Stefan Ingves: Regulatory challenges of cross-border banking - possible
ways forward
Speech by Mr Stefan Ingves, Governor of the Sveriges Riksbank, at the Reserve Bank of
Australia, Sydney, 23 July 2007.
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Introduction
As the integration of financial markets has picked up speed in recent years the subjects of
supervision and crisis management of internationally active banks have gained in
importance. I myself have on several occasions argued that policy actions are needed in
order to cope with the challenges arising from financial integration. Today, I will elaborate on
one of my ideas, namely the creation of a special body for supervision of the major
crossborder banks in Europe. For the sake of this speech let us name this body the European
Organisation for Financial Supervision (EOFS).
Lessons from the past
Before elaborating on my proposal let me start by noting that financial and banking crises
can be costly. From history we know that the economic and political crisis costs can be very
large. The US depression and the hyperinflation in Germany during the 1930s are clear
examples. After the Second World War, the conclusion was that the financial sector had to
be heavily regulated. This gave the national authorities a certain control over the risks in the
different national financial sectors, but at the same time regulation stifles competition,
product development, efficiency and proper risk management. Eventually, these
inefficiencies became large and apparent and many countries started deregulating in the
1970s and 1980s. In my country we have painful experiences of a banking crisis that
occurred partly because the new deregulated environment posed new challenges for banks
as well as for regulators; challenges they were not prepared for.
Eventually banks developed more appropriate risk management techniques and supervisors
adopted a more risk- and process-oriented form of supervision rather than the previous
rather formalistic type. This has clearly lowered the risk of financial crises.
Internationalisation of banking
Also after the deregulation, most banks have remained predominantly national. Only in the
last decade have we seen the emergence of some big cross-border banks with major
activities in several countries. And this financial integration is accelerating. Let me here be
perfectly clear. This development is positive for the economy. It stimulates competition and
product development across countries. It also means that the banks can profit from
economies of scale and scope. The spread of cross-border banking has reached different
levels in different parts of the world. In Europe it has been increasing rapidly in the last few
years, but there are also several active cross-border banking groups here in the Pacific
region.
This integration is not without challenges. In particular supervision and crisis management
arrangements have to be addressed hopefully with some foresight, before we get another
crisis. To explain this allow me to draw a parallel to the perhaps most burning issue in
contemporary debate; the problem of global warming and climate change. The challenges of
financial integration share some of the same characteristics as the environmental problems
facing us. There are in short negative externalities.
As you all know, the impact of industry emissions on the environment is the classic example
of what we economists call negative externalities. If the market is left without any intervention
at all, the costs for the pollution will be borne by others than those who have actually been
directly involved in the polluting business. The same reasoning can be applied to financial
crises. A crisis that severely affects the functioning of the financial system will cause
substantial costs to the entire economy, ultimately in the form of loss of output. These costs
go far beyond what the financial firms can possibly take - or are willing to take - into account
when conducting their day to day business activities.
Both with regard to pollution and financial crises there are ways to manage the negative
externalities. Public interventions can be used so that the negative externalities are
internalised in a way acceptable to society as a whole. For industries polluting the
environment, authorities can for example impose taxes or issue emission rights to
compensate for the social cost of pollution. For banks and financial firms this is achieved by
regulatory and supervisory measures, such as capital requirements and rules for the
establishment and conduct of business as well as provisions giving central banks the right to
grant emergency liquidity assistance.
Many stakeholders, but no single authority
If the negative externalities are limited to a national scale, sufficient public intervention may
be possible. National authorities have - or could be given - sufficient power to act. When
environmental pollution crosses national borders, containing the negative externalities
becomes more difficult, since the national authorities only have national mandates. Then
some kind of supra-national organisation or some form of cross-border agreement may be
required. Similarly, in the financial area, as long as the externalities are limited to one nation,
the domestic authorities can - at least potentially - be used to internalise the problems.
Thus, when banks start becoming important in several countries, there will be a mismatch
between the potential problems and the roles of financial supervisors and regulators. In the
prevailing regulatory structures there are very few arrangements for supervision and crisis
management designed for managing externalities with cross-border impact. Given that the
financial markets get more and more integrated the lack of adequate cross-border regulatory
structures creates a number of challenges.
