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Cross-border stability framework: Lessons from the global financial crisis Jerzy Pruski. BFG 15 th Anniversary Conference Warszawa, 21 M a y 2010. 1. Domestic financial stability framework Completeness & efficiency of the system. 2.

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Cross-border stability framework: Lessons from the global financial crisis Jerzy Pruski

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Cross border stability framework lessons from the global financial crisis jerzy pruski

Cross-border stability framework:

Lessons from the global financial crisis

Jerzy Pruski

BFG 15th Anniversary Conference

Warszawa, 21 May 2010

1


Cross border stability framework lessons from the global financial crisis jerzy pruski

Domestic financial stability framework

Completeness & efficiency of the system

2


Cross border stability framework lessons from the global financial crisis jerzy pruski

Low effectiveness of existing crisis management tools

Global financial crisis 2007 – 2010 / response options

Private sector solutions

Bailout/nationalization

Standard bankruptcy proceedings

Very limited

Broadly used

Very limited

Scope

Examples

  • Important M&A

  • Bear Stearns (JP Morgan)

  • Merrill Lynch (BoA)

  • Negative examples:

  • ABN Amro (RBS, Santander

  • and Fortis)

TARP, AIG, CitiGroup, RBS,

Lloyds TSB, Northern Rock, Fortis,

Dexia, KBC, AIB, Commerzbank,

Hypo Real Estate

Available only for small banks.

Not resorted to after the collapse

of Lehman Brothers for fear of

systemic risk

Standard legislation

  • Ineffective:

  • need for quick decisions

  • inadequate for specific

  • circumstances

Significant changes required

Fiscal burden of financial turmoil must to be drastically limited

3


Cross border stability framework lessons from the global financial crisis jerzy pruski

Robust domestic stability network

as prerequisite for effective cross-border safety net

  • Regulations

  • Rescue function

    (temporary)

Ministry of

Finance

MoF

DGS

Rescue function:

to be extended

& implemented

Central

Bank

  • Liquidity

Financial Services Authority

strong & complete

domestic

financial stability system

  • Regulations

  • Supervision

Deposit Guarantee Scheme

?

Special resolution regimes:

to be implemented

  • Pay-box

  • Rescue function

Periodic financial crises remain inevitable in a market economy

even despite strong domestic stability network

4


Cross border stability framework lessons from the global financial crisis jerzy pruski

Need for effective rescue and resolution functions

Complete toolkit of instruments a pre-condition for effective crisis management

Rescue

Resolution

Change of ownership required

No change

of ownership

Private sector solution not available

Bailout/Temporary

nationalisation

Private sector

solutions

Bank restructuring

or capital injection

Rescue activities not justified

Moral hazard

Tools

to support M&As

Assistance for

existing shareholders

Special receivership powers

Authority for Purchase and Assumption

Orderly liquidation

Rescue function (capital injection and/or liquidity support)

Insurance

Pay-box function

5


Cross border stability framework lessons from the global financial crisis jerzy pruski

Resolution function

Sell the whole bank

Receivership

Cost and systemic risk assessment

Failed Bank

Quick decision

Sell asset pools

Liquidate assets

FDIC

Sell deposits & branches

Coverage for insured deposits

(DGS)

Alternative

model

Insured deposit pay-out

  • Reduction of:

  • systemic risk

  • amount of required funds

  • moral hazard

6


Cross border stability framework lessons from the global financial crisis jerzy pruski

Significance of special resolution regimes

Fiscal and stability costs*

Advantages

*based on Čihák & Nier (2009)

  • Reduction of systemic risk of default

  • Transfer of control to regulators

  • Reduction of fiscal cost

  • Costs transferred to existing shareholders

  • Reduction of moral hazard

  • Better market discipline

(Indirect costs)

„Bailout”

Fiscal costs

Ordinary resolutions

Disorderly bankruptcy

(Direct costs)

Special resolution

Stability costs

Systemic financial stability impact

7


Cross border stability framework lessons from the global financial crisis jerzy pruski

Cross-border interconnectedness

Additional risks and challenges

8


Cross border stability framework lessons from the global financial crisis jerzy pruski

