bank in one country that
have to be involved, but all of these authorities in several countries. If there are no prior agreements
on the division of responsibilities between the national central banks and the other relevant crisis
management authorities, and on how to coordinate decisions in the case of a crisis, there is great risk
that any attempt to manage the crisis will fail miserably.
Language differences and different legal structures can often reinforce the problems. On top of this,
there is a clear cross-border mutual dependence, which means that no single country's authorities are
entirely sovereign in implementing a solution to the crisis without the risk of significant repercussions in
other countries.
Recently, there have been a number of initiatives, regionally as well as on a European level, to
enhance coordination. For example, a number of memoranda of understanding (MoUs) have been
worked out and agreed, either bilaterally or multilaterally, and more MoUs are underway. These MoUs
detail a number of principles and practical issues regarding the cooperation, the exchange of
information and assessments between authorities and certain issues concerning the delineation of
responsibilities. Some MoUs focus primarily on supervision, whereas others involve crisis
management as well. Notably, they are not legally binding and give the national authorities
considerable scope for discretion. Although the emergence of these MoUs is very positive, they are no
guarantee for efficient crisis management. Probably, these MoUs will work well under normal
conditions. And they will also be most helpful in facilitating coordination in some financial crises.
However, in a more wide-spread crisis involving a large cross-border bank, MoUs alone will probably
be insufficient. Take, for example, the issue of assessments. We have in Europe in principle agreed to
share each other's views and assessments in the event of a distress scenario. However, to be able to
act decisively in a crisis situation involving a large cross-border bank, you would preferably need a
joint assessment between the countries involved. I don't think it would be too speculative to think that
each country in an acute situation would be prone to present an assessment that supports its national
interests as part of a negotiation strategy. Arriving at a joint assessment may therefore prove difficult,
and above all take valuable time away from crisis management. To be able to act efficiently in a crisis
situation, it is instrumental that conflicts of interests, as far as possible, are taken care of in advance.
For that you need something more than the MoUs we have seen so far.
Personally, I believe that crisis management simulation exercises involving supervisors, central banks
and finance ministries in all EU countries would provide valuable ideas on how to develop and improve
cooperation and coordination of financial crises. On top of the obvious need for coordination of
information and decision-making, there is as I just mentioned - and I will elaborate more on this shortly
- also the additional element of conflicting interests that may be an even more serious impediment to
efficient crisis management. In order not to waste valuable time in an emergency, you need to have
ways to settle them as efficiently as possible already in place. In my opinion, specifically ex ante
arrangements for burden sharing between countries are needed.
Managing conflicts of interests
Conflicts of interests can become apparent in many ways, for example, if a cross-border bank
becomes insolvent and incurs social costs that somehow need to be shared between the countries
involved. The problem of burden sharing becomes particularly precarious when, for example, the bank
is significant to the banking system in some country but not in some other countries, or if there are
great discrepancies between the ratio of the bank's size to the GDP of the different countries involved.
The social costs that may call for some burden sharing can take many forms. For example, there may
arise situations in which the taxpayers in one country may be faced with the prospect of essentially
bailing out the depositors of a branch in another country through their national deposit guarantee
scheme. Incidentally, there is a recent example from my own country (although, technically, it
concerns a bail-out under the investor compensation scheme rather than the deposit guarantee
scheme). After a long and complicated investigation the Swedish Deposit Guarantee Board decided
around two weeks ago to commence payments to a group of mostly Italian investors that were the
unfortunate clients of the hair-raisingly ill-managed securities company CTA, which went bankrupt in
2004. Fortunately, CTA was not one of the bigger players - in fact I had never heard of it before it
became an item for the Deposit Guarantee Board - and the fund will be able to cover the payments to
the approximately 1 200 clients, amounting to around €10 million in total. However, if a larger
institution had gone bust, the fund alone would not necessarily have been able bail out the investors.
All deposit guarantee schemes - as well as investor compensation schemes - are typically
underfunded and are not able to cope with failures in large cross-border financial institutions. In such events,
additional government funding will be needed.
Or, if emergency liquidity assistance was provided at some point during the course of the crisis (on the
erroneous assumption that the bank was basically solvent), a loan loss may be incurred on the
national central bank that acted as a lender of last resort. And, of course, when giving liquidity support
to a bank with cross-border operations in many countries, you can never be entirely sure in what
jurisdiction your money ends up. In the case of a branch structure, it may end up in any country in
which the bank operates, and ring-fencing a subsidiary may prove equally difficult in practice.