Challenges
One challenge is that the interdependence between different countries increases. Problems
in the banking system in one country are more likely to spill over to the other countries where
the bank or group is active. The cross-border contagion effects are likely to be larger as
banks are actively involved in several countries. This can be illustrated by one of the largest
banks in my country, Nordea. It has substantial activities in four of the Nordic countries, and
is also a significant part of the financial system in all these countries. Any serious problem in
Nordea will therefore most likely affect all four countries.
Another challenge is that decisions and actions by national authorities are likely to have
considerable implications for the financial stability in foreign economies. This is of course
particularly true in cases where foreign operations are run through branches, meaning that
they are subject to foreign supervision. However, in Europe at least, the consolidating
supervisor has an increased influence also on foreign subsidiaries, within the new capital
regulation - the Basel II-framework. In the Nordea case - which is now a group with a
subsidiary structure - the Swedish consolidating supervisor has a possibility to influence the
risk management of the group as a whole but also in the different subsidiaries. Now, Nordea
has announced plans to convert its subsidiaries in the Nordic countries into branches. When,
and if, this plan eventually becomes a reality, Swedish authorities will have the full
responsibility for supervising three foreign branches, all of which may be of systemic
importance in the different host countries.
A third challenge is that the legal distinction between branches and subsidiaries is becoming
blurred. Increasingly banking groups are starting to organize themselves along business
lines rather than along legal and national lines, concentrating various functions to different
centres of competence. There are several examples of this trend. Again Nordea is one
illustrative example. In order to reap the benefits from economies of scale and scope, Nordea
has chosen to concentrate its different functions, such as treasury operations, credit
decision-making and risk management to specific centres of competence within the group. It
is therefore questionable whether the different entities within the group really are
selfcontained, even if they are legally independent subsidiaries. With this structure, it is also less
likely that the group as whole can survive a failure of one of its entities. Hence, operationally
and in economic terms, Nordea increasingly resembles a bank with a branch structure. A
consequence is that the present regulatory structure may be less well-suited for efficient
supervision and regulation of the group.
A fourth challenge is that the practicalities of supervision and crisis management are greatly
complicated as the number of relevant authorities increases. In normal times, this means that
the regulatory burden for the financial firms increases. Also, the need for supervisory
cooperation increases, which demands new supervisory procedures and the creation of
common supervisory cultures. In times of financial crises, sharing information and
coordinating action becomes a difficult priority, especially since time is a scarce resource in
crises.
A fifth challenge is that conflicting national interests emerge as banks become truly
crossborder. The national authorities have a national mandate and are responsible to the national
government or parliament. They are therefore unlikely to take the full external effect of their
actions in other countries into account. Different countries may also have different priorities in
terms of resources for supervision and crisis management or in terms of their regulatory
structures. One reason may be that the financial systems differ quite significantly between
countries. Additionally, in crisis management, the use of public funds can never be
completely ruled out. In a cross-border context, serious conflicts of interest can arise when it
comes to agreeing on how to share the potential burden of such interventions.
All these challenges have a common theme. Increasingly, national financial stability is
becoming dependent on the activities of banks and authorities in foreign countries. Also,
given the roles and responsibilities of these authorities, conflicts of interest are likely to occur.
The typical illustration of this problem is a bank being of limited size in the home country
while having a systemically important branch abroad. While a potential failure of the bank
would not create any substantial disturbance in the home-country economy the
consequences to the host country could be destructive. As the host country, in the event of
failure, is likely to end up with the bulk of the bill for resolving the crisis, the incentives to
conduct close supervision of the bank are substantial. For the home-country on other hand
the same incentives do not exist.
Financial integration also raises a number of practical issues. Do the present legal
frameworks provide authorities with the necessary tools for supervising cross-border banking
groups in an efficient way? And do the authorities themselves have arrangements in place to
produce comprehensive assessments of the operations and the risks of these groups? Under
the prevailing regulatory structures I am afraid that the answers to both of these questions
are likely to be no.
