John Gieve: Practical issues in preparing for cross-border financial crises
Speech by Sir John Gieve, Deputy Governor of the Bank of England, at the Financial Stability Forum
Workshop: Planning and Communication for Financial Crises and Business Continuity Incidents,
London, 13 November 2006.
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Introduction
My subject this evening is the challenge that globalisation poses for handling and resolving financial
crises.
If that seems a typically gloomy subject for a meeting of central banks, regulators and finance
ministries, I would like to start by emphasising two points. First, I do not believe that globalisation is a
source of instability; indeed in financial as in other markets, the opening up of international competition
has been a huge force for good; by spreading and diversifying risk, it has in many ways made financial
markets more efficient and stable. However, the fact is that governments, regulators and central banks
remain largely national and our machinery for cooperation has not kept pace with the
internationalisation of markets.
Second, I have not chosen the subject because I believe a crisis is imminent. Indeed, in the UK and
elsewhere economic and financial conditions currently are mostly benign and are forecast to remain
so. Of course concerns about global imbalances and the search for yield in financial markets remain
but our central projections like those of the IMF and most other international forecasters show the
'Great Stability' of the last 10 years continuing at least in the near term. But remote events do happen
- and by their nature we cannot always see them coming. Researchers at the World Bank have
recorded 13 borderline or full-blown financial crises since the late 1970s, involving at least one
Financial Stability Forum (FSF) member country.1 And there are well known incidents not on the list:
including the 1987 crash, the less developed countries' debt crisis and LTCM's near collapse.
So we are fortunate in having a time of relative calm to work out together how we should react when a
problem does arise. And we have in the FSF a body that was established "to co-ordinate the efforts of
...various bodies in order to promote international financial stability, improve the functioning of
markets, and reduce systemic risk"2. In its first 7 years, much of the FSF's focus has been on the
identification and assessment of risks in a rapidly changing financial system; it has played a valuable
role in building a common understanding among authorities and among market participants of what
the risks are and how they can be reduced. However, that level of progress has been less apparent on
putting in place arrangements for handling and resolving cross-border crises.
During that period a number of countries, including the UK, have improved their processes for
handling financial crises - including for crises sparked by business continuity events. And there have
been a number of exercises and co-ordination initiatives in different regional groups (for example
amongst the Nordic countries, Dutch and Belgian authorities, and more widely across the EU). But
there has been less progress on the wider international front. Overall, I do not know anyone who
believes that we have established either the common approach to crises or the practical machinery
which would enable us to handle a complex cross-border failure with confidence.
I would like to make some suggestions tonight on how we might take matters forward.
When and how should the State intervene to prevent or manage a financial crisis?
Of course the underlying questions are very difficult even for one country. Financial markets are often
volatile and they can only work well if investors and firms expect to live or die by their own decisions
and do not come to rely on a safety net to mitigate their losses. To avoid that 'moral hazard',
authorities have tended to be reluctant to spell out in what circumstances and what ways they would
be willing to help support a market or a participant, beyond making clear that it would only be in
exceptional circumstances and where it was essential in the wider systemic interest. But the difficulty
in spelling out underlying reasons must not become an excuse for lack of analysis and preparation. In
order to make cross-border crisis management work, we may have to consider sacrificing some
mystery - even if only amongst ourselves - for greater effectiveness.
The most recent cases of official emergency liquidity support to UK banks occurred in the early 1990s,
when the Bank lent to a few small banks in order to prevent wider loss of confidence in the banking
system. The Memorandum of Understanding (MoU) between the Treasury, FSA and Bank which sets
out our current roles in maintaining financial stability makes clear that decisions on support operations
now rest with the Chancellor, acting in the light of advice from both the Bank and the FSA.
Following the early 1990s experiences, Eddie - now Lord George - discussed various options for
intervention.3 He argued that, in deciding whether to provide support, the authorities should: explore
every option for a commercial solution before committing public funds; structure any support such that
losses would fall first to shareholders and any benefits fall first to the authorities; not, in normal
circumstances, lend to a firm known at the time to be insolvent; and, look for a clear exit from provision
of the lending.
These guidelines go more to the question 'how' rather than the question 'when' the authorities should
intervene, and they were drawn up before the globalisation of banking and capital markets had got
fully underway. So I do not put them forward as the complete answer; rather I think we should be
discussing whether there are some common understandings which could inform and shape
crossborder cooperation.
International complexity
Of course reaching a common view will be difficult. But it seems to me a necessary step towards
meeting the challenges of handling financial instability in the new world of open international capital
markets and giant complex financial institutions.
Many of the challenges have been discussed in the international community. In particular: the potential
difficulty in amassing a complete picture of the health of firms and capital markets in crisis from
different authorities; the potential complexity of large firm structures, where entities within a firm may
be subject to different legal arrangements, preference rules and rules concerning ownership interests
and creditor arrangements; and the possible technical difficulties in winding down an entity that is
engaged in complex trading strategies. There are also of course issues around how liquidity and
capital can be moved around a group: whether collateral, funding or capital can be moved quickly
across borders to where it needs to be.
Further, some of the commonly preferred methods for resolving a financial crisis, before moving to
winding down methods, may be less easy to deploy than they were even a few years ago. I think many
of us would share Eddie George's view that we should look first for a private sector solution before
committing public money to a rescue operation. When LTCM got into serious difficulties in 1998, and
there was a risk that its liquidation could further destabilise markets, the New York Federal Reserve
was able to facilitate discussions that resulted in a cooperative market solution.