Cross-border interconnectedness

Global economy

cross- border dimensions

Broad range of benefits of globalisation

  • Insufficient information

  • Crisis contagion

Increased risk of crisis

&

Extraordinary challenge for crisis management

9


Cross border stability framework lessons from the global financial crisis jerzy pruski

Cross-border risk management

  • Cross-border banking groups imply:

  • enormous complications for financial safety net

  • modifications in the toolkit of stability instruments and new regulatory authorities

Domestic market risk

External risk

Microprudential

Default

risk

Country 1

Macroprudential

Country 2

Bank 11

Cross-border dimensions

Bank 21

Bank 12

Prevention instruments

Bank 2

Bank 1

Bank 22

Bank 13

Crisis management

Bank 14

interbank links

10


Cross border stability framework lessons from the global financial crisis jerzy pruski

Cross-border connections

Risk monitoring limitations

Limitations

Systemic risk

Identification of systemically important

institutions requires access to data on entire

cross-border network

Total picture of the risk is not visible

from the perspective of a single country

Source - IMF

  • In addition to a local component, the risk imposed on domestic banks depends

  • on external foreign risk, which is only partially visible

11


Cross border stability framework lessons from the global financial crisis jerzy pruski

Limiting the risk of crisis

Available solutions for mitigation of cross-border crisis risk

Robust domestic safety net

Harmonization + cooperation

Integrated solutions

Effective domestic financial

stability system

Mostly non-binding

Some decisions are transferred

to international level

Pending construction

Difficult to implement

  • Involves the issue of individual state independence

  • legal aspect – different legal rules

  • burden sharing aspect

12


Cross border stability framework lessons from the global financial crisis jerzy pruski

European Union

Financial stability system enhancement

13


Cross border stability framework lessons from the global financial crisis jerzy pruski

Existing cross-border stability framework in the EU

  • monetary policy

  • stabilization policy

European

ECB

Euro Area

Regulations

ESRB, EBA

not authorized to impose

fiscal cost

New solutions

Union

  • Crucial importance however still:

  • non-binding

  • limited efficiency

Harmonisation

Crucially important but remain:

Coordination

Urgent need for new and rigorously enforced fiscal rules

14


Cross border stability framework lessons from the global financial crisis jerzy pruski

Proposed cross-border stability framework

European stability framework legs behind domestic standards

Fragmented

Non-binding

Lack of funds

Currently discussed solutions

Basel III

  • Limitations and barriers

  • lack of ex-ante burden sharing

  • non – existant legal framework for transfer of assets

  • legal differences

  • lack of common bankruptcy law

ESF European Stability Fund

ERA European Resolution Agency

EDGS European DGS

IES Integrated European Supervisor

EMF European Monetary Fund

15


Cross border stability framework lessons from the global financial crisis jerzy pruski

Risk of overregulation

Sources of global financial crisis

Macroprudential

Microprudential

Macroeconomics

European Systemic Risk Board

New regulations

Theory and practice

of macroeconomic policy

essentially unchanged

  • selective scope

  • (only banking sector)

  • - effectiveness not fully proved

  • incomplete cost-benefit analysis

  • limited territorial scale

  • limiting the scale of operations

- focus on stability of consumer prices

- not oriented to asset prices and

monetary aggregates

- fiscal policy

- FX regime

Remains to be tested

Risk of overregulation

  • Outstanding:

  • fiscal problems

  • global imbalances

  • asset bubbles

16


Cross border stability framework lessons from the global financial crisis jerzy pruski

Risk of suboptimal policy mix

Monetary policy

Fiscal policy

Supervisory and regulatory

policy

Low interest rates and monetary

easing despite improvement

of economic situation

Recently reached deficit and debt

levels force budgetary restraint

Focus on new regulation rather than

more effective supervision

Banking regulations

Restrict the range and scope

of banking activity

Counter-cyclical measures

Pro-cyclical measures

Pro-cyclical measures

  • The risk of inconsistent monetary – regulatory policy mix

  • The entire burden of emerging from the crisis rests on monetary policy with successively

  • lowerinterest rates and a familiar potential for future assets bubbles

17


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