Designing arrangements for cross-border financial crisis management

1. Designing arrangements for cross-border financial crisis management Pedro Gustavo Teixeira Washington D.C., June 8, 2006 The views expressed do not necessarily correspond to those of the European Central Bank

2. Contents • Pressure points for cross-border financial crisis management • Designing cooperation agreements • Designing simulation exercises • Challenges and policy suggestions

3. 1. Pressure points for cross-border financial crisis management

4. Definition of financial crisis management arrangements • Policy tools and procedures for limiting damages and spillovers when: • A financial institution (or more) is unable to meet its obligations due to liquidity / solvency problems • The financial systems faces severe and binding liquidity constraints • Market infrastructures are hindered by operational problems or other disturbances

5. Global financial stability architecture • Domestic and segmented financial stability functions • Central banks, supervisors, deposit insurance, treasuries • International standards • Home-country control/ mutual recognition • Cooperation structures • Basel Committee, FSF, EU committees

6. Pressure points for dealing with cross-border spillovers • Communication and information-sharing • if it is inefficient, decision-making may be sub-optimal • Coordination of decision-making • division between home/host responsibilities may be challenged • Conflict of interests of each authority • national mandates vs cross-border externalities • Complexity of constellations of authorities for • Detecting crisis events • Sharing local knowledge • Assessing cross-border systemic risk

7. 2. Designing cooperation agreements

8. European experience • 2003 MoU between EU banking supervisors and central banks (51 authorities) • 2005 MoU between EU banking supervisors, central banks and treasuries (76 authorities) Aiming at: • Preserving the stability of the financial system of individual Member States and of the EU as whole • Facilitating detection and assessment of systemic risk at cross-border level • Facilitating coordination of decisions between authorities in a systemic crisis with spillovers in several countries

9. 1st component: Information-sharing provisions • Who receives, pools/ disseminates information? • Role of home-/host-country authorities, central banks/supervisors • What information should be shared? • General information on the crisis (structure of the financial institution(s), authorities involved, urgency) • Information on banks (capital and liquidity positions, exposures to different risks) • Information on systemic risk (counterparties, markets and market infrastructures that may be affected) • How does information flow cross-border? • Special channels, confidentiality safeguards

10. 2nd component: Provisions on coordination of decision-making • Clarifying responsibilities for crisis management • home-country supervisors vs. host-country central banks • responsibility for banking groups • overall crisis manager (s) • Ensuring prior notification or consultation among authorities of policy measures • compatibility with national laws • without prejudice to swift decision-making • Coordination of public statements • Risk-sharing (potential costs) between countries

11. 3rd component: Provisions for managing conflict of interests • Mismatch between national mandates and need to consider cross-border externalities of the crisis • Risks and pay-offs not evident • Social cost at the cross-border level potentially greater than domestic, but … accountability is domestic • Conflicts of interest cannot be removed but managed / highlighted through mechanisms such as • pooling of information • joint assessments • Other procedures for consideration of systemic impact at the cross-border level

12. Design challenges • Drafting • risk of general provisions and exceptions • identifying possible institutional and legal constraints in advance • Moral hazard • the existence of ex ante arrangements may give the perception of public intervention • transparency of arrangements (also in line with IMF Code on transparency of monetary and financial policies) • Infrastructure for communication • contact lists, internet site, teleconference facilities • Lack of practice/ memory (dormant periods) • As with any tool, authorities need to become familiar with using it through regular financial crisis simulation exercises

13. 3. Designing financial crisis simulation exercises

14. European experience • EU-wide simulation exercise 2003 with banking supervisors and central banks • EU-wide simulation exercise 2006 with banking supervisors, central banks and treasuries • ECB/ Eurosystem stress-testing exercises • Regional simulation exercises in the Nordic countries • Domestic exercises between authorities

15. Generic features • Neutrality principle - exercises not designed to • test validity of institutional arrangements • highlight vulnerabilities in financial systems (systems are stylized) • test individual authorities (“Laboratory-environment”) • Open in terms of the resolution of the crisis • no “right answer” against which participants could be judged • Diverse propagation channels • institutions, markets, market infrastructures • increase the potential for spillovers • uncertainty on whether shock is idiosyncratic or systemic • Incentives-framework • to highlight conflicts of interest, participants are subject to different domestic and cross-border incentives for considering policy actions • High-speed developing crisis • to simulate time pressure and constrain cooperation

16. Design of a simulation exercise: stages of crisis management Cross-border level How are propagation channels identified, information collected, and systemic risk assessed? How is a crisis detected and identified? How is decision-making processed, what conflicts emerge, and is it coordinated with other authorities? National level Policy tools Triggering event Contagion to markets, institutions, infrastructures

17. Logistics Distribution of materials (e.g. Website) Participant Authority A Participant Authority B Participant Authority C Participant Authority D Moderators “Actors” representing external entities Participant Authority E Participant Authority F Flow of communication between the participants through paper, email and/or teleconference.

18. Potential findings • Insights into real-life financial crises in terms of • Time pressure • Imperfect information • Complexity of analysis of cross-border systemic implications • Different responsibilities and incentives of home/host-authorities • Different incentives for supervisors, central banks, treasuries • Path-dependence in crisis management • Different modes of cooperation and information-sharing in the stages of the crisis (domestic/cross-border) affects the assessment of system risk, which in turn affects ultimately policy choices • Exercises not so realistic regarding • Participants’ “pre-disposition” to play the exercise • Greater scope for coordination issues in real crises

19. Usefulness of simulation exercises • Planning phase: • better understanding of the transmission channels for shocks to the financial system • Running of the exercise: • better understanding of information flows and decision-making processes • Evaluation phase: • identifying potential pressure points in arrangements • enhancing crisis management arrangements

20. 4. Challenges and policy suggestions

21. Challenges to cross-border financial crisis management • Institutional • Clear/ transparent/ credible allocation of responsibilities in crisis situations • Coordination and alignment of policy decisions • Analytical • Cross-border/-sectoral/-functional sharing and processing of information • Assessment of cross-border systemic risk

22. Value-added of ex ante arrangements: mitigating potential coordination failures • Cooperation agreements: • Signaling the authorities’ commitment to cooperation • Clarifying responsibilities and roles • Setting information-sharing procedures • Setting-up a crisis management infrastructure • Simulation exercises: • Understanding the workability of financial stability arrangements in a crisis with cross-border ramifications • Testing the efficiency of information flows • Practicing the assessment of cross-border systemic threats • Testing the possibilities for a (un) coordinated policy response to a crisis

23. Policy suggestions • The pressure points for cross-border crisis management may lead to inefficient or costly outcomes if tackled in a disorganised manner • Cross-border arrangements should not aim at resolving such pressure points, but instead providing authorities with a procedural structure for tackling them • In addition to cooperation agreements and simulation exercises, other arrangements may include: • Standards on best practices • Development of operational networks between authorities • Contingency planning

24. Thank you!