Furthermore, in some situations it may be socially optimal to spend public money in order to
reconstruct a failed bank. If the reconstruction is successful, the money spent may eventually be
recovered by the public. But it could take a considerable amount of time before this happens, and a
precondition is that you are not betting on the wrong horse. The taxpayers in one country may not be
so keen to take on such risks in another country.
In addition to fiscal costs, there may of course be substantial indirect social costs in the form of a
dipping GDP that may occur when the financial system is suffering efficiency losses or is being
temporarily disabled as a result of a financial crisis. These indirect costs are basically a function of the
systemic relevance of the financial institution(s) in question. According to a study by Hoggarth et al,
the average drop in GDP following a financial crisis is 15-20 percent.
The social costs from a banking failure can thus be substantial and involve many countries in various
degrees. This, in turn, will most certainly have the effect of giving rise to difficult negotiations on how
burdens should be shared between the countries involved. The larger the banking group, the more
countries that are involved in its cross-border activities, and the more important the bank is to the
functioning of the financial system in a country, the higher the stakes will be for individual countries
and the trickier and tougher the negotiations will be. But why is this relevant in a crisis management
perspective? Couldn't we just go about and deal with the most urgent phase of a crisis first, and take
care of burden sharing later, when we all know the facts?
In my opinion, we cannot afford to wait that long. Uncertainty about the distribution of social costs in
the event of a cross-border banking bankruptcy can seriously hamper the ability to act in an
emergency situation. In particular, there is a risk that crisis management will be held up by a
negotiation game between nations unless there are some previously made arrangements for burden
sharing. When the stakes are high, the incentives of the involved nations to keep their cards close to
their chests until the last minute will also be strong, and the decisive actions that would be desperately
needed in a crisis situation may be taken too late or not be taken all. In the worst case, this may result
in a failure to prevent a crisis from developing further with the effect of greater overall social costs to
share. On top of this "prisoners' dilemma", things can get even more complicated by the fact that
banks will shop around for the most favourable support among the countries involved.
Let me be a little bit more specific. Take emergency liquidity assistance, for example. A central bank
could decide to act as a lender of last resort and provide emergency support to an illiquid but basically
solvent institution. The problem is that, in the heat of a crisis, it may be almost impossible to be certain
as to whether the bank has merely liquidity problems or has serious solvency problems as well.
Information will almost certainly be incomplete. Therefore, providing emergency liquidity assistance
could in principle result in losses to the central bank, so the ultimate cost of the assistance is therefore
uncertain at the outset. (If the bank could pay back with certainty, there would typically not be any
need for emergency liquidity assistance and the market would be able to handle the liquidity
shortage.) Thus, a central bank providing emergency liquidity assistance must base its decision on the
possibility of a loss.
Given the uncertainty about the ultimate cost of emergency liquidity assistance and the central banks'
national mandates, conflicts of interest are likely to emerge in a decision to grant emergency liquidity
assistance to a bank with major cross-border activities. It is not difficult to see how these conflicts
could complicate crisis management, in particular if the bank is systemically important in any of the
host countries. In the present situation, the home country's authorities are likely to have the principal
responsibility, at least if it is organised according to a branch structure. If the bank is systemic in the
home country, the decision to provide emergency liquidity assistance may not be so difficult; the risk of
incurring a loss may be worth it to avoid a systemic crisis in the home country. But if the bank is not
systemic in the home country, but systemic in the host country, there may be some hesitation on
behalf of the home country's authorities to provide liquidity assistance. If the bank has a branch
structure, the demise of the bank means that the foreign branch goes down with it, and, because it's
systemic in the host country, financial stability may be at risk and greater social costs are incurred at
the host than in the home country. If it is a subsidiary that is systemic in the host country, one solution
might be for the central bank of the host country to grant emergency liquidity assistance to the
subsidiary. However, it may not be possible to successfully ring-fence it, and the money is lost and the
rescue mission fails.