Policy actions are needed
As I have tried to illustrate so far, financial integration gives rise to several challenges related
to the supervision of cross-border banks. Most importantly, I have argued that the present
supervisory arrangements are not designed to prevent the cross-border externalities that
financial crises may result in. This, of course, is a growing problem in an integrated world.
Furthermore, I have argued that there are deficiencies in how the supervision of
internationally active banks works in practice, which can partly be explained by limitations in
legislation and partly by supervisors not being sufficiently coordinated.
In my opinion all this gives us good reasons to reflect on how to take actions for revising the
present regulatory frameworks. We need to find ways for countries to cooperate closely and
establish mechanisms for coordination and conflict resolution.
Motives for a coordinated financial supervision
Most of what I have said so far is probably pretty uncontroversial both in terms of the
analysis of the challenges of integration and of the need for action. However, it may be more
difficult to reach agreement on how to move forward. A number of alternative solutions have
been brought into the debate. For example, proposals such as prohibiting foreign branches
from doing business domestically or extending home-country responsibility have been
discussed.
My take on this, as I said in the beginning, is instead to gradually move towards the creation
of a common international body with a mandate to conduct supervision of banks with
substantial cross-border activities. The simple rationale is that the creation of such a body is
the only way to fully manage the conflicting national interests. Also, such a body would have
several other benefits. A single authority supervising cross-border banking groups instead of
several would most certainly increase the comprehensiveness and the effectiveness of the
supervision. For the firms subject to supervision, it could mean that the regulatory burden
would eventually be reduced considerably.
In a European context, the idea of a European Organisation for Financial Supervision
(EOFS) may at a first glance seem overly idealistic, and to be honest, in some respects it is.
One can argue that it would be virtually impossible to make countries give up parts of their
sovereignty to a supranational authority. However, looking at this from a European
perspective, there is hope. Within the European Union there is already a framework for
supervisory and regulatory cooperation, based on the common legislative process in the form
of EEC-directives and regulations. Moreover some institutional arrangements for supervisory
cooperation are in place, even if they do not have any legal powers. It may therefore be
easier to reach some progress in Europe than elsewhere in the world. Still, even in Europe, it
is not very likely that a full fledged Pan-European supervisor can be established in the near
future. Therefore, my proposal should be seen as a gradual process rather than a fast-track
to a European FSA.
Institutional set-up and powers of EOFS
Let me now go into more detail on how the EOFS would work. As I said earlier, the mandate
of the EOFS would be to perform a form of supervision of the major cross-border banks at
the European level. As the focus is strictly on prudential supervision, the supervisory tasks
related to market conduct and consumer protection would still rest with national supervisors.
Aligned with the EU-principle of subsidiarity the supervisory duties of the EOFS should only
include the banks with major cross-border activities. What I have in mind is a three layered
structure. The 8000 or so European banks which mainly operate domestically would remain
under the exclusive competence of national authorities. The regionally oriented banks, active
in a few countries, could use a structure similar to that of today, where supervisory colleges
deepen the cross-border cooperation. The limited number of truly Pan-European banks
would on the other hand be dealt with by the EOFS.
In the first step the tasks for the EOFS, would in my view, be threefold: Firstly, it should
gather information about the cross-border active groups. Secondly, with the information
acquired, unified risk-assessments should be produced for the banks subject to EOFS
supervision. The third and final task should be to oversee the activities and risks of these
banking groups.
To set up the EOFS one would, to start with, need to second staff from national supervisors
and central banks. Initially the EOFS should probably only have limited powers, namely to
collect information and undertake on-sight inspections together with national supervisors. All
other powers, such as licensing activities, regulations, interventions and corrective actions
would still remain the responsibility of national supervisors. Consequently, the EOFS would
act alongside the national authorities producing comprehensive risk analysis of the
designated banking groups and based on those analysis give advice on policy actions to the
national authorities. In the event of conflicting interests between authorities the EOFS could
also act as neutral mediator.
Further, a coordinated European supervision of banks and groups with significant
crossborder activities would facilitate a more efficient management and resolution of cross-border
crises. It would be easier to reach a common assessment of the systemic importance as well
as the solvency of the bank or group in question.