But would this kind of approach still be possible today? Certainly private sector solutions looked easier
when lending was the predominant source of funds, banking systems were arranged predominantly
along national lines, and it was possible to get the key counterparties round a single table. Will firms
that have actively engaged in methods to lay off risk when a problem occurs - through, for example,
credit derivatives and collateralisation - be as ready to contribute to solutions predicated on the give
and take of long-term relationships? And will the increasing complexity and size of large complex
financial institutions deter previously willing possible participants?
Since the FSF's creation, there has been further consolidation of international banking groups and
globalisation of markets. Our vulnerabilities are more concentrated: although the firms and capital
markets in which they are concentrated are probably more resilient, we have bigger and potentially
more complex points of failure. This concentration has brought efficiencies, and has been supported
by enhanced oversight of global firms and the capital markets they operate in. But the price we pay is
more complicated (and therefore potentially more costly) crisis resolution.
A practical way forward
So how can we make more progress? I have spoken about drawing up a shared framework or set of
principles but I am only too aware how easily that could become a drafting exercise in which difficult
issues are evaded rather than dealt with.
Clearly initiatives such as this workshop are a useful way to bring relevant policymakers together -
and I am encouraged by the shared commitment to make progress that you have shown by being here
today.
My suggestion is that probably the best way of making further progress on a genuine and useful
common approach is to work together on practical examples; to consider some of the operational
problems that we would face if particular sorts of crises arose. And thus establish a shared fact base
and understanding of what we might expect from each other in a crisis, and how we should go about
handling it.
This idea of informal groups of relevant authorities is not new. In a sense, it is borrowed from the
supervisory world, where colleges of regulators have existed for some time, with the aim of devising
ways of pooling knowledge and developing common approaches - to supervise firms efficiently and to
reduce the supervisory burden for them.
The groups to discuss crisis management issues would need to bring together supervisors and central
banks. Both are likely to have day to day information which is relevant in a crisis, and both will also
have control of tools which can be used to handle the problem. At the same time, the number of
participants would probably need to be smaller than in a regulatory college if these group are to be
effective. To remain focused, the core group might perhaps need to be limited to authorities from two
or three countries each, rather than wider groups.
And selectivity, flexibility and pragmatism would be absolutely key. I am not advocating, for example,
that we form a group for every firm that includes all authorities in every jurisdiction where that firm has
a presence. Instead, that we use a risk-based approach to concentrate on those authorities with a
mutual interest, identify the specific firms and capital markets that that mutual interest might cover, and
bring together those relevant authorities to discuss those firms and the capital markets they interact in.
Indeed, some countries' authorities have already met bilaterally or in small groups to discuss crisis
management topics of particular mutual interest.
There are a number of practical aspects of crisis management that these interest groups could
enhance. First, co-ordination in a crisis. This, alongside information-sharing, is the area that has
received most generic attention at the cross-border level. Our challenge is to embed processes that
will be relevant for crises into our everyday interactions: co-ordination is likely to be much easier
amongst colleagues who are already familiar with each other and with each other's views and
approach, than with someone who is simply a name on a contact list. This is one positive feature of
discussing these issues, just as some of the value of MoUs lies in the process of negotiation and the
relationships that fosters.
Second: information-sharing in a crisis. Interest groups would be a good forum to discuss in advance
what information it might be appropriate to share on specific firms, and to ensure that it would in
practice be readily available. And in doing so, we will better understand the information and therefore
be able to assess it more quickly and more confidently in-crisis.
Third: in-crisis systemic impact assessment. A key first step in deciding how to handle a crisis is in
understanding the likely cost of not intervening in it - the likely systemic impact of it. The impact of a
particular problem or failure of a particular firm will of course depend on the characteristics of that
specific problem - and importantly on the resilience of the financial system, and the interlinkages
amongst different elements of it at the time. However, there are common channels through which
shocks propagate. And some of those channels will be more relevant for particular firms than others.
The important aspect of developing this work is in providing a common vocabulary in which
policymakers can discuss the possible impact of a problem. This may also help to provide a framework
for deciding whether to intervene in a crisis, as well as helping to understand who may be interested in
intervening.
And fourth: the types of measures we have available in a crisis. I outlined earlier a number of
challenges in resolving a crisis involving a large complex financial institution, and the obstacles we
may face in addressing them. The Contact Group 2002 report on legal underpinnings4 provided more
detail on the extent to which different legal regimes created vulnerabilities in managing crises. Through
discussion of hypothetical problems for real firms we may get closer to understanding more concretely
what these obstacles will look like in practice and therefore what we might want to put in place to
mitigate them. Put another way, it is potentially a way to develop practical solutions, or at least a
practical understanding of the specific issues we might face, within the parameters of our current legal
and fiscal set up.
What we learn from firm-focussed interest groups should also put us in a better position to tackle some
of the thorny issues we face. One which particularly exercises me is ensuring that we should always
have the option of closing down a large firm in an orderly way, even if we need to use emergency
liquidity assistance as a bridging loan to do so (rather than as a step towards keeping the firm open).
Looking further ahead, it is clear that these interest groups should not remain inward-looking. In order
for any preparations for crisis to be relevant, authorities will need to ensure that they are informed by
firms' plans and views - for example on their likely own actions in crisis, where they see their
vulnerabilities in managing a problem, what they expect the authorities to do, and where arrangements
could be improved. So the ongoing dialogue that the relevant authorities have with firms may well
inform, and be informed by, the work of interest groups.
What role could the FSF play in promoting these kinds of bilateral or small multilateral discussions and
exercises on practical topics regarding specific firms and markets? As we all know, it is not the role of
the FSF to manage cross-border crises. But my view is that the FSF does have a role in this area. To
me it seems the ideal group to draw out the common messages and lessons that may emerge from
these interest group discussions, and to establish a common framework for handling crises which will
be of use both to its members and more widely.