Similarly, the decisions in an emergency situation may also be distorted by conflicts of interests
regarding deposit guarantee schemes and other crisis resolution measures. Through deposit
guarantee schemes, bank deposits are partly insured in the event of a bank default, thereby protecting
depositors from losses (up to some maximum amount), which in turn reduces the risk of bank runs that
may jeopardise financial stability. Deposit guarantee schemes are thus a vital part of the safety-net for
banks, apart from the central banks' ability to grant emergency liquidity assistance.
All EU-countries are required to have deposit guarantee schemes that are supposed to be financed by
the financial industry, for example through fees to a fund. Typically such funds would be designed so
that any deficits in the fund are financed by the banks from future fees. However, it seems doubtful
that such financing would be sufficient in all cases. In the case of default of a very large bank, it seems
more likely that the government would then have to intervene somehow. Either the deposit guarantee
fund would have to borrow from the government, or the government would step in directly and provide
some retribution to depositors on behalf of the deposit guarantee fund. In both cases, government
debt increases. The ultimate cost of a major banking crisis is therefore likely to hit the taxpayers in one
way or the other. So, any deposit guarantee scheme will in practice contain an element of a
government guarantee, which could be either implicit or explicit. In the case of a cross-border bank
with branches in other countries, the important question is, of course, how far the taxpayers in the
home country would be willing to go in order to bail out the depositors in the host countries. This could
entail substantial cross-border transfers, which is something that most politicians tend to view with
considerable scepticism.
There are also challenges in the potential reconstruction of a failing cross-border bank. A
reconstruction of a cross-border bank will increasingly impact the financial system in the other
countries where the bank has major activities. To achieve a successful reconstruction, coordination of
the activities of the authorities in the different countries would therefore be essential. In addition, as
banks merge cross-border, some banks tend to grow in size to the extent that it will be very difficult for
a small country to save the entire group. Traditionally there has been a fear that banks are becoming
"too big to fail" because of their critical importance for the stability of the financial system. For a small
country, which is home to a large bank with an extensive network of foreign branches, there is a real
risk that the bank will rather be "too big to save". This suggests that burden sharing may be an issue in
reconstruction as well.
Scenarios like the ones I've sketched suggest that negotiation could be extremely complicated and
may hold up the entire crisis management process - I know how extremely complicated things can get
even when a crisis is contained within national borders. It is obvious that the organisation of
supervision, crisis management and crisis resolution for cross-border banks are strongly linked to each
other. The avenues we choose in any one of these functions will have an impact on the effectiveness
of the other. Therefore, we cannot deal with supervision, crisis management and crisis resolution as
separate issues.
The success of crisis management and crisis resolution depends on coordinated arrangements for
burden sharing with respect to deposit guarantee schemes, emergency liquidity assistance and public
money being spent in the aftermath of a banking crisis. If the uncertainty about this burden sharing
cannot be reduced, there is a great danger of failure in the attempts to manage a bank in distress and
that the overall burden of a crisis will be greater for all of us to bear. To me, it seems clear that some
prior agreements outlining responsibilities for decisions and potential loss distributions are necessary.
There is, of course, also the accountability issue. For the host country's authorities, there is a risk that
domestic opinion would not consider that the home country's authorities were doing enough to save a
cross-border bank or group, and vice versa.
A basic challenge for the authorities dealing with cross-border banks is how to find an acceptable
formula for sharing the burden and the costs of a crisis. Goodhart and Schoenmaker have in their
paper suggested a number of keys that could be explored to create such a formula, for example the
relative size of GDP, the ECB capital ratio, and the relative amount of bank assets in the country. As
pointed out by Goodhart and Schoenmaker, the first question to be asked is whether one would want
a general solution where all countries contribute according to some fixed key, or more specific burden
sharing arrangements, where only the directly involved countries participate according to a more
flexible key, presumably taking into account the geographic spread of the bank's business. To achieve
the latter, it would be necessary to find some commonly agreed criteria for assessing a bank's
systemic relevance to the financial system of a country. Merely using market shares as a criterion will
probably not be adequate as other aspects, such as the bank's relevance to the payment system,
clearing and settlement, involvement in inter-bank securities markets and so on would also be
important in this respect. At the same time, in a constantly changing banking landscape, it would be
difficult to find criteria that are so clear-cut that assessments will not be "up for negotiation" in a sharp
crisis scenario. In order to avoid having crisis management being held up by conflicts of interests more