What I, in content, am proposing is that the EOFS in its embryonic stage would function more
like a non-regulatory central bank than a traditional supervisor. The EOFS would conduct
macro-prudential oversight and act as an enlightened speaking partner to the supervisory
authorities.
In my view, it is important that the EOFS is a separate agency with an independent status.
The reason is that in order to be successful the EOFS would need a high level of operational
independency and integrity. It is also important to achieve a necessary division of power. The
EOFS should cooperate closely with other organisations but should still be free from direct
guidance and involvement from national authorities as well as from the European
Commission and the ECB. In my opinion, it should be given the same independent status as
the ECB has today. With many other Pan-European regulatory bodies already in existence, it
should not be too hard to come up with suggested proper financing arrangements.
If successful in its initial role, the tasks of the EOFS can gradually be extended by assuming
additional supervisory powers for the truly cross-border banks. It would however first have to
prove its merits.
As long as the EOFS operates in addition to the national authorities another layer of
supervision is added to the present structure. From an industry perspective this would imply
a greater regulatory burden. However, I believe - and hope - that it is something that
authorities and banks can live with if the supervision as such improves and if the proposal
increases the chances of a substantially lower regulatory burden in the future.
People acquainted with the present regulatory and institutional set-up within the EU may ask
if what I am proposing is not already in place, considering the existing consolidated
supervisory model and the role of the Committee of European Banking Supervisors (CEBS).
However, even if both of these functions have their obvious merits they do not quite satisfy
the needs. The CEBS mandate is to promote harmonisation of regulatory frameworks and
not to conduct ordinary supervisory work. And even if the consolidated supervisor has group
responsibility it is an undeniable fact that the authority answers to the home-land
constituents. Thus, the EOFS would contribute important functions in addition to the present
regulatory structure within the EU. What I have in mind is an institution with real resources
and not a "talk shop" primarily designed to build consensus.
Conclusions
Let me summarise. During the last decade, the banking sector has increasingly become
cross-border. We should welcome this rather new form of financial integration as it enhances
competition and stimulates economic growth. This development also raises challenges for
the regulatory community. Our answer to these challenges should not be increased
protectionism. Instead, we need to find new forms for cooperation and supervision that allow
the benefits from integration to be realised. Today I have presented to you my thoughts on
the need for a special body with the mission to supervise the major European cross-border
banks. Since this proposal to some probably seem rather radical and not very conceivable in
the shorter term, I have advocated a gradual approach. In my view, the time has now come
to set up the modalities for achieving this goal.
The reason why I have chosen a European focus is simply that there are already institutional
arrangements in place which can be used as a platform for bringing us closer to the goal of
supra-national supervisory frameworks. In my view though, the underlying challenges of
financial integration are of a global nature. Therefore, even if it may not be possible to
achieve the same solutions outside Europe, it should be of wider international interest to at
least move in the direction of enhanced cooperation between supervisory authorities. I hope
that I have been saying here today can serve as inspiration for further discussions on this
issue.
Considering that financial integration is already widespread and that the process of revising
present regulatory structures will most certainly be demanding and protracted, we need to
get to work. Returning to what I said in the beginning, history shows us the importance of
having proper regulatory structures in place. Therefore, it would be highly unfortunate if the
appropriate measures have not been taken before the next major financial crisis occurs. For
once, it would be encouraging to see pre-emptive policy actions rather than a crisis being the
catalyst for such actions.
Thus, in the same way as the international community is facing increasing challenges to
cope with the negative externalities in the environmental area, the financial regulators have
to face the consequences of financial integration. It is my hope that we as regulators show
enough courage and determination to tackle the negative externalities a potential financial
crisis would entail - before it hits us.
Let me finish by saying that the issue of financial integration comprises many more aspects
than merely how to set-up supervisory structures for cross-border banks. For example,
questions on how to establish proper arrangements for emergency liquidity assistance and
deposit guarantee schemes also need to be considered within the same context. And even if
these issues are of a somewhat different nature I believe that they do require the same type
of supranational considerations I have talked about here. The simple reason is that it is only
when the frameworks for regulation, supervision and crisis management match the actual
structure of financial markets, that the negative externalities of financial crises can be
managed properly.
Thank you.